Distressed homebuilder stocks are on sale

These companies boast strong growth prospects and represent attractive value opportunities.

Vikram Barhat 31 October, 2018 | 5:00PM

Barely a month after showing signs of a rebound, U.S. homebuilding has come under pressure as the September data points to a sharp pullback. Natural disasters like Hurricane Florence coupled with rising interest rates and higher home prices are making homeownership a wishful dream for many prospective homebuyers south of the border.

Despite evidence of the current weakness, however, longer-term macroeconomic indicators -- including job growth, rising income, a strong economy and favourable demographics -- remain supportive of the U.S. housing market. In fact, Morningstar forecasts U.S. housing starts to peak at 1.6 million in 2022, from 1.2 million at present, as pent-up demand is unlocked. Morningstar equity analyst Brian Bernard remains bullish on "several more years of solid residential construction ahead, driven by the large and aging millennial population, continued job and wage growth and an increased supply of entry-level homes.

For now, though, the Dow Jones U.S. Select Home Construction Total Return Index has fallen nearly 30% for the year to date compared to nearly 5% gains for the S&P 500, as of Oct 24. Given the current levels of market softness, this may be a good time to comb the sector for good bargains.

The following undervalued residential construction companies that boast strong growth prospects represent attractive value opportunities. These homebuilders are well positioned to benefit as the U.S. housing market continues to recover from the 2009 bottom and are trading at a significant discount to their fair value, according to Morningstar equity research.

Toll Brothers Inc.
Ticker: TOL
Current yield: 1.31%
Forward P/E: 6.3
Price: US$31.01
Fair value: US$48
Value: 35.4% discount
Data as of Oct. 29, 2018

A leading U.S. luxury homebuilder,  Toll Brothers (TOL) operates in 50 markets across 22 states and caters to homebuyers looking to move to a larger home (known as "move-up"), active adults and those buying a second home. While traditional homebuilding operations represent approximately 93% of the revenue, the company also builds luxury for-sale and for-rent properties in urban centres.

The company owns some of the best land in the industry and boasts luxurious, customizable designs, which allows it to command industry-leading selling prices, says a Morningstar report.

A combination of factors creates a tailwind for Toll Brothers that is driving increased demand for its traditional offerings. "Strong demand for entry-level homes should encourage established homeowners to sell their first homes in favour of new move-up homes," says the report, which lists "increased popularity of empty-nester homes and active-adult communities among baby boomers" and growing household wealth in younger households as other key factors that will drive Toll Brothers' revenue.

As the most recognizable brand name in the industry, the firm is well positioned to capitalize on an improving housing market. Bernard expects the homebuilder to "generate strong earnings growth over at least the next five years." He cautions, however, that given its luxury focus and high price tag, Toll may not be able to harness demand from first-time millennial buyers relative to its lower-priced peers.

The company has also been investing in for-sale urban high-rise infill and for-rent projects that help diversify revenue and leverage existing assets. "Although these projects are riskier, the firm mitigates some of this added risk by careful underwriting and joint venture partnerships," says Bernard, who appraises the stock's worth to be US$48 and projects revenue to grow 11% annually through 2022, boosted by "a robust project pipeline that will continue to contribute profitable growth."

PulteGroup Inc.
Ticker: PHM
Current yield: 1.50%
Forward P/E: 6.6
Price: US$23.63
Fair value: US$32
Value: 26.2% discount
Data as of Oct. 29, 2018

One of the largest homebuilders in the U.S.,  PulteGroup (PHM) mainly builds single-family detached homes (88% of unit sales) and offers products to entry-level, move-up and active-adult buyers. The firm operates across 25 states and also offers financial services.

The company operates three main brands -- Centex, Pulte Homes and Del Webb -- each targeting a distinct segment of the homebuyer market. Centex caters to the price-conscious entry-level buyer, Pulte Homes pursues move-up buyers, and Del Webb targets active adults. "First-time buyers and revitalized move-up activity will stimulate future housing demand, and PulteGroup is well positioned to capture these potential buyers with its Centex and Pulte Homes brands," says a Morningstar report, adding that Del Webb benefits from the aging baby boomer cohort.

PHM is seeking growth by expanding to new markets as it follows the burgeoning segment of first-time homebuyers. "Increased new-home demand, coupled with the company's renewed focus on returns, should drive strong revenue and earnings growth through at least fiscal 2022 and allow the company to achieve returns in excess of its cost of capital," says Bernard, who pegs the stock's fair value at US$32.

The firm, though, is not immune from the impact of market cyclicality and capital-intensive nature of the industry. CEO Ryan Marshall recently noted that attracting buyers has become more challenging in the environment of high home prices and rising mortgage rates. Overall, he maintains a positive outlook for housing based on high buyer interest, low unemployment, wage growth and low inventory of existing homes.

PulteGroup recently reported strong third-quarter results including a 25% year-over-year jump in homebuilding revenue, a 190-basis-point operating margin expansion and 74% rise in earnings per share.

NVR Inc.
Ticker: NVR
Current yield: -
Forward P/E: 10.6
Price: US$2,206.20
Fair value: US$2,390
Value: 7.7% discount
Data as of Oct. 29, 2018

Another U.S. homebuilding behemoth,  NVR Inc. (NVR) operates in 31 metropolitan areas across 14 states. The company builds single-family detached homes, town homes and condominium buildings under the Ryan Homes, NVHomes and Heartland Homes brands. The firm also manages a mortgage banking segment and building products operations.

NVR pursues a land-light strategy whereby it avoids direct land development activity and speculative homebuilding, which is unique among public homebuilders and drives outsize return. The strategy results in "relatively low inventory levels on the balance sheet, more consistent profitability and cash flows and higher returns as compared with other public homebuilders," says a Morningstar equity report, pointing out that NVR is the only public homebuilder that reported both positive earnings and positive operating cash flows each year between 2006 and 2011 when the housing downturn crushed homebuilders.

Instead of purchasing and developing raw land, the company extensively uses purchase agreements to acquire presold finished lots. The approach helps achieve capital efficiency and differentiates the company from other homebuilders. Bernard, who puts the stock's fair value at US$2,390, says the company is well positioned to capitalize on an improving housing market. "NVR's Ryan Homes and NVHomes brands stand to benefit from increased first-time and move-up new home purchases," he says, noting that the company's commitment to a capital-efficient homebuilding will "continue to generate industry-leading ROICs as the housing recovery strengthens."

Bernard forecasts NVR's home sales gross profit margin to stay around 19.3% over the next decade, and consolidated revenue to grow 9% annually through 2022.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
NVR Inc3,892.89 USD3.00
PulteGroup Inc38.30 USD0.16
Toll Brothers Inc40.59 USD-0.02

About Author

Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.