Forget the saying "best house in a bad neighborhood," PulteGroup (PHM) is the best house in a rebounding neighborhood. In this case, PHM is the best company in the rebounding homebuilder industry. The key investment thesis is a deferred tax asset that's currently unaccounted for, and when adjusted for, puts PHM's valuation at a steep discount to other homebuilders. Other catalysts include the rebound in the housing market, and PHM's diversified geographical revenue stream and target base. We see upside of over 50%.
PHM targets a cross-section of home buyers nationwide (30 states to be exact). The company buys land to build single-family houses, duplexes, townhouses, and condominiums and then sells the properties to a variety of customers. PHM's PulteGroup brand captures customers looking to move-up in the housing market, while its Centex brand markets to entry-level buyers.
PHM also builds retiree and senior living facilities via its Del Webb brand. Its breakdown of property closings in 2012 were 43% move-up buyers, 31% entry-level buyers and 26% active adults.
Deferred tax asset
Now let's get to the heart of our thesis. Per its recent quarterly filing, PHM notes that it has an estimated $2.4 billion deferred tax asset (DTA) that's not currently on the books.
PHM has left the DTA unbooked given the uncertainty of future profitability:
We evaluate our deferred tax assets to determine if a valuation allowance is required. At March 31, 2013 and December 31, 2012, we had net deferred tax assets of $2.4 billion and $2.5 billion, respectively. The ultimate realization of these deferred tax assets is dependent upon the generation of sufficient taxable income during future periods. Changes in existing tax laws could also affect actual tax results and the valuation of deferred tax assets over time. Based on our evaluation, we fully reserved the net deferred tax assets due to the uncertainty of realizing such deferred tax assets. The accounting for deferred taxes is based upon an estimate of future results.
On the latest PHM earnings call, management believes that it can book the DTA after achieving two years of profitability and having a view towards future profitability. We believe, and management has hinted at a similar outcome, that PHM is likely to book its DTA in the next 6 to 18 months. When it does, the company's book value could get a near $2.4 billion boost.
The other major homebuilders have already reversed their DTAs, given they returned to profitability sooner than PHM. 2012 was PHM's first year of profitability since the beginning of the financial crisis.
Meanwhile, Lennar (LEN) returned to profitability in 2010, D.R. Horton (DHI) in 2010, Toll Brothers (TOL) in 2011, while NVR (NVR) never lost money. As a result, they have all reversed their deferred tax assets, boosting their book values, which is why PHM trades at a superficially high price to book value.
That's why we are excited about PHM's valuation. On the surface PHM trades at a large premium to the industry and its major peers, with a P/B ratio that's 68% higher than the industry average.
Notice that KB Homes (KBH) trades with an outsized P/B as well. That's because KB has not returned to profitability and is carrying a deferred tax asset of $879 million.
PHM's premium valuation could easily be justified given its leading market position; however, when taking into account PHM's DTA of $2.4 billion, it's actually heavily undervalued with a P/B at only 1.6x.
Source: PHM Annual Report & BWI estimates
In our base case, we assume that after PHM reverses its DTA, it will trade in line with the select peer average of 2.1x (its select peers include DHI, LEN, NVR and TOL), which gives us a near $34 price target for the end of fiscal 2014, suggesting 83% upside.
In our worst case, we assume that PHM's P/B multiple actually retracts to its 10-year average of 1.3x, putting the downside to $18.38, which is only 3.4% downside from current trading levels.
Interest rate headwind?
One big key for the rebounding real estate market is low rates. The average rate for a thirty-year fixed rate mortgage has remained below 4% since January 2012.
However, many "experts", and investors alike, have become bearish on the homebuilders given the expected rise in interest rates. But, if interest rates rise, the housing market could continue to grow nicely.
Goldman Sachs has modeled out the workings of the housing market and believes that at a 3.8% interest rate, the typical American home buyer can afford a $279,000 house, which is 45% higher than current home prices.
What's more is that based on the current median home price of $200,000, mortgage interest rates could actually rise to nearly 7% before becoming "unaffordable" for home buyers.
All told, a rise in interest rates would not be detrimental to the housing recovery.
