Homebuilders ready to run

I wrote the following in my trading journal a couple of weeks back. Since then, the homebuilders have run a little bit, but I think they have a lot of room to go. I am looking for feedback on this idea, so please comment below!

I am wildly bullish on the housing market, and I can’t quite figure out why the market isn’t repricing the homebuilders to higher multiples. It seems to me that market participants are awarding end of cycle PE multiples (high single digit) to the homebuilders when we are much more likely to be mid cycle.

I won’t rehash the arguments in full about housing supply – there are analysts who have done a much better job of this than I will. But the basic thesis is that the housing bust in 2008-2011 created an overhang of inventory, that has gradually been sopped up by the marketplace, and there is now little available housing inventory on the market. At the same time, millennials are reaching peak household formation age and there is a rush out of the cities amid a renewed focus on “home” during the pandemic.

I would also add some less discussed bullish points. Household debt to GDP has declined steadily since the great financial crisis (and I would wager this deleveraging of the household sector is a prime contributor to the low economic growth we experienced in the last decade). Household debt service as a percentage of disposable personal income, pre-pandemic, was at the lowest level since the government started collecting records in the 1940’s. Since the pandemic, this measure has broken to new lows. The average U.S. household could afford to take on a lot more debt, particularly at these interest rate levels.

The market seems to also trade down the homebuilders when mortgage rates rise, but we are still at such absurdly low levels, with the 30-year fixed mortgage at 2.8%, that I don’t think a rise of 20 basis points in the mortgage rate is going to make a difference. In the meantime, stimulus payments ought to strengthen the consumer balance sheets faster than they increase the treasury rate, so I don’t think an increase in rates is a valid concern for the homebuilder group.

The homebuilders as group are much stronger companies than they were pre-2008. They have consolidated further, with the larger homebuilders taking increasing share from the more fragmented small homebuilder group. As Michael Porter pointed out in his analysis of the homebuilders back in 2003, the large homebuilders have a lot of advantages over smaller homebuilders – like lower cost of capital since they can issue bonds rather than rely on bank debt, and lower costs per home due to better negotiating power versus suppliers. In the pandemic, I would also add better technological capabilities, allowing things like virtual tours, which may be more difficult for smaller homebuilders to set up.

In addition to consolidating the industry, the homebuilders have worked to reduce the capital intensity of their land developments. The pioneer of reduced land holdings is NVR, which has been an incredible stock, returning 100X the initial investment over the past 20 years, due to its capital light strategy and return of cash to shareholders via buybacks. NVR doesn’t buy land outright, but controls the land via options. It then pre-sells the home to a buyer, and only buys the land when it is ready to build the home. This process produces industry leading return on capital and reduces the capital intensity of the business. NVR is awarded a premium multiple typically in the high-teens, currently at 20X earnings.

Other homebuilders have seen NVR’s success, and all are in the process of reducing land holdings and transitioning to an option-controlled business model, which is freeing up a ton of cash flow at the major homebuilders. They are using this cash flow to reduce debt and strengthen the balance sheet, as well as for opportunistic buybacks. As a group, this change in business model should mean they command higher multiples, closer to NVR’s 20X, rather than the measly 10X earnings that they are trading at currently.

Lennar (LEN) is the homebuilder I’ve researched the most, but I am also open to exploring investments in the other homebuilders, provided I can get a grasp on the unique characteristics of each one. Lennar has grown via acquisition into the largest homebuilder in the U.S., and has focused on cost-control and improving margins over the past several years, achieving its highest homebuilding gross margin ever in Q4 2020 of 25.0%. Lennar is in the process of reducing land holdings and switching to a 50/50 mix of owned land and option-controlled land, which is freeing up a ton of cash flow – the company generated over $4 billion in cash in the last 12 months, on a $27 billion market cap. The company used a lot of this cash to reduce debt, and achieved an investment grade credit rating in 2020. There aren’t many homebuilders with an investment grade rating, and a higher credit rating lowers the cost of capital for the company. The ultimate return to shareholders over the longer term depends on the return on invested capital (ROIC) – weighted average cost of capital (WACC), and this spread seems to be in the process of widening. A widening of this spread also ought to lead to an increase in the multiple.

There’s an added kicker for Lennar that comes from its 4% stake in OpenDoor (OPEN). OpenDoor depleted its inventory during the pandemic, and is looking to rebuild housing inventory to pre-pandemic levels, which would entail net additions of about $1.2 billion of houses to its balance sheet. Zillow also depleted inventories in its iBuyer segment and is looking to rebuild inventories on the same order of magnitude. As the only homebuilder with a stake in an iBuyer (to my knowledge), I’d guess that Lennar would have a special ability to sell homes into OpenDoor’s inventory build.

Other relevant tickers are D.R Horton (DHI), KB Homes (KBH), Pulte (PHM), Toll Brothers (TOL), LGI Homes (LGIH).