Housing/Homebuilding: Finding Value in the Golden State

Dan Oppenheim
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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Dan Oppenheim , CFA
(415) 889-5617

doppenheim@ssrllc.com

March 25th 2019

Finding Value in the Golden State

  • California-focused builders trading at or below book value, offering value despite slowing. The trajectory of home sales and prices in California is likely the key issue for homebuilders in 2019. This is important not just for builders such as TOL, KBH, WLH, and LEN that have the most exposure (ranging from approximately 30-47% of homebuilding profits), but also for the industry as most diversified builders generate approximately 20% of their homebuilding profits from California. Valuations of the builders with the most exposure – near or below book value – imply price declines and land impairments. However, while conditions are slower than in recent years (and we’ve been focused on this slowing for quite some time), 1) we see some positive signs in early 2019 via both our market visits and trends in the existing home market, 2) we do not expect significant impairments given the high margins in California, 3) our detailed analysis of components of inventory suggest companies such as TOL have limited impairment risk, and 4) we see value in the stocks at current levels. Overall, we see opportunity in the CA-exposed homebuilders and prefer TOL.
  • Valuations at levels that typically represent opportunity or times of severe price risk. California-focused homebuilders are now trading at lower-than-typical multiples of price-to-tangible book value, with TOL trading at 1.1x fiscal 1Q19 tangible book value, WLH at 0.8x 4Q18 tangible book value, KBH at 1.0x fiscal 4Q18 tangible book value, and LEN at 1.4 fiscal 4Q18 tangible book value.
  • Margins in California provide cushion against impairments even with tougher conditions. The strong conditions in recent years have allowed homebuilders to generate gross margins in California that are either in line with, or above the margins in other regions. TOL’s 26.2% gross margin in California in fiscal 1Q19 was 520 basis points above its company-wide gross margin, with gross margins for KBH and LEN slightly higher in their West regions than overall, and we estimate that WLH’s gross margins in California were consistent with its other regions (based on its disclosure of pretax income by region).
  • Detailed analysis of inventory components favors TOL. TOL has the least portion of its homebuilding inventory in land, with just 32% of its inventory in land and land under development and land deposits, well below the 48% for LEN, 59% for WLH, and 62% for KBH. Land typically involves more risk than work in progress, with the lower percentage of inventory in land for TOL indicating lower risk relative to other homebuilders.
  • A more difficult environment in early 2019, but reason for optimism. Trends in both the new and existing home markets in most California markets have slowed over the past year, as seen via a slower pace of sales, greater inventory, and increased prevalence of discounts on homes listed for sale. However, in early 2019, we have seen some moderation in these worsening trends during our market visits and in recent existing home sale statistics. Importantly, trends seen in existing home sales in February in California markets are more meaningful than trends in other states due to the shorter time between contract signing and closing in California and the earlier start to the selling season due to the warmer climate relative to other markets.

 

Exhibit 1: SSR’s Preferences Among Housing-Related Sectors
Source: SSR analysis

California’s trends are crucial to the outlook for homebuilders and housing broadly. Large, diversified builders such as D. R. Horton (DHI) and Pulte (PHM) generate approximately 20% of homebuilding pretax profits from California (typically a large portion of the west region for those builders), with other homebuilders such as Toll Brothers (TOL), KB Home, William Lyon (WLH), and Lennar (KBH) having from 47% of pretax profit exposure for TOL in fiscal 2018 (43% in fiscal 1Q19), approximately 45% for KB Home, 36% for WLH, and approximately 30% for Lennar. Overall housing permits in California only represented 8.9% of total permits across the country in 2018, but the state has greater importance due to the higher price point (median single-family home price of $538,690 in California in January 2019, more than double the $249,400 national median), with median home prices even higher in coastal markets of California. In addition, gross margins on homes in California are typically several hundred basis points above margins in other regions, although this is somewhat dependent on how the land is controlled. Adding to the exposure, many homebuilders have focused attention on the coastal California markets, with less focus on the Midwest and Northeast, as California’s economic and job growth, and land constraints leading to limited new construction typically generate strong returns for homebuilders.

