HOV - Buy Homebuilder Hovnanian It's Still A Solid Value Play

2023-06-02 14:27:07 ET

Summary

• Hovnanian's stock is still undervalued, with a fair value estimate at $120, despite doubling since my last article.
• The long-term outlook for homebuilders remains positive, with a significant housing shortage in the US and promising near-term signs.
• Hovnanian is a capable builder with a weak balance sheet, but its debt position is improving, and its capabilities as a builder support a higher valuation.

I last wrote on Hovnanian's stock for Seeking Alpha back on September 6 of 2022 , arguing that it was “Crazy Cheap” at $39. Today, after a sell-off following fiscal Q2 earnings, it sits at $87. Did that double soak up all the value? Not yet. I believe a fair value is more like $120.

The valuation

Hovnanian expects to earn $17-$20 per share this year (Wall Street doesn’t have any estimates on the company – yes, this is an under-the-radar stock). That puts its P/E at 4.7x and its E/P at 21%.

In other words, if Hovnanian just keeps earning at its current pace, investors will earn 21% a year. To put that in perspective, the S&P 500 has an E/P of 5%. Even CCC rated bonds (flirting with bankruptcy) yield 15%. I’m not going out on a limb by saying that investors don’t expect much from Hovnanian.

I am confident that Hovnanian can surpass the low bar that investors have set, for several reasons:

• The long-term picture for homebuilders remains positive.
• The near-term is also showing promise.
• Hovnanian is a good builder, albeit with a weak balance sheet.

The long-term outlook for homebuilders remains positive

Three charts summarize where the homebuilding industry stands today. This chart tracks housing affordability over the past 40 years:

Source: Yardeni Research , from National Association of Realtors data

This picture appears pretty grim. Housing today is less affordable than for all except a brief moment in 2006 and then back in the high-interest rate days of the early ‘80s. But you’ll be making a big mistake if you just take this data at face value without asking, “Why is housing so unaffordable today?”

One reason is because of a sharp increase in mortgage interest rates, from 3% post-COVID to nearly 7% today. The other reason is critical, and the subject of my next chart – the housing supply/demand balance. The chart shows the single-family housing vacancy rate since 1981:

Source: Census Bureau

The chart clearly indicates why housing affordability is currently so low – the U.S. has a significant housing shortage. To get back to the normal 2% vacancy rate, we need another one million new single-family homes to be built. A shortage of any product, including houses, pushes its price up.

This last chart shows a history of single-family homes construction (“starts”):

Source: Census Bureau , from FRED

You can see the reason for the current housing shortage – the shock of the ’08-’11 housing bust kept builders and their construction lenders very conservative ever since.

Flat home construction going forward from its current level will not put much of a dent in the shortage, if any at all. That suggests Hovnanian’s sales and earnings should have an upward bias. That’s a pretty good scenario for a stock with a 21% earnings yield.

The near-term is showing promise

The chart above shows that the affordability challenge hit homebuilders hard, reducing construction by 30% from the early ’22 peak. But there are a number of signs of stability and even progress:

New home sales are up. The last reading of 683,000 in April was up 10% from the prior year and up 25% from the recent bottom.

Home prices may have stabilized. The most recent S&P CoreLogic Case-Shiller home price index report had this to say:

“Data released today for March 2023 show a continuing recovery in housing prices, as all 20 major metro markets reported month-over-month price increases…March’s results suggest that the decline in home prices that began in June 2022 may have come to an end.”

Hovnanian added in its FQ2 conference call that:

“We were able to raise net home prices in 30% of our communities during the first quarter and 69% of our communities during the second quarter.”

Job growth remains decent. The Federal Reserve may not be happy about job growth, but homebuilders sure are. This past week we learned that jobs rose by a strong 339,000 in May, and unfilled jobs jumped by 350,000 in April.

Mortgage rates should benefit from narrower credit spreads. Mortgage rates are by definition the sum of the 10-year Treasury bond yield plus a spread above that yield. That spread today is nearly 300 basis points, a near record level. The widespread is a function of selling of mortgage-backed securities (MBS) by the Federal Reserve and banks. But when is it more certain that the Fed is finally done tightening, the odds are good that fixed income investors will pile into those high-yielding MBS, which will lower mortgage rates.

The supply chain issues have largely dissipated. Homebuilders struggled with sharply rising costs after COVID hit because of supply shortages, particularly lumber. But lumber costs are down 40% from their peak. Hovnanian noted on its FQ2 conference call that it has negotiated a number of other cost reductions as well.

Hovnanian is a good builder, albeit with a weak balance sheet

Hovnanian doesn’t have to be the best homebuilder in the country to make it a cheap stock, but it should be capable. And it is, by many measures, according to Hovnanian’s FQ2 financial review :

• Return on investment- Hovnanian’s return on investment (before interest and taxes) was 33% versus the 25% industry average.
• Inventory turns- The faster a builder can turn housing inventory into sales, the more efficient and profitable. Hovnanian’s inventory turnover the past 12 months was 1.7, compared to the industry average of 1.1 times.
• Option share- Land control through options to buy lots rather than current ownership reduces financial risk when the market turns down. 71% of the building lots Hovnanian controls are optioned, compared to the industry average of 45%.

Finally, Hovnanian’s trouble spot – debt. Hovnanian has $1.2 billion of debt outstanding, 300% of its $429 million of shareholders’ equity. Peer builders currently have a 40% or lower ratio. Hovnanian’s high financial leverage is a remnant of the ’04-’11 housing bubble and bust, which Hovnanian went into far too aggressively.

While troubling, Hovnanian’s debt position is heading in the right direction. At the end of ’17, it had $1.6 billion of debt and equity of negative $460 million. And assuming $20 per share of annual earnings going forward, Hovnanian is adding $130 million a year to its equity. Finally, its $1.3 billion tax loss carryforward will add $337 million of cash over time, aiding debt paydowns.

The downside is that Hovnanian will be unable to pay cash to its investors, through dividends or stock buybacks, for many years. This fact argues for a below-average valuation for Hovnanian versus other homebuilders.

Summing up, A Target Price of $120

I think $20 per share is a quite reasonable and possibly conservative run-rate for Hovnanian’s EPS going forward, considering the bright outlook for homebuilding near-term and long-term, and Hovnanian’s capabilities as a builder. I believe a reasonable P/E ratio for a builder is at least 8. Discounting Hovnanian’s P/E for its high debt level suggests a fair multiple of 6. $20 x 6 = $120. That’s about a 40% upside.

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