Builder Spec Construction at High Levels; Wise Positioning or Significant Risk?

Dan Oppenheim
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Dan Oppenheim , CFA

(415) 889-5617

doppenheim@ssrllc.com

January 31st 2019

Spec Construction at High Levels; Wise Positioning or Significant Risk?

  • Odd commentary for 1Q closing expectations given high spec construction. We’ve been puzzled by conservative comments from homebuilders about expectations for closings in calendar 1Q19 given the level of spec construction (homes under construction, but not under contract), which ought to motivate them to generate sales and closings. Yes, we understand that some of the conservatism reflects concern due to the slower sales in late 2018. However, we would expect greater urgency to reduce spec inventory, as Horton’s construction in progress ended fiscal 1Q19 at the highest level ever for the company and almost twice as high as 1Q05, when Horton had similar closing volume. Pulte also indicated that its spec construction increased, but its spec homes were at a lower level than Horton’s, as Pulte is less of a spec builder.
  • Horton’s work in progress well above 2005 peak, potentially presenting risk to margins. Horton’s $5.843 billion inventory of construction in progress and completed homes at the end of fiscal 1Q19 is the highest in the company’s history and represents 145% of backlog value. Its construction in progress and completed homes only represented a higher percentage of backlog value in fiscal 1Q from 2008-2011, when backlog levels were just 20-50% of current levels. Higher spec levels were necessary at that time as buyers did not want to make a long commitment in the uncertain environment. Pulte’s 3,246 spec homes were more modest, representing 37% of 4Q18 backlog.
  • Guidance from DHI and PHM for closings seems detached from spec levels. Horton’s guidance for fiscal 2Q closings of 12,800-13,300 homes implies a backlog conversion rate of 94-98%, modestly lower than the 100% conversion rate in fiscal 2Q18. The guidance seems especially low given that Horton ended fiscal 1Q19 with 20,100 spec homes (4,900 completed), with specs representing 154% of expected fiscal 2Q19 closings. Pulte’s guidance represents backlog conversion of 49-53%, consistent with 51% in 1Q18, but with specs representing 73% of expected 1Q19 closings. The slow sales activity in late 2018 likely instilled some caution and that the late timing of orders (December was stronger than October and November) also contributed to the conservatism. However, we’d expect that companies would place more emphasis on reducing spec inventory.
  • Upside to closings, or pressure on margins. If homebuilders work to reduce their inventory levels, or if demand improves with the lower mortgage rates, Horton and Pulte could generate higher closings than their guidance. With mortgage rates now back to the level of spring 2018, we do expect to see improving demand relative to late 2018. However, we see risk of margin pressure if sales activity does not improve in spring 2018. Historically, builders have faced the greatest pressure on prices and margins at times of weak demand and high spec inventory. Builders had generally been disciplined in building spec homes in recent years, but we see a much higher level of specs in 2019 than in the past, creating risk if demand does not improve.
Exhibit 1: SSR’s Preferences Among Housing-Related Sectors
Source: SSR analysis
Exhibit 2: A Fork in the Road: Horton’s Spec Construction Positions the Company
to Either 1) Capture Sales or 2) Face Margin Erosion
Source: Company reports and SSR analysis

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