Homebuilder Earnings: Feeding the Optimism

Excerpt from Footnotes and Flashbacks: Week Ending Feb 3, 2023

The past week saw a slew of earnings reports from the major builders with earnings releases from Pulte, NVR, Meritage, and MDC among the larger builders and Century Communities and M/I Homes among those below the Top 10 in the stock chart.  

The homebuilder equity list materially outperformed the market again last week for various reasons even in the face of what will be continued bad YoY numbers from the top down in starts and home sales (new and existing). Rising jobs, easing rates, and creative homebuilder incentives have tag teamed with the longer-term realities of a housing shortage to keep buyers in the game as this year wears on. This could help housing perhaps duck a hard landing.

The YoY math for inflation is on the side of the more optimistic around inflation. The things that can go wrong are things that can go very wrong (think debt ceiling), but that problem should be resolved (or the Congress disaster will be upon us) one way or the other before the summer peak for home sales. The “crazy extremist” X-factor has to be put in portfolio context anyway, and the builders have impressive cash flow profiles and flexibility in a way that many industries do not. 

The moderating of inflation has changed the forward-looking mentality around builders as the yield curve threat eases somewhat with mortgage rates now sitting on top of 6%. As covered in numerous commentaries, the high 5% to 6% mortgage rate zone was what the market saw in the 2005 housing bubble peak. Then the battle is about price and what builders can design and communities they develop for a reasonable profit margin and acceptable price to the buyer. The challenge of late has been about managing the suddenness of the mortgage spike for communities in process and contracts in hand and prices that are on the table.

As we have covered in some other commentaries, the strength of the homebuilder equities after a very tough period in early 2022 has been remarkable.  The worst of the pain for homebuilders in equity markets was in January 2022.  Looking back over the LTM period, we see only a single builder in the Top 10 builders by market cap (MDC) underperform the broader market. None of the names shown underperformed over trailing 6 months, 3 months, or YTD.  

Each builder has their own distinct set of operating profiles across price tiers, regions and financial policies, but most major issuers have demonstrated their financial resiliency over time. The builders have shown their ability to adjust quickly to conditions given their high variable cost (read “low fixed cost”) business lines where weaker markets generate cash even if earnings suffer.

Below we offer a few highlights from the latest round of releases:

PulteGroup: The #3 homebuilder posted very strong 4Q22 numbers with impressive revenue and earnings growth and sharply higher average selling prices and higher margins to go along with lower leverage. PHM delivered 28.8% gross margins and net debt to cap of 9.6%. That is a rock-solid credit. With unrestricted cash + inventory at 6X notes payable, that is a very low financial risk profile.

PHM stock was a big winner this past week and has been delivering very strong performance and playing catch-up with leader D.R. Horton, another top name that has IG rated bonds and a bullet-proof balance sheet. PHM posted Average Selling Prices (“ASPs”) of $571K (up 17%) but new orders declined 41%. We see over 40% of closings overall are in Florida and Texas and 60% of closings if we add in the other Southeast states.

NVR: NVR was one of the only “zero worry” homebuilders during the crisis as it ran a cash rich, low debt balance sheet. The history of the company as “option heavy and land lite” kept risks low and made it one of the strongest equity performers in bad times and across cycles. NVR essentially traded off margin for lower risk through a heavy use of land options (“finished lot purchase agreements). That approach has been embraced by more builders during the post-crisis housing cycle since it worked so well for NVR. 

The company’s performance has earned a following and the right to not do earnings call. They earned being cocky by way of the housing crisis performance. The disclosure is good, and the results are consistent. The company’s cash alone is almost 3X notes payable. Cash + Housing units under sales contracts with customers are 4.5X debt. New orders were down 27% in 4Q22. Average selling prices were up 9% to $464K.

