Clicks vs. Bricks: How To Profit From A Housing Turnaround
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 stabilized in the United States. In some regions, they have seen a broad increase. Should investors consider once-beleaguered homebuilders as turn-around plays? Alternatively, should investors try to play a housing recovery with online real estate search stocks Zillow (Z) or Trulia (NYSE: TRLA)?
Signs of a Homebuilder Recovery
Hovnanian is a homebuilder which once faced the strong possibility of default in October 2011, and is now decreasing it debt as house prices are increasing. The market value of the company’s bonds rose from $910 million to $1.2 billion as of Sept. 30. This thirty percent increase in market value implies that lenders have much more faith in the company. In the past five years, bond prices implied that the chances of Hovnanian 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 Sept. 7. This is great news for the company that bet on real estate by buying land even as home selling prices were declining.
These bets seem to be paying off. Hovnanian‘s Red Bank recently reported revenue increasing by 36%. This good fortune was used to strengthen the company’s balance sheet by paying down debt to $1.55 billion as of July; this is 44% less debt than the $2.74 billion in 2008.
The Los Angeles based homebuilder, KB Home (NYSE: KBH), is also enjoying the housing recovery. Net income of $3.3 million from the past three months shocked analysts who had grown used to quarterly losses and disappointments. The company benefited 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 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 8% compared to last year and 5% 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.
Clicks vs. Bricks
Investors must consider multiple factors when evaluating established businesses and their newer tech entrants as ways to play industries. They must consider whether the newer company’s business model represents a real improvement over incumbent businesses.
If the newer business model is more attractive, then investors should be willing to pay higher valuations for the newer companies. However, if the new business model is not more attractive, then investors should require a discount. There are no ties here: a new business model should be considered more risky, so if it is not an improvement over more seasoned business models, then investors should wait for a discount before taking on the risk of a new business concept.
Trulia’s Successful IPO
Trulia operates the popular real estate website Trulia.com, which lists residential properties, recently raised over $100 million in a public offering. Trulia has been gaining more users, and generating income by selling subscriptions to smartphone and tablet apps. The company has stated that its website and mobile applications are currently being used by over 20 million visitors per month.
Conceptually, online search is a much better business than building homes. There is no inventory, so there should be higher return on assets. Moreover, housing is largely a commodity market in which homebuilders have to compete on price. Websites can operate as network goods which can avoid price competition for advertisers and content providers. They don’t have to compete on price if they have one of the more popular platforms. This avoidance of price competition is also a big plus for online real estate search sites.
Unfortunately, excitement over the Trulia IPO seems to be driving shares beyond reasonable valuations. The IPO valued total debt and equity of Trulia over $400 million, which is about 8.8-times last year’s sales of over $50 million. The proceeds from the IPO are expected to be used to boost its working capital.
The success of the IPO has been attributed to how the U.S. housing market is showing broad evidence of a recovery. Thus, investors are thinking of Trulia as though it is in the residential real estate business.
Its growing operations are exciting. Unfortunately, Trulia appears even more overvalued at its current market price of $23. Equity in this this company is rich on a price-to-sales basis since shares trade at an 11.68 multiple, almost 10 times higher than the 1.29 the S&P 500 average. TRLA shares are trading at an incalculable price-to-earnings ratio because it suffered a net loss for the last twelve months
Zillow is another online real estate research tool whose stock is too expensive. At a price of roughly $38 this stock is rich on a price-to-sales basis since shares trade at a 12.42 multiple, 10 times higher than the 1.29 the S&P 500 average. Z shares are trading at an indefensibly high 345 price-to-earnings ratio. As was the case for Trulia, these multiples cannot be reasonably justified.
Since these online real estate stocks are overprice, should investors buy homebuilders? Which ones?
Shares of Hovnanian Enterprises are not trading low enough, near $4, to compensate investors for the risks. HOV shares are trading at an incalculable price-to-earnings ratio (there was net loss for the last twelve months). 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 $16 per share to compensate investors for risk. Like Hovnanian, KB Home more than doubled over the past year. KBH shares are trading at an incalculable price-to-earnings ratio (there was net loss for the last twelve months). The 3.23 price-to-book multiple of this stock is higher than the 2.05 S&P 500 price-to-book ratio. These are not compelling results, and they do not justify jumping into these shares.
Fortunately, a growth-at-reasonable-price opportunity is available through the purchase of Lennar (NYSE: LEN) stock trading around $38 per share. The shareholders of this residential construction industry mid cap stock have benefited from a 94% jump in price over the past year, which is less dramatic than the price movements of its competitors. The firm's 1.94 price-to-sales ratio is in line with today's prevailing market multiples. LEN shares are trading at a fair 14.26 price-to-earnings ratio, again in line with the S&P 500 average. Shares trade at a 2.65 price-to-book ratio which is a little above the 2.05 S&P 500 average.
Lennar offers the most attractive investment opportunity among its peers. For most homebuilders, the time to profit from distress is long gone. Investors looking to profit from a housing turnaround should consider Lennar and wait for a collapse in the price multiples of online real estate search companies prior to investing.
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