Follow The Returns In Homebuildilng Stocks - 2 Buys And 1 Sell

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Includes: KBH, LEN, LEN.B, MTH, XHB
by: Spring Mill Research

Summary

Homebuilding is a return-driven business.

This article recommends two builder stocks to buy in Lennar and Meritage and one to Sell in KB Home.

In my recommendations I parse through the individual drivers of each company's returns on equity.

The performance of homebuilding stocks is strongly positively correlated with returns on equity (ROE). In fact, the correlation ranges from 80-90%, depending on (the point in the) housing cycle.

This relationship holds because the measure speaks not only to underlying drivers of returns in the numerator (e.g., sales, margins), much like profit growth, but ROE also places significant weight on the denominator (equity), and the key drivers of it that are unique to the homebuilding industry.

*All figures in this report for CalAtlantic prior to 2016 are pro forma for the merged Standard Pacific and Ryland, closed Oct. 1, 2015.

This report analyzes both sides of the critical ROE equation. I essentially look at a builder's efficiency in turning housing inventories - easily the industry's largest use of capital - into profitable home sales.

On this basis, I recommend two homebuilding stocks to buy (Lennar and Meritage) and one to sell (KB Home).

Lennar

Lennar (NYSE:LEN) (NYSE:LEN.B) has both a strong track record for ROE and visible prospects for further improvement in returns.

The company's pretax margins, typically in the mid-teens (~14% in FY16 and FY17E) is more than respectable. That's especially true in context to LEN's focus on entry-level and first move-up buyers, from which LEN's average home price of $362,000 in 2016 is below the group's estimated $388,000 (excluding it and Toll Brothers).

Where Lennar truly stands out, though, is in its inventory turnover ratio, which at nearly three times (sales), puts it ahead of all production builders except NVR. But unlike NVR, which uniquely obtains land exclusively through option contracts, LEN typically owns 75-80% of its controlled land, not unlike nearly all other peers.

Inventory Turns

17 / 13

13

14

15

16E

17E

chg.

Lennar

2.1x

2.4x

2.8x

2.9x

3.0x

43%

DR Horton

1.2x

1.1x

1.4x

1.5x

1.6x

34%

Toll Brothers

0.6x

0.7x

0.6x

0.7x

0.8x

22%

Meritage

1.4x

1.3x

1.3x

1.5x

1.6x

9%

KB Home

1.0x

0.9x

0.9x

1.1x

1.1x

2%

Pulte

1.4x

1.4x

1.2x

1.2x

1.4x

1%

NVR

4.5x

4.1x

4.0x

4.3x

4.5x

1%

CalAtlantic**

1.1x

1.0x

0.9x

1.0x

1.0x

-9%

MDC

1.3x

1.1x

1.1x

1.2x

1.2x

-13%

Average

1.6x

1.6x

1.6x

1.7x

1.8x

*2017 estimates use 2016 inventories in denominator, rather than 2016-17 avg.

**CalAtlantic through 2015 is pro forma for merged Standard Pacific and Ryland.

The above forecasts suggest further improvement in 2017's housing turns at Lennar, building on its leading growth in this measure since 2013.

In 2017, Lennar's pending acquisition of WCI Communities will tuck neatly into the company's existing multi-family business and may, in fact, improve overall turns. (The financial impacts from the merger will be included in my forecasts after closing, and are unlikely to significantly impact the measures presented in this report.)

Lennar's valuation, at around 1.3 times book, is attractive, given likely further improvement on its already superior track record for returns. Finally, additional multiple expansion ought to result as LEN transitions to becoming a pure-play homebuilder - post the likely sales or IPO's of Rialto and FivePoint.

Meritage

Meritage (NYSE:MTH) has solid, if unspectacular, ROE through cycles, and offers potential ROE increases that would make my relatively favorable outlook appear conservative. MTH has the most potential upside among the nine names in this report.

Much of my positive investment thesis for Meritage rests on my view that the company will improve its execution, which in my opinion is about average.

I expect reduced cycle times, i.e., faster absorption rates. Sales pace will improve as community openings are being slowed and as MTH increases its focus on first-time buyers - toward its aim of up to 45% of the total by 2018.

The table below shows selling 'neighborhoods' by builder. I expect an absolute decline in 2016-17 community counts at Meritage. This would come after 2013-15 period in which its subdivision count-increases led the group.

Active Neighborhoods (year-end)

13

14

15

16A/E

17E

CAGR

DR Horton

1,313

1,457

1,538

1,580

1,858

9%

Pulte

577

598

620

719

809

9%

Toll Brothers

232

263

288

310

329

9%

Lennar

492

576

625

675

702

9%

CalAtlantic *

456

494

558

600

630

8%

Meritage

188

229

254

241

241

6%

KB Home

191

227

247

235

239

6%

MDC

146

159

167

169

178

5%

NVR

451

488

508

518

535

4%

Avg. chg (y/y)

4%

11%

8%

6%

6%

Before its hiccup in the September (2016) quarter, Meritage had made good progress in reducing its relatively costly overhead. In this most recently reported quarter management attributed the jump in SG&A largely to 'front-end loaded' costs for opening entry-level subdivisions associated.

I buy this rationale. The declines in overhead (as % of sales) during the first half of this past year should resume as we move into the key spring selling season, if not in MTH's upcoming Q4 16 results.

Meritage is mainly valued at about a 10% premium to book and, secondarily at around six times my forecast for 2017 pretax profits. A purchase around current levels could allow for meaningful upside in the stock, mostly reflecting the improvements cited above.

