DIY Value Portfolio's Most Recent Addition: PulteGroup

| About: PulteGroup, Inc. (PHM)

Summary

I added PulteGroup to my DIY Value Portfolio on February 22nd.

The US economy will grow steadily in 2017, which is great for homebuilders.

There will be only 2 interest rate hikes in 2017, also great for the homebuilders.

PulteGroup, Inc. is undervalued compared to its peers.

President Trump plans to institute new tax reform in 2017. In theory, his new plan will lower corporate taxes across the board, while also deregulating some industries that have been crippled by regulation. He claims this will boost the US economy, as companies will be able to repatriate their foreign cash reserves and they will have more money to invest in growth prospects, and will have the ability to add new hires. Trump's new Treasury Secretary, Steven Mnunchin, has even come out and said that the growth estimates for the administration is a sustained 3% or higher annual growth rate. I find that very hard to believe. I see a growth rate right around 2% being more realistic. However, setting aside all politics, I think it is safe to say that with these decreased taxes and deregulation we will cause a greater growth in GDP than we have seen since the Financial Crisis. With the assumption of solid GDP growth, I believe that a great area to focus on is the homebuilders. The homebuilders are a very cyclical area of the market because they are reliant on consumers having the ability to purchase new homes, thus they don't come without risks. I wanted to find a company that was a strong company with the possibility to find some value in the valuation of its stock at current prices. I decided on PulteGroup (NYSE:PHM) because of its sector and its valuation compared to its competitors. To compare the companies, I am going to use a DCF analysis, P/E, and an their inventory turnover ratios (I know it's odd, but I find this a very important ratio to judge the health of a homebuilder).

Market Risks

After the Financial Crisis, it was obvious that homebuilders are very susceptible to a systemic market crash, like most other stocks. However, they are also reliant on the US consumer being prosperous and having a job. Hence why the possible increased growth rate of the economy makes them an interesting purchase. Still, at the moment there is a more pressing cloud that is hanging over the homebuilding industry and that is rising interest rates. Homebuilders are exposed to changes in interest rates because with higher rates it makes it more difficult for consumers to afford mortgages. Some experts hypothesize that the post-election rally in mortgage rates was one of the main reasons that single-family homes sales struggled in December 2016, to cap off another strong year for home sales in general (5 straight year of sales growth). Thus, it is very important to keep an eye on interest rate hikes by the Federal Reserve. Especially for a company like PulteGroup, which had 82% of its home sales involved a mortgage. Any effect on mortgages could greatly affect their earnings. but after their most recent minutes I don't believe that the originally predicted 3 rate hikes will happen in 2017. I believe that they are uncertain about the effect that Trump's policies will have on the economy and the job market. Recently, the Federal Reserve has only wanted to enact rate hikes at meetings that have a press conference attached to them. This leaves only three meetings as options in 2017: June, September and December. They will raise rates in their June and December meetings. They won't force three rate hikes into that time period. We will see bumps of 25 bps twice this year. I believe that the deputy chief economist at PNC Bank, Augustine Faucher, did a good job describing the trend for the next few years:

"Mortgage rates will continue to increase over the next few years, raising the cost of homeownership and gradually taking some of the steam out of the housing market. But rates won't move up quickly enough to cause another housing market crash. They will remain well below their earlier highs."

Basically, interest rate hikes in the next few years may slow growth but it won't end in a catastrophic crash this time. Another great quote is actually from PHM's CEO, Ryan Marshall, who said:

"We believe that continued favorable trends in the economy, job growth, demographics and consumer confidence can more than offset the impact of modestly higher rates, allowing the housing recovery to continue at a steady pace."

I agree with Mr. Marshall in that slight increases by interest rates will be offset by an increase in other aspects of the economy which will help the housing market to grow at a healthy and stable rate. Other factors that have hurt homebuilders are lack of developed plots of land and skilled labor shortage. However, I see these as short term issues which can be remedied and shouldn't be looked at as strongly as interest rates.

Analysis Against Competitors

For this analysis, I am going to look at the three largest homebuilders in the US market based off closings in 2016. These three companies are D.R. Horton (NYSE:DHI), Lennar Corp. (NYSE:LEN), and PulteGroup, listed in order of size. I believe that all of these companies are strong and healthy, but I see the most value in the equity price of PHM. These three stocks will be compared by their DCF value, P/E value and their inventory turnover ratio.

Discounted Cash Flow Analysis

For the DCF analysis, I will be using data and analysis supplied by simplywallst.com. Their analysis uses a 5-year forecast of leveraged FCF and then calculates a terminal value of the stock at year 5 by using a constant growth rate for every year after year 5. After these calculations were made PHM had a DCF value of $36.14 vs. an equity price of $21.60.

Source: www.Simplywallst.com

Whereas, DHI has a discount DCF of 37.19 vs. a share price of 30.98.

Source: www.Simplywallst.com

Lennar Corp. was not given a DCF value because the company's free cash flows have been very volatile in recent years, and were actually negative in 2014 and 2015. Nevertheless, with just PHM and DHI it is obvious where the cheaper purchase is. With PHM, there is a 67% upside on the value of the equity from current prices to fair value. Whereas with DHI, there is only a 20% upside on the stock to fair value. Based on this analysis, both of these stocks are undervalued but PHM is the better pick.

P/E and Inventory Turnover

PulteGroup trades at a price to last year's earnings ratio of 12.3, which is the same as DR Horton. Lennar Corp. trades at a P/E of 11.4. I believe that Lennar group trades at a slight discount to these two others in the group based off the fact that they are less capable of producing consistent free cash flows. Nevertheless, I am willing to say that these three companies tie in this metric. Lastly, I want to look at the inventory turnover ratios of these three companies. This may seem like an odd metric to look at, but I think that is critical when it comes to seeing the health of a real estate developer. That is because the inventory that they are carrying (actual houses) has far higher value than most other industries' "inventory". If a real estate developer can't move their inventory, they won't be in business for much longer. Using 2016 COGS and average inventory for the three companies: PHM had a ratio of .938, LEN had a ratio of .996, and DHI had a ratio of 1.172. Although PHM had the worst ratio of these three companies, it isn't the biggest deal because they are still in a very healthy range. I would be worried about this ratio if it was starting to creep down towards .5 because it would be showing that they are just carrying way too much inventory.

Conclusions

The upcoming year, 2017, looks like it will be a solid economic environment for the homebuilders. I believe that PulteGroup shows the most value out of the top three homebuilders in the United States. I make that decision primarily based off the DCF valuation that I displayed above, and the fact that PulteGroup doesn't blow me away with their P/E or their inventory turnover doesn't hinder my decision. I still believe that they show the best value out of the three and they will be a prosperous investment for 2017. The above thesis is why PHM is the most recent addition to my DIY Value Portfolio.

Disclosure: I am/we are long PHM.

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.

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