Sentiment on Homebuilding Stocks Turns Negative Suddenly

Homebuilding stocks have been crushed since the beginning of the year and especially over the past few weeks. The Lark Research Homebuilder Stock Price Index, (an equal-weighted price-only weekly index of the share prices of 12 publicly-traded homebuilders, rebalanced at the start of each year), is down 18.8% year-to-date (as of Feb. 5), much worse than the 8.0% decline in the S&P 500 and 13.2% drop in the Russell 2000.

Similarly, the Dow Jones U.S. Home Construction Index, a share price index of six builders, is down 16.6% year-to-date and ranks 87 out of 98 industry sectors in year-to-date performance.

The chart below highlights this relatively poor performance.

Lark Research Homebuilder Share Price Index

For the two-year period ended December 31, 2015, homebuilding stocks had been range-bound after a sharp recovery that began in early 2012. That earlier run-up had left homebuilding shares looking somewhat pricey, because it preceded the equally sharp recovery in their profitability. From 2013 on, homebuilding shares traded flat, while the profitability of their underlying businesses showed steady improvement. During this period, homebuilder P/E multiples declined steadily as earnings recovered rapidly. Forward earnings multiples on the homebuilders fell throughout most of 2015 and have plunged so far in 2016.

At current prices, based upon my calculations and adjustments to consensus earnings projections as published in Yahoo! Finance and Barron’s, this group of homebuilders is trading at about 12.5 times adjusted 2015 earnings (with three builders yet to report), 9.4 times projected 2016 earnings and 7.8 times projected 2017 earnings. By comparison, the S&P 500 is currently valued at 18.1 times estimated 2015 operating earnings, 15.7 times projected 2016 operating earnings and 13.5 times projected 2017 operating earnings. It is not unusual for homebuilding stocks to trade at a discount to the market, but the current discounts are large, even by historical standards.

Fundamentally, there is support for a downward revaluation of homebuilding stocks. The pace of gains in single-family housing starts and sales has decelerated over the past couple of years and especially in the second half of 2015.

Quarterly Single Family Housing Starts 2010-2015

Source: U.S. Commerce Dept., Bureau of the Census. Non-seasonally adjusted figures.

In 2011 and 2012, coming off the cyclical trough, single-family housing starts increased at an accelerating rate, so that by the end of 2012, year-over-year increases in quarterly starts approached 30%. Since that time, the pace of gains has decelerated, reaching a weather-related bottom of zero in the 2014 first quarter, but failing to show improvement much above 10% in 2015. In the 2015 fourth quarter, the year-over year gain in single-family starts dipped to 8.5%.

Quarterly New Home Sales 2010-2015

Source: U.S. Commerce Dept., Bureau of the Census. Non-seasonally adjusted figures.

A similar but not as pronounced pattern appears in the new home sales figures. Although quarterly sales peaked in the seasonally strong 2015 second quarter, they have decelerated since. The year-over-year gain in 2015 fourth quarter new home sales was only 6.7%, after averaging more than 20% in 2012 and the first half of 2013 and again, briefly, in the 2015 first quarter.

Concerns about the housing market have been amplified by broader trends in the U.S. economy. Although job growth has remained strong, weakness in key sectors of the economy, such as energy and exports (as a result of the decline in oil and natural gas prices and rise in the value of the dollar, respectively) has reduced the momentum of the economy, slowing its rate of growth.

In 2015, for example, single-family permit activity declined in Oklahoma for the second straight year and plunged by more than a third in North Dakota. In Texas, an important state for the large builders, growth in single-family permits declined from 10.1% in 2014 to 4.4% in 2015. Although Texas’s economy is more diverse, it too will increasingly feel the impact of a slowing energy sector, if oil and natural gas prices remain low.