PHM has an impressive geographical diversification. For 2012, no geographical segment accounted for more than 22% of revenues.
We also believe that PHM is the key operator in the fast rebounding Southwest market, which is focused on Arizona, Colorado, Nevada, New Mexico and Southern California. The Southwest accounts for the majority (22%) of the company's total inventory.
Other major homebuilders are spread across other parts of the U.S. Lennar generated 36% of its 2012 revenues from the East, which includes Florida, Georgia, Maryland, New Jersey, North Carolina, South Carolina and Virginia.
NVR and Toll Brothers are battling it out in the Northeast. NVR got a whopping 62% from the Mid-Atlantic region (Virginia, Maryland, West Virginia and Washington D.C.).
Toll Brothers got 28% of revenue from its North segment and 30% from the Mid-Atlantic. These key areas encompass Northern Connecticut, Illinois, Massachusetts, Michigan, Minnesota, New Jersey, New York, Delaware, Maryland, Pennsylvania and Virginia.
DR Horton has the South Central on lock, accounting for 31% of its 2012 revenues, which encompasses Louisiana, New Mexico, Oklahoma and Texas.
Back to PHM, the other impressive aspect about its Southwest segment is that it is one of the most profitable for the company. As of the first quarter, the EBT (earnings before taxes) margin for the Southwest was 13.19%.
PHM also has a solid position in one of the fastest rebounding real estate markets, Florida. The state has six (Miami, Fort Myers, Tampa, Sarasota, Jacksonville and Orlando) of the top 25 most active real estate areas. Florida is also one of the leading destinations for retirees, which is a positive given PHM's exposure to the adult communities via Del Webb.
Florida accounts for 14.5% of the homebuilder's total inventory and has the highest EBT margin among PHM's six segments.
Leading market share: PHM became the top U.S. homebuilder after the 2009 Centex acquisition. PHM has 2.23% of the market share by revenues.
Leading sales price: PHM saw its 2012 average selling price at $276,000, which is well above some of the other top homebuilders. DHI (#2 in market share) had an average selling price of $228,000 and LEN (#3 in market share) averaged $257,000.
Baby boomers: PHM's Del Webb business makes it the leading builder of active adult (55 years old and older) communities. This segment is expected to be one of the fastest growing housing segments over the next few years, given the rising number of "baby boomers."
High-quality customers: In 2012, PHM homebuyers had an average FICO score of 743. This is a big positive given mortgage underwriting standards remain relatively strict. A "high" FICO score means that customers are less sensitive to higher housing prices and tighter credit standards.
A few of the key drivers for PHM are outlined below. These include a rebound in both units sold and average selling price.
Source: PHM Annual Report & BWI estimates
The rise in the average sales price should help PHM see a nice rebound in income during 2013 and 2014, but we believe that both revenue and income will remain below pre-crisis levels:
As an investment case bonus, let's look at how PHM looks from a P/E and EPV case. We believe these measures only further reinforce the fact that PHM remains deeply undervalued.
Price to earnings. PHM currently trades at 11.6x forward earnings, but we believe that PHM deserves to trade in line with its major industry peers, near 15x earnings.
In using our 2014 EPS estimate of $1.59, and applying a P/E of 16x, we get a price target at $25.60. This suggests upside of 26%.
Earnings power value. For the earnings power value, let's calculate PHM's normalized earnings and capitalize that using the company's weighted average cost of capital.
We assume that the company's long-term EBT margin is around 13%, and accounting for the company's deferred tax asset, the normalized earnings is $1.25 billion, which is also close our free cash flow estimations for 2014. Using an 8.6% weighted average cost of capital, the equity value is $14.5 billion. Netting out debt and cash and the intrinsic value for the stock is $35.23, upside of 85%.
On the surface, many PHM investors are "scared" away given its superficially high price to book ratio. We believe that after accounting for PHM's deferred tax asset (DTA) the company is deeply undervalued. Based on our estimates, we see downside to only $17, putting the risk/reward for PHM at over 5:1.
For current shareholders wanting to wait on more color related to the DTA, they should consider buying some protection with covered calls (an income oriented strategy).