Why You Shouldn't Miss These Home Builders This Month

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Includes: LEN, PHM, TOL
by: Fusion Research

Growing employment and low mortgage rates are encouraging more U.S. residents to buy homes. The increasing demand and low availability of new homes for sale has resulted in a surge in home prices, which will help homebuilding companies improve margins and generate better returns. Home prices in the U.S. increased 12.1% year over year in June 2013. Although few economists suggest that the home price index may slow down in the upcoming months, we think that the fundamentals of the housing market still look solid. Homes are still much more affordable for buyers than prior to the housing crash. Many households that put off buying homes earlier are now getting back into the market, boosting demand.

In this article, we analyze three home building companies that are taking advantage of the housing recovery to enhance their earnings by focusing on improving margins and acquisition of new home sites.

Focus on margin improvement

PulteGroup (PHM) reported home sales gross margin of 18.8% in the second quarter ended in June 2013, up from 15.1% in the same quarter a year ago. An increase in the average selling price, or ASP, its cost cutting initiative, and better product mix all contributed to this margin growth. In the second quarter ASP increased 9% year over year to $294,000. The rising demand will further push prices and will drive its gross margin in the second half of the year. Pulte's product mix targets 75% of sales from move up and active adult buyers. These buyers are less sensitive to higher prices and interest rates due to higher income compared to first-time buyers who are sensitive mortgage payment increases.

The company is making efforts to reduce costs with commonly managed floor plans and its value engineering model. These plans help better manage designs and optimize material cost.

With these initiatives, Pulte has seen an improvement in its margins. We are optimistic that these factors will help the company maintain at least the current gross margin of around 18% or drive margins even higher.

In the second quarter ended in June 2013, Pulte's net new order declined 12% year over year, instead of showing recovery in the housing market. Its peer Lennar (LEN) posted 27% year-over-year growth in net orders. The fall in Pulte's orders was due to a 16% decline in the number of communities and its decision to slow sales in a number of communities, like Arizona, Nevada, and Southern California. The company has intentionally slowed its sales since as it has a shortage of finished lots and a lack of land for development. Pulte is working on enhancing its gross margin by focusing more on price than volume, which affected order growth. The decline in order growth is not a concern going forward, as both order and community growth are expected to rise with new communities in Sarasota, and Naperville, which are expected to be operational in 2014.

Lennar is going to benefit from the recovering U.S. housing market with its large land position. In the second quarter ended May 2013, the company reported 27% year-over-year growth in new orders, and ASP increased 13% year over year to $283,000. The company has sufficient land to meet its order growth through 2014, giving it a competitive advantage over peers that are facing constraints from land availability. Beginning in 2015, it will invest $2 billion per year for land acquisition. The company has been focusing on acquiring new home sites in high margin communities. In June, Lennar acquired 40 home sites in Nashville's Tollgate Village community. With this acquisition, it now has homebuilding operations in 19 states in the U.S. Lennar has presence in high-end communities in places like Arizona, California, Colorado, and Florida, which allows it to sell homes at higher prices. The acquisition of new home sites will drive its margins and earnings.

Stock Valuation

Trailing PE

Forward PE

Pulte

20.95

12.02

Lennar

17.73

13.05

Click to enlarge

Source: Yahoo finance

Looking at above table, the forward PE of both companies is lower than the trailing PE, which implies that the companies' earnings are expected to grow in the future. Further, both companies have generated more earnings in comparison to the industry average, as their PE ratios are lower than the industry PE of 28.2.

Increasing Home deliveries to drive revenue

Toll Brothers (NYSE:TOL) is one of the leading luxury homebuilders in the U.S., and it reported a year-over-year increase of 10% in home deliveries, reaching 1,059 units in the third quarter ended June 2013. The increase in home deliveries was due to rising home demand and less competition in the luxury homes market. The average price of homes delivered in this quarter increased 13% year over year to $651,000 and backlog grew 56% year over year to 4,001 units. Looking at the demand and backlog growth, the company expects to deliver 1225-1425 homes priced from $675,000 to $695,000 in the fourth quarter of 2013. With increasing home deliveries and prices, the company expects its revenue to reach $2.62 billion in this fiscal year compared to $1.88 billion last year.

Toll Brothers' revenue will also enhance from its high-price luxury project, 'Touraine', which is one of the largest projects undertaken by the company. It is a 22-story residential building in Manhattan's Upper East Side in New York. Out of the 22 units, 21 units are already booked. The company delivered 16 units in the third quarter ended in June 2013, which resulted in revenue generation of approximately $50.7 million. It expects to deliver the remaining five units in the fourth quarter ending in October 2013, generating revenue of $38.3 million. The delivery of this high-price project will be accretive to its margin. At a recent event -- Martin Connor, CFO, stated:

Our gross margin and operating margin continued to improve with the increase in pricing power and volume. We expect this to continue in financial year 2013's fourth quarter and in financial year 2014 as we deliver our backlog.

The company's gross margins ranged from 23% - 25% in the past three quarters. We support the company's statement and assume margins will be on the higher side. The company reported EPS of $0.26 in the third quarter compared to $0.14 in the second quarter. EPS will further increase with margin improvement; the EPS is expected to reach $0.38 in the fourth quarter of 2013, showing improvement quarter over quarter.

Conclusion

These homebuilding companies are going to benefit from the increase in home prices. PulteGroup's double-digit decline in order growth is disappointing, but it is expected that the order growth rate will rise with new communities in 2014. Its margin improvement will offset the current decline in orders. On the other hand, Lennar is well positioned with its land availability to meet order growth. Both companies offer substantial future earnings growth, and we recommend a buy for them. Toll Brothers' high luxury project and increase in home deliveries will enhance its revenue and margins, which will improve its EPS. Therefore, we recommend buy for Toll Brothers as well.

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.