Flat Rates, High Earnings Boost Builder Stocks

Home building stocks are finally getting the favorable attention that has eluded the group for years.

In a matter of a few weeks during July and August, a composite index of home building stocks rose nearly 40%. It will likely go higher in the coming months as investors begin giving the group a closer look, analysts who track home building say.

Keying the rally in stock prices has been a number of leading indicators showing that the economy is slowing -- perhaps heading for a soft landing without a full-blown recession. For investors this is a signal that the Federal Reserve Bank will continue to hold the line on interest rates after successive increases over a 14-month period.

In addition to news of a slowing economy, many of the leading home builders are reporting another round of record earnings on margins that have either grown or stabilized. This notable absence of margin pressure stems from the fact that costs of labor and materials have been held in check or have gone down, says analyst Tim Jones of Ryan Beck & Co.’s Southeast Research. He also points out that home buying activity has remained strong despite mortgage interest rates that have increased considerably in the past 12 months.

"We have been telling investors for the past nine months that these earnings would hold up, and they have," says Jones. "You are now seeing margins that are just astronomical. Not only have builders been able to raise prices, but also home buyers have been purchasing more amenities on larger homes. In addition, these builders have great land positions, so it is all falling into place."

The analyst community may also take part of the credit for the recent surge of home builder stock prices. The surge in stock prices, margins and earnings also seems to be broad-based. Production builders serving all segments of the market -- first-time buyers as well as move-up buyers -- are flourishing but for different reasons. For builders marketing to first-time buyers, there are reports of greater efficiencies associated with fast-selling neighborhoods. For builders of move-up homes, price increases on bigger homes with more options seem to have made a big difference.

In terms of earnings, analysts agree that price increases for homes have been the key driver during the past few quarters. Most of the leading builders are showing flat to moderate increases in closings year-over-year, and the same can be said of the unit volume of backlogs.

Luxury production builder Toll Brothers Inc. announced that its average home price is $50,000 higher than it was a year ago, going from $447,000 to $492,000. Toll is one of only a few companies to announce notable increases in unit sales and backlog.

"We’ve continued to raise prices to maximize profits and to keep our backlog from extending out beyond one year’s production,’’ notes chairman and CEO Robert Toll. "Other positive factors include our expanding production in California and our increased number of larger master-planned, golf course communities offering more expensive homes."

Toll is not alone in profiting from the continued strong growth in home building sales in California. Indeed, builders with strong land positions in western states are doing particularly well and have similarly positive outlooks. Irvine, Calif.-based Standard Pacific Corp., for example, reported a 23% increase in earnings for the quarter that ended June 30 with a backlog 27% higher than the previous year's. Similarly, Sun Belt-focused Del Webb Corp. recently reported a 29.7% increase in year-over-year quarterly earnings.

Also among those experiencing record earnings and strong backlogs are the biggest of the big. Centex’s home building unit reported quarterly earnings 21% higher. D.R. Horton Inc. reported a 13% increase in orders for its third quarter and a record sales backlog of $1.6 billion on 7,823 units. Meanwhile, Pulte Corp. reported a 29% increase in earnings and a 5% increase in unit closings.

"Pulte’s results reflect earlier decisions to emphasize the purchase and development of larger, premium land positions, along with a gradual shifting of our product mix toward higher price points," notes chairman and CEO Robert Burgess. "As a result of these actions, we are continuing to realize increasing revenues and profitability per home sold."