Long Century Communities: Homebuilders Are Significantly Undervalued

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About: Comcast Corporation (CCS), Includes: LEN, LGIH, MTH, NWHM, PHM, TMHC, TPH
by: David Orr
Summary

Homebuilders' share price hasn't caught up to strong fundamental performance yet.

It is unlikely the current level of home building suggests oversupply.

I will cover Century Communities, a particularly attractive homebuilder.

Homebuilders performed well fundamentally over the past 5 years, yet share price is lagging behind. A basket of 6 random homebuilders since 2015 only has a CAGR of 4.8%. But each individual company, except for one, significantly improved earnings and book value per share in that time. Current levels of earnings and growth present a good opportunity unless the market is correct that demand for new homes will reverse. After carefully reviewing long term homebuilding trends I believe the market has it wrong.

First, I will analyze the homebuilding trends. This is the key factor in an investment decision in any homebuilder. Then I will discuss possible attractive homebuilders, followed by my top pick: Century Communities (NYSE:CCS). I will conclude with a price target and risk section.

1. The big picture

The two main factors that drive demand for housing are:

  • US population increases by about 2 million people per year, which has remained steady in recent years.

  • Household size decreases slowly. Young people might live with mom longer but the overall figure is what matters.

Considering this, it seems unlikely that the current number of new homes being built right now should reverse because we're still below the long-term average:

Source: Trading Economics

I read through some bear arguments in the comment section of another homebuilder article.

The most common idea is that people cannot afford homes anymore. This seems overblown even if directionally true. There are also builders like LGI Homes, Inc. (LGIH) that focus on cheap homes for folks that strongly believe this. Most importantly, people still need homes even if they do not own. An investor can step in and rent out a newly built home instead.

A few people predict that we’re late in the business cycle. This is an abstract idea about the entire economy and has little meaning to me. Is there strong evidence that we’re late in the home building cycle? As you can see in the graph above, home starts haven’t reversed below the long-term average before. With continued population growth, there are just as many people that need new homes as in the past.

Another good sign is that mortgage delinquency rate is low and price to rent is normal, implying that the housing market is healthy. Regardless, there is always some risk that home building trends reverse suddenly anyway.

Here is a similar perspective to the first graph:

What is commonly brought up is that rising interest rates put downward pressure on home prices. First, this hasn’t been reflected in homebuilder performance last year. In the '90s many homebuilders did well during periods of rising rates. Why might that be? Rising rates indicate a strong underlying economy which could offset slightly higher mortgage payments. This narrative helps explain why homebuilders are priced so attractively here, though. Similarly, it is claimed that increased labor costs would negatively impact homebuilders - but this also means more buying and renting power.

Another article brings up that the NAHB housing market index dropped recently. This is only a very short-term indicator - and it has already reversed in the latest release:

Source: Investing.com

Lumber prices are important for home building. If they were to get too high it would no longer be economical to build new homes unless selling prices rose drastically. Last year saw elevated lumber prices yet homebuilders posted record earnings. Those prices have already reversed:

Source: Nasdaq

2. Possible Homebuilder Picks

I read these annual reports picked by strong basics:

Company

Market Cap

P/E

P/B

4 Year EPS Growth

Lennar (NYSE:LEN)

$16b

9.5

1.12

192%

M/I Homes (NYSE:MHO)

$768m

7.4

.93

114%

Century Communities

$727m

7.6

.85

207%

William Lyon Homes (NYSE:WLH)

$572m

6.5

.66

73%

LGIH

$1.4b

10.4

2.3

350%

TRI Pointe (NYSE:TPH)

$1.8b

6.8

.97

213%

I can see a reasonable case for any of these. I went with Century Communities and TPH. I’ll pick up LGIH too if the price drops to $50 again. All three have rapid growth, management with a strong track record and attractive current earnings.

There were a few builders that I would avoid. Taylor Morrison (TMHC) had no EPS growth. Meritage Homes (MTH) only suddenly grew its EPS in the last year, though there might be a good explanation. And The New Home (NWHM) actually lost money.

Another idea is to buy long-dated, out-of-the-money call options for PulteGroup (PHM). Low option implied volatility gives attractive odds - specifically the Dec 2021s might be underpriced here.

3. Century Communities

Dale and Robert Francescon are brothers who founded Century Communities in 2000 and still act as co-CEOs. They hold 4.1m in stock worth $100m or 13% of outstanding shares. Their large personal stake aligns their incentives with ordinary investors. I couldn’t find any red flags about either of them in a couple of hours of scouring the internet. The company remained profitable through the financial collapse of 2008 suggesting management has some foresight. The backlog increased 17% year on year, pointing toward continued growth. Its strategy is outlined as follows:

Source: CCS Annual Report

CCS also originates loans and sells them at a profit within 30 days, mostly eliminating credit risk. This business is convenient for the customer and a profit stream for CCS. It is odd that more builders aren’t in the same business considering the synergy and very high margins. Lastly, management is taking a lesson from LGIH and is growing its own entry-level home specialty business, which already represents 20% of CCS' profits.

The following chart illustrates the absurd price anomaly in play. This isn’t just true for CCS but many homebuilders:

Source: Yahoo

4. Price Target and Risks

The biggest risk to going long any homebuilder is new home starts falling or mortgage delinquencies rising. I will follow these two key factors. If either figure gets too far above its long-term average, it could be time to quit the position. I expect overbuilding to be probable in a couple of years given the cyclical nature of the business. If CCS grows/profits at the same rate until then that would put shareholder equity at +50%. With the same discount to book that implies a 50% upside in 2 years or price target of $33, and it could go much higher.

Importantly, if the building trend reverses suddenly the downside here should be limited given the current discount to book value. It is possible that the market allows these stocks to trade down to an even smaller fraction of book value. How low that could get is hard to forecast - but seems unlikely given the floor I see across most industries.

Disclosure: I am/we are long CCS, TPH. 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.

Additional disclosure: I wrote this article when CCS share price was $23.74