The housing momentum seen in 2012 and in the first half of 2013 has slowed down a bit in the past 3-4 months due to the recent spike in mortgage rates, rising home prices, tight credit availability and the political uncertainty in Washington. While interest rates are rising, they are still below historical levels and housing is still affordable. In addition, accelerating job growth and increasing consumer confidence are also boosting demand for new homes.

Supply, however, is constrained by low home inventories, both of new single-family and multi-family homes. A shortage of land and labor is restricting the construction of homes, both single and multifamily. Home prices have thus started to move up with market demand gaining momentum and supply remaining limited.

Rising home prices and the spike in interest/mortgage rates since May this year slowed down the pace of orders and traffic. Buyers were taken unawares by the sudden increase in rates and a few put off their purchase decision, thereby increasing cancellation rates and lowering orders for most homebuilders in the last reported quarter.

Orders declined around 17% at PulteGroup, Inc. (PHM), 2% at D.R. Horton, Inc. (DHI) and around 9% at Hovnanian Enterprises, Inc. (HOV). Though order trends improved year over year for others like Lennar Corporation (LEN) and Toll Brothers, Inc. (TOL), they slowed down from the past quarter.

However, most homebuilders believe that this is only a temporary factor and are confident of demand picking up in the forthcoming quarters. These builders expect buyers to adjust to rising prices and interest rates and return to the market. Also, Federal Reserve’s promise to keep interest rates low for some time despite tapering its $85 billion stimulus plan by $10 billion from Jan 2014 removes a major overhang for the homebuilders.

A slew of housing data released lately clearly shows that the housing recovery is still very much intact. Data released by the U.S. Department of Housing and Urban Development and the U.S. Census Bureau showed that sales of newly built, single-family homes rose 25.4% in October. Another data release by the department showed that November housing starts surged to their highest in nearly six years.

The National Association of Home Builders (NAHB)/Wells Fargo Housing Market Index (HMI), known as the homebuilder sentiment index, jumped 4 points to 58 in December from 54 in July. This was the seventh consecutive monthly increase in the index showing that the recent interest rate hikes have not dampened the housing recovery completely.

OPPORTUNITIES

Land as Native Strength

Homebuilders like Lennar and Toll Brothers who boast of a solid land position have been able to better capitalize the rising demand for homes during the upturn. This gives these companies a competitive edge over peers like Pulte which are facing land availability constraints.

During the downturn, Lennar strategically focused on acquiring new home sites in well-positioned markets. The company thus has enough land now to satisfy deliveries through 2014 and is now pursuing land opportunities for 2015 and beyond.

However, others like Pulte have intentionally slowed down the sales pace across some of their communities (thus lowering the community count) due to a lack of land development and scarcity of finished lots. Housing inventory, both existing and new homes, remains tight in most markets. Instead, Pulte is focusing more on driving price and margin in most communities. This strategy has hurt net order growth significantly year to date, with orders declining 12% in the second and almost 17% in the third.

California-based homebuilder KB Home (KBH) is also emphasizing more on price and margin improvement to optimize returns from its land assets and slowing down its sales pace leading to lower order growth. Though the price optimization initiatives of Pulte and KB Home have boosted profits so far, the companies need to increase their volumes to boost long-term top line growth.

Some homebuilders are speeding up their land investments. Ryland Group has spent $498 million on land acquisition and $184 million on site development in the first nine months of 2013. Texas-based D.R. invested $2.6 billion in land, lots and development in 2013 and seems well positioned to meet demand for fiscal 2014 and 2015.

High-End Homes Driving Prices

Most homebuilders like Lennar, KB Home and Toll Brothers have shifted their focus on high-end communities, primarily of California, Arizona, Colorado and Florida, which allow them to sell larger, higher-priced homes, driving the ASPs up.

Homebuilders like KB Home also target the higher income, move-up buyers who are more likely to qualify for home loans. Pulte is shifting its focus towards its high-priced Pulte-branded, move-up homes, which improve the overall ASP.


Another small homebuilder, Meritage Homes Corporation (MTHTM), is also seeing improving selling prices from a mix shift towards move-up homes in higher priced communities and states. Luxury home-builder Toll Brothers is focused on improving the quality and the luxury quotient of its homes, thus giving it a competitive advantage.

Strategic Restructuring & Cost Saving Initiatives

Improving homebuilding revenues combined with tight cost control and better overhead leverage (as volumes improve) continue to boost margins for most homebuilders.

Most housing companies are striving to improve their operating and financial performance through strategic restructuring initiatives. The initiatives taken include workforce reductions, improving overhead leverage, managing inventory tightly and implementing new pricing strategies. The homebuilders expect these cost reduction and operating efficiency improvement plans combined with positive housing demand to further boost profitability in 2014.

Ancillary Companies also Gain from Housing Recovery

Construction material companies, Vulcan Materials Company (VMCTM) and Eagle Materials Inc. (EXP), and building product makers Masco Corp. (MAS) and Louisiana-Pacific Corp. (LPX) are fast gaining momentum from improving new home demand. These companies are also seeing a concomitant rise in demand and volume for their products.

Fed to Keep Interest Rates Low

In mid December, the Federal Reserve announced plans to scale back its currency $85-billion-a-month bond buying program by $10 billion to $75 billion. The Fed has been buying $85 billion in government bonds and mortgage backed securities a month, known as quantitative easing, to keep interest rates low and boost economic growth.


