Image Source: Montgomery County Planning Commission
Homebuilding stocks have experienced volatility following recent earnings reports from major companies in the industry. The economic backdrop for the group has translated into robust top-line growth, but cost increases have called into question the group’s ability to turn that growth into bottom-line gains, at least for some operators.
By Kris Rosemann
A strong job market with low levels of unemployment and rising wages are providing tailwinds to homebuilders as the US housing market recovery marches on, and rising home prices are offering additional equity for buyers to spend on new move-up homes, too. Supply remains relatively constrained while home ownership and new household formation continue to rise. For example, PulteGroup (PHM) notes that it is seeing home supply at about half of the six-month mark that it considers to be a healthy level in the markets it serves.
Toll Brothers Hit By Rising Costs
Mortgage rates have risen of late, and are expected to continue doing so, but homebuilders have yet to notice a negative impact from the higher borrowing costs, which remain very low when taking a longer-term perspective. Despite the healthy backdrop and robust top-line growth, Toll Brothers’ (TOL) weak bottom line results in its fiscal second quarter, released May 22, highlighted a key concern for homebuilders as the group battles rising ‘stick-and-brick’ and labor costs, neither of which are expected to recede in the near term.
Toll Brothers drove revenue growth of 17% on a year-over-year basis in its fiscal second quarter (ended April 30) to a record $1.6 billion for the quarter, and net signed contract value set a quarterly record as it rose 18% from the year-ago period to $2.38 billion. However, delayed higher-margin closings in certain markets and growing labor and material costs weighed on its margin performance as its adjusted gross margin contracted nearly two percentage points from the comparable period of fiscal 2017 to 22.5%, and its operating income margin fell to 8.4% from 10.1%. Net income per diluted share fell to $0.72 in the quarter from $0.73 in the year-ago period. Though concerns regarding its bottom-line performance persist, Toll Brothers tightened and raised the midpoint of its deliveries guidance range for fiscal 2018, which now sits at 8,000-8,500 compared to previous guidance of 7,800-8,600.
DR Horton and PulteGroup Fare Better
DR Horton (DHI) reported similarly-strong top-line performance in its fiscal second quarter (ended March 31, results released April 26) as its net sales orders advanced 13% and revenue grew 16% on a year-over-year basis. However, the company was able to expand net income 53% from the year-ago period to $351 million as its gross margin and pre-tax profit margin expanded 1 percentage point and 80 basis points, respectively. Management attributes the margin growth to lower interest, litigation, and warranty costs in addition to controlled construction cost increases, reduced incentives, and higher prices. The strong quarter gave DR Horton the confidence to raise its fiscal 2018 pre-tax profit margin guidance to 12.1%-12.3% from 11.8%-12.0%.
Continuing with the trend of strong top-line performance, PulteGroup reported 21% year-over-year growth in home sale revenue in its first-quarter 2018 report, results released April 24, and its value of new orders advanced 18% from the year-ago period. The company more-than-doubled its bottom line in the quarter as earnings per share came in at $0.59 compared to $0.28 in the first quarter of 2017. PulteGroup’s operating margin expanded an impressive 270 basis points on a year-over-year basis in the first quarter, which management attributes to its strategic pricing methodology driving enhanced profitability. The aforementioned supply constraint is certainly exacerbating the effect of the pricing lever, and the company expects to continue to be able to offset sustained high levels of lumber costs.
The strong backdrop should continue to provide homebuilders with plenty of top-line expansion opportunities for the foreseeable future, but labor and construction costs are rising. Strong execution from the likes of DR Horton and PulteGroup provided optimism surrounding these dynamic factors, but Toll Brothers’ shortfall in its fiscal second quarter is a prime example of what may be a more realistic outlook from some homebuilders.
Conclusion
Investors looking for diversified exposure to equities in the US housing market may consider the iShares US Home Construction ETF (ITB), which has ~65% exposure to home building via high weightings in DR Horton, Lennar (LEN), NVR (NVR), PulteGroup, and Toll Brothers, or the SPDR S&P Homebuilders ETF (XHB), which has ~33% exposure to homebuilders and ~32% exposure to building products. The XHB provides a higher level of diversification, despite having fewer holdings, as it pursues the tracking of a modified equal weighted index and includes Lowe’s (LOW) and Home Depot (HD) as its top tow holdings as well as Williams-Sonoma (WSM), Whirlpool (WHR), and Johnson Controls (JCI) in its top ten holdings.
We expect the healthy fundamentals driving top-line performance for homebuilders to be felt in adjacent markets as well, with the home improvement market being particularly noteworthy. Retailers such as Home Depot and Lowe’s have been experiencing a strong fundamental backdrop for some time now, and the ongoing price appreciation and increasing home equity levels, not to mention other indicators of a healthy economy, bode well for spending levels on home improvement projects. Temporary weakness in Home Depot’s first quarter report is of little concern, in our opinion, as weather-related issues do little to impact the long-term outlook for the company, “Home Depot’s First-Quarter A Little Light; Long-term Still Bright.”
That said, the homebuilding group is not one of particular interest for income investors, in our view, given the relatively low yields found within the space, and for good reason. The capital-intensive nature of the industry makes free cash flow generation difficult and often leads to a bloated balance sheet. The cyclical nature of the industry only gives investors another reason for pause when considering depending on a homebuilder for income generation. We’re not crazy about the industry, but we do note the relatively healthy backdrop.
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.