Meritage Homes: MTH also posted a strong stock performance week behind only PHM of the four cited here among the Top 10 builders.  MTH’s 4Q22 themes sounded a lot of similar favorable notes with higher volumes in 4Q22 (+29%) and higher average selling prices (+3%) to $437K.  

The negative noise was also evident. MTH saw gross margin compression on rising incentives with gross margins down to 25.2% in 4Q22 from 29.0% in 4Q21. We would expect to see more of that in the coming periods as more competition for a declining homebuyers base and more challenging affordability erodes pricing power. These gross margins that the market has seen are very high in historical context. MTH is guiding to 21% to 22% gross margins for 1Q23.

Total sales orders were down for MTH by 46% with a high mix of entry level buyers at 89% in 4Q22 vs. 82% in 4Q21. The cancellation rate was 39%. Net debt to cap was 6.8% at year end with total debt to cap at 22.6%. MTH is in a very strong financial position with cash and real estate at 4.6x senior notes. The operating risk is higher here with a spec-heavy mix of homes in inventory.

Given the traditional customer base, mortgage rates play a bigger role with MTH than some other builders. The company bills itself as an “affordable spec builder” so the job headlines and rising wages are a good macro signs for MTH if sustained. The strategy of focusing on move-in ready specs when many other builders do not have inventory is a strategy they embrace. It is also one to watch closely for how they execute.

MDC Holdings: The past vs future dichotomy continues with MDC, who cited FY 2022 as one of the best in their history. Unit deliveries were down (-4% to 2,554), but average selling prices (+8% to $582) rose in 4Q22. Revenues in turn rose on the greater ASP impact by 4% to $1.49 bn. 

The future question marks come with the 55% decline in gross orders and cancellation as a % of beginning backlog increasing to 24.6% from 8.7%. That makes a statement on mortgage rates and buyer fears of being underwater if mortgage rates do not turn around. Gross margin for MDC was squeezed slightly to 22.4% from 23.1% for the year with 4Q22 gross margin really feeling the pressure with a decline to 15.0% from 23.5%.

So where is the housing recession?

It sometimes gets to be a challenge to look at the quarterly earnings results of the major homebuilders and reconcile strong revenues and earnings with the YoY plunge in starts as well as the scary headline on mortgage rates. As we have covered in recent commentaries, the sequential action has been more constructive and mortgages rates have trimmed back to around 6.0% with some quotes even just below the cusp at high 5% handle seen in some of the trade rags.

The timing of contracts under build-to-order and the long lead time for working capital and customers occupying their homes makes the wild action along the yield curve, at the Fed, and in inflation metrics seem so fast when the homebuilding process and closing seems to move at a glacial pace. That reality shows up on the very strong revenue lines, pricing, and profitability of the homebuilders.

Beyond the good quarterly numbers on the income statement, the crosscurrents show up in high cancellations rates, creative incentive programs, mixed pricing strategies by builders, and downward land spend trends. The companies are preparing for a very slow period of new business ahead unless the economic forces turn more in their favor. 

Mortgage rates and jobs and wages and how that dovetails with home prices gives all parties a fresh game clock into 2023. The builders will need to see how much they want to eat on their options and how they want to plan new communities with a sound pricing strategy.

The customer needs to make decisions on whether to buy at higher mortgage rates with a view to perhaps refinancing later. Some will pay cash and exploit the lower prices ahead.  Failure to buy the home now could mean it trades away to someone else. Buying a home is an emotional decision and a family planning issue in many cases (town, school system, relationships, etc.).

A 6% mortgage rate is not that high at all looking back before the credit crisis. Homes in good areas generally appreciate, so a few incentives here and there can make a difference. Builders figure these things out and lower materials costs and some changes in design can make the next community competitive in a 6% mortgage environment. They are usually just loathe to undermine pricing structures for communities completed and in an ongoing selling process.

The pressure to adapt strategies will be subject to the swings in inflation, the monetary policy reactions, and what surprise the fiscal chaos in Washington will bring. These companies have become used to challenges and how to react.