J.P. Morgan’s Rehaut Courtesy of Big Builder Online
J.P. Morgan home building and building products company analyst Michael Rehaut asserts his outlook for 2011 breaks ranks with the consensus of his brethren when he writes, “we believe our outlook for stable to modestly improving trends, as well as for home prices to be flat to down only 3% in 2011, is materially more positive than our view of the current buyside consensus, which we believe expects home prices to decline at least another 5-10%, resulting in a resurgence in land-related charges, margin compression, and book value erosion.”
The pivot point of Rehaut’s analysis–and the unknowns for anyone in the unenviable position of having to produce an economic “outlook” for housing in 2011–is prices. The linkage of prices to demand tangibles such as job formation, consumer spending, and small business expansion, as well as to supply tangibles such as current absolute vacancies, new-home inventory, and resale months’ supply is complex enough in a good year to model out a forecast. This year, intangibles weigh heavily. Prices could swing significantly based on relative contagion of stragegic default, the Animal Spirits of “recession fatigue,” the potential innovation–after a stumbling process of elimination–of housing finance policy that actually stems the tide of homeowner distress, etc.
Rehaut’s betting that the operational drivers in home building pre-indicate a technical “comfort zone” on prices–with a fall on a national basis of 3% or less.
Here’s his sum-up of the way things look to him in early December 2010 for the year ahead. Give him credit for bravery in his conviction.
Following a 2010 that featured a striking amount of volatility due to the expiration of the federal housing tax credit, but overall reinforced our view when we upgraded the sector to positive in September 2009 that the recovery would emerge slowly and over the next 24 months, we believe 2011 will mark stabilization and modest improvement in the housing market. Critically, however, we believe our outlook for stable to modestly improving trends, as well as for home prices to be flat to down only 3% in 2011, is materially more positive than our view of the current buyside consensus, which we believe expects home prices to decline at least another 5-10%, resulting in a resurgence in land-related charges, margin compression, and book value erosion. By contrast, we believe land-related charges should continue to be minimal in 2011, while margins should expand modestly and book values should largely hold. Moreover, we estimate order growth to resume and more builders to generate positive Operating EPS in the upcoming year. Trading at 1.05x current P/B (ex-adj. FAS 109, ex-NVR), at the low end of their historical range, we believe the stocks fully reflect the more pessimistic buyside consensus. Hence, we view the sector as representing a compelling risk/reward dynamic, as we expect improving fundamentals in 2011 to result in investors anticipating a return to normalized EPS and book value growth, which in turn should drive P/B multiple expansion over the next 12 months. Using an average targeted 10% discount to the group’s 10-year P/B multiples against our 2011-end book value estimates, we slightly adjust our price targets, which now represent an average 28% return potential (previously 31%). Lastly, we round out our coverage universe by initiating on NVR (OW) and MTH (N), the former of which we add to our favored OW-rated names of LEN, KBH, and TOL.
Demand, having largely stabilized post-tax credit, should improve moderately in 2011, coincident with macroeconomic trends. While highly depressed, importantly, we note that housing demand – i.e., housing starts and new and existing home sales – has largely stabilized over the last four months, following the expiration of the federal housing tax credit. We see this recent stability as critical in terms of our outlook for only modest downside for home prices, in contrast to 2006-2008, when consistently falling demand trends played a key role in declining home prices, in our view. More importantly, coincident with JP Morgan’s Economics Team’s outlook for moderate macroeconomic improvement, we believe housing starts and home sales should improve 15-20% in 2011 off of current six month moving averages. We also point to the recent stability in credit standards for mortgages, which should support stable to improving demand over the next 12 months. Lastly, while we believe a more material improvement in demand is more dependent on a more aggressive absorption of excess, which we do not expect to begin until 2012-2013, we note housing demand remains roughly 60% below its 30-year averages and 30% below its last major trough in 1991.
Perhaps more importantly, supply, while elevated, is down solidly from peak levels and should continue to be more manageable, in our view. As a result, we note that both current demand and supply trends are different than 2006-2008, when demand consistently fell and supply consistently rose, the combination of which we believe resulted in declining home prices. Specifically, existing homes for sale are down 16% from peak levels in 2008, while the top 23 markets tracked in our Bi-Weekly Inventory Watch are down 27% on average, and have recently exhibited above average seasonal declines over the last two months, down 3% each in October and November vs. historically rising 1% in October and being flat in November. Lastly, but perhaps most importantly, in our view, we believe shadow inventory will continue to be liquidated at a moderate pace, with REO sales persisting at roughly 50K/month, and annual liquidations of distressed units continuing at a 2.0-2.5 million pace through 2012, in-line with 2009’s 2.2 million.
