Where Are the Buys in the Housing Sector?

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

There are many ways to play the U.S. housing recovery. Investors could buy the stocks of home-improvement retailers, homebuilders, or online real estate search providers. Which represent the best investments for a recovering housing market? Do any of these stocks qualify as buy candidates?

Homebuilder Confidence

The real estate market in the U.S. seems to be improving, based on robust U.S. homebuilder confidence, sales volume, and rising home prices. The homebuilder confidence index is at 46, a four year high and five points up from its October level of 41. According to a Bloomberg survey, economists forecast no change to the market, which is good news after a bounce.

Another report indicated that sales of preowned homes in the U.S. increased 2.1 percent to a 4.7 million annual rate in the previous month. Mortgage rates at record lows are also helping bring buyers into this real estate market. Inventories of distressed and foreclosed properties are coming down across various regional markets.

Homebuilders Recover

Larry Sorby, CFO of homebuilder Hovnanian (NYSE: HOV), sees a bright spot for homebuilders. He said, "It's clear to us that the industry is in a period of recovery. We've bounced off the bottom."

Hovnanian appeared to be a candidate for bankruptcy in 2011, but now its outlook is positive. The market value of the Hovnanian debt rose thirty percent in 2012, suggesting restored faith in the company among lenders. Bond prices over the past five years implied the chances of a Hovnanian default were as high as 91%. By September, bond prices suggested that likelihood of a negative credit event is lower than 45%. Hovnanian stock investors could profit from the company's risky strategy of buying land even as home selling prices were declining.

Home Improvement and the Housing Recovery

Hurricane Sandy and the recovering U.S. housing market have prompted homeowners to spend more on home repairs. This helped Home Depot (NYSE: HD) post third-quarter profit that topped analysts' estimates. The largest U.S. home-improvement retailer's net income climbed about 2 percent to $947 million; as sales rose by around 5 percent to about $18 billion, beating the $17.9 billion average estimate by analysts.

The healing U.S. housing market has recently seen construction rise at the fastest rate in four years, and sales of new homes have reached an all-time high in two years. According to the U.S. Commerce Department, sales of new homes climbed around six percent to a 389,000 annual pace in September, the highest since April 2010. Similarly, housing starts also jumped 15 percent to the fastest rate since July 2008. Beginning construction rose to an 872,000 annual rate, higher than previous forecast by survey. Home Depot's average transaction value in the third quarter rose around 3 percent to about $55, while the number of purchases climbed 2 percent to 331 million. Rising property values are bolstering household finances and spurring consumer spending. This is projected to push Home Depot sales up about 5 percent, slightly higher than analyst projections for a 4.6 percent gain. Home Depot CEO Frank Blake said "The earnings reflect the start of the path toward the healing of the housing market."

Like Home Depot, America's second largest home improvement retailer, Lowe's (NYSE: LOW), saw increased third quarter earnings. Sales beating analyst growth forecasts of 0.8% to $11.9 billion with actual sales growth of 1.8% to $12.1 billion. Gross margin also improved from 34.1% last year to 34.3%. Cost-cutting measures eliminated more than 500 of its staff this year and closed 27 of its stores, keeping operations lean. Net income for the quarter ended at $396 million, up by a whopping 76%.

Shares of Lowe's gained 6.2% record after the quarter earnings announcement. Greg Melich, an analyst at International Strategy & Investment Group said, "Lowe's made progress on recovering some of the gross margin over the last year and comps were up."

Trulia's Successful IPO

Trulia (NYSE: TRLA) operates Trulia.com, a real estate search website which is popular for residential property searches. It raised over $100 million in its recent public offering. The number of users who visit Trulia has been growing. This growth has produce revenue through the sale of mobile device apps. Trulia estimates that its mobile apps and website are being used by over 20 million visitors per month.

Conceptually, online search is better than homebuilding as a business model. Without housing inventory there should be higher return on assets. In addition, residential property is essentially a commodity market which forces homebuilders to compete on price. Websites connect buyers and sellers, acting as network goods which can avoid price competition. They don't have to compete on price for traffic as long as they are among the most popular platforms. Immunity to price competition is a big plus for online search sites.

