PulteGroup (PHM) recently reported better-than-expected quarter with its top and bottom line beating consensus estimates. The company’s EPS of $1.15 (up from $0.86 last year) was better than sell-side estimates by 29 cents while its revenue of $2.59 bn (up 4% y-o-y) was better than consensus by ~$60 mn. More importantly, the company’s net new orders declined only by ~4% to 6,522 homes, which were much better than consensus estimates of 4,829 homes. While orders for the month of April were down 53%, they increased by 50% in June. This intra-quarter turnaround resulted in a year-over-year increase in the company’s backlog.
There were several factors driving this turnaround in the housing market from March and April lows to a significant uptick in June. The biggest driver behind recent momentum in housing demand is historically low interest rates which have increased affordability for many customers. There was also a lot of pent-up demand as late March and April are a peak selling period for homebuilders. Due to the coronavirus, sales got impacted during that period and some of them are coming back. Also, while there are plenty of headlines about job losses, the most affected are low-paid hourly workers in the retail and restaurant industry. Most of them were not likely to buy a home in the near term anyways. So, the housing industry hasn’t been impacted as badly from high unemployment this time. There has also been a shift in consumer preference from renting in multifamily buildings in dense urban areas to buying single-family homes in suburban areas for social distancing reasons. In addition to these factors, a low existing home inventory available for sale is also helping the homebuilders.
Homebuilders have seen below-average demand for almost a decade now. From 1959 to 2008, annual housing starts in the U.S. have averaged around ~1.5 mn homes. But after 2008, they have remained below this level for almost a decade. The demand for new homes wasn’t lost – the population was still growing and households were still getting formed – but it was postponed. Recent action by Federal reserve has catalyzed this demand and we are likely to see above-average housing starts for the next several years to compensate the under-build during the last decade.
Most of this demand is coming from first-time home buyers. Behind PulteGroup’s 50% increase in total new orders in June was a 77% increase in first-time buyer category, a 48% increase in first move-up category and 21% increase in active-adult category.
Looking forward, I expect the company to continue posting good net new orders growth. However, it might be slightly lower than 50% y-o-y growth seen in June as some of the pent-up demand vanishes. Also, I believe as the coronavirus scare eases, more existing home inventories could come to the market. Right now homeowners and prospective buyers are not comfortable with the sales process of already occupied homes due to social distancing reasons. At the end of May, the total housing inventory was 1.55 million units, which were down 19% from the prior year. As the situation normalizes and the coronavirus scare decreases, I expect more existing home inventory to hit the market. But even after considering these factors, I expect the new home sales to be significantly above their pre-coronavirus levels over the next couple of years.
PulteGroup ended the quarter with a backlog of 13,214 homes, which is a 12% increase over the prior-year backlog of 11,793 homes. The total value of homes in backlog was $5.8 billion, an increase of 13% over last year, reflecting a favorable geographic and product mix. Management talked about continued strength in new orders in July which I believe will further help the backlog going into the back half of this year.
The company also has a very strong balance sheet and can easily fund land acquisitions and developments to support this growth. As of the last quarter, the company had a net debt to capital of just 15.5%, which was a significant improvement from 29.1% a year ago. While the company has remained disciplined so far in terms of its land investment, it can leverage its balance sheet strength to fund growth if the strong order growth continues.
On the margin front, I expect the company to benefit from improvement in overhead leverage as well as actions taken to lower overhead expenses last quarter. The company’s adjusted SG&A expense as a percentage of home sale revenues was 10% last quarter, which is 80 basis points improvement over the second quarter of last year. For the third quarter, management is expecting it to be in the range of 9.9% to 10.4%. If the sales momentum continues, I believe there is further scope of improvement in this metric.
One thing which is worrying some investors on the cost side is the recent rise in lumber prices. If we look at September future contracts of Random Length Lumber on CME, they are trading more than 25% above pre-coronavirus levels. I am not too worried about them as of now as I believe the company will be able to pass most of these increases to customers if the current sales environment sustains. Even in the last quarter, the company was able to increase prices by 1% to 3% in more than half of its communities. This despite coronavirus and economic shutdown related uncertainty. With market strengthening further, it shouldn’t be difficult for it to pass on price increases to the customers. Also, Pulte Homes usually purchases lumber on a trailing 13-week basis. So, it will not be a big factor next quarter. But I will certainly be keeping a close eye on it for 2021.
Overall, I believe PulteGroup is benefiting from a resurgence in home-buying demand triggered from historically low mortgage rates, and I expect this trend to continue for the next couple of years. However, in addition to business direction, I also look at valuations before making an investment decision, and this is what keeps me on the sidelines. PulteGroup’s shareholder equity is 5,852 mn and its share count is ~268 mn, giving it a book value per share of $21.8. The stock is currently trading at almost twice its book value, and I don’t find it attractive from a valuation standpoint.
I also don’t like Pulte’s positioning in the market as a mid-range builder. While Pulte has some presence in entry-level, lower price point homes, it also has a big exposure towards active adult and other mid to high price point homes.
Source: Company Presentation
As discussed above, entry-level homes and first move-up homes are seeing much stronger trends than other categories. So, if I have to choose a homebuilder, I will look for the ones with disproportionate exposure to the entry-level market as net order growth is much stronger in there. For example, D.R. Horton (NYSE:DHI) posted 38% in year-over year net order growth last quarter helped by its entry-level positioning while PulteGroup posted a 4% decline in net orders for Q2.
Hence, I rate the stock neutral given its valuation and mid-range positioning.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.