Investors are looking for any signs that the economy is turning around; they may have found those signs in the recent improvement in housing starts. Amid record low interest rates created by Fed Chairman Ben Bernanke's quantitative easing program, housing has shown signs of life. Housing starts for privately owned homes rose from a trough of 554 thousand in 2009 to approximately 587 thousand, 609 thousand, and 780 thousand in 2010, 2011 and 2012, respectively. And as housing starts have risen, so have the earnings and stock prices of home builders. But have they risen too far? A recent Wall Street Journal article seems to think so:
Yet investors should be cautious. At current levels, say analysts, home-building stocks have priced in much of the recovery ahead ... the Philadelphia Stock Exchange Housing Sector Index has rebounded far more significantly than housing itself. Shares of D.R. Horton now trade at 1.9 times the per-share value of the company's net assets, approaching the 2.3 level seen in 2004-05. During the crash it sank as low as 0.6 times assets. PulteGroup has swelled to 3.7 times its per-share net assets, a record ... Yet Stifel's Mr. Widner says the recovery "is already baked into prices." Even though he expects the housing market to recover steadily over the next few years, he rates the stocks no better than a "hold" across the board. For the average investor, housing surely offers a better bet than housing stocks.
The following table examines the price-to-earnings (p/e) ratios of seven home builders that may be headed for a fall - Toll Brothers (TOL), Lennar Corporation (LEN), KB Home (KBH), Beazer Homes (BGH), Hovnanian Enterprises (HOV), DR Horton (DHI) and PulteGroupe, Inc (PHM).
The rule of thumb is that a stock's p/e ratio should correlate to its expected earnings growth rate. The p/e ratios range from 11.4x for Toll Brothers to as high as 49.7x for Pulte Homes, implying that earnings growth for home builders and the housing starts that drive them are expected to remain robust. Three of the home builders I examined achieved a net loss in the previous fiscal year, yet their market capitalizations still ranged from approximately $456 million to $1.5 billion.
- Toll Brothers achieved revenue of $1.5 billion, $1.5 billion and $1.9 billion in FYE 2010, FYE 2011 and FYE 2012, respectively. Earnings increased from a $3.4 million loss in 2010, to profits of $39.8 million and $87.1 million in 2011 and 2012, respectively.
- The company delivered 3,286 homes in 2012, compared to 2,611 homes in 2011. The increase in the number of homes was primarily due to the increase in the number of homes in backlog at the beginning of fiscal 2012, the increase in the number of homes delivered from available inventory, and homes delivered (201) from its Cam West operations acquired in November 2011.
- Through year-to-date February 1, 2013 the stock achieved a 52.2% return.
- Lennar Corporation achieved revenues of $2.7 billion $2.7 billion and $3.6 billion for FYE 2010, FYE 2011 and FYE 2012. Earnings increased from $94.7 million in FYE 2010 to $222.1 million in FYE 2012.
- In FYE 2012 new home deliveries, excluding consolidated entities, increased to 13,707 from 10,746 in FYE 2011 - a 28% increase. Meanwhile, the company experienced a 4% increase in the average sales prices of homes delivered.
- Through year-to-date February 1, 2013, the company's stock price increased nearly 76.0%.
- KB Home's revenues were $1.6 billion, $1.3 billion and $1.5 billion for FYE 2010, FYE 2011, and FYE 2012, respectively. The company achieved net losses of $69.4 million, $178.8 million and $59.0 million for FYE 2010, FYE 2011, and FYE 2012, respectively.
- The company has some of the highest SG&A expenses in the industry. Its FYE 2012 SG&A expense was 16.2% of revenue, which compares unfavorably to Pulte (11.5% of revenue) and DR Horton (11.4% of revenue). Given its gross margin of 14.9%, KB Home achieved an FYE 2012 operating loss, prior to its interest expense incurred on borrowings to finance land purchases and housing inventory.
- The stock price increased 71.3% through year-to-date February 1, 2013.
- Beazer Homes achieved revenues of $742.4 million, $1.0 billion and $1.1 billion for FYE 2011, FYE 2012, and last twelve months ended December 31, 2012. The company achieved a net loss of $204.9 million, $145.3 million and $145.3 million over that same period.
- For the last twelve months ended December 30, 2012, the company's gross margin was 14.6%, while is SG&A was 16.1% of revenues. That said, the company achieved an operating loss each year during the review period.
- Through year-to-date February 1, 2013, the stock achieved a 0.00% return.
- Hovnanian Enterprises achieved revenues of $1.3 billion, $1.1 billion and $1.4 billion for FYE 2010, FYE 2011 and FYE 2012, respectively. It's net income was $2.6 million in FYE 2010, while it achieved a net loss of $286.1 million and $66.2 million in FYE 2011 and FYE 2012, respectively.
- For FYE 2012, gross margin was 16.1% and SG&A was 9.6% of revenues. However, other expenses (including other interest) were 11.7% of revenues, causing the company to incur a pretax loss.
- Year-to-date February 1, 2013 the stock achieved a 98.9% return.
- DR Horton achieved revenues of $3.5 billion, $4.2 billion and $4.6 billion for FYE 2011, FYE 2012 and last twelve months ended December 31, 2012, respectively.
- It earned net income of $71.8 million, $956.3 million, and $994.9 million over that same period; however, its pro forma net income (excluding the benefit of a reduction in its deferred tax asset allowance), would have been $7.3 million, $145.7 million and $193.0 million for FYE 2011, FYE 2012 and last twelve months ended December 31, 2012, respectively.
- DR Horton's gross margin of 18.0% for the last twelve months ended was the highest of any of the selected home builders, giving it ample cushion to cover its SG&A at 12.0% of revenues.
- Year-to-date February 1, 2013 the stock achieved a 65.7% return.
- Pulte achieved revenues of $4.4 billion, $4.0 billion and $4.2 billion for FYE 2010, FYE 2011 and last twelve months ended September 30, 2012, respectively. The company achieved a net loss of $1.1 billion and $210.4 million in FYE 2010 and FYE 2011, respectively. For the last twelve months it earned net income of $161.2 million.
- For the last twelve months the company's gross margin was 14.3% and its SG&A was 10.8% of revenues. For FYE 2010 and FYE 2011, Pulte's gross margins were lower than its SG&A expense ratios, resulting in an operating loss.
- Year-to-date February 1, 2013 the stock achieved a 159.9% return.
"The Pain Ahead" For Home Builders
Though housing starts have rebounded from their 2009 trough, they may not reach pre-crisis levels of one million annually any time soon. In fact, if interest rates increase, they could retest the lows of 2009. According to the new book "SHOCK EXHCHANGE How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead":
Housing starts of 609 thousand in 2011 are less than a third of the 2.1 million starts at the peak of the review period (2005), and about 10% above the 2009 trough of 554,000 - the lowest since WWII. Falling home prices, rising foreclosures, sticky unemployment levels and banks' higher underwriting standards have attributed to some of the most dismal housing starts on record. Contrastly, housing starts during the recession of the early 1990s never fell below 1 million. The "tale of two recessions" reiterates that the crisis of 2008 was driven by real estate speculation - fueled by Wall Street - that will take years to rectify ... If mortgage rates reach double digits, housing starts could retest the lows of 2009.
The "smart money" invested in home builders in 2012 prior to the run up in stock prices. The eventual rise in interest rates could stall housing starts, and the earnings of home builders. That said, investors should look to take profits and potentially re-invest at a lower entry point.