PulteGroup: A Leading Home Builder At A Discount (NYSE:PHM)

Introduction

Home builders have traded at a lower earnings multiple than the S&P 500 for the past decade. This article discusses factors in play that strengthen fundamentals for home builders. I believe home builder stocks have strong upside in the next few years. While the bullish thesis applies to the entire home builder sector, I am particularly bullish on PulteGroup (PHM) due to its lower valuation among peers in the sector despite strong performance in 2020.

Background

PulteGroup is the third largest home builder in the US in terms of number of homes closed (data source: builderonline.com), and it operates in 23 states and 42 major markets. Their business is diversified to cater to a wide range of buyer budgets.

Image Source: PulteGroup website

Image Source: PulteGroup website

Performance and Valuation

Since my previous article on the company – PulteGroup: Bullish On Home Buying, the stock is up almost 48%. I still consider PulteGroup undervalued in comparison with its peers. PHM currently trades at a TTM EV/EBITDA of 8.72.

Source: Seeking Alpha

Source: Seeking Alpha (P/E Ratio GAAP)

PulteGroup closed 11,310 homes during the first 6 months of 2020, an 11% increase in comparison with the same period in 2019. Cancellation rates were 3% higher, and the company ended Q2 with a backlog of 13,214 homes (up by 13% YoY). I think 2020 is great for the company, and I believe the factors discussed in later sections of this article should provide tailwinds for the foreseeable future. PulteGroup also has under 20% debt as a percentage of the enterprise value, and this metric is at par with peers in the sector such as LGI Homes (NASDAQ:LGIH), D.R. Horton (NYSE:DHI), KB Home (NYSE:KBH), NVR Inc. (NYSE:NVR), and Lennar Corp. (NYSE:LEN).

Source: Author’s calculations

In my opinion, we will see home builders be valued better in the next 5 years due to these tailwinds. I believe PulteGroup is a great buy at current prices, with a good upside through continued performance and better valuation from the market.

Source: Author’s calculations

Data Source: Company 10K and 10Q

Why is the home builder segment poised for a big upside?

Rising New Home Sales

Since the beginning of the COVID-19 pandemic, we can see a sharp rise in new home sales, to levels above what was seen in the past 15 years. I believe this trend will continue strongly for the foreseeable future due to supporting factors discussed in this article.

Source: TradingEconomics.com

Record-Low Mortgage Rates

US mortgage rates continue to hit record lows this year, and mortgage refinancing activity remains strong in comparison with previous years, according to data from Mortgage Bankers Association.

Image Source: Freddie Mac

Low mortgage rates are great opportunities for individuals to make the shift from being renters to homeowners. Obviously, due to unemployment and financial stress due to the pandemic, many may not yet be able to utilize these mortgage rates. However, I believe with improvement in job numbers, we will see increased home buying activity.

New Home Supply-Demand

According to the US Census, the number of homes under construction was just 1% higher than in 2019. However, the new home sales reached their highest levels in almost 15 years. Since most builders shut down operations in March and April due to the pandemic, they have been caught off guard by the soaring demand since May. We are now facing a shortage of finished homes (current supply is 3.3 months according to the US Census).

A six-month supply is considered a balanced market – CNBC

But not everything is good news for home builders. The pandemic has caused a spike in prices of lumber, an essential commodity for construction of houses.

Source

National Association of Home Builders economists estimate that these recent price spikes of lumber would increase the price of a new single-family home up to $16,000 (Data Source: builders.com). This is a problem for home builders since it either increases the price of the homes (discouraging buyers) or results in reduced margins. How this affects the company’s fundamentals will be seen in the upcoming quarters.

I see the shortage of new homes as a growth opportunity for home builders. American Housing Survey 2019 data tells us that majority of the homes were built before 2000, with more than 50% of homes more than 40 years old. The country is in need of new homes.

Data Source: American Housing Survey

Moving Out of Bigger Cities

Data from moving companies indicates people are fleeing larger cities during this pandemic. Bigger cities like San Francisco, New York, Arlington, Los Angeles saw significant moveouts, while tier 2 and tier 3 cities like Scottsdale, Durham, and Columbus witnessed move-ins.

Source: Hire A Helper

Source: Hire A Helper

PulteGroup is well positioned to cater to these needs, since they are well diversified across the country and typically have communities away from the locations of dense populations.

Image Source: PulteGroup website

Growing Divorce Rates

As couples have been stuck at home for an extended period of time due to the COVID-19 pandemic, US divorce rates have spiked 34% between March and June, compared to the same period in 2019. Added stress due to financial hardships, unemployment, homeschooling kids, working from home, illness and limited accessibility of support and counselling services have resulted in increased strain on relationships.

While it is an unfortunate metric, it is good business for home builders (and lawyers) since rising divorce rates mean more people are on the lookout for homes.

Working From Home

Work from home (WFH) has been widely adopted by large and small companies alike, to keep productivity going, and their employees safe during this pandemic. While renowned leaders of major companies have mixed opinions about the pros and cons of WFH, I believe, to a great extent, we will be seeing more remote work than pre-pandemic days.

Image Source: GettyImages (westend61)

According to a Zillow survey from May,

If given the flexibility to work from home when they want, nearly one-third say they would consider moving in order to live in a home with a dedicated office space (31%), to live in a larger home (30%), and to live in a home with more rooms (29%)

With more WFH on a permanent basis, home buyers will be on the lookout for energy efficient homes with dedicated office space and storage space among other requirements. Home builders like PulteGroup, Lennar Corp, and D.R. Horton are targeting customers with these requirements, by offering smart home compatibility, optimal wiring for strong WiFi connectivity, dedicated storage spaces, among other improved designs.

Source: PulteGroup Investor Relations Website

Working out at home

According to insights from Alpha (Source: FastCompany.com),

54% of Americans who work out at least once a month are interested in buying at-home fitness equipment.

However, in the survey, these individuals mention certain concerns that prevent them from proceeding with the investment. Among the concerns, the largest percentage of individuals (34%) mentioned lack of space at home as the primary factor preventing them from going ahead with a home-gym setup.

Image Source: GettyImages (RyanJLane)

In my opinion, the practice of working out from home will gain more traction over time due to the convenience, privacy and long-term cost benefits. We can see the growing popularity of home-gym equipment companies such as Peloton (PTON), Mirror, and Hydrow during this pandemic. I am not saying that home sales would improve due to the need to have a home gym. However, this will be one of many factors that go in the “pros” column for the need for a bigger house.

Conclusion

Strong industry fundamentals such as low mortgage rates, growing popularity of WFH, increase in the preference to move away from busy city areas and a need for more space in the house for misc. requirements, provide strong tailwinds to the home builder business. PulteGroup is an undervalued leader in the sector and, despite strong performance at par with its peers, trades at a considerably low valuation. Hence, I believe there is a good upside for patient investors. I also believe that home builders will be valued better by the market as a result of these strong business fundamentals. I recommend PulteGroup to long-term investors.

Disclosure: I am/we are long PHM, LGIH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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