Unfortunately, excitement over the Trulia initial public offering seems to be driving shares beyond reasonable valuations. The initial public offering valued Trulia's total debt and equity over $400 million, about 8.8 times the $50 million sales generated in the prior year.

Financial Metrics

There is a wide range of price multiples among these real estate stocks:

<table> <tbody> <tr> <td> <p><strong>Ticker</strong></p> </td> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>P/E</strong></p> </td> <td> <p><strong>P/S</strong></p> </td> <td> <p><strong>P/B</strong></p> </td> <td> <p><strong>P/FCF</strong></p> </td> <td> <p><strong>D/E</strong></p> </td> </tr> <tr> <td> <p>HD</p> </td> <td> <p>Home Depot</p> </td> <td> <p>22.9</p> </td> <td> <p>1.35</p> </td> <td> <p>5.51</p> </td> <td> <p>29.62</p> </td> <td> <p>0.61</p> </td> </tr> <tr> <td> <p>LOW</p> </td> <td> <p>Lowe's</p> </td> <td> <p>20.92</p> </td> <td> <p>0.78</p> </td> <td> <p>2.78</p> </td> <td> <p>22.88</p> </td> <td> <p>0.64</p> </td> </tr> <tr> <td> <p>HOV</p> </td> <td> <p>Hovnanian Enterprises</p> </td> <td> <p>NA</p> </td> <td> <p>0.47</p> </td> <td> <p>NA</p> </td> <td> <p>NA</p> </td> <td> <p>NA</p> </td> </tr> <tr> <td> <p>KBH</p> </td> <td> <p>KB Home</p> </td> <td> <p>NA</p> </td> <td> <p>0.77</p> </td> <td> <p>3.03</p> </td> <td> <p>NA</p> </td> <td> <p>4.64</p> </td> </tr> <tr> <td> <p>LEN</p> </td> <td> <p>Lennar</p> </td> <td> <p>14.17</p> </td> <td> <p>1.99</p> </td> <td> <p>2.26</p> </td> <td> <p>NA</p> </td> <td> <p>1.31</p> </td> </tr> <tr> <td> <p>TRLA</p> </td> <td> <p>Trulia</p> </td> <td> <p>NA</p> </td> <td> <p>7.52</p> </td> <td> <p>5.17</p> </td> <td> <p>NA</p> </td> <td> <p>0.12</p> </td> </tr> <tr> <td> <p>Z</p> </td> <td> <p>Zillow</p> </td> <td> <p>130.55</p> </td> <td> <p>8.52</p> </td> <td> <p>3.16</p> </td> <td> <p>81.05</p> </td> <td> <p>0</p> </td> </tr> </tbody> </table>

Unfortunately, traditional homebuilder stocks are unattractive. As a cyclical Homebuilder stock, Lennar (LEN) braves terrible risks, yet it has a price-to-earnings ratio that is roughly the same as the S&P 500. For this reason it is not a compelling buy candidate. KB Homes (NYSE: KBH) is unattractive for an entirely different reason. It is too risky because it has a huge debt-to-equity ratio and has not generated a profit for the last twelve months. Despite its comeback, Hovnanian is not a compelling stock either. Investors should be dissuaded from investing its negative book value for equity. (Its negative accounting equity is why the P/B and D/E ratio are incalculable). Stocks with negative book values for equity have underperformed other stocks historically.

Worse yet, Trulia and Zillow (Z) are not investible at their huge price multiples. Their P/E ratios cannot be calculated or are in triple digits. They have price-to-sales multiples which are very high, near eight. These firms are just too rich.

Of home improvement retailers, Lowe's is the better stock. Investors can buy more sales per dollar than they can from Home Depot stock, which is trading at a higher price-to-sales multiple. Lowe's turned a profit-unlike many firms involved in real estate-over the past year.


Lowe's provides the least unattractive entry into real estate. Unfortunately, none of these stocks leap out as attractive buy candidates on an absolute or industry-agnostic basis.

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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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