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Homebuilder PulteGroup (NYSE:PHM) has pulled back from its recent high and may offer investors who want to play the housing market rebound an attractive entry point. Although we have witnessed the stock price almost quadruple in 2012, it appears the outlook moving forward is still one of optimism. CEO Richard Dugas reiterated his enthusiasm during the Q4 earnings call, "The combination of incredibly low mortgage rates, continued increases in rental rates and especially rising home prices and very low and likely to stay low inventory levels for housing, lead us to believe that 2013 will be a better year for U.S. housing than 2012."

If management is correct and the housing market rebound we are currently witnessing has staying power, the homebuilder's sector may likely catch investor's attention again. There are numerous companies which operate in this industry to choose from, KB Home (NYSE:KBH), Toll Brothers (NYSE:TOL), D.R. Horton (NYSE:DHI), Hovnanian Enterprises (NYSE:HOV), Lennar (NYSE:LEN) and Beazer Homes (NYSE:BZH) to name a few. Each company has a slightly different niche they go after and depending on which segment of the market you wish to invest, further research will be necessary. The purpose of this article is to highlight the operations and growth plan of PulteGroup. Pulte gives investors exposure to a diversified homebuilder providing exposure to entry level home buyers (Centex brand), move-up home buyers (Pulte brand), and active adult communities (Del Webb brand). Before we dive into PHM, I will provide a quick economic backdrop for my argument on a housing rebound.

Chart forPulteGroup, Inc. (<a href=

Source: Yahoo! Finance

Economic Data

One of the pros and cons to real estate is the multitude of data available in the marketplace. You can gain very detailed information from various credible sources on virtually any topic in this industry. The downside to all this information is the monthly volatility of reports and the effect they can have on investors' emotions. For example, on April 15th the National Association of Home Builders (NAHB) released its monthly Housing Market Index, a survey which measures builder confidence. The report showed a two point drop in the index and all homebuilders mentioned above were sold heavily throughout the trading day (many analysts argue the drop was actually due to a shortage of construction workers). Was this a sign the housing rebound was beginning to stall out? Not quite, the very next day (April 16th) the US Census Bureau released its monthly data of housing starts which showed a 46.7% increase in March year over year of privately-owned housing starts. Homebuilders rose following the positive announcement.

Although these are just two reports of many released for the month of March, it appears to solidify the argument for a housing rebound. The sustainability however is a different story. If you are a believer in the housing recovery and rebound (as I am) then looking to acquire stocks on these pullbacks offers a good way to build your position. If you are still uncertain then sitting on the sidelines may be your best bet. From the housing data I follow, it appears we are still in the early innings of a sustainable recovery and the entire sector appears ripe for further returns. You can view more of my research on the housing rebound in the following article, Toll Brothers: Betting Big On The Future.

PulteGroup Overview

PulteGroup Inc. builds homes in 58 markets throughout 28 states in addition to mortgage and title operations. The company operates through various subsidiaries however the largest are Centex, Pulte, Del Webb, and Pulte Mortgage. Home closings in 2012 ranged from under $100,000 in value to over $900,000 however 85% of all closings were in the range of $100,000 to $400,000. The average unit selling price rose 6.5% in 2012 to $276,000.

Like many competitors, Pulte learned its lesson from the housing collapse a few years ago. The company was over-leveraged and peaked out at $48 per share in 2005 before hitting a low of $3.29 less than two years ago. In addition to over building, PulteGroup acquired Centex in 2009. Whether or not management was aware what they were getting into is questionable, because Centex was a major player in the subprime mortgage market. Pulte is still setting aside reserves to cover the ongoing claims coming against them and points out in the recent 10-K filings that "it is reasonably possible that the future losses may exceed our current estimates."

Given the rocky past few years PulteGroup laid out the following blueprint recently in order to enhance shareholder value through the following steps:

  • Improving inventory turns
  • More efficient risk-based capital investment approach
  • Enhancing revenue through various strategies
  • Reducing costs and maintaining an efficient overhead structure

Thus far management has improved on all the bullet points above and with the help of an upward moving housing market, appears to be headed in the right direction once again. In 2012 home closings were up 8% over the prior year, SG&A costs were down 1%, and inventory acquisitions/dispositions were moving forward as planned.