These expected gains would serve as reminder of MTH's favorable track record for shareholder returns, steady balance sheet, and leading positions in attractive, mainly southwestern markets.

Price to Book Value

Price to Pre-Tax EPS

16A/E

15

14

18E

17E

16A/E

15

KB Home

0.8x

0.7x

1.0x

7x

8x

9x

10x

CalAtlantic*

0.9x

1.0x

2.2x

4x

5x

6x

9x

MDC

1.0x

1.0x

1.0x

10x

11x

13x

18x

Meritage

1.1x

1.1x

1.3x

5x

6x

8x

7x

Pulte

1.2x

1.3x

1.7x

4x

5x

6x

8x

Toll Brothers

1.2x

1.4x

1.6x

7x

8x

9x

11x

Lennar

1.3x

1.8x

1.9x

6x

6x

7x

8x

DR Horton

1.6x

2.1x

1.8x

7x

7x

8x

12x

NVR

5.2x

5.3x

4.9x

9x

10x

11x

12x

Average**

1.1x

1.3x

1.5x

6x

7x

8x

10x

KB Home

KB Home (NYSE:KBH) has earned its cost of capital just once (2012) in the past decade. Moreover, its 2017 ROE is unlikely to look much different than the 4-6% it generated since 2013. Yet its stock has been the best performing builder of this group dating to year end 2015, in large part due to speculation the company will be acquired.

KB Home's sub-par results begin with the critical land-buying process. As does each builder, the company talks to only buying land that meet its high(-return) hurdle rates, and importantly, without having to assume rapid home-price appreciation as it moves toward sale.

That's well and good. However, no large builder has pushed at price harder since 2012 than KBH itself…

Change in ASP

12

13

14

15

16E

17E

Avg.

KB Home

10%

18%

13%

8%

3%

3%

9%

CalAtlantic*

4%

14%

16%

8%

8%

5%

9%

Meritage

6%

21%

8%

6%

5%

3%

8%

MDC

5%

12%

9%

12%

7%

3%

8%

Toll Brothers

1%

12%

13%

4%

12%

5%

8%

Pulte

7%

11%

8%

3%

11%

10%

8%

Lennar

5%

14%

13%

6%

5%

2%

7%

DR Horton

5%

11%

9%

6%

2%

1%

6%

NVR

3%

10%

6%

3%

-1%

0%

3%

Average

5%

14%

10%

6%

6%

4%

Yet, the company's gross margins (and pretax margins) rank at- or near the bottom. If KBH struggles to earn capital costs with home prices rising double-digits, how can it possibly earn an attractive return in the moderate-inflation environment expected in 2017 - let alone flat or down house prices?

Gross Margin

12

13

14

15

16E

17E

Avg.

Lennar

20%

22%

25%

24%

23%

23%

23%

CalAtlantic*

20%

25%

25%

23%

22%

22%

23%

Pulte

16%

21%

23%

23%

22%

22%

21%

DR Horton

20%

21%

21%

20%

20%

20%

20%

Toll Brothers

19%

20%

21%

22%

20%

20%

20%

Meritage

18%

22%

21%

19%

18%

18%

19%

NVR

17%

17%

18%

19%

17%

17%

18%

KB Home

17%

19%

18%

16%

16%

16%

17%

MDC

15%

18%

17%

17%

16%

16%

17%

Then there's the problem with the KB Home's land-acquisition strategy. The table below shows the company's lot positions peaking in 2013, following the only year KBH earned a decent return, as mentioned.

Lots / Homesites (year end, in 000)

12

13

14

15

16A/E

CAGR

DR Horton

153

184

184

174

205

8%

Lennar

128

154

165

166

159

5%

Pulte

120

124

131

138

145

5%

NVR

59

65

77

81

83

9%

CalAtlantic*

59

73

78

70

74

6%

Toll Brothers

40

49

47

44

49

5%

KB Home

45

61

52

47

45

0%

Meritage

21

26

30

28

28

7%

MDC

11

13

15

15

16

9%

Avg. chg (y/y)

17%

4%

-2%

5%

Since 2013 KB Home's land acquisition team has acted to reduce its lot counts, as bondholders weigh risk against reward. (Note however that KBH remains within its bond covenants.) Yet these lower lot counts are incongruent with corresponding rises in inventories.

Though the company professes to have now seen the light, as exemplified by the formidable 2020 goals it recently outlined, KBH's land purchases continue at a rapid clip since those objectives were set this past fall.

At current levels, the company's real estate inventory is valued close to Lennar's. However, Lennar generates about 2.5X KBH's homebuilding revenues while selling comparably priced homes.

Housing Inventories ($M)

12

13

14

15

16A/E

CAGR

CalAtlantic*

3,048

4,186

5,301

6,070

6,961

23%

DR Horton

4,165

6,197

7,700

7,807

8,340

19%

KB Home

1,707

2,299

3,218

3,313

3,403

19%

Toll Brothers

3,732

4,650

6,491

6,998

7,354

18%

Meritage

1,113

1,405

1,878

2,098

2,098

17%

MDC

1,003

1,412

1,668

1,764

1,871

17%

Pulte

4,214

3,979

4,392

5,450

6,950

13%

NVR

870

976

1,164

1,350

1,353

12%

Lennar

2,792

2,905

2,889

3,059

3,605

7%

Avg. chg (y/y)

24%

24%

9%

11%

Due to its uneven land buying strategy and its lackluster pace at turning that land, the company finds itself today with a considerable debt load - at around 60% of total capital - and the likelihood of further inventory impairments, two areas where KBH ranks near the bottom among all builders.

Disclosure: I am/we are long LEN, MTH.

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.