US Homebuilder Stocks Losing Luster
The US housing market is slowing down, as evidenced by the sluggish growth in new home orders and rising inventory levels
Although homebuilders have so far maintained their revenue growth rates by charging more for the houses they sell, they may soon lose pricing power and struggle to maintain margins as costs rise. Coupled with analysts’ forecasts that the housing market may be slowing down, the prospects for the homebuilding industry seem to be getting bleaker and bleaker. Here is why we at Bidness Etc feel that it is time for investors to exit the homebuilding industry.
The homebuilders industry comprises companies like D.R. Horton (DHI), PulteGroup, Inc. (PHM) and Lennar Corporation (LEN). It generates roughly $34.5 billion in revenues annually, from which D.R. Horton, the market leader*, rakes in over 18%. The industry is highly cyclical, and the SPDR S&P Homebuilders ETF (XHB) has a high beta of 1.5.
The Homebuilders ETF has risen 146% since 2008 as the economy recovered, outperforming the S&P 500 index’s performance by 45 percentage points over the same period.
Changes in mortgage rates, housing affordability, issuance of building permits, and the housing market index directly impact the industry’s performance, which is tracked by data on housing starts, home inventories, new home orders, and order backlog levels.
*Using publicly-listed companies’ data only
Housing starts – a measure of how many new residential construction projects are ‘started’ during a particular timeframe – started rising in the fourth quarter of 2009 (4QCY09) after a consistent decline every quarter following the 2007 implosion of the housing bubble. They reached a peak year-over-year (YoY) growth rate of 42.1% in 1QCY13. However, growth in housing starts has since slowed to 3.4% by 3QCY13.
Housing starts data is correlated with the number of building permits issued within the comparable period. Authorities issued 14.4% more permits year-over-year during October 2013, compared to a lower increase of 5.8% for the entire third quarter of the year. But though the issuance of more building permits may encourage more housing starts during the last quarter of 2013, the change will likely not be very significant.
Rising Mortgage Rates
US mortgage rates, which bottomed out at 3.32% in December 2012, have since risen to 4.47%. Furthermore, the Fed has finally announced that it will begin tapering its bond-buying program starting January 2014. It will now spend $75 billion per month purchasing bonds, compared to the $85 billion it spent up till now. As the yields on 10-year bonds rise in response to the tapering, mortgage rates are expected to rise and reduce the affordability of new housing, which will depress demand.
Rising Home Inventories
Home inventories reflect the number of unsold homes in the market. New home inventories have grown at incremental rates this year, and were around 25% higher YoY in October.
Inventories of existing homes also started to increase during October 2013, after continuously falling since March 2011. The growing inventory of existing homes will adversely affect homebuilders, who supply new homes to the market, and affect their pricing power.
Fall in Growth of New Home Orders
Growth in new home orders dropped to 1.4% in the third quarter of 2013, having consistently declined from a growth rate of 34.1% in 4QCY12. Although homebuilders raised the prices of homes they sold to counter the impact, it was not able to offset the overall impact of lower unit sales.
In the future, the impact of slowing unit sales on homebuilders’ income statements will become more pronounced, as they cannot continue raising their prices as the inventories of new and existing homes grow and housing affordability declines.
Input Costs and Margins
At the same time, homebuilders’ input costs have continued to rise. Though, as mentioned earlier, industry players have propped up gross margins by increasing prices, their inability to keep increasing prices at the same rates in the future will eventually pressure their bottomlines.
Industry gross margins expanded to 20.9% in the third quarter, helped by a sharp increase in average order prices, which offset the higher input costs.
Valuation and Earnings Estimates
The S&P 500 Homebuilders Select Industry Index has an average forward price to earnings multiple of 14.5x, and is currently trading at a discount of 20% to the Consumer Discretionary Select Sector SPDR Fund (XLY), and a discount of 9% to the S&P 500 (SPX). It is valued cheaply compared to the two benchmarks despite, even though some analysts estimate 25% annual growth in homebuilders’ earnings over the next three years, largely because the industry is still mired in uncertainty.
The Bottom Line
Homebuilders stocks will lose much of their appeal if data points to a housing slowdown. Falling growth in home orders and rising input costs, which were previously offset by higher home prices, will eventually start showing on companies’ balance sheets. With inventories of new and existing homes rising and housing affordability declining, companies will lose much of their pricing power. That affect will also trickle down to their profitability margins, and we may see the industry returning to the red shortly.