How Does Homebuilding Demand Stack Up to Available Supply?
This week, we use AAII’s A+ Investor Stock Grades to provide insight into three homebuilder stocks that are struggling to keep up with an ongoing demand surge due to supply disruptions. For investors focused on opportunities in this industry, should you consider the three homebuilder stocks of D.R. Horton Inc., LGI Homes Inc. and Toll Brothers Inc.?
Homebuilder Stocks Recent News
In recent months, we have seen large variability in the homebuilding industry. In the most recent report from the U.S. Commerce Department, existing home sales in August fell 2% as supply remained tight, with key numbers moving in opposite directions compared to a year ago — a decrease of 13.4% in housing inventory and an increase of 14.9% in median house prices. The frenetic demand for homes was fueled by the coronavirus pandemic, but signs are showing that this demand and the corresponding surge in house prices appear to be decelerating. As the housing market boomed early in the pandemic, primarily for single-family homes, total home sales increased as resales fell. Sales of existing homes account for the bulk of U.S. home sales. The rise in existing home prices is expected to slow as the housing inventory shortage eases and demand moderates.
Despite negative news regarding material supply and labor shortages and declines in existing home sales, new home sales increased 1.5% month over month in August to a seasonally adjusted annual rate of 740,000 units. The current inventory of new homes on the market represents the largest supply in nearly 13 years. However, about 78% of these homes are either under construction or yet to be built, and sales in August decreased 24.3% year over year. New home sales have struggled to post significant gains since surging to a rate of 993,000 units in January, which was the highest since the end of 2006. However, the new homes market remains attractive and is supported by an acute shortage of previously owned homes for sale.
The increased demand for homes in the suburbs and other low-density areas far outpaced supply, leading to bidding wars. The industry fundamentals remain strong, including funding from the U.S. government, improved wages in the labor market and continued low interest rates.
Grading Homebuilder Stocks With AAII’s A+ Stock Grades
When analyzing a company, it is useful to have an objective framework that allows you to compare companies in the same way. This is one reason why AAII created the A+ Stock Grades, which evaluate companies across five factors that have been shown to identify market-beating stocks in the long run: value, growth, momentum, earnings estimate revisions (and surprises) and quality.
Using AAII’s A+ Stock Grades, the following table summarizes the attractiveness of three homebuilder stocks — D.R. Horton, LGI Homes and Toll Brothers — based on their fundamentals.
AAII’s A+ Stock Grade Summary for Three Homebuilder Stocks
What the A+ Stock Grades Reveal
D.R. Horton Inc. (DHI) is a leading homebuilder in the U.S. with operations in 90 markets across 29 states. D.R. Horton mainly builds single-family detached homes (over 90% of home sales revenue) and offers products to entry-level, move-up, luxury buyers and active adults. The homebuilding divisions are primarily engaged in the acquisition and development of land and the construction and sale of residential homes. The company’s 55 homebuilding divisions are aggregated into six segments: East Region, South Central Region, Midwest Region, West Region, Southwest Region and Southeast Region. The Forestar segment is a residential lot development company with operations in 55 markets across 22 states. The company offers homebuyers mortgage financing and title agency services through its financial services segment.
Recently, D.R. Horton updated its guidance for homes closed, consolidated revenues and home sales gross margin for the fourth quarter of fiscal 2021. The company expects homes closed in the fourth quarter to be in a range of 21,300 to 21,700 homes compared to the previous range of 23,000 to 24,500 homes. This decrease is due to continuing significant supply chain disruptions, including shortages and delivery delays in certain building materials, along with tightness in the labor market. Due to lower-than-expected closing volume, partially offset by an expected increase in the average sales price of homes closed during the quarter, the company now expects its fourth-quarter consolidated revenues to be in a range of $7.7 billion to $7.9 billion compared to the prior range of $7.9 billion to $8.4 billion. As strong new home demand and limited housing supply continue to support pricing power across most of its operating footprint, the company now expects its fourth-quarter home sales gross margin to be in the range of 26.5% to 26.8%. This is an improvement from the previous range of 26.0% to 26.3%.
Earnings estimate revisions offer an indication of what analysts are thinking about the short-term prospects of a firm. The company has an Earnings Estimate Revisions Grade of C, which is considered neutral. The grade is based on the statistical significance of its last two quarterly earnings surprises and the percentage change in its consensus estimate for the current fiscal year over the past month and past three months.
