Digging Beneath the Surface of 1Q19 Results

Dan Oppenheim
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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Dan Oppenheim, CFA

(415) 889-5617

doppenheim@ssrllc.com

April 30th 2019

Digging Beneath the Surface of 1Q19 Results

  • Improving sequential trends reinforce our confidence in the housing sector. The positive demand trends seen in 1Q19 – sequential improvement in orders – and the continuation of this as seen in our market checks in April reinforce our expectation that housing stocks are likely to perform well in the coming months. We view the continued healthy trends in April to be especially important, as this suggests greater depth to demand than in 2018, when buyer traffic and orders lost momentum in April.
  • West coast issues more of a short-term for-sale challenge than an overall housing problem. The slower for-sale demand in California and the Pacific Northwest in late 2018 and early 2019 (DHI’s west region orders fell 6.6% in calendar 1Q19, MTH’s west region orders slipped 2.9% with the decline muted by community count growth in Colorado, and PHM’s west region orders declined 0.5%) appear isolated to the for-sale market, as multifamily REITs reported stronger revenue growth on the west coast than elsewhere. AVB reported stronger rent growth on the west coast than the east, with AVB’s same-store revenue growth 30-160 basis points higher in its west coast regions than its east coast regions (page two). In addition, we have seen signs of stabilization in west coast markets as of late.
  • DHI’s margin pressure less anomalous than at first glance. Homebuilders saw modest margin erosion in 1Q19 (year/year gross margin declines of 20 basis points for PHM, 40 basis points for MTH, and 150 basis points for DHI), driven by the slower demand in late 2018. DHI’s more significant decline likely reflected the impact of slower demand and a negative impact from higher spec sales, but also the faster realization of changing margins due to DHI’s shorter cycle from order to closing, with over 40% of DHI’s fiscal 2Q19 closings coming from orders received in fiscal 2Q19. This is a significantly higher percentage of homes ordered and closed in the same quarter than for other builders, making DHI’s margins more “real time”, as compared with a lag for other builders.
  • Specs driving higher backlog conversion for most builders. For MTH and PHM, the 2Q19 closing guidance implied backlog conversion of 59-66% and 51-54%, respectively, which reflects some benefit of spec closings, given the modestly higher backlog conversion than 51% and 61%, respectively, in 2Q18. However, calendar 2Q19 guidance for closings represents a slightly lower backlog conversion rate for DHI than in the same quarter last year. DHI’s guidance implies backlog conversion of 86-89%, with 89% conversion last year.
  • Continue to expect favorable affordability to drive better demand. We continue to expect that the low mortgage rates and attractive affordability will drive improving home sales. Buyer activity in both the new and existing home markets over the end of the spring season are key to sustaining the recent momentum from the affordability-driven improvement.
Exhibit 1: SSR’s Preferences Among Housing-Related Sectors
Source: SSR analysis

Digging Beneath the Surface of 1Q19 Results

Improving sequential trends reinforce our confidence in the housing sector. The positive demand trends seen in 1Q19 – sequential improvement in orders – and the continuation of this as seen in our market checks in April reinforce our expectation that housing stocks are likely to perform well in the coming months. We view the continued healthy trends in April to be especially important, as this suggests greater depth to demand than last year, when buyer traffic and orders lost momentum in April.

West coast issues more of a short-term for-sale challenge than an overall housing problem. The slower for-sale demand in California and the Pacific Northwest in late 2018 and early 2019 (DHI’s west region orders fell 6.6% in calendar 1Q19, MTH’s west region orders slipped 2.9% with the decline muted by community count growth in Colorado, and PHM’s west region orders declined 0.5%) appear isolated to the for-sale market, as multifamily REITs reported stronger revenue growth on the west coast than elsewhere. We do expect that builders will still see some negative impact on margins in coming quarters from the slower demand. PHM’s operating margins increased year/year in the West (up 70 basis points) and remained well above other regions, while operating margins declined in other regions. We believe this reflects the lag with slower activity first leading to slower orders, but often taking several quarters to impact margins. However, this likely means that margins will likely show the impact in upcoming quarters.

