Warren Buffett's Interest In Housing; Which Homebuilders To Buy

Includes: DHI, HOV, KBH, LEN, TOL
by: Bidness Etc

Homebuilders - Update after Buffett's Interest

What Happened Yesterday?

Yesterday, it was reported that Berkshire Hathaway Inc. (NYSE:BRK.B) is going to purchase the mortgage division and loan portfolio of Residential Capital LLC after mortgage rates have hit record-low levels. This can be a signal of a potential entry of Berkshire Hathaway in the homebuilders market, anticipating its future growth potential.

Warren Buffett has remained bullish on U.S. homebuilders as he thought U.S. residential real estate slump will end by the end soon. On Feb.27, 2012, he said: "I'd buy up a couple hundred thousand single-family homes if i could."

Our Investment thesis:

We have identified and analyzed the homebuilders that have shown an increase in the number of new orders, contract backlogs and reduction in the order cancellation rates. We think Lennar Corp (NYSE:LEN), Hovnanian Enterprises Inc. (NYSE:HOV) and Toll Brothers (NYSE:TOL) are most exposed to a housing recovery. On the other hand, DR Horton Inc (NYSE:DHI) premium valuation is fully reflecting the growth opportunity. We are recommending investors to short sell KB Homes (NYSE:KBH) as it has failed to show a meaningful growth in sales orders.

Industry Overview:

The slump in residential construction market after the subprime mortgage of 2007-8 was attributable to low demand, decrease in home prices, and generally rising unemployment rates. However, recently, there are few factors indicating a turnaround in the industry, as indicated by Buffett's move too.

  • Mortgage rates have plummeted to record low levels. Home-buying and refinancing are more attractive options now

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  • The MBA (Mortgage banking Associations) Purchase Application Index, a leading indicator for single-family home sales and housing construction, has shown signs of improvement, recently
  • Homebuilders are exposed to single-family new home sales which have stabilized. Meanwhile, existing home sales are continuously rising

Lennar Corp

We recommend a long position due to the following factors:

  1. LEN recently experienced a decade-high quarterly backlog growth of 39%
  2. Its new orders have increased by 33%, on a year-over-year basis
  3. Its order cancellation rate has also remained low at 18%
  4. Recently, LEN entered into a $525 million revolving credit facility, which will reduce the company's borrowing costs and increase its liquidity
  5. Its long-term growth rate of 30% is very lucrative vs. the industry average of 14%

Toll Brothers

We are reiterating our overweight stance as:

  1. TOL's quarterly backlog is 37% higher on a YoY basis.
  2. Number of deliveries and the number of new orders have increased by 14% and 47% respectively.
  3. Relative to its peers, it has exhibited the highest stock price appreciation of 3.5% over the past three months
  4. Its debt-to-equity ratio of 75% makes it one of the least leveraged firms in the industry
  5. It is exposed to luxury buyers who have better credit records. Hence the tightening in lending standards has not affected it materially

Hovnanian Enterprises Inc

HOV posted a quarterly profit for the first time in the past two years. The following factors enable U.S. to recommend a long position:

  1. HOV's home deliveries grew by 25%, and the contract backlog rose by 49% on a YoY basis
  2. Contract cancellation rate in this quarter decreased to 17% from 20% a year ago
  3. Its price-to-sales ratio of 0.17 is the lowest among its competitors
  4. After the announcement of this quarter's results, its share price received an upsurge of 18%

DR Horton Inc

Like most of its peers, the following figures show a positive outlook for DHI's future:

  1. Number of net sales orders for 2Q2012 increased by 19% on a year-over-year basis
  2. The sales order backlogs in this quarter increased by 17% over the last year
  3. The order cancellation rate dropped to 22%

However, we believe that the current price is reflecting its upside potential. We have a neutral rating on the stock because of its premium valuations.

  1. Its PEG ratio of 4.26 is the highest among its peers and its long-term growth rate of 5% is the lowest in the industry
  2. Its price-to-book ratio of 1.75 is the highest amongst the lot

KB Homes

Unlike its peers, KBH's orders have declined by 8% from the previous year, and its cancellation rate has jumped to 36% from 29% on a year-to-year basis. Furthermore, the annual decline in cash and cash equivalents of almost 54% is a major concern regarding its liquidity. Its long-term debt-to-equity ratio of 403% makes it the most-leveraged homebuilder. We recommend investors to short sell the stock.

To reiterate, Warren Buffett's recent purchase of mortgage division of Residential Capital LLC indicates that like us, he too is bullish on homebuilders. It is a high time to invest in companies showing growth in sales orders, quarterly backlogs and where order cancellation has improved. We recommend long positions in LEN, TOL, and HOV. DHI should be avoided by the investors because of its high valuations. Due to weak operating performance of KBH, we are recommending a short position in the stock.

We recommend investors to read our previous article on homebuilders in order to get a more detailed view of current industry dynamics.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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