Are These 5 Real Estate Based Stocks Smart Buys?

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

The macroeconomic picture looks good for stocks involved in U.S. residential real estate transactions. These stocks include homebuilders, online real estate search stocks, and home-improvement retailers. Are any of these stocks trading at reasonable valuations that could qualify them as buy candidates?

Trulia Goes Mobile

Trulia (NYSE: TRLA), a popular website featuring useful real estate information, has indicated that there had been a substantial increase in its third quarter revenues. There are signs that show that the real estate market is recovering while advertisers maximized on the usage of mobile devices therefore this had a positive effect on the sales generated by Trulia.

Trulia is ensuring that it has a competitive advantage over its larger rivals such as Zillow (NASDAQ: Z) by developing innovative smartphone applications that ensure that homeowners receive market updates on the go. Pete Flint, Chief Executive Officer said, “Our business works well in a downturn, but we feel better in an upturn. With momentum in the housing market, the amount of money in the ecosystem expands.” Recent figures obtained from the National Association of Realtors show that prices for houses had been on the rise in most cities across the U.S.

Analysts had predicted Trulia to average sales of $18 million while Trulia itself had projected revenues to hit $19 million, an increase of about 60 percent from last year’s sales of $12 million.

Trulia’s initial public offering raised over $100 million. There is a lot of enthusiasm for this stock, probably too much enthusiasm.

To be fair, online search is a better business model than more traditional real estate plays like homebuilding. Online real estate search companies should enjoy a higher return on assets because they don’t need an expensive housing inventory. Online search sites also compete based on popularity instead of price; a huge advantage over the homebuilder business model. Residential real estate resembles a commodity market where homebuilders compete with the secondary market based on price. In contrast, online search sites are network goods which 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.

New Homebuilding Up

The U.S. housing market is picking up momentum as U.S. housing starts climbed a record high of 3.6%, an annual rate of 894,000. This value is the highest since July 2008 thus outpacing all of Bloomberg surveys. Economists that were surveyed forecasted an annual rate of 840,000. UniCredit Group’s Chief Economist Harm Bandholz said, “Excess supply has been wound down and there’s a steady increase in demand. That’s good for construction.”

There were some sluggish signs, though they were minor. Single-family house construction declined 0.2% to a 594,000 rate from 595,000 the previous month. Total building permits in October decreased by 2.7% attributed to less multifamily construction.

Record-low mortgages have created positive impact in the U.S. housing industry thus benefiting home builders and attracting buyers. The Federal Reserve absorbs $40 million a month in property debts in order to keep borrowing costs low. Meanwhile, payroll numbers rose in 35 states for the month of October. Unemployment rate fell in 37 states, only proving a more stable US job market. The jobless rate was significantly lesser in South Carolina, Alaska and Wisconsin while California and Texas were able to cut down unemployment by adding 45,800 and 36,600 jobs, respectively.

Homebuilder Confidence

Robust U.S. homebuilder confidence, rising home prices, and healthy sales volumes bode well for residential real estate in the United States. The homebuilder confidence index is at  a 4-year high according to a Bloomberg survey.

The CFO of homebuilder Hovnanian (NYSE: HOV), Larry Sorby, sees a great future for homebuilders. He said, “It’s clear to us that the industry is in a period of recovery. We’ve bounced off the bottom.” The bottom was very rough for Hovnanian, which appeared to be a candidate for bankruptcy in 2011. By 2012—only one year later—its outlook is positive.

Home Improvement Recovery

The recovering U.S. housing market and Hurricane Sandy have prompted homeowners to spend more on home repairs. These forces helped Home Depot (NYSE: HD) post a third-quarter profit that topped analysts’ estimates. The largest U.S. home-improvement retailer’s net income rose about 2% to $947 million and revenues rose by 5% to $18.0 billion, more than the $17.9 billion average estimate.

In the third quarter Home Depot’s average transaction value rose around 3 percent to about $55 while the number of purchases climbed 2% to 331 million. The housing rebound is projected to drive Home Depot sales up about 5%, slightly higher than analyst projections for a 4.6% rise. 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 higher earnings in the third quarter. Its sales also beat analyst growth forecasts with actual sales growth of 1.8% to $12.1 billion outpacing projections for 0.8% growth to $11.9 billion. The company’s gross margin also improved from 34.1% last year to 34.3%. The firm became more lean by cutting more than 500 of its staff this year and by closing 27 of its stores. Overall, net income for the quarter leapt up 76%.

After the quarter earnings announcement Shares of Lowe’s gained 6.2%. 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.” Are share prices too high for prudent investors, or is there some opportunity to exploit the growth trend of Lowe’s?

Financial Metrics

The price multiples among these real estate stocks range from reasonable to expensive:

<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>The Home Depot</p> </td> <td> <p>22.99</p> </td> <td> <p>1.35</p> </td> <td> <p>5.53</p> </td> <td> <p>29.73</p> </td> <td> <p>0.61</p> </td> </tr> <tr> <td> <p>LOW</p> </td> <td> <p>Lowe's Companies</p> </td> <td> <p>21.48</p> </td> <td> <p>0.81</p> </td> <td> <p>2.85</p> </td> <td> <p>23.49</p> </td> <td> <p>0.64</p> </td> </tr> <tr> <td> <p>HOV</p> </td> <td> <p>Hovnanian</p> </td> <td> <p>NA</p> </td> <td> <p>0.46</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>0.76</p> </td> <td> <p>2.98</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>13.93</p> </td> <td> <p>1.96</p> </td> <td> <p>2.22</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>8.2</p> </td> <td> <p>5.64</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>137.6</p> </td> <td> <p>8.98</p> </td> <td> <p>3.33</p> </td> <td> <p>85.42</p> </td> <td> <p>NA</p> </td> </tr> </tbody> </table>

Unfortunately, traditional homebuilder stocks are not attractively priced. As a cyclical Homebuilder Lennar (LEN) braves market risk yet its earnings multiple is roughly the same as the S&P 500s earnings multiple. Its price-to-sales multiple is even higher than the sales multiple of the broader stock market. This makes no sense.

In contrast, KB Homes (KBH) is unattractive for an entirely different reason. Its huge debt-to-equity ratio and loss for the last twelve months make it too risky.

Hovnanian is not a compelling stock either based on its equity’s negative book value. (This negative number makes its P/B and D/E ratio incalculable). Stocks with negative equity accounting values should be avoided because they have underperformed other stocks historically.

On the opposite end of the spectrum, the huge price multiples of Trulia and Zillow make these stocks too expensive for disciplined investors. Their P/E ratios are in triple digits or cannot be calculated. They have price-to-sales multiples which are more than five times the S&P 500 average. These two stocks are just too rich.

If you have to buy a stock to participate in the housing recovery, consider Lowe’s. Investors can buy more revenues per dollar invested than they from Home Depot stock since it is trading at a higher price-to-sales multiple. Better yet, Lowe’s actually turned a profit over the trailing twelve months, a stark contrast to many firms involved in real estate. Though not compelling, this stock provides the least unattractive entry into real estate.

BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of Zillow. Motley Fool newsletter services recommend The Home Depot, Lowe's Companies, and Zillow. 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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