Rental market continues to fare well on west coast. AVB’s same-store revenue trends pointed to better growth on the west coast than the east coast, with the strongest growth in the Pacific Northwest (up 4.8% year/year), followed by SoCal (up 3.7%) and NorCal (up 3.5%), better than the 3.2% in east coast regions. Occupancy levels were also slightly higher in the west than in eastern regions.

DHI’s margin pressure less anomalous than at first glance. Homebuilders saw modest margin erosion in 1Q19 (year/year gross margin declines of 20 basis points for PHM, 40 basis points for MTH, and 150 basis points for DHI), driven by the slower demand in late 2018. DHI’s more significant decline likely reflected the impact of slower demand and a negative impact from higher spec sales, but also the faster realization of changing margins due to DHI’s shorter cycle from order to closing, with over 40% of DHI’s fiscal 2Q19 closings coming from orders received in fiscal 2Q19. This is a significantly higher percentage of homes ordered and closed in the same quarter than for other builders, making DHI’s margins more “real time”, as compared with a lag for other builders.

Builders likely to de-emphasize spec homes as season progresses. Pulte noted that it is tapering spec starts after increasing spec activity for production reasons in 4Q18. We expect most other builders to also slow spec construction, but with DHI likely to continue with its more spec-focused strategy. DHI’s spec homes remained high in 2Q19 and increased 25% year/year, although down sequentially from 1Q19 levels (the 17,800 specs at the end of fiscal 2Q19 were up from 14,200 in fiscal 2Q18, but down sequentially from 20,100 at the end of fiscal 1Q19). We were somewhat concerned that the level of DHI’s completed homes increased on a sequential basis (5,300 at the end of fiscal 2Q19, up from 4,900 at the end of fiscal 1Q19), which could also put pressure on margins, but would expect added focus on selling these homes in the current quarter. The ratio of DHI’s construction in progress to backlog value increased to 122% in fiscal 2Q19, up from 106% in fiscal 2Q18, with the 1600 basis point year/year increase being similar to the 1500 basis point year/year increase in fiscal 1Q19.

Exhibit 2: DHI’s Construction in Progress Remains Elevated as Compared with Backlog in Fiscal 2Q19
Source: Company reports and SSR analysis

Watching to see DHI’s inventory trends in the west. DHI has not yet filed its 10-Q for the quarter and will likely report its regional inventory in the filing. We believe a key metric to watch will be its inventory in the west. Horton’s inventory to backlog value was significantly higher in the west than in other regions in both fiscal 4Q18 and 1Q19 (see table below), a function the high spec inventory and a lower backlog level in the west (backlog in the west was down 8% year/year in fiscal 4Q18 and down 25% year/year in fiscal 1Q19). We anticipate that this ratio will remain elevated in the west given the 26% year/year decline in backlog in the west, but would think DHI will begin to slow spec starts in the west to avoid self-inflicted margin pressure.

Exhibit 3: DHI’s Inventory/Backlog Significantly Higher in the West
Source: Company reports and SSR analysis

Backlog conversion likely to increase for MTH and PHM. For MTH and PHM, the closing guidance equates to backlog conversion of 59-66% and 51-54%, respectively. The midpoint of both are slightly above the backlog conversion these companies realized in 2Q18, with MTH having backlog conversion of 61% in 2Q18 and PHM closing 51% of its beginning backlog in 2Q18.

DHI’s closing guidance appears more conservative. The mid-point of fiscal 3Q19 guidance for closings represents a lower backlog conversion ratio for DHI than in the same quarter last year, despite the higher level of spec homes. DHI’s guidance implies backlog conversion of 86-89%, with 89% conversion last year. The higher level of spec homes (17,800 spec homes at the end of fiscal 2Q19, above the 14,200 spec homes at the end of fiscal 2Q18) should enable DHI to close more sales during the quarter if demand is sufficient.

Continue to expect favorable affordability to drive better demand. We continue to expect that the low mortgage rates and attractive affordability will drive improving home sales. Buyer activity in both the new and existing home markets over the end of the spring season are key to sustaining the recent momentum from the affordability-driven improvement.

©2019, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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