MHO - M/I Homes: A Speculative Rally Built On Sand

2023-12-29 16:12:59 ET

Summary

• US home affordability is at a record low due to rising mortgage rates and home prices.
• Despite the decline in existing home sales, homebuilder stocks like M/I Homes have performed well, backed by higher sales prices.
• M/I Homes' stock rally may be driven by speculative activity and not a fundamental improvement in outlook, with short interest being a telling signal.
• A normalization of M/I's profit margins and continued stagnation of its sales may make its fair valuation around half of its current level.

The US Pending Home Sales index is at its lowest since the 2008 housing market crash. Due to the rise in mortgage rates in 2022 and the continued increase in home prices, home affordability is also around a record low today. After nearly reaching 8%, the average US 30-year mortgage rate has dropped just below ~6.7%, still creating affordability strains but encouraging some bullish sentiment. That said, existing home sales have continued to drop despite the slight improvement. See below:

Affordability levels, home sales volumes, and the median home price-to-income ratio are all around as extreme, and often more extreme, than the levels seen during the peak of the housing bubble around 2006 to 2007. Mortgage rates and inflation are also around nearly the same level today as then.

Given the similarity in trends, many might expect homebuilder stocks to suffer catastrophic declines, such as in 2008. On the contrary, most homebuilders are performing well today. For example, M/I Homes ( MHO ) has risen by around 192% YTD and is trading over 10X above its post-GFC price and nearly 3X above its 2006 housing bubble peak price. The company's equity performance this year is nothing short of stellar. See below:

Notably, the stock's value has risen at an extreme pace while its EPS has stagnated over the past year. Indeed, its EPS growth from 2020 to the end of 2022 was wonderful, but that occurred mainly under the ultra-low mortgage rate paradigm, which does not exist today. Given this, it is possible that M/I Homes is not rising due to a fundamental improvement in outlook but due to speculative reasons that will likely result in a "boom and bust" cycle. Of course, there are also fundamental differences in the housing market today compared to the 2006-2008 period, which may improve its profitability over the coming years.

Bullish Factors Behind M/I Homes' Rally

Short interest on MHO is currently around 4.12% today (of outstanding shares), which is not a very high figure. Still, it is higher than the typical stock and implies some speculative activity is betting against it. Short interest was rising with the stock for most of the past year, implying speculative betting against it rose as its valuation increased. The stock began to decline in the fall, but quickly reversed course as short interest levels declined. See below:

The decline in short interest combined with the sharp rise in the stock price is a tell-tale sign of a short squeeze, or at least a minor one. Most likely, those shorting the stock as it rose in value had lost a decent amount and sought to close the trade during the fall decline but might now be racing out as it undergoes a massive rally. If an improvement does not match this rally in fundamentals, I do not expect it to last.

Two economic factors mainly drive M/I's gross profits: home sales volumes and home prices. Today, M/I's gross profits have only risen by ~3.6% YoY, which is not a considerable increase compared to its nearly 80% increase ~2021. Today, existing home sales volumes are shallow, while new home sales are around half of the 2020 peak but still much higher than after the 2000s property crisis. That said, home prices are still rising on a YoY basis. See below:

Increased home prices are the primary avenue by which M/I's income has risen recently. The company's overall sales have stagnated over the past year, but higher home prices have greatly aided its profit margins. Further, building materials prices have declined since the 2021 peak of massive construction parts shortages. Though building materials have not become any cheaper over the past year, this factor has also improved construction profitability. Home price stability likely comes from two factors. One is low single-family home inventory levels. Two, further increases in rental costs compared to inflation. Housing starts, though elevated, are also not as high today as they were in the bubble peak. See below:

While homes are much less affordable today due to higher prices and mortgage costs, renting is also extremely unaffordable after rising by around 35% faster than inflation over the past two decades. There are also a few existing homes on the market. That said, it is notable that home inventories have risen over recent months, usually a prolonged season marked by lower home inventories. Inventories usually hit a minimum in January but are going into January 2024, much higher than in January 2023. While inventories should not rise too quickly, this is one strong signal that home prices may not maintain stability.

What is M/I Worth Today?

The company has a few means to hedge against market risks. For one, it is focused primarily on the Southeastern US and the Midwest, which are far more affordable markets than the West and Northeast. The Southeast also has very high population growth rates as people migrate toward more affordable areas. The firm also focuses on smaller, more affordable homes through its "Smart Series" program. According to the company, over 50% of its buyers are first-time buyers, a very strong metric given the general lack of new buyers, particularly amid higher mortgage rates. This cohort has low home ownership levels but will likely be a significant area of prolonged growth as that naturally changes.

Overall, I believe M/I's focus on more profitable and growing geographic and demographic demand avenues will improve stability over the coming years. That said, it is rarely the case that homes can stay in "extreme" low affordability levels indefinitely. Amid low pending sales, we're seeing an increase in inventories going against the seasonal trend. While rent growth should continue to aid home demand, I believe we're starting to see signs that home prices will slow and potentially decline in costlier areas.

Will that certainly result in a repeat of 2008? Not necessarily, but investors should not assume M/I will continue to thrive. I would not predict a housing market crash at this point, particularly among more affordable single-family residences in high-growth areas. Still, I do not expect the 2021-2022 strength to continue amid higher mortgage rates. Indeed, M/I's EPS and sales growth have been stagnant over the past year, so it is unreasonable to assume it will pick up, given the continued decline in economic housing market fundamentals.

M/I's EPS is highly cyclical as its profit margins fluctuate dramatically with the market's trend. Usually, the company trades in a firm price-to-sales range of ~0.2X to ~0.6X, with a higher valuation only justified under the possibility of profit margin and sales growth expansion. Today, its profit margins are around a record level, making them unlikely to rise higher (technically slipping), while its sales growth is stagnating and should continue to do so if inventories rise in 2024. Thus, I do not see any means to justify its high valuation premium today. See below:

MHO trades at a ~100% premium to its typical price-to-sales range. Its abnormally high-profit margins justify some of that premium, but its margins are generally unlikely to remain so high as the market is in a peak cycle. The construction industry is cyclical, and MHO's valuation is only justifiable if we assume it is not. Further, MHO's inventories and liabilities are incredibly high today. See below:

These factors are roughly normal compared to its TTM sales but illustrate how the company is not preparing for a potential market slowdown. The firm is continually reinvesting its profits back into new projects. While that is a great way to ensure decent growth, this practice nearly killed the company in 2008 when its inventories were very high, leading to a housing market downturn. If its profit margins are not sustained, M/I will have a considerable liability burden that may not be feasibly payable.

The Bottom Line

Overall, I am very bearish on MHO today because it appears to be rising in a speculative fervor, not backed by its fundamentals. M/I is a decently run company focusing on expanding into a more substantial area of demand. The company has also had stellar EPS growth in recent years, mainly attributable to the goldilocks dynamic around 2021 of meager mortgage rates.

Looking forward, record low home affordability and low sales should result in higher inventories and lower sales prices. M/I could face issues even if prices stagnate as building materials and labor costs are unlikely to stagnate, causing its volatile margins to swing lower. The stock is trading at a considerable valuation premium, potentially due to a small short-squeeze that began around the end of October. At the very least, I believe the stock would be more fairly valued at its October price of ~$76 per share. That price would give it a price-to-sales of ~0.5X, which is well within its normal range and would reasonably account for the natural cyclicality of its profit margins.

I would not short MHO today because it appears to be in a short squeeze. However, that may change over the coming weeks if its technical momentum diminishes. Still, I am very bearish on MHO and expect it will likely be trading closer to the ~$75 level by the end of 2024.

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