Yet, the slowdown in the momentum of the housing market is not nearly as evident from the new order activity of the builders. For those builders who have reported so far (nine of the twelve), the average increase in order growth was around 15%, compared with 5% in 2014. Thus, the pace of orders accelerated in 2015. The 2014 slowdown in order growth figured prominently in the flat performance of builder share prices that year, but the market still expected that the pace of sales and deliveries would pick up in 2015 and beyond. Despite the favorable job numbers, slowing expectations for overall economic growth have weighed on builder shares in 2015 and early 2016, even though order activity was up in 2015.

The recent declines in builder share prices also reflect concerns about whether they can achieve consensus earnings estimates in 2016 and 2017. My calculations suggest that the average expected rate of earnings growth for the builders exceeds 30% in 2016 and 20% in 2017. Even if the builders are able to grow deliveries at the 15% pace indicated by net new orders, the builders would have to achieve a meaningful expansion in profit margins to meet those projections. This would almost certainly require continued mid- single digit gains in average sales prices.

Although house price increases, as measured by the major indices compiled by S&P/Case-Shiller, Corelogic and the FHFA all indicate continuing year-over-year gains of 5% or better, the average price of new home sales in the U.S. has decelerated over the past few years and was only 2.8% in 2015, according to the Commerce Dept.

Annual Avg New Home Sales Prices 1995-2015

Source: U.S. Commerce Dept., Bureau of the Census. Non-seasonally adjusted figures.

Many housing economists still complain about the lack of available sales inventory, which is helping to drive prices higher. However, higher prices serve to hold back first-time buyers, whose absence has been a key factor in the rather sluggish pace of the housing recovery. Although sales inventories are low, there are many vacant houses that are still being held off market.

Given reduced expectations for GDP growth, it is not unreasonable for investors to question whether homebuilders can meet current consensus earnings projections. Under the circumstances, earnings growth projections do seem aggressive. However, the magnitude of the stock price plunge suggests that the markets have probably overshot on the downside, expecting a more significant downward revision of consensus earnings estimates than is likely, given the current outlook for the U.S. economy.

For example, if earnings remain flat going forward (which would imply declines in forward estimates of 25% in 2016 and 38% in 2017 from current levels), the builder’s average P/E ratio of 12.5 would still be below the S&P 500’s forward operating earnings multiples of 15.7 times for 2015 and 13.5 times for 2016. Yet, the S&P 500 forward multiples assume annual earnings growth of 16%-17% in both 2016 and 2017. It is hard to imagine that earnings for the overall market would grow at that pace, if homebuilder earnings remain flat. (In other word, if earnings and P/E multiples remain flat, it is also likely that forward multiples for the broader market would rise from current levels.)

Unless there are sudden changes in the economic environment, it is also unlikely that builder earnings will decline in 2016 (and probably for 2017), given that net orders were up about 15% on average in 2015 and builders are starting 2016 with unit order backlogs up 23% on average.

There are concerns that some unforeseen event – such as one or more terrorist attacks – could change the economic picture suddenly for the worse. On the other hand, it is not hard to imagine positive developments – such as better economic news out of China, Europe or the emerging markets, actions by major oil producers to strike a better supply-demand balance and others – that could quell the negative investor sentiment. Under the circumstances, therefore, the sharp decline in homebuilder shares in recent weeks seems overdone and the risk-reward balance for the sector seems quite favorable, at least in the near-term.

If builder shares do recover, it is likely that the shares of smaller cap builders will see the greatest recoveries. Shares of Beazer Homes (BZH), Hovnanian (HOV), KB Home (KBH), M/I Homes (MHO) and Meritage Homes (MTH) are all trading between 5.5 and 8.5 times projected 2016 earnings. With the recent plunge in BZH, for example, (down 42% this year and 22% just last week), its stock now trades at 34% of book value and 70% of book value minus deferred tax assets.

To be sure, larger cap builders also have significant upside, but valuations for most of the smaller cap builders were lower before the recent slide, giving them greater upside potential if and when sentiment turns positive again.

February 7, 2016

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036
(908) 448-2246

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