Too Early To Break Ground On A Homebuilding Recovery – Searching High and Low for Conviction
Homebuilding stocks have benefited from the “Trump bump,” but to a much smaller extent than the broader indices, indicating homebuilders remain out of favor despite a steadily improving housing market. Year-to-date, the S&P 1500 Homebuilding Sub-Industry Index is only up 0.9%, versus the 12.3% gain in the S&P 1500, and the sub-industry is still 6% below its late July peak.
Macro indicators of the housing market remain strong. New and existing home sales have been in a steady up-trend for several years with new home sales in October showing close to 18% growth year-over-year. October housing starts rose to the best level since August 2007. The Case-Shiller home price index has generally risen since March 2012, and is up 43% since then. The Housing Market index, a survey of homebuilder sentiment, was 63 in November, well above the neutral level of 50 and near 2015 highs. Consumer confidence reached its highest level since 2007 in November, and has historically been a tailwind for the housing industry.
That paints a pretty picture, so why is there a seeming disconnect between housing market indicators and homebuilding stocks?
It’s easiest to point a finger at rising interest rates or the expectation for interest rates to rise in the future as the reason for weakness year-to-date. The Federal Reserve Board was initially expected to raise rates four times in 2016, which weighed on the sub-industry throughout the year, despite short-term interest rates remaining unchanged. The market is pricing in a 25 basis-point increase from the Fed to be announced today. Since the election, the national average rate on a 30-year fixed mortgage suddenly rose to 4.13%, from 3.54% on November 3rd according to data from Freddie Mac. Rates haven’t been that high since 2014, though mortgage rates are still below historic standards (averaged 8.4% between 1972 and 2015). Understandably, the sharp increase in rates since the election is a concern, especially if wage growth doesn’t follow suit. Regardless, the recent move doesn’t account for the year-to-date performance of the homebuilders.
A closer look at industry specific data provides a more telling story. Two key metrics investors keep a close eye on, and oftentimes drive the sub-industry’s stocks, are backlog and gross margins. We entered 2016 with homebuilders anticipating gross margin expansion in the wake of less speculative housing inventory and easier comparisons versus 2015, which was hurt by labor shortages. Backlog on the other hand was expected to slow from peak levels reached in 2015, but still remain strong. Backlog is the foundation for future revenue and profit growth, so it is crucial to see not only growth but also conversion in this area.
Gross margins steadily improved from a mid-single digits rate in the early years of the recovery, to a peak of 21.90% in the fourth quarter of 2014. This drove higher profits, resulting in strong results and stock appreciation during this period. Small changes in the gross margin lead to large changes in bottom-line results. In 2015, the quarterly average gross margin contracted by 30 basis points from the peak. Thus far in 2016, another 30 of contraction has been experienced with the year-to-date quarterly average margin now 21.3%. While that is still well ahead of the post recession average of 18.8%, further contraction is expected in the fourth quarter. As seen in Chart 1, margins peaked in 2014 and the S&P 1500 Homebuilder Sub-Industry Index followed, as its performance lags by about a quarter. Since then, the index is down 6%.
Land costs and availability, along with labor shortages and increased construction costs have put pressure on gross margins for many homebuilders. In the most popular areas (where employment growth is strongest), land prices are bid up as the housing recovery ages. Labor availability has been impacted by minimum wage laws and higher regulation, in addition to fewer individuals willing to participate in the trade. Not all homebuilders are impacted in the same way from the aforementioned inputs. Much of the pressure can be attributed to regional differences (also known as a shift in mix) – location, location, location.
On the bright side, pricing power has been a benefit over several quarters as inventories and interest rates remain low. D.R. Horton and Toll Brothers have maintained or increased their gross margin rates in the last several quarters as pricing power has been a key component in their success. Several companies mentioned their ability to increase average selling prices in their most recent quarters, though not all have been able to offset costs. Lennar and PulteGroup are prepared for lower margins as lower cost land purchased years ago is now running off their pipelines.
Backlog ended Q4 2015 on strong footing, with the largest builders averaging growth of 24.1% in backlog dollars. Investors anticipated a bit of a decline in that rate for 2016 as the group was going up against the outsized growth rates of 2015 (in the low-to mid-twenty percent range). The drop-off has been larger than thought. In the matter of three quarters, backlog growth decelerated from 23.5% to 12.3%. A move that sharp makes it hard for investors to reward the stocks.
Reduced backlog growth, gross margins falling from peak levels, increased input costs, rising interest rates and cycle high home prices have investors worried that the homebuilders are in the final innings of an economic cycle. The sentiment is clear in the forward price-to-earnings (P/E) multiple of 11.4x, which is a significant discount to the 14.8x averaged since the start of 2013. Heading into the election, the group traded at about 10.5x earnings. The only time the group has seen that low of a multiple (since the recession) was at the start of 2016 when the market was hit with weak economic data and global stock market gyrations that suggested a major slowdown could be imminent.
What we are having a hard time reconciling is that even if the housing recovery is slowing, it doesn’t seem that it will grind it to an absolute halt. The market feels as though it is prepared to price in this scenario. Household formation has lagged since the housing boom, but the U.S. Census Bureau projections suggest that household formations will average about 1.5 million per year through 2020, which is well ahead of the 900,000 annual average in the last 5 years. Trends to move to suburbs are once again improving, and millennials are getting older. They are expected to finally begin to form families as they feel more comfortable with their jobs prospects, a trend that will benefit the housing market.
To be sure, for those millennials to buy homes, the job market and wages will need to improve and overall economic activity will need to sustain an increased pace of growth. Interest rate increases and inflation will have to rise slow and steady. That adds up to a lot of uncertainty and combined with margin pressures explains the underperformance of the homebuilders as a group.
Despite that, we think that as long