Buy Homebuilders Now: Growth In The Sales Orders And Contract Backlogs Is Strong Enough

Executive Summary

The record-low mortgage rates, decline in the number of months' supply, and an increase in existing and new homes' sales have enabled the industry to pick some momentum. Furthermore, the recent increase in sales orders and contract backlogs, along with a reduction in order cancellation rates, is going to benefit certain homebuilders. In this scenario, our advice is to take long positions in Lennar Corp. (LEN), Toll Brothers (TOL) and Hovnanian Enterprises (HOV) as these stocks are most exposed to a housing recovery. We are neutral on DR Horton (DHI) because its premium valuation is already reflecting the growth potential. On the other hand, KB Home (KBH) is way behind its competitors in terms of financial performance and we recommend a short position in the stock.

Industry overview

The housing industry has been in a severe downturn since the financial crisis of 2007-8. Many investors are still doubtful on industry future.

Bearish Factors:

• The continuous decline in U.S. home prices is putting pressure on homebuilders revenues and margins.
• Slow job market recovery has hampered housing demand.

Bullish Factors:

• Mortgage rates have plummeted to record lows . Low mortgage rates should help create an incremental demand for new homes. However, banks are less willing to lend causing housing demand to remains low. However, for those borrowers who qualify, home-buying and refinancing are more attractive options now. Below is a chart of mortgage rates in the U.S.

(Click to enlarge)

• The Mortgage Banking Associations' (MBA) Purchase Application Index is a leading indicator for single-family home sales and housing construction. It has started to improve recently.
• The supply situation in the housing market has started to reverse. Supply has decline from 12 months in 2012 to 6.5 months now.

(Click to enlarge)

• Credit Suisse is expecting the momentum in homebuyer traffic index to improve in coming quarters.
• U.S. homebuilders are exposed to single-family new home sales; the graph below shows single family new home sales bottoming out. The existing home sales are also on the rise which implies that consumer confidence to purchase homes is improving.

U.S. New Single-Family Home Sales US Existing Home Sales
(Click to enlarge)

• The contract backlogs and new orders reported by listed homebuilders has started to rise in addition to lower cancellation rates.

Comp Sheet

	KBH	DHI	LEN	HOV	TOL	Industry
P/E ratio (TTM)	N/A	36.17	59.14	N/A	59.5	16.36
PEG Ratio (TTM, 5 years expected)	-0.95	4.26	0.94	-	2.45	0.58
P/S ratio	0.37	1.16	1.37	0.17	2.73	0.7
P/B (MRQ)	1.28	1.75	1.76	-	1.58	1.59
LT Growth Rate (5 years)	7.67%	5.00%	30.35%	11.67%	15.44%	14.03%
LT D/E (MRQ)	403.03%	64.99%	130.23%	-	73.93%	-
Dividend Yield (annual)	1.40%	1%	0.60%	-	-	2.52%
Beta	1.75	1.08	1.72	3.01	1.05	1.05
Stock price Performance (past 3 months)	-42.58%	-3.76%	-0.90%	-29.47%	3.50%	-

Lennar Corp

Lennar Corp.'s ability to maintain a sustainable competitive advantage, future growth opportunities, recent credit-facility agreement and an additional accretion from its Rialto segment makes us recommend a long position in the stock.

According to management, LEN is able to maintain a sustainable competitive advantage because of:

• A strong balance sheet position, especially its liquidity position
• The Relatively high gross margins
• Access to distressed real estate assets though its Rialto segment
• The cost leadership obtained through its national purchasing programs
• A customer-friendly marketing program - Everything Included

LEN primarily sells single-family homes. It has recently experienced a decade-high quarterly backlog growth of 39%. It is expected that this will translate into greater operating margins and profitability in the future. LEN's number of new orders has increased by 33% on a year-over-year basis, and its order cancellation rate has also remained low, at 18% for this quarter. Recently, it has entered into a $525 million revolving credit facility arrangement for 3 years which will reduce the company's borrowing costs and increase its liquidity. It will also help them to meet current working capital requirements and achieve growth targets.

Lennar's price-to-book ratio of 1.76 is the highest amongst its competitors. However, its lucrative long-term growth rate of 30.35% and last 3 months of price outperformance makes it a company worth investing in.

