For still more opinions about the pros and cons of homebuilders as value stocks, here's a column from Individual Investor Online where several analysts are interviewed:
Industry Analysis
Aug 17, 1999
Other: Why Homebuilders are Dirt Cheap
Bob Hirschfeld (8/17/99)
Wondering about the effect of rising mortgage rates on the homebuilder industry?
On August 12th, the 30-year fixed mortgage rate went over the 8% level for the first time in two years, reaching 8.17%, according to the Bank Rate Monitor, as compared to 6.75% at the beginning of February, and about 6.95% at the end of April.
Mortgage rates are rising in synch with bond market rates. Because 30-year mortgages typically last only 5 to 10 years -- as homeowners move or refinance -- the 10-year Treasury is a better proxy for mortgages than the 30-year. Of course, both 10- and 30-year Treasury rates have been rising in recent weeks, on fears that the Fed will raise rates when it meets August 24th.
Higher mortgage rates tend to dampen the housing sector by increasing monthly mortgage payments, which tends to scare away prospective homebuyers. However, higher rates generally take a while to impact housing sales, since the home-buying process typically takes 30 to 90 days.
Right now, the average consumer is still filled with a lot of 'so what?' when it comes to rates. Consumer confidence is still super-high. The National Association of Home Builders looks for 1999 housing starts to reach 1.62 million, a new record.
Mortgage rates have been climbing since mid-January and home buying has remained strong. As analyst John Stanley of Warburg Dillon Read points out, despite the 130 basis point rise in mortgage rates so far this year, in July new home orders rose 19% overall and about 10% on a per community basis.
And homebuilders are making good money, virtually across the board. For the second quarter, according to Stanley, the group turned in average earnings per share (EPS) gains of 50% over last year, and exceeded the consensus estimate by 25%.
Looking ahead, Stanley says he is looking for a 35% EPS increase for 1999, year-over-year. If you compare that to the S&P 500's approximate 10% EPS increase, you'll see one reason why many value investors have found the homebuilding sector so attractive.
Another reason why homebuilding stocks look great is that shares are trading at historically low multiples of 6 to 7 times 1999 estimates, while the S&P 500 still sports a mid-twenties multiple. And the potential upside is huge. As Stanley writes, during times when 'cyclical concerns have been in remission,' homebuilders trade at 10 to 15 times earnings.
However, here's a case in which the value argument has gone largely unheard on the Street. For example, an average of the four homebuilder stocks mentioned in this article is off 17% year-to-date.
Are rising interest rates a death knell for the homebuilders? Stanley thinks not. On August 11, the analyst wrote that he was 'cheering along' rising rates, in hopes that the Fed might engineer another soft landing, which, he believes, could set the stage for a 'dramatic expansion in multiples.'
Del Webb
Stanley said his favorite stock in the group is Del Webb (NYSE:WBB - news) , which is building a national network of retirement communities for baby boomers, a segment Stanley claims is recession-resistant. Stanley says the stock is very cheap at 6.8 times current 1999 earnings of $3.11 (which is up 37% from one year ago), and at 6 times the analyst's June-fiscal, year 2000 estimate of $3.50 per share. Stanley has a Strong Buy on shares and a $38 price target on shares. The stock closed Monday at $21.
Homebuilder analyst Bill Crow, at Raymond James, is less sanguine than Stanley about interest rates. On August 12, Crow told us that rising interest rates over the past thirty days were prompting a 'macro call,' and leading him to downgrade three homebuilders: Crossmann (NASDAQ:CROS - news) , Lennar (NYSE:LEN - news) and Pulte (NYSE:PHM - news) . All were dropped to Accumulate from earlier Buy ratings.
Crow said, 'we're already fighting negative sentiment,' adding, 'now that investors are questioning the duration of the economic expansion, we're facing a double whammy.' Crow noted that, 'we've reached historically high levels of home ownership,' which is another negative, in its implication that the market may be close to saturation. Crow conceded, though, that the fundamentals remain intact. In Crow's words: 'if you look at the numbers alone, there's no reason to be negative on the sector, given the companies' strong market shares and gross margins.'
Reiterating a theme he sounded in May, Crow said that most builders show strong backlogs, which provide a revenue cushion, noting in particular that, as of two weeks ago, Lennar's cancellation rate on ordered homes had not changed one bit.
Crow added that inventory levels continue to be low because the builders 'can't get in front of themselves,' given the still-very-strong demand visible in certain markets, like California, where it's not unheard of for prospective buyers to wait overnight to sign on new homes.
Crossman Communities
Crow's favorite builder, despite his recent downgrade, is Crossmann, a company he believes will do better than others in a rising rate environment, given its specialty of building lower-cost homes (Crossmann is the top builder of low-cost, single-family home in the Midwest and Southeast).
According to Crow, the rate-related mortgage payment differential on a mortgage for a $90,000 home is 'a lot less' than on one for $200,000. The company's average sales price is $117,000. In addition, the analyst likes the firm's rapid turnaround time. By turning inventory an average of six times per year, Crossmann delivers a return on equity (ROE) that is at or among the top of the industry. For the second quarter, it was 24%.
Crossmann's second quarter earnings of $0.75 per share were 63% higher than a year ago, and $0.09 ahead of consensus estimates. As Crow notes, the company's backlog augers a solid second half.
At $26, Crossmann trades at 7.7 times Crow's recently raised 1999 estimate of $3.39 and 6.4 times his year 2000 estimate of $4.07. The analyst rates Crossmann a Buy and writes that 'outstanding financial results and strong backlogs essentially assure that 1999 results will be impressive, with year-over-year EPS growth expectations of 32% for Crossmann.'
Bottom Line:
Homebuilders continue to be an extremely undervalued sector, which makes it hard to counsel selling shares. While higher interest rates are seen as a threat, higher rates, as Stanley points out, might serve to reduce the economy's excess steam, rather than turn the engine off. We recommend that investors stick with their picks in this sector, and perhaps add to their holdings by including shares of the two recession-insensitive companies mentioned here -- Dell Webb and Crossmann.
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