 

Exhibit 2: Builders Have Significant Exposure to California, Despite California Representing Less than 10% of National Housing Permits
Note:
1) Toll Brothers and William Lyon report profitability for California.
2) D.R. Horton includes California in the West region, which includes California, Hawaii, Nevada, Oregon, Utah, and Washington, with the region representing 27% of pre-tax homebuilding income in fiscal 2018.
3) KB Home includes California in its West region, which includes both California and Washington. The West region represents 53% of KB Home’s pre-tax homebuilding income.
4) Lennar reports California within its West region, which includes Arizona, California, Colorado, Nevada, Oregon, Utah, and Washington, with the region accounting for 48% of pre-tax homebuilding income in fiscal 2018.
5) MDC includes California in its West region, with the West generating 46.7% of pre-tax income. California represented 43% of revenue in MDC’s West region.
6) Meritage includes California in its West region, with the West representing 46.9% of pre-tax income. California represented 41% of revenue in the West, but likely a slightly greater proportion of profitability.
7) Pulte includes California in its West region, with the region comprised of Arizona, California, Nevada, New Mexico, and Washington. The West region represented 36% of Pulte’s homebuilding operating income in 2018, or 35% excluding a $26.4 million profit from two land sales in California.
Source: Company reports, Census Bureau, and SSR analysis

 

California-focused builders trading at valuations typically seen during a downturn. The builders with the greatest exposure to California are trading near book value or below book value. TOL trades at 1.1x fiscal 1Q19 tangible book value, KBH trades at 1.0x fiscal 1Q19 tangible book value, WLH trades at 0.8x 4Q18 tangible book value, and LEN trades at 1.1x 4Q18 tangible book value. Typically, builders have not traded at these valuations outside of times when significant price declines (and land impairments) are expected.

 

Exhibit 3: CA-Exposed Builders Trading Near Historic Lows on Price/Tangible Book

Source: S&P Capital IQ, Company reports, and SSR analysis

 

Margins in California high enough to absorb softening without triggering significant impairments. The key metric in determining impairments for homebuilders is the level of expected gross margins on communities. Future communities will likely have lower margins than current and recently-completed communities due to both higher land costs and easing demand, but we believe that recently-reported margins can at least provide perspective on the likelihood of significant impairments on these future communities. Toll Brothers achieved a 26.2% gross margin in California in fiscal 1Q19 (well above its company-wide gross margin of 21.0%), with KB Home generating an 19.2% gross margin ex charges in its West region in fiscal 4Q18 (18.7% gross margin ex-charges for the company), William Lyon producing an approximately 18.3% gross margin in California in 4Q18 (estimated based on $31.3 million of pretax income in California in 4Q18 and our estimates for allocation of corporate expense and SG&A) consistent with its other regions, and Lennar noting an 20.2% gross margin in its West region for 2018, slightly above the 19.6% gross margin overall (Lennar revised its regional reporting at the end of fiscal 2018, with more markets included in the West region than previously when the West region had been comprised only of California and Nevada). As these companies all had gross margins in California/West that were at or above the overall gross margins (with all four companies reporting healthy levels of gross margins), we believe it would require significant price declines in addition to the slower pace of sales to result in meaningful impairments.

Exhibit 4: High Margins in California Suggest Softening Conditions Won’t Bring Severe Impairments
Note:
1) KBH gross margins reflect West region, which includes California and Nevada.
2) LEN gross margins reflect fiscal 2018 West region gross margins. The West region includes Arizona, California, Colorado, Nevada, Oregon, Utah, and Washington.
Source: Company reports and SSR analysis

Inventory not comprised only of land, and will shift more to work-in-progress as year progresses. Toll Brothers in best shape of California-focused builders, with less of its inventory in land. Looking at inventory on the balance sheet of homebuilders, the greatest risk is typically from land, rather than work in progress. The mix of inventory can vary during the year, as the seasonality of orders and deliveries means that work in progress is typically lowest at the end of the year/start of a year and then increases during the selling season. It is important to look at the components of each company’s inventory to get a sense of the risk of impairments. In general, there is greater risk of impairment to land than to work in progress, with land for future development typically having the greatest risk, given that land is essentially the residual as homebuilders evaluate opportunities. Work in progress typically has lower risk of impairments as much of the investment represents costs incurred from development of the land, construction materials, and labor, rather than just raw land. In addition, much of the work in progress is part of the backlog of homes under contract, with these homes to be delivered in the coming months and at a gross margin typically consistent with (or only slightly below) what has been reported in recent quarters.

Toll Brothers has the least portion of inventory in land, KB Home has the most.. Toll Brothers has 32% of its inventory in land and land under development or land deposits, well below the 48% for Lennar, 59% for William Lyon, and 62% for KB Home.

Exhibit 5: Toll Brothers Has the Less Inventory in Land than Others CA-Focused Builders
Source: Company reports and SSR analysis

Toll Brothers had almost two-thirds ($4.870 billion, or 63%) of its inventory in construction in progress at the end of fiscal 1Q19, with $2.179 billion (28%) in land and land development, with just $410 million (5%) in sample homes, and $256 million (4%) in land deposits. Toll has made significant strides in reducing its investment in land – especially land for future communities – as it has worked to both reduce the risk from land and boost its ROE. Specifically, Toll has reduced its land held for future communities to $1.088 billion at the end of fiscal 1Q19, down by 55% since 1Q15, when Toll had $2.42 billion of land for future communities.