As a result, we expect home prices to be flat to down only 3% in 2011, in contrast to our view of the buyside consensus of at least down 5-10%. Importantly, not only is housing affordability at near-record levels following a roughly 30% decline in home prices since late 2006/early 2007, but also, the cost of owning a new home versus renting is only at a 4% premium, the lowest on record, versus a historical premium of 35%. Moreover, existing home ownership is at a 10% discount to renting, versus a historical 16% premium and only slightly above the record low of the 12% discount seen in 1Q09. We believe this favorable cost of owning versus renting should only improve in 2011, as rents are expected to increase further due to a continued decline in apartment vacancy rates. Lastly, we believe builder cancellation rates returning to normal levels, and total specs per community being at their lowest level in four years, should result in far greater control over pricing trends for homebuilders, compared to 2006-2008 when elevated can rates resulted in the aggressive discounting of large amounts of unwanted spec inventory.
Builders should demonstrate stronger fundamentals in 2011. We believe our outlook for a reemergence of order growth, core operating margin expansion, continued minimal land-related charges, and more builders generating positive Operating EPS in 2011 all represent positive catalysts for the sector over the next 12 months. Specifically, regarding order growth, we note that after 1Q11’s tough year-ago comp which includes the benefit from the tax credit, we estimate that community growth and a modestly better sales pace should drive order growth of 14% for the year, following a 10% decline in 2010E. Moreover, we estimate closings growth of 7% should drive SG&A leverage of 50 bps in 2011, resulting in core operating margin expansion of 60 bps. Also, we estimate the builders will continue to experience a minimal level of land-related charges, based on our outlook for home prices to be flat to down only 3% in 2011. Finally, we estimate two more builders will become profitable on an Operating EPS basis in 2011, bringing the total to 7 out of the 12 builders in our universe.
Risks to our positive sector stance include greater than expected price competition during the Spring selling season and tighter credit standards. We believe three potential scenarios represent the leading risks to our positive sector stance. First, while we believe more normal can rates and the lowest total spec levels in four years should support pricing discipline, nonetheless, if builders become more aggressive with spec building amid a high level of new community roll-outs, incentives and discounts could rise at a greater than expected rate in the Spring and lead to gross margin compression for the year, versus our outlook for flat gross margins. Second, while we believe the banks are near the end of a sharp credit tightening cycle that has occurred over the last 3 years, if home prices weaken more than expected, and other macroeconomic indicators show weaker than expected trends, banks may even further tighten credit standards for mortgages, which could result in lower housing demand and higher incentives and discounts. Finally, we believe that the current health of the housing market is highly sensitive to the overall economy, and in particular, employment growth and consumer confidence, which, if these trends soften, could result in weaker housing demand, declining home prices and higher incentives and discounts.
Valuation compelling; we highlight Overweight-rated LEN, KBH, NVR, and TOL. Trading at 1.05x P/B (ex-adj. FAS 109, ex-NVR), at the low-end of its historical range and reflecting at least a 5-10% decline in home prices in 2011, in our view, we believe our homebuilding universe is attractively valued. Moreover, given our outlook for home prices to be flat to down only 3%, resulting in continued minimal land charges and stable book values, as well as for order growth, margin expansion, and more builders generating positive Operating EPS in 2011, we believe investors should begin to anticipate a return to normalized earnings and book value growth over the next 2-3 years, which should result in P/B multiple expansion. We highlight OW-rated LEN, which currently trades at only a modest premium to its peers despite our outlook for near-industry-leading margins and profitability in 2011, as well as increased accretion from its Rialto subsidiary; KBH, which trades at a 23% discount to its peers, an attractive entry point, in our view, as we estimate industry leading order growth in 2011 and strong improvement in its SG&A ratio; NVR, which trades at a P/B peer premium below its historical average despite our outlook for industry leading OMs, solid EPS growth, and the restart of its share buyback program in 2011; and TOL, which trades at a P/B peer premium below its historical average, while we believe our outlook for above average order growth in 2011, and the company’s below average exposure to the more credit sensitive first-time homebuyer, represent relative positives.
Well and good. That’s pretty inspiring news for all home builders out there to never lose sight of the goal whatever happens.