- Lennar Corp. and KB Home beat quarterly earnings estimates yesterday
- After this year's massive sell-off, the housing sector is presenting an attractive risk-reward proposition with some stocks' forward multiples down to a low single-digit
- KeyBanc Capital Markets in a note this week double upgraded the homebuilding sector to overweight from underweight, saying history points to higher prices after declines
Despite the highly expected cooling of the U.S.'s housing market amid rising interest rates, it seems things are not that bad for the nation's largest homebuilders after all—at least not for now.
Lennar Corporation (NYSE:LEN) and KB Home (NYSE:KBH) beat quarterly earnings estimates by a reasonable margin yesterday, bringing more evidence that the sector's broad-based sell-off may have gone too far.
The Miami-based Lennar, the nation's second-largest home builder by market capitalization, posted third-quarter net earnings per diluted share of $5.03, an 11% jump from the same period a year ago. Sales rose 19% to $8.9 billion from the year prior. Consensus estimates by FactSet had anticipated earnings per diluted share of $4.81 on revenue of about $8.9 billion.
The smaller, Los Angeles-based KB Home reported earnings per diluted share of $2.86 in the third quarter, a 79% increase compared to the same quarter last year and beating estimates of $2.67 per share. Furthermore, according to yesterday's release, total revenue was $1.84 billion—an increase of 26% from last year's same quarter.
Investors have sent housing-related stocks tumbling this year in anticipation of a significant slowdown in the U.S. housing market. The S&P Homebuilders Select Industry index, which includes companies such as Lennar, KB Home, and DR Horton (NYSE:DHI), has slumped around 36% this year—and is now poised for its most significant annual decline since 2007.
However, after this massive sell-off, the housing sector is beginning to present an attractive risk-reward proposition for long-term opportunities amid the current bear market. Some homebuilders' forward price/earnings multiples are down to a low single-digit (Lennar's: 5.37, KB Home: 2.96), sending investors a significant buy signal.
KeyBanc Capital Markets, in a note this week, double upgraded the homebuilding sector to overweight from underweight, saying history points to higher prices after declines this year. The note pointed to data from 1963, showing that the relationship between homebuilders and the S&P 500 now offers an attractive risk-reward.
The note says:
"On balance, we see fundamental and rate pressure persisting, but positive relative performance, supporting our upgrades ... with approximately 20% upside to our [overweight] price targets from current levels."
Demand Remains Strong
Homebuilders face rough seas ahead with mortgage rates climbing fast. The Federal Reserve delivered its third consecutive interest rate rise of 0.75 percentage points and signaled that significant increases were likely even though they raise the risk of recession.
As a result, the average rate on a 30-year fixed mortgage climbed to 6.29%, according to a survey of lenders released Thursday by Freddie Mac. It was the second week in a row that rates topped 6%. The last time rates were this high was October 2008, when the U.S. was deep in recession.
Amid the current macro environment, Lennar said new orders fell 12% to 14,366 homes in the third quarter, while KB Home's net orders fell 50% to 2,040.
Despite acknowledging that the market has slowed, Lennar and KB Home said in their earnings statements that their businesses remain resilient, mostly on the back of a solid labor market.
Another stark difference in this cooling housing market is that while buyer interest and home price growth have slowed, demand remains strong due to supply shortages and the work-from-home environment.
Stuart Miller, Executive Chairman of Lennar, said in a statement:
"Sales have clearly been impacted by rising interest rates, but there remains a significant national shortage of housing, especially workforce housing, and demand remains strong as we navigate the rebalance between price and interest rates."
Bottom Line
Homebuilder stocks reflect investors' fear that rising mortgage interest rates will dry up demand for housing and crush the sector's earnings. However, many favorable factors, such as supply shortages, a strong labor market, and work-from-home culture, are still supporting the housing market. In addition, homebuilders' stock prices already reflect a worst-case scenario, thus offering a good entry point to long-term investors.
Disclosure: The writer doesn't own any of the stocks mentioned in this report.