Exhibit 6: Majority of Toll Brothers’ Inventory in Construction in Progress, Limiting Risk
Source: Company reports and SSR analysis

KB Home’s inventory had greater concentration of land and land under development, with $2.22 billion (62% of inventory) in land and land under development, with another $238 million (7%) in land held for future development. Just $1.125 billion (31%) represented construction in progress. Given the greater proportion of land in KB Home’s inventory, there’s likely greater risk of impairments than for other homebuilders that have a lower percentage of inventory in land.

Exhibit 7: 62% of KB Home’s Inventory in Land
Source: Company reports and SSR analysis

59% of William Lyon’s inventory at the end of 2018 was in land, with $660 million (28%) in land and land under development, $564 million (24%) in finished lots, and $147 million (7%) in land deposits. The remaining 41% of inventory was in construction in progress ($839 million, or 36%) and model homes ($122 million, or 5%).

Exhibit 8: Nearly 60% of William Lyon’s Inventory in Land
Source: Company reports and SSR analysis

Slightly less than half of Lennar’s inventory was comprised of land investments, with $8.178 billion (48%) in land and land under development. The remainder of inventory was in construction in progress ($8.681 billion, or 51%), with the remaining 1% in consolidated inventory not owned.

Exhibit 9: Lennar’s Inventory Split Between Land and Construction in Progress
Source: Company reports and SSR analysis

Market conditions slower than in recent years, but some positive signs as of late. Home sales activity in California in early 2019 has been slower than in recent years, but trends suggest that the spring is not a wash-out, despite initial fears that it would be. February existing home sales in key California markets such as Los Angeles, Orange County, Riverside, San Diego, and San Jose showed more modest year/year declines in sales than in prior months. In these markets, the year/year decline in existing home sales lessened by 260 basis points in Los Angeles relative to January, 150 basis points in Orange County, 540 basis points in Riverside, 710 basis points in Sacramento, 540 in San Diego, and worsened by 100 basis points in San Jose (but was 610 basis points better than the decline in December). In addition, our market checks in March suggest reasonable traffic and home sales as prospective buyers have responded to the lower mortgage rates and improved affordability.

Exhibit 10: More Modest Year/Year Declines in Existing Home Sales in Key Markets in February
Source: Redfin and SSR analysis

February existing home sale trends matter more in California than elsewhere. Importantly, trends in California in February are more important than in other markets across the country due to both the shorter timing between contract signing and closing and the warmer climate, which leads to an earlier start to the spring season. Existing home contracts in California typically include 30 days between contract signing and closing, whereas closing periods are often longer (60 days) in many other parts of the country. As a result, existing home sales that close in February in California likely went into contract in January, whereas existing home sales that closed in February in other markets likely went into contract in December. Part of the reason for the shorter time between contract signing and closing is that California law limits the deposit that a seller can keep to 3% of the purchase price if a buyer does not complete a transaction. In addition, the warmer climate in California leads to an earlier start to the selling season so that contract activity in January is less depressed (seasonally) than in other markets.

California far more important to builder profitability than as a share of housing construction volume. Land constraints, regulation, difficult local zoning, and high costs lead to lower levels of construction than would be seen otherwise. The 62,236 single-family home permits issued in California in 2018 represented just 7.3% of the 852,856 single-family permits issued nationally. Looking at total housing permits, California’s 117,079 permits represented 8.9% of the 1,317,895 housing permits issued nationally based on California having an 11.8% share of multifamily construction (buildings with two or more units) nationally. The higher share of multifamily construction reflects the higher cost of housing in California, with the higher cost driving greater density.

Risks and key metrics to watch: depth of buyer demand, inventory, and price reductions. We view the depth of demand as a key issue to watch in 2019. That is, for those homebuyers looking to purchase a home, the process typically starts early in the year. As a result, traffic and sales activity typically looks healthy at the beginning of the selling season. However, as time passes and the initial buyers have purchased homes, the question then becomes about the depth of the buyer pool. Inventory levels are higher in 2019 than in 2018 (although year/year increases have eased in recent months), and further increases in inventory levels could lead to an additional shift to a buyer’s market and added pressure on home prices. Inventory growth year/year ranges from modest increases of 4.5% in the Inland Empire (Riverside-San Bernardino) to 17.4% in Los Angeles and 20.6% in Orange County, and up to 82.1% in San Jose, although the increase in San Jose is off of an extremely low base, with the months of supply of inventory at just 2.5 months, the lowest of the key California markets. We will continue to watch both the inventory levels in key California markets and also the percentage of homes for sale that have seen price reductions, which would indicate the balance in the market.

Exhibit 11: Year/Year Growth in Inventory Slowing in Recent Months – A Positive Sign
Source: Redfin and SSR analysis

©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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