The Great Unanswered Question

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

I hate it when I’m looking at an earnings report and I’m left with a big unanswered question. Unfortunately, that’s exactly what investors have been getting from PulteGroup (NYSE: PHM). Each time the company reports earnings, they report numbers like revenue growth, backlog growth, margins, and balance sheet strength. However, there is one number that is left out, and that is the all important cancellation rate. What is even more disconcerting is, all of PulteGroup’s peers report this number every quarter. The question for investors is, does PulteGroup have something to hide?

Impressive Results?

There are a few key numbers that investors need to keep track of when it comes to home builders. One way to gauge PulteGroup’s performance versus their competition is by looking at their operating margin. Home builders essentially compete in a commodity-based business. Each company may have their specialties, but there is no denying that homes are essentially made of the same basic materials.

Some of PulteGroup’s competitors are Toll Brothers (NYSE: TOL), Lennar (NYSE: LEN), and KB Home (NYSE: KBH). While Toll operates in the higher-end housing market, and the others are more direct competitors, they all compete for the customer’s home-building dollar. When it comes to profits, one way to compare these companies is by their operating margins. The leader of the group by this measure is Lennar with an operating margin of 13.3%, but PulteGroup comes in second with a respectable 7.49% margin. By comparison, KB Home’s margin of 4.69% and Toll Brothers’ margin of 1.81% look low.

A second way to compare these companies is by looking at their selling, general, and administrative expenses versus their revenue. A company that can leverage their expenses against larger revenue may deliver better profits and cash flow. The best by this measure is Lennar with an SG&A percentage of just 10.9%. Again PulteGroup comes in second by this measure at 11.8%. KB Home and Toll Brothers spend a higher relative percentage at 13.4% and 15.4% respectively.

One big challenge facing home builders on an ongoing basis is managing the debt required to make their projects happen. These companies are forced to take on debt to fund their projects and then hope that the homes sell to recoup their expenses and make a profit. PulteGroup and their peers Lennar and KB Home each are not only home builders, but they also offer financing divisions. This causes each of these companies to carry more relative debt than Toll Brothers that offers no financing division.

With that being said, if you look at PulteGroup, they have the second lowest debt-to-equity ratio at 1.10 compared to a debt-to-equity of 0.73 at Toll Brothers. By comparison, Lennar’s debt-to-equity looks fairly reasonable at 1.37, but KB Home’s debt-to-equity could be problematic at 4.13. As you can see, whether we look at margins, expense management, or debt-to-equity, PulteGroup is reporting impressive results. 

Too Bad You Can’t Trust These Results

There is little question that PulteGroup is performing well, and when it comes to their backlog growth, the company looks impressive as well. There is just one big problem with PulteGroup’s backlog growth, no one really knows if these contracts will be finalized.

If anyone doubts the growth in the housing sector, you only have to look at the backlog growth reported by these four major homebuilders. Lennar reported the strongest overall growth with 55% unit growth. Toll Brothers reported the second best growth with a 52% increase, and in third place, PulteGroup reported 35% unit growth. In last place of this group, KB Home seems to be falling behind their peers with just 6% unit growth. However, these numbers change a bit once you include the cancellation rate at each company.

When you adjust unit growth for the cancellation rate at each company, take a look at how the unit growth at each company changes.

<table> <thead> <tr><th> <p><strong>Name</strong></p> </th><th> <p><strong>Unit Growth Before</strong></p> </th><th> <p><strong>Cancellation Rate</strong></p> </th><th> <p><strong>Unit Growth After</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>KB Home</p> </td> <td> <p>6%</p> </td> <td> <p>27%</p> </td> <td> <p>4.38%</p> </td> </tr> <tr> <td> <p>Lennar</p> </td> <td> <p>55%</p> </td> <td> <p>14%</p> </td> <td> <p>47.3%</p> </td> </tr> <tr> <td> <p>PulteGroup</p> </td> <td> <p>35%</p> </td> <td> <p>??</p> </td> <td> <p>??</p> </td> </tr> <tr> <td> <p>Toll Brothers</p> </td> <td> <p>52%</p> </td> <td> <p>3.4%</p> </td> <td> <p>50.23%</p> </td> </tr> </tbody> </table>

As you can see, though, Lennar looks like the leader without accounting for their cancellation rate; with this adjustment, Toll Brothers is the clear leader. The challenge of course for investors is, what is PulteGroup’s real backlog growth?

With a 35% growth rate without a cancellation, the company already comes in second to last. If the company’s cancellation rate is relatively small, investors can believe in this future growth. However, if PulteGroup has a cancellation rate of 14% like Lennar, their unit growth drops to 30.1%. While this still sounds good, with better options available, investors might stay away.

The bottom-line is, though analysts expect 42.77% growth in earnings from PulteGroup over the next few years, Toll Brothers is expected to grow faster at over 62%. The fact that Toll Brothers has such a small cancellation rate, and is straightforward in reporting their results, would seem to make Toll the better option. Unless PulteGroup is willing to report their cancellation rate each quarter and come clean to investors, I would suggest investors avoid the shares in favor of their competition.

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Chad Henage has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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