Inventory

PulteGroup, like many homebuilders in the industry is building their inventory position at a rapid pace. The entire sector appears to have made it through a very rough patch of writing down overvalued assets and now appear financially healthy. Pulte is gathering its capital through a combination of operating cash flows and access to inexpensive debt. One of the reasons I am bullish on homebuilders is due to this extremely cheap debt. Given the current trend in housing data, I applaud companies who are investing in land for new building projects. While some analysts argue that empty land provides no return (and they are correct), with interest rates at such depressed levels, the ROIC can still be quite robust. In my opinion, the cost to carry this debt is far outweighed by the potential returns.

At the start of the year, PulteGroup raised its level of spending for land in 2013 and 2014 by $250 million per year. We are expected to see $1.2 billion annually be set aside for new inventory. In the Q1 earnings release the company bumped this number up by another $200 million per year to $1.4 billion annually. Management cited "strong first quarter results and ongoing expectations for a housing recovery" as the reason for the increase. This is a tremendous jump in spending and amounts to roughly 68% of the current inventory position. If sales prices were steadily declining and the order flow began to slow, I would be cautious about increased inventory spending of this magnitude. But given the current trend, it appears to be a prudent decision by management to prepare for the foreseeable future.

The chart below shows PulteGroup's quarterly cash position (red line right hand scale) and inventory (blue line left hand scale). Given the selling of non-core inventory and write-downs over the past few years we have seen a gradual decline in the company's inventory. I anticipate this to begin moving upward over the next few quarters. Cash has also begun to trend upward as Pulte currently sits with a healthy $1.6 billion pile (as of 3/31/13). Cash may decline throughout the year given that the company recently announced the retirement of $399 million of senior notes due in 2014.


(Click to enlarge)

Source: PulteGroup SEC Filings

It is worth noting that PulteGroup's "controlled lots" (inventory) are comprised of 23% Centex, 38% Pulte, and 39% Del Webb. This data is as of 12/31/13, more details should be provided when the company releases a 10-Q from Q1. The Dell Webb segment has a much slower completion time and build outs can last substantially longer than the other two segments. If the inventory position were to remain unchanged I would be concerned with the current mix. CFO Robert O'Shaughnessy said on a recent earnings call:

"… the Del Webb buyer has been slower to return to the market, given the discretionary nature of their purchase, their need to sell an existing property and their fiscal conservatism. Over the course of 2012, we saw a very positive trend developing in the demand for Del Webb homes."

While there is a bit of optimism in the statement, the beginning sentence is worrisome. However given that management is planning on allocating the lion's share of land purchases to the Pulte segment (the best performing segment of the three), PulteGroup is building what appears to be a very attractive portfolio by the end of 2014.

Digging further into the inventory line item of the balance sheet reveals the current breakdown. In the table below you can see that just 16% of inventory is comprised of "raw land" (undeveloped). An advantage for Pulte is the rapid construction once a parcel of land is purchased. However not all inventory is created equal, a common industry practice is to capitalize interest expense and then amortize accordingly. PulteGroup had $332 million of capitalized interest at the end of 2012. Investors may want to adjust the inventory number based upon a net-inventory level to get a clearer picture of current tangible assets.

Inventory as of 12/31/12

$

% of Total

Homes Under Construction

$1,116,184,000

26.49%

Land under development

$2,435,378,000

57.79%

Raw Land

$662,484,000

15.72%

Total

$4,214,046,000

Capitalized interest

$331,880,000

Adjusted Inventory

$3,882,166,000

Source: PulteGroup SEC Filings

Improving Financial Results

Following suit with the majority of homebuilders, PulteGroup witnessed a "turnaround" year in 2012. As you can see in the table below, the number of new closings, average selling price, and net new orders all grew substantially from the prior year. Impressively for PulteGroup, these results were achieved with 30 less communities than the prior year. I want to emphasize that I believe this company is truly turning a corner. They have now proven the ability to increase home sales with less inventory and lower costs. As of 3/31/13 new order units increased by 5,200, equating to a new order value of $1.6 billion. The average selling price per unit also rose to $287,000.