Ideally, tapering of the bond-buying plan would have led to adoption of a tighter monetary policy, which would have increased interest rates further. However, the Fed said that the interest rates will be kept low for even longer than previously promised, irrespective of the reduction in the bond buying program; thus removing a major overhang for homebuilders.

WEAKNESSES

Rising Interest Rates


Since mid-2012, homebuilders have largely benefited from historically low interest rates, eventually leading to the sharp increase in home buying activity. With the recent improvement in economic conditions and the housing market in general, mortgage/interest rates are edging upwards to more normalized levels since May 2013. According to the Freddie Mac mortgage survey, the 30-year fixed mortgage rate has risen from 3.59% on May 23 to 4.42% as of Dec 12.

High interest rates dilute demand for new homes, as mortgage loans become expensive. This lowers a buyer’s purchasing power. This can hurt volumes, revenues and profits at the homebuilders.

Homebuilders at large admitted that higher interest rates have eaten into volumes in the last reported quarter. But the homebuilders are also convinced that sluggish demand in the past quarter is only a fleeting phenomenon and buyers would soon return to the market overcoming their inhibitions of rising rates and climbing home prices.

In fact, while interest rates are an important part of the home buying business, sustainable increases in housing and housing demand for the long term will require the overall economy to strengthen. This means further job growth, improving household incomes, rising consumer confidence and easing of credit availability. The economy, while still improving slowly, is far from experiencing a full-fledged recovery. Until there is more robust economic activity, new home sales will continue to lag historical levels.

Interestingly, with the rise in mortgage rates, lenders are beginning to ease credit standards to more normalized levels which could, in fact, have a modest positive impact on demand.

Rising Input Costs

Rising input costs are a concern due to increasing costs of building material and labor. As housing starts accelerate, both labor and construction material costs would continue to experience upward pricing pressure, impeding margins in the future.

Supply Constraints

A shortage of approved home sites, labor constraints in some markets and a lack of available capital for smaller builders are lowering the supply of homes, both new and existing. The supply of homes is still not meeting current demand let alone the pent-up demand. If the supply picture does not improve, home prices could shoot up further, causing many homebuyers to hold back on their purchase decisions.

Performance of Key Players in the Last Reported Quarter

Despite the rising interest rates, key housing companies like Lennar and Toll Brothers delivered stronger-than-expected results in the last reported quarter driven by volume growth and aggressive pricing. Pulte beat the Zacks Consensus Estimate for both earnings and revenues driven by margin growth and pricing power which made up for the order shortfall.


However, housing giant D.R. Horton missed the Zacks expectations for both revenues and earnings due to slowing order trends. Others like Hovnanian Enterprises beat earnings expectations on the back of price increases and cost savings, while missing out on the revenue consensus due to weak order trends.

A look at the Earnings ESP in the table below shows that KB Home could beat the Zacks Consensus Estimate in the next quarter (first quarter of fiscal 2014) due to pricing and margin improvement.



Note: For Pulte, the last reported quarter was Q313 while for others it was Q413

Zacks Industry Rank

Within the Zacks Industry classification, we rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a guideline, the outlook for industries in the top 1/3rd of all Industry Ranks or a Zacks Industry Rank of #88 and lower is 'Positive,' the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is 'Neutral' and the bottom 1/3rd or Zacks Industry Rank of #177 and higher is 'Negative.'

The Zacks Industry Rank for the construction industry is currently #69. This is in the upper 1/3rd of all industries ranked, highlighting the group’s near-term positive outlook as the housing recovery continues despite rising interest rates and increasing home prices.

Earnings Trends

The Construction sector depicts stable earnings trends. The September quarter results for the sector have been average in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

The earnings "beat ratio" was a strong 81.8%, while the revenue "beat ratio" was 63.6%. Total earnings for this sector increased 32.1%, reflecting a sharp moderation from 53.6% growth registered in the second quarter. We note that comparisons have become difficult considering that the housing industry started to improve steadily from the second quarter of 2012. Total revenues grew 9.2% in the quarter versus a 10.1% jump in the previous quarter.

The consensus earnings expectations for the December quarter look encouraging with earnings projected to grow 1.5% thereby pegging the full-year 2013 growth outlook at 95.2%. For revenue, growth will likely be 6.9% in the December quarter. Full-year revenue will likely increase 9.8%.

For more details about earnings for this sector and others, please read our ‘Earnings Trends.

Bottom Line

Though the sudden jump in interest rates has brought a short-time halt to housing recovery, we expect sales to continue to rise in 2014 as pent up demand is released and buyers return to the market. Most homebuilders also expect the housing momentum to continue into 2014 with the gradual strengthening of the economy.

Our proprietary Zacks Ranks indicate the movement of the stocks over the short term (1 to 3 months). At present, 16% stocks post a positive outlook while 84% has a neutral outlook. None of the stocks show a negative outlook.

Stocks which will likely outperform the broader market and currently hold a favorable Zacks Rank #2 (Buy) include MRV Engenharia e Participa (MRVNY), M/I Homes, Inc. (MHO) and Meritage Homes. We are currently not too enthusiastic on Zacks Ranked #3 (Hold) NVR, Inc. (NVR) due to weak net order trends.



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Tickers in this Article: LPX, RYL, GFA, MHO, TOL, CNRFF, HOV, KB, VMC, DHI, MTH, EXP, PHM, LEN, MAS, TPH

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