Reasons D.R. Horton Could Have An Impressive 2013

| About: D. R. (DHI)

Some investors are worried that they have missed the move in homebuilders after last year's impressive stock moves. But there is plenty of steam left in this train. A healthy yearly housing starts number would be about 1,500,000 per year. Between 1959 and 2007 we had not dropped below 1,000,000 housing starts per year. But for the last five years we have averaged between 500,000 and 800,000 housing starts per year. That was probably necessary to burn off extra inventory built during the mid-2000's. I believe that it is quite reasonable to expect that supply and demand have come close to reaching equilibrium now, and you will see steadily increasing housing start numbers as we move towards the long-run average of 1,500,000 housing starts per year.

Most recently, the past eight months have seen increases in the National Association of Home Builders (NAHB) Housing Index up until a pause this month. Single Family Housing Starts were up a solid 8.1% in December, and rent prices have steadily risen the past 2 years, making owning a home more attractive. As today's index of contracts for the purchase of previously owned homes shows -- it fell 4.3 percent -- the ride back to normalcy may be bouncy.

So what's preventing you from buying into the homebuilder recovery? Well, I suppose it is not that easy. One snag is the run-up in their stock prices last year. No one wants to buy before a major correction. Other more fundamental issues are the slow pace of the U.S. economic recovery, and particular to housing, the signs of tight labor supply in the sector as noted by contributor Dr. Duru here.

This tight labor supply might cause wage increases and gross operating margin pressure if the sector starts to sizzle. Although it seems odd to me that there can be tightness in the construction labor market after all of the layoffs in 2006-2008, we should address that somehow in our analysis and I think we can. To do that we will include gross margin rates in our comparison to see which companies manage their input costs the best. This should help us find a good management capable of dealing with labor price issues.

While I believe that most homebuilder stocks will benefit from the "return to normalcy" in the housing market, it is worth comparing them to one another to see which represents the "best of breed." With that in mind, we will look at price-to-book ratio, return on assets, gross operating margins, debt-to-assets, and then a couple of other factors.

I am looking for a stock in the homebuilders that is inexpensive compared to its peers, with relatively low debt (I hate debt), and stellar management. Since we are just looking to choose the best stock out of this sector, we will compare ratios rather than attempting a deeper review using a discounted cash flow analysis. For valuation we will compare price-to-book ratios rather than price-to-earnings ratios, because book value is harder to manipulate than earnings. Additionally, many of these companies have a lot of capital in the form of land, which will show up in book value.

We will compare gross operating margin because it shows management's efficiency at using labor and supplies (as noted above). We will compare return on assets (ROA) because it takes into consideration profitability before debt, unlike return on equity (ROE). Finally, we will compare debt-to-assets, which is important to me because it displays a company's flexibility. This screen does not look at PEG or earnings forecasts for next year, so yes it might leave out a company with a projected 90% growth rate, but in my mind that also means more of a possibility for an earnings miss. I want to limit beta with a strong stock to ride this trend.

Financial Comparison of Large Homebuilders
Stock Gross Margins Price-to-Book Return-on-Assets Total Debt-to-Assets
LEN 10.95% 2.51 6.00 1.31
HOV 14.46% NA (4.03) NA
PHM 14.33% 3.95 2.24 1.48
DHI 19.86% 1.94 15.70 .69
TOL 19.41% 2.05 8.67 .72
NVR 18.32% 3.66 7.12 .43
SPF 20.63% 2.40 2.50 2.17
RYL 20.21% 3.91 .84 2.40
KBH 15.55% 3.80 (2.32) 4.57
Industry 15.80% 2.69 .50 1.29

The first note is that I only included stocks with market caps above approximately $1.4 billion -- no little guys here. Second, let's eliminate -- Scraaaatch! -- some outliers apparent in this table. SPF, RYL, KBH, HOV, LEN, and PHM are all eliminated because they have too much debt to be agile, in my humble opinion. PHM also has the second highest price-to-book ratio which indicates it is fully priced.

That leaves us with DHI, TOL and NVR. Any of these three could be solid picks, but that's not the point of this article. The point is to pick one. NVR has the highest price-to-book ratio and that's good enough to disqualify it for me. And while TOL is interesting because it builds high-end homes, I don't see that as a major coup in a landscape still spooked by the collapsing prices of the previous 5 years. My feeling is that customers will be less inclined to "over-reach" on a house with memories of 2007-11 firmly in their brains and with the economy still fluctuating. TOL also lags DHI in every one of the categories above, so that does make DHI my pick. Of the three, DHI sticks out the most as the winner.

DHI has the second lowest debt-to-assets, meaning it is agile. Its price-to-book is the lowest of all the stocks compared, meaning it is possibly undervalued. Its gross margins are the third highest, meaning it manages its input costs well (important if the construction labor market tightens further). And its return on assets is highest, so it is very profitable without using leverage.

Daily Chart for DHI (approaching resistance just above $22)

There's one more reason that DHI is a solid choice. Of all major homebuilders, it has been one of the best at not diluting existing shareholder stakes, meaning it doesn't issue many new shares.

Do not fret if your stock isn't the one I picked. I suspect that if this sector continues ripping like I think it could, then a bunch of these names could benefit again this year. I just picked my stock because it meets my preferred parameters.

Since the market as a whole, and these homebuilders in particular, seem to be running a little hot, it would be prudent to either scale into a position over a couple weeks or wait for a pull back before purchasing. For options traders, a JAN14 22/30 call spread is going for about $2.25, and looks interesting.

Disclaimer: We do not know your personal financial situation, so the information contained in this article represents my opinion, and should not be construed as personalized investment advice. Past performance is no guarantee of future results. Do your own research on individual issues.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.