Building the Case for Housing Stocks

Unabated homebuilding activity boosts profitability for companies that supply goods and services to the real estate market – these stocks could benefit

Vikram Barhat 19 August, 2020 | 12:38AM
Facebook Twitter LinkedIn

House Builders

Despite the unprecedented, pandemic-led blow to the economy, real estate markets in both the U.S. and Canada continue to show resilience. In Canada, home construction roared back with 245,604 units in July, nearly 16% jump from 212,095 units in June, in a stark contrast to steep declines and sluggish recovery in other area of the economy. In a similar trend south of the border, the U.S. housing starts, a key measure of U.S. homebuilding, rose more than 17% in June compared with May.

Although well below its pre-pandemic high, the trend still represents a strong turnaround in construction activity. A conspiracy of factors including favourable demographics, demand growth, ultra-low borrowing rates and softer stress test requirements have created a growth tailwind for the housing sector, helping it spring back stronger than anticipated.

Increased homebuilding activity boosts profitability for companies that supply goods and services to the real estate market. These companies stand to benefit from demand growth that underpins the continued momentum in homebuilding both in the U.S. and Canada, according to Morningstar equity research.

Norbord Inc.
  Ticker OSB
  Current yield: 2.73%
  Forward P/E: 11.01
  Price $39.74
  Fair value: $44
  Value 33% premium
  Moat None
  Moat Trend Stable
  Star rating **
Data as of Aug. 14, 2020

Canadian lumber giant, Norbord is the largest global producer of oriented strand board (OSB), with majority of its mills located throughout the U.S. and additional capacity in Northern Europe.

“After seven lean years for residential construction, we expect favourable demographics, a tighter labour market, and looser mortgage availability to spur a mild improvement in homebuilding activity over the coming decade,” says a Morningstar equity report, published before the coronavirus outbreak.

In his August note, Morningstar equity analyst Charles Gross points to Norbord's strong second-quarter performance, which was supported by better-than-expected homebuilding activity. “Sales fell nearly 6% because of production cuts, but adjusted EBITDA more than doubled to US$84 million in the quarter,” he says, noting elevated OSB prices have prompted him to materially raise the 2020 profit outlook.

He recently raised the stock’s fair value from $30 to $33, prompted by strong performance. He cautions, however, at the current market price the stock is overvalued, but forecasts North American OSB prices will gradually rise over the coming decade as homebuilding gains momentum.

Lennar Corp
  Ticker LEN
  Current yield: .67%
  Forward P/E: 11.74
  Price US$74.25
  Fair value: US$79
  Value 12% discount
  Moat None
  Moat Trend Stable
  Star rating ***
Data as of Aug. 14, 2020

The largest U.S. homebuilder, Lennar (LEN) operates the eponymous brand that targets first-time, move-up, and active adult homebuyers. The firm’s financial-services segment provides mortgage financing and related services to homebuyers.

The company’s strong second-quarter performance shows it’s shaken off the COVID19-induced weakness prompted by large-scale economic shutdown. With buyers returning to the market and restrictions easing, “Lennar's orders increased 7% year over year in May, and through the first two weeks of June, orders were up 20% compared with the same period last year,” says a Morningstar equity report, noting that “the company is seeing an influx of buyers looking to move out of densely populated urban areas, while other buyers feel safer buying a new home rather than an existing home.”

Historically low mortgage rates, ownership affordability, and an unprecedented spike in the personal savings rate indicate that “more households may have a large enough nest egg for a down payment,” adds the report. “We expect first-time buyers will be a key driver of future housing demand, and Lennar is well positioned to capture these potential buyers as this market segment represents 40% of Lennar's homebuilding business,” says Morningstar sector director, Brian Bernard, who recently raised the stock’s fair value by about 5% to US$79.

Toll Brothers Inc
  Ticker TOL
  Current yield: 1.11%
  Forward P/E: 11.67
  Price US$39.74
  Fair value: US$44
  Value Fairly valued
  Moat None
  Moat Trend Stable
  Star rating ***
Data as of Aug. 14, 2020

Leading luxury homebuilder in the U.S., Toll Brothers (TOL) operates in 50 markets across 23 states and caters to move-up, active-adult, and second-homebuyers. While traditional homebuilding operations represents approximately 95% of the company’s revenue, it also builds luxury for-sale and for-rent properties.

Toll Brothers owns some of the best land in the industry, which “combined with luxurious, customizable designs, allows the company to charge industry-leading average selling prices,” says a Morningstar equity report, adding that while the pandemic had put the skids on the housing recovery, the longer-term forecast of healthy housing starts has remained intact.

For-sale and for-rent urban projects help the builder diversify revenue and leverage existing assets. “The company has a robust project pipeline that will continue to contribute profitable growth in a healthy market,” says Bernard, who pegs the stock’s fair value at US$44. He cautions, though, revenue could decline in near-term “because it can take Toll nine-12 months to build a home” and “periods of weaker orders [this year] will translate into lower home deliveries in 2020-2021.”

West Fraser Timber Co. Ltd.
  Ticker WFT
  Current yield: 1.16%
  Forward P/E: 15.67
  Price $69.09
  Fair value: $42
  Value 65% premium
  Moat None
  Moat Trend Stable
  Star rating *
Data as of Aug. 14, 2020

One of the largest softwood lumber producers in the world, West Fraser Timber (WFT) also produces wood panels and pulp products. The company operates throughout North America, with lumber mills in both the U.S. (37% of total production) and Canada (63% of total production). The Canadian lumber behemoth exports significant volume to China, which accounted for 12% of total sales in 2018.

The company’s second-quarter performance was impressive, as rising lumber and panel prices more than offset relatively low volumes. While consolidated sales fell to $1.28 billion, down 3% from last year, adjusted EBITDA skyrocketed to $142 million from negative $28 million. “Lumber segment performance was excellent, thanks to a mild decline in log costs and a significant uptick in prevailing prices,” says a Morningstar equity report, pointing out the jump in segment EBITDA margins to 16% from 4% last year.

Lumber prices, the report adds, will soften as the year goes on and supply constraints will ease up due to strong rebound in U.S. homebuilding activity. “Despite our bullish U.S. housing forecast, investors should expect benchmark lumber and panel prices to retreat from current levels in the long run,” cautions Gross, who puts the stock’s fair value at $42.

Do You Want To Take Control Of Your Finances?

Find out all you need to know here

Facebook Twitter LinkedIn

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Lennar Corp Class A151.57 USD0.92Rating
Toll Brothers Inc113.81 USD1.43Rating
West Fraser Timber Co.Ltd107.41 CAD0.93Rating

About Author

Vikram Barhat

Vikram Barhat  A Toronto-based financial writer specializing in investing, stock markets, personal finance and other areas of the financial services industry, Vikram also writes for CNBC, BBC, The Globe and Mail, and Toronto Star.

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy       Disclosures        Accessibility