The Zacks Analyst Blog Highlights: Home Construction ETF, D.R. Horton, Meritage and MDC Holdings

CHICAGO, July 29, 2013 /PRNewswire/ -- Zacks.com announces the list of stocks featured in the Analyst Blog. Every day the Zacks Equity Research analysts discuss the latest news and events impacting stocks and the financial markets. Stocks recently featured in the blog include Home Construction ETF (AMEX: ITB-Free Report), D.R. Horton (NYSE: DHI-Free Report), Meritage (NYSE: MTH-Free Report) and MDC Holdings (NYSE: MDC-Free Report).

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Here are highlights from Friday's Analyst Blog:

What's Knocking Homebuilders Down?

Housing stocks have stumbled in recent weeks and the drop is raising a few eyebrows.  The sector has been hit by a number of factors with a shift in the interest rate environment, rich valuation, and a crowded long leading to a correction despite generally favorable Q2 earnings results.

Higher interest rates and rising mortgages catch investors over exposed:

From a macro perspective, the sector has been pressured by higher mortgage rates and a pickup in existing home inventories.  The Home Construction ETF (AMEX: ITB-Free Report) posted a high close on May 14th shortly after the MBA mortgage purchase index peaked on May 3rd.  The MBA purchase index has dropped about 10% from its May high. 

Below the surface and less noticed is the rise in existing home inventories.  Since January's low, existing home investors have jump about 420,000 units and the months supply has expanded to 5.2 from 4.3.  Inventories are very manageable, especially new home inventories, which are near record lows.  However, the increase does reduce the need for new construction.  It appears that higher home prices are drawing supply onto the market.

Rising home prices and increasing mortgage rates may be putting a damper on affordability.  The National Association of Realtors Fixed Rate Affordability Index peaked at 209 in January and was last reported at 171.1 in May. It is down 18% from its peak.  Higher home prices look to be the largest drag on affordability.

In terms of homebuilder comments on the macro landscape, D.R. Horton (NYSE: DHI-Free Report) noted that the spike in interest rates slowed orders in the back half of its quarter.  Meritage (NYSE: MTH-Free Report) said it saw a little bit of cooling in July due to higher rates, but indicated that demand remained stronger than July 2012.

Profit results have been solid:

The table following displays a history of recent earnings surprises (actual result compared to the Zacks Consensus Earnings per Share Estimate).  Five of the six home builders that recently reported achieved a positive earnings surprise. The average gain was 27.8%.   Pulte was the exception missing by slightly more than 10%.   

Although recent results were strong, analysts are starting to turn a bit more cautious. The Zacks Consensus EPS Estimates for the upcoming quarter have declined in three cases (RYL, LEN, and TOL) and lifted in one case (MTH).  Looking to the next quarter, think December, the situation is more mixed with the consensus up for three companies (RYL, MTH, and TOL) and down for two companies (PHM and LEN).

Valuation is stretched:

Given the hit to earnings during the Great Recession, it is tough to measure the valuation of homebuilders based on earnings. The companies posted material losses creating not meaningful PE ratios.  However, price to sales and price to tangible book values provide sustainable historical metrics. 

Based on both the price to sales and price to tangible book metrics, housing stocks are stretched. The average price to sales ratio in the sector is trading 90% over the median with MDC and BZH helping to pull the average down and SPF and RYL raising the average.   The average median price to sales ratio is 0.73 and the average current value is 1.40.  The market is pricing exceptional sales growth.  The historically low price to sales ratio, mostly below 1.0, is a function of investors viewing the industry as cyclical.

The average of the median price to tangible book ratios is 1.42.  The current average is 2.24 or a 56% premium to the median.  RYL and PHM are most bloated, while MDC and TOL have the narrowest premiums.  

Traders have become optimistic on the housing sector:

Actions by the Federal Reserve to lower mortgage rates, historically low new home inventories, and reduced competition due to the exit of local and regional builders have attracted buyers to publically traded home builders.  Investors have been searching for a growth story in a slow growth environment.   The short interest in a number of the companies has declined sharply in recent years suggesting investors are less positioned for a price decline. The buying power linked to shorts is also drastically reduced.   Picking a few examples, the short interest ratio for MDC has declined from a peak near 11.5 to about 3.0.  LEN and RYL have seen their short interest ratios drop from roughly 9.5 to 5.4 and 8.5 to 3.7 respectively. TOL's short interest ratio is below 2.0 and at a 10 year low.

Conclusion:

Homebuilders are priced for continued strong profit growth and the bar is high for meeting or exceeding investor expectations given stretched valuations.  Value investors may have trouble playing in this sector, but if you are looking for exposure MDC Holdings (NYSE: MDC-Free Report) seems to stand out.  It is carrying a price to sales and price to book value which is relatively low to its peer group.  It is also a Zacks Rank #1 which suggests its earnings revisions backdrop is favorable.   MDC does, however, release its earnings July 30 presenting event risk.  Bottom line, the easy money in the housing sector appears already built up.

Today, Zacks is promoting its ''Buy'' stock recommendations. Get #1Stock of the Day pick for free.

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