PulteGroup: Strong Contrarian Value Play 25% Undervalued

Summary

• Industry has been plagued by supply chain challenges that lack any quick remedy.
• Strong backlog growth, robust demand momentum, and disciplined operational management point to material upside.
• Significantly more pathways to multiple expansion.

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In 2020, homebuilders outperformed the broader market. While the S&P 500 delivered a total return of ~29%, homebuilders PulteGroup (NYSE:PHM), Lennar (LEN), and D.R. Horton (DHI) delivered returns of ~35, ~54%, and ~59%, respectively. This strong performance is in defiance to industry-wide supply chain disruptions that have resulted in extended build cycles and higher input costs (eg. labor, materials, logistics). Materials have been so hard to come by, in fact, that order fulfillment for some products has gone from 6 to 16 weeks. Nevertheless, this headwind has been more than offset by a strong demand and pricing environment in the sector. For its part, Pulte targeted $4 billion in land acquisition and development investments in 2021, reflecting increased optimism on the demand side. This amounted to nearly a $1 billion more for the first nine months of 2021 compared to last year. Home sale revenues in the third quarter jumped 18% over last year to $3.3 billion, driven by a 9% increase in closings to 7,007 homes in combination with an 8% increase in average home sales prices.

Data by YCharts

According to Seeking Alpha data, the Street is roughly split on the stock. 5 of 16 analysts are “very bullish” on the stock, but half are "neutral" or worse. November housing starts were up 11.8% month-over-month to 1.679 million and above the 1.502 million anticipated. However, homes under contract to be sold actually dipped 2.2% month-over-month versus the 0.8% increase anticipated. Reservations about the low housing supply are tempering expectations, although buyer competition remains unrelenting. With the median price of a home surging from $323K in just 2Q20 to $405K in 3Q21, there’s the obvious concern that the market may have reached its peak.

DCF Analysis Indicates Significant Upside

To get a sense of the company’s intrinsic value, I ran a DCF analysis. No DCF analysis can provide a perfect picture of future returns for shareholders; however, they can provide an illustrative “story” of the likelihood of different scenarios. In my DCF analysis, I assumed a conservative growth CAGR of 5%. I also assumed EBIT margins holding flat at 15.8%. I kept depreciation, capex, and changes in net working capital levels in-line with historical levels.

Source: Created by author using data from Yahoo! Finance

Assuming a terminal EBITDA multiple of 9.0x and a discount rate of 7%, the stock has 25% upside potentially. I believe this EBITDA multiple is reasonable given that Pulte was trading in the 9-14x range back in 2012-2017. At the current multiple of 6.5x, the downside appears to have been materially been baked in. Even if the multiple were to contract to 6x and keeping my other assumptions the same, the stock would be fairly valued. This isn’t all that bad for a downside scenario given how lofty multiples currently are in the market. On the flip side, if the multiple were to expand to 11x, even at just a 5% growth rate, the stock would have nearly ~50% upside. Thus, I believe the stock has compelling risk/reward.

Source: Created by author using data from Yahoo! Finance

For context, Lennar trades at 6.2x, but generally traded in the 10-14x range throughout the last decade. DR Horton currently trades at 7.7x and also more or less traded in the 8-12x range.

Catalysts For a Price Correction

There are several factors that could cause Pulte to close its discount to intrinsic value. First, investors need to see a normalization in the supply chain and improvement in the labor market. There don’t appear to be any quick fixes, and management has admitted as much. In addition, the third quarter saw a decrease of 20% orders from first-time home buyers versus last year. While this was partly due to the company’s restricted sales approach to its first-time community count, orders from move-up and active adult buyers still decreased 22% and 4%, respectively in the third quarter. The market is looking for momentum across a broader swath of customers to validate an uplift to the trading multiple.

The company’s unit backlog was up 33% over last year to 19,845 homes amounting to $10.3 billion in value, largely driven by robust price increases. Signs of clearing this backlog will become increasingly important in convincing the market that there is still further momentum in the homebuilding sector despite the supply challenges. While the company’s gross margin increase of 200 bps to 26.5% in the third quarter indicates that management has netted up well against input inflation and a labor shortage, sign-ups in the quarter were still lower relative to last year. Management is currently outright restricting sales pace in more than half their communities, so backlog in conjunction with housing affordability will be the key drivers of value in 2022.

Downside Risks

As bullish as I am on Pulte, there are multiple reasons to be hesitant. Windows, paint, and appliances remain pressure points for the industry in terms of raw materials. At the same time, transportation capacity is limited. A recovery in the supply chain is unlikely in the first half of 2022, and, in my view, will not come at all this year. Moreover, it’s not clear the extent to which the company is going to be able to continue to push price increases, and management has not yet provided guidance on go-forward margins, although they anticipate some improvement. The company is pegging a lot of its optimism on the highest lumber loads coming in Q3 and Q4, with benefits accruing the first half of this year, but the payoff remains to be seen after management spent above and beyond what they were contracted for.

Conclusion

At a time when the stock market appears overvalued, it’s an odd feeling to be bullish on a stock where the Street is so lukewarm. While strong competition in the sector, slowing population growth, and uncertainty in supply chain will remain long-term headwinds, Pulte’s stock trades as if a significant EPS contraction is around the corner. To be clear, Pulte trades at just 8.8x earnings and a PEG ratio just under 0.5x. This, at time when the Shiller PE multiple is at 40x, makes the stock a meaningful value play for those willing to bear the risk. With a dividend yield of 1% and a beta of 1.43, there admittedly isn’t much downside protection; however, management has started to take a more shareholder friendly capital allocation policy, hiking the dividend by 7% in December. With the company’s controlled lot position increasing to 222.6K with 54% held through option and a unit backlog growth of 33%, there is momentum to the company to warrant a significantly higher multiple. The company has $1.6 billion in cash and materially lowered its debt-to-capital ratio to 22.4% from nearly 40% back in 2018, demonstrating strong execution amidst disciplined financial management. Accordingly, I strongly recommend investing in Pulte as a contrarian value play.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Comments

[AwokenTheLBC]

Homebuilders plummeted today. Nary reason why anywhere

[old maid]

lennar class b is 22% cheaper with better fundamentals.

[OverTheHorizon]

Agree with your assessment. Homebuilders experiencing Golden Decade—hardly a contrarian play. BZH TPH TMHC. Need lots too FOR.