3 Mortgage-Housing Stocks to NOT Buy
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
After the housing collapse and subprime mortgage mess that gave way to the Great Recession, many investors are naturally hesitant about buying shares in D.R. Horton (NYSE: DHI) and KB Home (NYSE: KBH). In my view, both are not worth holding. Ditto for some mREITs like Annaly Capital Management (NYSE: NLY) that have seen dividends cut from poor earnings. If you invested in Annaly twelve months ago, you would have lost 2.4% of the principal. By contrast, you would have been 27% up if you backed the S&P 500 during the same time period. While I expect the spread to decrease in the next few years ahead, I still believe that D.R. Horton, KB Home, and Annaly have more risk than reward.
While D.R. Horton has performed much better than expectations over 4 of the last 5 quarters, the operational future is still uncertain. Over the last few years, management has been busy increasing productivity through cutting costs and improving the balance sheet. There is still $2.1 billion on the balance sheet, but it is nicely contrasted with a $1.2 billion cash position. The issue of $350 million in senior notes with a ~4.75% coupon will help to drive expansion, but the credit markets have been weakened for home ownership. Mortgage lending has been fairly horrific for banks, and they will likely be tighter in the next few years ahead into the full recovery.
To play devil's advocate, consider that the reasons to be optimistic about D.R. Horton. During the 3Q earnings call, management released record quarterly pretax income since FY2007 as net sales went up 25% y-o-y. This strong return was driven by an average sales price hike and greater volume. Demand has been so high that the backlog value has gone up by 40%, and management is addressing the shortage by increasing investments in construction and lot development, among other areas. Management has also been successful in cutting costs, which resulted in a gross profit margin from the home segment increasing 150 bps against the period one year ago. All of this, however, does not change how FCF has been on the deleterious decline from $2.2 billion for the TTM ending 2Q08 to -$114.3 million for the TTM ending 2Q12.
KB Home and Annaly are similarly in a high risk / low reward situation. KB Home trades at 227.5x forward earnings and is rated closer to a "sell" than a "buy" on the Street. Annaly is similarly rated a 3 out of 5 where "5" is a "sell." Poor performance has resulted in the dividend distribution being cut from 75 cents in late 2009 to just 55 cents today. I urge investors to get off the sinking ship.
On the positive side, QE3 will help feed business into mREITs. The whole strategy of mREITs is to borrow short and lend long, and this process can become more lucrative with the Fed injecting money into the system. The QE3 announcement of $40 billion per month in mortgage-backed securities will be particularly a boon for the industry. On the flip side (one the bulls have not addressed enough), lower rates will yield higher prepayment risk. Annaly is being more exposed to the flattish part of the yield curve, and investors will continue to fear the cut off of financing. Finally, there is too much leverage into Annaly that risk will deter investor entry before visibility emerges.
As for KB Home, future growth forecasts are not nearly great enough to justify the current valuation. Assuming the company meets expectations, it will generate 2013 EPS of $0.06. But EPS over the twelve trailing months was -$0.85, which means the company's presentation of a bright future is in marked contrast to the past. Under such a climate, I recommend holding out from investing in KB Home.
Two mortgage brokers left during 2011 largely due to Dodd-Frank regulations. A legal decision against KB Home later in 2011 added to the list of woes, which included a billion dollars worth of cash burn and market uncertainty. High cancellation rates for the first half of the year make it clear why KB Home should be on your "don't buy" list.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. 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.If you have questions about this post or the Fool’s blog network, click here for information.
