Homebuilder Sentiment Surges Above Expectations

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Mortgage rates have picked up substantially in recent weeks ahead of the FOMC meeting, reducing homebuyers’ housing affordability. As a result, homebuilders may become concerned about falling demand. On the bright side, the housing outlook remains positive due to housing starts up a strong 28.6% YoY and permits up 20.8% YoY. Moreover, the National Association of Home Builders (NAHB) Housing Market Index, a measure of homebuilder sentiment, surged to 52 in June from 44 in May. This is the highest level since March 2006 and the first time the index reached above breakeven levels since April 2006. Expectations were looking for a modest uptick to 45.

Helped by public constructions

Vulcan Materials (NYSE: VMC) is the largest producer of construction aggregates with a diversified customer base. The downturn in construction activity has hit them big time, but as the U.S. economy recuperates, the company should be able to bounce back quickly. As a producer of asphalt mix, concrete, and cement in Florida, it has benefited from gains related to starts activity that were higher than average in the Southeastern part of the country.

The company expects earnings to improve in 2013 and deserves a strong "buy" recommendation, founded on the following four reasons:

  1. Pricing power: high barriers to entry should help Vulcan bear price increases ahead of inflation, resulting in expanding margins and resilient returns on invested capital.
     
  2. Growth: aggregates shipments are expected to grow in the range of 1%-5% in 2013, ahead of 2012’s 1% decline. The company’s production facilities and aggregates reserves are situated at close proximity to large metropolitan cities, thus giving it a competitive advantage to invest in high-return projects.
     
  3. Cost-cutting: aggressive cost control initiatives are still in progress. Last year, cost saving actions resulted in improved per-ton margins and lowered its Selling, General, and Administration costs by 11%. EPS is expected to increase 109% this year and 19% next year.
     
  4. Demand: the company should benefit from increasing demand volumes in the private and public sectors. Some outstanding initiatives include the new highway bill and an expanded Transportation Infrastructure Finance and Innovation Act (TIFIA) program that provides credit assistance in the form of secured loans, loan guarantees, and lines of credit to major transportation infrastructure projects.

Growth and acceleration in EPS

Martin Marietta Materials (NYSE: MLM) is the nation's second-largest producer of construction aggregates and a large producer of magnesia-based chemicals and dolomitic lime. As such, the firm is highly sensitive to economic conditions associated with the housing and construction markets. During challenging times, however, the company's strong balance sheet serves as a dose of protection.

Marietta's management predicts a 2%-4 % increase in pricing of heritage aggregates for the current year, based on stronger new construction activity across the country. Last March, the company's CFO announced a regular quarterly cash dividend of $0.40 per share of common stock, which represents a cash dividend of $1.60 per share on an annualized basis. It is payable on June 28 to shareholders of record at the close of business on June 3, 2013.

I recommend buying Marietta's stock based on consistent growth and acceleration in the company's earnings. Last year, EPS grew 19%. This year, it's expected to increase by 22%, and next year by 45%. ROE of 7%, compared to the industry average of 5%, shows that the company reinvests its earnings more efficiently than its industry peers. On a P/E basis, valuation also looks attractive, as the shares currently trade at 11.8 times, a 5% discount to the industry average of 12.4.

Definitely a growth stock

USG (NYSE: USG) is a leading manufacturer and distributor of building materials for both residential and non-residential construction, repair, and remodeling. The most important product is the Sheetrock brand gypsum drywall/joint compound. In April, the company reported first quarter 2013 net sales of $814 million, up 4% from last year’s Q1 net sales of $783 million. James S. Metcalf, Chairman, President, and CEO, said that improvement in all segments in the period resulted from executing the company's “Plan to Win” and its commitment to innovation and lowering breakeven levels as the recovery continues in core markets.

Even though earnings surprises have been consistently negative in the past, I can see this stock bringing some positive ones in the future. Sales are expected to grow at almost 10% per year for the next two years. Much of this growth comes from residential remodeling and repair activities. Many homeowners have delayed selling their homes, waiting for a better real estate market. Consequently, an improved real estate market has encouraged many homeowners to remodel and repair their homes in preparation for sale. Additionally, new home sales have been trending upward and should help sales of drywall for new residential construction.

In terms of valuation, I believe that USG is a good buy for the following reasons:

  • EPS growth is estimated to be more than 145% this year and 192.1% next year.
     
  • Warren Buffett's Berkshire Hathaway is the largest shareholder of USG, with a 15.73% stake in the company.
     
  • USG has a solid balance sheet with $494 million in cash.
     
  • S&P has a "Strong Buy" rating on the stock (5 out of 5 stars) and a 12-month price target of $40.00 per share.

Bottom line

In brief, demand for basic materials should increase, supported by household formation. This should help reverse the trend of homeowners turning into renters due to foreclosures and the credit crunch. An  environment of rising long-term rates can also mean more lending, and credit expansion has the effect of creating more demand for housing and driving GDP growth. The current pace of improvement in the labor market, together with historically low rates and homebuyers with equity to buy, will help these three construction stocks outperform the S&P 500 this year and in the years to come.

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