The company reported positive earnings surprises in the prior two quarters. Over the last month, the consensus earnings estimate for the third quarter has decreased from $3.51 to $3.42 per share based on 10 downward revisions. Three months ago, the consensus earnings estimate was $3.06 per share.
A higher-quality stock possesses traits associated with upside potential and reduced downside risk. Backtesting of the quality grade shows that stocks with higher quality grades, on average, outperformed stocks with lower grades over the period from 1998 through 2019.
D.R. Horton has a Quality Grade of A. The A+ Quality Grade is the percentile rank of the average of the percentile ranks of return on assets (ROA), return on invested capital (ROIC), gross profit to assets, buyback yield, change in total liabilities to assets, accruals to assets, Z double prime bankruptcy risk (Z) score and F-Score. The score is variable, meaning it can consider all eight measures or, should any of the eight measures not be valid, the valid remaining measures. To be assigned a quality score, though, stocks must have a valid (non-null) measure and corresponding ranking for at least four of the eight quality measures.
The company ranks highly in terms of its return on assets and buyback yield, ranking in the 94th and 88th percentile of all U.S.-listed stocks, respectively. However, it ranks poorly in terms of its accruals to assets, putting it in the fifth percentile.
D.R. Horton has a Momentum Grade of D, based on its Momentum Score of 30, and a strong Growth Grade of B. D.R. Horton has a 1.0% dividend yield.
LGI Homes Inc. (LGIH) is engaged in the design, construction and sale of new homes in markets. The company’s current product offerings include entry-level homes, including both detached homes and townhomes; move-up homes, which are sold under LGI Homes brand; and luxury series homes, which are sold under the Terrata Homes brand. It offers a set number of floor plans in each community with features that include upgrades, such as granite countertops, appliances and ceramic tile flooring.
The company is engaged in the design, construction and sale of new homes in markets in Texas, Arizona, Florida, Georgia, New Mexico, Colorado, North Carolina, South Carolina, Washington, Tennessee, Minnesota, Oklahoma, Alabama, California, Oregon, Nevada, West Virginia, Virginia and Pennsylvania.
LGI Homes has an A+ Growth Grade of B. The growth grade considers both the near- and longer-term historical growth in revenue, earnings per share and operating cash flow. The company reported second-quarter revenues of $792 million, up 64.3% from $482 million in the year-ago quarter. The company reported quarterly diluted earnings per share of $4.71. LGI Homes does not currently pay a dividend.
LGI Homes has a Momentum Grade of D, based on its Momentum Score of 29.
Toll Brothers Inc. (TOL) is the leading luxury homebuilder in the U.S. with an average sales price well above public competitors’ prices. It is engaged in designing, building, marketing, selling and arranging financing for detached and attached homes in luxury residential communities. The company operates through two segments: traditional homebuilding and urban infill. The traditional homebuilding segment builds and sells homes for detached and attached homes in luxury residential communities located in affluent suburban markets and caters to move-up, empty-nester, active-adult, affordable luxury and second-home buyers in the U.S. The traditional homebuilding segment operates in five geographical locations across the U.S. The urban infill segment builds and sell homes in urban infill markets through Toll Brothers City Living (City Living). It operates its own architectural, engineering, mortgage, title, land development, golf course development, smart home technology and landscape subsidiaries.
Toll Brothers has a Value Grade of A, based on its Value Score of 10, which is considered deep value. The company’s Value Score ranking is based on several traditional valuation metrics. The company has a score of 14 for the price-to-free-cash-flow ratio, 14 for shareholder yield and 19 for the price-to-sales ratio (remember, the lower the score the better for value). Successful stock investing involves buying low and selling high, so stock valuation is an important consideration for stock selection.
The Value Grade is the percentile rank of the average of the percentile ranks of the valuation metrics mentioned above along with the price-earnings, price-to-book and enterprise-value-to-EBITDA ratios.
Toll Brothers has a Momentum Grade of D, based on its Momentum Score of 35. This means that it ranks in the second-worst tier of all stocks in terms of its weighted relative strength over the last four quarters. The weighted four-quarter relative strength rank is the relative price change for each of the past four quarters.
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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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