2010

2011

2012

Number of Closings (units)

17,095

15,275

16,505

Value

$4,427,605,000

$3,956,225,000

$4,555,380,000

Average selling price (per unit)

$259,000

$259,000

$276,000

Net new orders (units)

15,148

15,215

19,039

New order Value

$3,898,950,000

$3,953,829,000

$5,424,300,000

From a profit margin standpoint, PulteGroup is moving up and to the right. In the table below you can see gross profit margins (red line right hand scale), operating profit margins (green line left hand scale) and net profit margins (yellow line left hand scale) all improving in the past few years. If you compare my margins with the company's reported results you will see some variation. Pulte prefers to report margins based upon the homebuilding portion only. However, since buying shares of PHM mean you also own the financing division, I feel it is prudent to combine those results and provide a consolidated margin number. During Q1 of 2013 (not pictured below) all margins improved substantially. Gross margins (given my adjustments) are at 18.64%, operating margins are at 7.49% and net profit margins sit at 7.03%.


(Click to enlarge)

Source: Adjusted Income Statement, all data pulled from PulteGroup 10-K filings

Backlog

The most promising number when scanning through the SEC filings lies in the current backlog. The number of units in PulteGroup's backlog has exploded in 2012 by 65% while the backlog value came close to doubling (see table below). During the first quarter of 2013, we saw a 21% increase in the backlog. For a home to be considered in backlog the company must receive a signed contract and deposit from the customer. Deposits are then considered "restricted cash" and deemed refundable under certain instances. Of the orders in backlog as of December 31, 2012 substantially all are expected to be closed during 2013.

2010

2011

2012

2013 Q1

Backlog at year end (units)

3,984

3,924

6,458

7,825

Backlog Value

$1,056,563,000

$1,059,649,000

$1,931,538,000

$2,400,000,000

Number of Selling Communities

786

700

670

Source: PulteGroup SEC Filings

I reiterate that this has occurred with a decrease in the number of selling communities, a major plus for Pulte's management. During 2013 management is projecting a 10-15% decline in selling communities before bottoming out and then beginning to move gradually higher in 2014 (as a result of the inventory purchases mentioned above).

While there is no guarantee these backlog numbers will continue to grow at such robust rates, one could certainly argue that the pent up demand from potential home owners is beginning to be released.

Risks

PulteGroup has numerous risks that investors should be aware of before initiating a position. To review all the pertinent risks please review the company's recent 10-K filing. The obvious risk is a slowdown or double dip in housing. I would recommend investors stay up to date with the latest housing reports to determine if this scenario is likely. Below are some potential risks which I will also be watching closely.

The Centex acquisition which I mentioned earlier continues to be a headache for PulteGroup. The company has set aside large amounts in a reserve fund, but there is no guarantee this will be enough. The level of all recorded reserves on the balance sheet as of December 31, 2012 was $721.3 million, the company's best estimate of potential claims is between $650 - $800 million (note that a large majority of these reserves are for general liability claims). I would recommend investors keep an eye on Pulte's behavior regarding continued funding of this reserve fund. Additionally I would watch how companies in other industries (banks, mortgage lenders, and homebuilders) are handling their reserve funds. As litigation continues to play out regarding the misrepresentation in subprime loans, we may see this dark cloud loom for years to come.

The company also has $146 million in intangible assets. These assets are valued based upon management's determination of fair value. Pulte uses a projected undiscounted cash flow method to determine if impairment exists. While I am not waving a red flag at management, one should be aware that small changes to the assumptions used in this estimation could have very different results.

Conclusion

Investors looking at PulteGroup or other homebuilders today have a very exciting story to evaluate. Companies have written down bad debt, are now borrowing at low interest rates, rapidly invest for the future, and have extremely strong backlogs. Another added plus for many builders is deferred tax assets. Now that profits appear a realistic scenario moving forward, the valuation allowances are beginning to be turned around. PulteGroup has $2.5 billion of deferred tax assets, it appears they will not be a tax payer for quite some time.

If you are a believer in the economic data regarding a housing rebound then I would urge you to perform further research on PulteGroup. Consider your investment goals and objectives before initiating a position in PulteGroup and remember that the value of investments in equity securities, like PHM, will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. If you see a fit in your portfolio, I think PHG offers a diversified play into the homebuilder sector.

Note: All data reported and graphed is pulled directly from PulteGroup SEC Filings, Investor Presentations, and Press Releases.

Source: PulteGroup: A Diversified Play On The Housing Rebound