Almost a week ago, Lennar's share price fell by 8.3% when U.S. Labor Department reported that the unemployment rate grew from 8.1% to 8.2%. However, the share prices of some of its peers saw even a larger decline with DHI's stock falling by 8.4% and PHM's by 11.8%.

Recently, Lennar's stock was up more than its competitors after ISM Services Index beat economists' expectations.

Toll Brothers

Toll Brothers competitive advantage stems from the fact that it is the only publicly-traded luxury homebuilder. Management believes that its diversified product line, brand name, strong balance sheet and access to capital differentiates TOL from its competitors. In addition, increase in number of new orders, quarterly backlog growth, and a modest leverage position makes us recommend a long position in the stock.

TOL's recent quarter (2Q2012 - Feb-Apr) results are very impressive. Number of deliveries increased by 14%, and the number of new orders showed a massive increase of 47% on a year-over-year basis. TOL's quarterly backlog was 37% higher on a YOY basis. It has lucrative growth prospects as evident from its relatively high long-term growth rate of 15.4%. Its price-to-book ratio of 1.6 is almost equal to the industry average. Amongst its peers, it's the only stock that has exhibited price appreciation of 3.5% over the past three months. Its debt-to-equity ratio of 75% makes it one of the least leveraged firms in the industry.

Toll Brothers uses a unique risk reduction strategy for purchasing lands for future developments. It uses options (or "land purchase contracts"). In addition, Toll is exposed to luxury buyers who have better credit records. Hence, tightening in lending standards has impacted its business less than the industry.

Hovnanian Enterprises Inc

Before this quarter's results, HOV's high beta of 3, incremental losses as well as concerns about its liquidity position caused investors to stay away from the stock. Analysts didn't favor the stock too. However, better than expected results for this quarter can be a gateway for taking a long position in HOV.

Hovnanian Enterprises posted quarterly profit for the first time in the past two years. Its home deliveries grew by 25%, and the contract backlog rose by 49%. Contract cancellation rate in this quarter decreased to 17% from 20% a year ago. Consequently, there was a 34% YOY increase in the total revenue and a 260 bps improvement in gross margins. Its quarterly EPS of 2 cents was able to beat the market expectations of a 32 cents loss. Its price-to-sales ratio of 0.17 is the lowest among its competitors. After the announcement of this quarter's results, its share price received an upsurge of 18% to $2.01.

DR Horton Inc

DR Horton, like most of its peers, has shown better margins this quarter due to an increase in order growth, reduction in order cancellation rates and an increase in sales order backlogs. We have neutral rating on the stock because of its expensive valuations and low long-term earnings' growth rate.

DHI has been able to maintain a strong balance sheet and high gross margins. Number of net sales orders for 2Q2012 increased by 19% on a year-over-year basis as the order cancellation rate dropped to 22%. Furthermore, its sales order backlogs increased by 17%.

Nevertheless, its PEG ratio of 4.26 is the highest among its peers. Furthermore, its price-to-book ratio of 1.75 is the highest amongst the lot. This shows that the current price is already reflecting the expected upturn in the U.S. homebuilders.

KB Homes

KB Homes stock price has dropped by 42.6% in the past three months, due to the reduction in new orders, increase in order-cancellation rates and investor's growing concerns regarding its liquidity position. In addition, management blames consistently high level of residential and commercial mortgage loan foreclosures, tighter lending standards and uncertainties in all types of lending markets as few of the reasons for its below-par performance.

KB Homes, like its peers, has suffered heavily after the subprime mortgage crisis of 2007-8. This is due to the persistently low demand, higher inventory of unsold homes and price-cutting techniques adopted by other market players.

Its annual losses have increased by 158% in 2011. However, there has been some improvement recently as KBH's loss of 59c in 1Q2012 is lower than that of $1.49 per share in 1Q2011.

KBH's orders have declined by 8% from the previous year. Though its gross orders have increased, their cancellation rate has jumped to 36% from 29% on a year-to-year basis. Furthermore, investors are highly concerned over the liquidity position of KB Homes. In this regard, the annual decline in cash and cash equivalents of almost 54% is a major concern. Its long-term debt-to-equity ratio of 403% makes it the most-leveraged homebuilder.

We think KBH's inability to show growth in new orders and backlog will result in investors punishing the stock further. We recommend to short sell KBH's shares.

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