Housing Industry Stock Outlook - February 2018

U.S. homebuilding was both hot and happening in 2017, giving investors ample scope to rake up gains. The industry looks equally attractive this year, given solid economic growth and tight inventory. Consistent job growth, growing interest from first-time homebuyers as well as seemingly high homebuilder confidence are adding to the momentum.

Yet a tight labor market, limited land availability, higher material costs and a constrained mortgage environment are restricting homebuilders to respond to the growing demands to some extent. Despite concerns over chances of a series of interest rate hikes by the Federal Reserve, optimism surrounding the housing market remains unruffled.

An Impressive 2017 for Homebuilding

Although the December housing data were not impressive, the larger picture is overwhelming for 2017. The most recent data from the National Association of Realtors (NARs) shows that existing-home sales increased 1.1% in 2017 to a 5.51 million sales pace, the strongest since 2006. Although December being an underwhelming month for existing home sales, the housing market performed remarkably well in 2017, with substantial wealth gains for homeowners and historically low distressed property sales.

Meanwhile, new-home sales dropped 9.3% in December, the largest monthly decline since August 2016. Nevertheless, sales in 2017 were 8.4% higher from 2016, according to the U.S. Census Bureau. That said, it is important to note that 8.4% growth pace is a slowdown from 12% increase reported in 2016 and 14.1% in 2015.

The only bright side in the December report was inventory of new-homes. Based on current-month sales, there were 5.7 months of supply in December, up from 4.9 months in November. The number of unsold homes left in the market rose from 284,000 to 295,000 units, which represents a 15.2% increase from a year ago.

For existing homes, supply shortage is still prevalent, as total housing inventory at the end of December fell 11.4% to 1.48 million existing homes available for sale, and is now 10.3% below a year ago, according to NAR’s report. Housing inventory has now fallen year-over-year for 31 consecutive months.

Economists are of the opinion that inventory shortage prevailing in the U.S. real estate market has been pushing up average home prices nationwide, gaining 5.8% nationally in 2017 for existing homes. The median sales price of new homes sold in 2017 was $321,100, 4.3% higher than 2016.

On the other hand, building permits increased 4.7% and housing starts increased 2.4% in 2017 from the 2016 figure, signaling a strong 2018 for the industry. Moreover, January 2018 builders’ confidence reading remained in the 70s, signaling that housing demand should continue to grow this year.

Reaffirming a Positive Outlook for 2018

Although inventory constraints have been consistently pulling the housing market down, robust demand is keeping the industry alive. This is primarily because of solid labor market that is near full employment.

Other hurdles such as rising prices, owing to the limited land availability, are keeping the affordability in check. Again, homebuilders continue to struggle with growing labor shortage, higher material costs and a constrained mortgage environment.

Market pundits are a shade worried that rising mortgage rates and caps on the deduction for mortgage interest following a recent overhaul of the tax code is likely to slow demand this year. That said, the latest report from the Mortgage Bankers Association, released on Jan 24, showed applications for loans to buy a home surging last week to their highest level since April 2010.

Hence, despite concerns of chances of a series of interest rate hikes by the Federal Reserve, that are restricting homebuilders to respond to the growing demand to some extent, the overall demand picture remains quite strong, courtesy of strong economic growth and low level of unemployment.

This is clearly evident from the Zacks Homebuilding Industry’s rally of more than 43% in the last 12 months compared with the 21% gain of the S&P 500. iShares U.S. Home Construction ETF (ITB) and SPDR S&P Homebuilders (NYSE:XHB) ETF (XHB), the two largest exchange-traded funds focusing on homebuilders and related fare, have rallied 37.6% and 20.7%, respectively, in the last year.

Let’s take a look at why it’s worth paying more premium for the stocks in the industry.

Homebuilding Industry Offers More Upside

Because of homebuilders’ asset-driven nature, it makes sense to value these based on price-to-book ratio. The valuation of the industry looks attractive at present. The industry currently has a trailing 12-month P/B ratio of 1.87. This is quite cheap compared with the market at large, as the current P/B for the S&P 500 is 3.89. Its lower-than-market positioning calls for upside in the quarters ahead.

What the Zacks Industry Rank Indicates

Within the Zacks Industry classification, homebuilding companies are broadly grouped in the Construction sector (one of 16 Zacks sectors).

We rank 256 industries into 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Our back-testing shows that the top 50% of the Zacks-ranked industries outperform the bottom 50% by a factor of more than 2 to 1. (Click here to know more: About Zacks Industry Rank)

The Zacks Industry Rank for homebuilding is currently #26 (top 10%).

Sector Level Earnings Trend

The Q4 earnings season is gradually gaining steam and investors should be content with the expectation of the broader Construction sector. Overall, earnings are on a growth track this quarter and construction seems to be one of the stand-out sectors.

Of the Construction companies in the S&P 500 cohort, 46.2% have already reported Q4 results. The sector saw quarterly earnings growth of 18.4% on 19.6% revenue growth as of Jan 31, 2018. For 2017, sector earnings are expected to grow 16% on 8.7% revenue growth.

For 2018, total earnings for the sector are expected to increase 28.4% on the back of 12.1% revenue growth, which looks quite compelling.

Notable homebuilders reported stellar fourth-quarter results. Among them, earnings and revenues of KB Home (KBH), a Zacks Rank #2 (Buy) company, increased 110% and 17.7% year over year, respectively, on strong demand. The company ended the quarter with a 9% rise in deliveries and a 17.4% increase in housing revenues.

The upside was primarily driven by an ongoing housing market recovery and favorable industry fundamentals. Strong orders in value (up 9%) and backlog (up 9%) bode well for KB Home in 2018.

Again, Lennar Corporation’s (LEN) fourth-quarter fiscal 2017 adjusted earnings of $1.29 per share decreased 1.5% from the year-ago level. The downside was primarily due to the strategic shift of a transaction to the first quarter of fiscal 2018. That said, revenues increased 12% year over year, as the homebuilding, financial services and multi-family segments performed significantly well.

The company remains positive about the overall homebuilding market, solid demand for homes, favorable job market, and solid economy, along with the added tailwinds of recent tax law changes that will continue propelling the housing market forward.

D.R. Horton, Inc. (DHI) came up with yet another stellar performance in the first quarter of fiscal 2018. The company’s adjusted earnings of 77 cents per share increased 40% year over year. Also, total revenues (Homebuilding, Forestar and Financial Services) grew 14.8% year over year.

Among other major homebuilders, PulteGroup Inc.’s (NYSE:PHM) fourth-quarter 2017 adjusted earnings beat the consensus mark by 1.2%. Also, quarterly earnings reflect a solid 27% jump from the year-ago quarter. Total revenues of this Zacks Rank #3 (Hold) company were in line with the consensus mark but increased 12.1% year over year on a rise in the number of homes delivered.

D.R. Horton sports a Zacks Rank #1 (Strong Buy), while KB Home and Lennar carry a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

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