Perhaps one of the most feared industries in the economy currently is in home construction. With looming concerns over foreclosures and a double dip, in addition to lingering weariness over the mortgage crisis, value investors have an opportunity now to exploit emotional anomalies. The important aspect to stress is fundamentals, intrinsic value, and margin of safety, since in the long-term, the market will adjust to operational performance. I find that homebuilders D.R. Horton (NYSE:DHI) and PulteGroup (NYSE:PHM) are currently overvalued, but are exposed to less risk than what the market appreciates.
From a multiples perspective, both companies are, in my view, expensive. D.R. Horton and PulteGroup trade at a respective 22.4x and 29.5x forward earnings. The latter is currently in the red and will likely return to profitability sometime in 2012. Management has been successful in turning around operations thus far, but the current valuation, in my belief, does not justify the risk from a declining housing market like it does for D.R. Horton. Since February 2007, D.R. Horton and PulteGroup have lost 57.6% and 82.8% of shareholder value, respectively.
At the third quarter earnings call, D.R. Horton's CEO, Don Tomnitz, noted:
"We have made many adjustments throughout our company to be competitive and profitable in the current housing environment. Our June results compared to the March quarter demonstrate the progress we are making. Our home closings and gross margin increased. SG&A and interest expense decreased and Financial Services pretax income increased, resulting in net a income of $28.7 million for the quarter.
Our balance sheet and liquidity remain strong, with cash and marketable securities of $1.1 billion and net homebuilding leverage under 20%….
Our sales order backlog grew throughout the selling season, increasing in March to 5,300 homes and further in June to 5,600 homes".
As the CEO highlighted, one of the reasons to be bullish about the stock is its strong liquidity. While the net debt of PulteGroup is more than market capitalization, the net debt of D.R. Horton is around only one fifth of market capitalization. This relatively clean balance sheet provides the firm protection in the event of a double dip, as well as opportunities for greater expansion in the event of a recovery. PulteGroup also has a beta of 1.23 versus 1.09 for D.R. Horton, which contributes to its relatively higher risk. So what then to expect in the fourth quarter earnings call for D.R. Horton?
Going forward, I anticipate that fourth quarter closings will exceed third quarter closings, but that the firm will make a sharper turn to profitability. Development in aged communities should be discussed in order to better inform the market of a prioritization of return on investment over margin expansion. Management would also be well to address the competitive environment in existing home market and how this will hedge against concerns over accelerating foreclosures.
In regards to the housing market, D.R. Horton is also a safer bet than what meets the eye, particularly in regards to FHA loan limits. As the home-maker focuses on a less affluent market, the negative implications of this are comparatively restrained. Investors can thus profit off of higher risk-adjusted returns from a market that is perhaps overly concerned about housing foreclosures. In the instance that the housing market weakens, debt may result in liquidity problems - but given free cash flow projections, I do not foresee this being too probable.
Consensus estimates for EPS are that it will decline by 66.2% to $0.26 and then increase by 88.5% and 71.4% in the next two years. Analysts currently rate the stock between a "hold" and a "buy". With the dividend yield at 1.29% and the stock expensive, I would nevertheless hold out for a better entry price.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.