Building a Bullish Case for Homebuilder
By: Steve Smith
The have been a multitude of signs and data showing that housing continues to gain slow but steady traction; from rising prices and sales volume, trending higher of building permits and mortgage applications and more recently an increase in homes purchased by those allusive ‘millennials’.
Last Friday’s jobs data was bolstered by the construction sector, which added 46,000 workers, the most in over 18 months. The number was helped by mild weather but still speaks to strong activity during a seasonally slow period, which bodes well for the Spring selling season.
The fact that interest rates are set to rise, albeit slightly and slowly, might actually provide a catalyst for those sitting on their (rental) couch to get up and pull the trigger on a purchase.
Housing Recovery is Slow but Steady
My basic investment thesis rests on two basic principles
- Economic, demographic and financial factors are aligning to create sustainable housing recovery built upon based solid fundamentals.
- Valuations of the homebuilding stocks are remain historically low and should see a multiple expansion as earnings accelerate leading to significantly higher share price.
I think Lennar (LEN) is the best way to investment in this theme in 2016.
Job security is probably the number one factor when considering purchasing a home. The trend of new jobs being added at a 200K per month and unemployment down to the 5% level are firmly in place. More importantly there continues to be an increase in wages which continue to post an average 0.4% monthly increases on a year-over year basis. The fact that major corporations such as Wal-Mart (WMT) and McDonald’s (MCD) have pro-actively raised their minimum wages suggests a tightening of the jobs market and will help first time buyers.
Offsetting this has been the sharp decline in oil prices which has turned boon towns in the Dakotas and the Texarkana region into sharp downturns. In fact, one of the reasons housing stocks sold off recently was a decline in sales in the regions that has had seen the largest gains.
In the long term that’s OK as those areas were becoming bubble like pockets. Better to find an equilibrium now than let it inflate too far.
Other economic indicators such as capital spending, purchasing managers index and consumer spending all suggest the U.S. economy is set for solid growth setting the foundation for a true housing recovery. Lower energy costs will effectively boost incomes and make mortgage payments more manageable.
In 2010 there was a flurry of speculative home buying from deep pocketed private equity firms for investment purposes. Now individuals may finally be on the secure enough footing to lead to long awaited demand led housing recovery.
The bull case is bolstered by the fact that household formations have now built up pent up demand, especially given that the rental market has seen very large price increases, should finally motivate millennials to move out of their parents’ homes and start a family of their own.
The millennials born during the early 90’s represented the highest birthrate since the 1950’s boomers with over 4.2 million births in 1990 alone.
That bulge in births has led to the U.S. now currently having the largest population in the prime 24-54 age bracket in its history in the coming year; some 125 million. They are now coming of age when they should start forming families. This ties in nicely with the improving job market and raising wages.
For those that cite the demographic trend toward a move into urban centers I say two things; that really doesn’t undermine a bullish housing thesis as many of the larger homebuilders and such as Lennar have exposure to multi-family dwellings. And for anyone that has experienced the joy of watching a toddler find their feet and vocal chords the appeal of a high rise or urban loft starts to pale to the benefits of backyard and ease a bike ride around the block.
In fact,the latest report from the National Association of Homebuilders showed that during the third quarter those between the ages of 24-35 accounted for 35% of new home sales, up from just 28% during the year ago period.
Decent Demand and Low Inventories
The most recent data point that hit homebuilders was that new home sales are on pace for 1.2 million for 2015. This is well above the 650,000 trough but still below the 1.6 million annual household formation. Homebuilders are slowly gaining the confidence to build more new homes especially at the lower entry level price point.
Indeed, the more forward looking building permits showed a 3.4% increase in November over the year ago period. The National Homebuilders Association Index climbed 3.2% to 53, its highest level in 8 months. As NAHB Chief Economist David Crowe says, “ the sales number is being constrained as there is not enough new product on the market. You can’t sell your house if you don’t have an attractive move alternative.”
The likelihood that interest rates will stay low by historical standards for the foreseeable future coupled with improved job market the housing should lead to attractive affordability.
For the post college generation finally finding job security means confidence to make that big purchase. For the older cohort that may have been forced from underwater mortgages have been getting their balance sheets in order.
Data shows total cash flow from mortgage debt and non-mortgage debt combined has turned slightly positive during the past four quarters, ending a five-year period of negative values, suggesting that, by this measure, the deleveraging process has ended.
All told the pieces are coming together; pent up demand, financial stability and affordability all aligning for a sustaining pick up in the housing market.
Lennar Provides Exposure to Growing Demand
Lennar (LEN) builds both single and multifamily homes geared toward first time and step up buyers. This is the group that has held back from buying and should provide the biggest jump in sales as lending loosens and demand trends normalize.
Lennar operates across the U.S. but has recently focused in the high growth regions of the across the Southeast and California. Neither region has much exposure to energy.
In third quarter results showed revenue growth of 32% as the number of homes delivered rose 17% and average sales price increased the 7.3% from $246,000 to $326,000. This increase indicates that pricing power is returning to the homebuilders. The company currently trades at just 12x forward earnings which is 20% below its 20 year average.
The chart has moved been trending slowly higher and even after this pullback remains above the both the 50 and 200 dma day moving average with good support near the $49 level.
Buying near this support level offers a good risk/reward entry point.
-Buy the May $50 calls for a $4.50 net debit.
I expect shares to hit a new high above $56 as we head into the seasonally strong spring selling period.