Are These Homebuilders Turnaround Plays?

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Home prices have begun to stabilize in the United States. In some regions they have seen a broad increase. Should investors consider once-beleaguered homebuilders as turnaround plays?

Homebuilders Rebuild Their Balance Sheets

Hovnanian Enterprises (NYSE: HOV), a homebuilder which once faced the strong possibility of default in October 2011, is now decreasing its debt as home prices are increasing. The market value of the company’s bonds rose from $910 million to $1.2 billion as of September 30th, 2011. This thirty percent increase in market value implies that lenders have more faith in the company.  In the past five years, the bond prices implied that the chances of Hovnanian Enterprises facing a default were as high as 91%. The rise in bond prices implies that the perceived chances of a negative credit event have fallen to less than 45% by September 7th, 2012. This is great news for a company that bet on real estate by buying land, even as home prices were declining.

These bets seem to be paying off as the housing market is recovering, and Hovnanian Enterprises has raw materials in hand. For example, Hovnanian Enterprises' Red Bank recently reported that revenue leaped 36%. This good fortune was used to strengthen the company’s balance sheet by paying down debt to $1.55 billion as of July 2012, 44% percent less than the debt burden of $2.74 billion in 2008. Jody Lurie, a corporate credit analyst at Janney Montgomery Scott LLC, said, “Provided that it doesn’t get as bad as things were in ’09 they should be fine. I think that’s the mentality about them.”

In a telephone interview, CFO Larry Sorby was optimistic. He said, “It’s clear to us that the industry is in a period of recovery. We’ve bounced off the bottom.”

The LA-based home builder, KB Home (NYSE: KBH) is also enjoying the housing recovery. A net income of $3.3 million from the past three months shocked analysts who had grown used to quarterly losses and disappointments. The company benefitted from insurance-related gains and more home sales in the rebounding US market.

In the first week of September homebuilder confidence rose to a six year peak according to the National Association of Home Builders/Wells Fargo sentiment index.  In a note to clients, Stephen Kim who is an analyst for Barclays (BCS), said, "We continue to be believe that 2012 is proving to be the beginning of a sustained housing recovery.”

KB Home’s fiscal 3rd quarter revenue surged 16%. The overall average home sales price increased eight percent compared to last year and five percent over the prior quarter. Jeffery Mezger, Chairman and Chief Executive Officer of KB Home, commented that the recovery in California is spreading from the coastal markets to the central valley. This is good news for KB Homes since its biggest market is the West Coast.

Valuation Considerations

Should investors buy homebuilders? Which ones?

Shares of Hovnanian Enterprises are not trading low enough at $3.50 to compensate investors for the risks.  Hovnanian shares are trading at an incalculable price-to-earnings ratio (there was net loss for the last twelve months). Though firm's reasonable debt-to-equity ratio demonstrates that the firm is not overleveraged, investors should shy away from the firm’s negative book value. The price per share has more than doubled in price over the past year, so a lot of the upside has already been realized in this stock.

Shares of KB Home are not trading low enough at $14 per share to compensate investors for risk. Like Hovnanian Enterprises, KB Home has more than doubled over the past year. KB Home shares are trading at an incalculable price-to-earnings ratio (there was net loss for the last twelve months). The 2.98 price-to-book multiple of this stock is higher than the 2.05 S&P 500 price-to-book ratio.  These are not compelling valuations, and they do not justify jumping into these shares.

Shares of PulteGroup (NYSE: PHM) are not trading low enough at $15.50 to compensate investors for the risk of investing in a cyclical stock. The shareholders of this residential construction mid cap stock have benefited from a 146% jump in price over the past year. The firm's 1.37 price-to-sales ratio is in line with today's prevailing market multiples.  Like the previously listed stocks, PulteGroup shares are trading at an incalculable price-to-earnings ratio (there was net loss for the last twelve months). The 3.02 price-to-book multiple of this stock is higher than the 2.05 S&P 500 price-to-book ratio.  Clearly, there is no discount to reward investors for betting on such a cyclical sector.

The same conclusion can be reached when reviewing Ryland Group (RYL), which currently trades around $30. The shareholders of this residential construction industry small cap stock have benefited from a 91.2% jump in price over the past year. Ryland Group shares are trading at an incalculable price-to-earnings ratio (there was net loss for the last twelve months). The firm's 1.31 price-to-sales ratio is in line with today's prevailing market multiples. The 2.94 price-to-book multiple of this stock is higher than the 2.05 S&P 500 price-to-book ratio.  Where’s the reward for taking a risk on homebuilders?

Fortunately, a growth-at-reasonable-price opportunity is available through the purchase of Lennar (NYSE: LEN) stock trading around $35 per share. The shareholders of this residential construction industry mid cap stock have benefited from a 77.8% jump in price over the past year, which is less dramatic than the price movements of its competitors. The firm's 1.92 price-to-sales ratio is in line with today's prevailing market multiples. Lennar shares are trading at a fair 14.61 price-to-earnings ratio, again in line with the S&P 500 average. Shares trade at a 2.07 price-to-book ratio which is near the 2.05 S&P 500 average. Analysts expect that the firm's earnings growth will accelerate with five-year estimates at 10.5% per year, considerably faster than -33.4% annualized earnings growth over the past five years. It’s profitable and its price-to-book multiple is among the lowest of firms on this list.

Conclusion

There is little reason to invest in homebuilders as a group. Lennar offers the most attractive investment opportunity among its peers. For most of these companies, the time to profit from distress has passed.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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