MHO - M/I Homes: Limited Incentive To Get On Board At This Juncture

2023-03-16 22:01:03 ET

Summary

• MHO has delivered solid alpha over the last 3 years.
• We touch upon a few unfavorable conditions that may dampen alpha-generation.
• The stock looks pricey and does not look like an attractive mean-reversion option in the home building space.

Introduction

M/I Homes ( MHO ) is a home-builder that specializes in the single-family housing segment in the US. The company has a presence across 17 markets, and in 5 of those markets, it is a top-5 builder. MHO also runs an ancillary financial services segment, which renders mortgage loans (although this business only accounts for 2% of group revenue) and abets the core business. Over the last 3 years, MHO stock has proven to be a rewarding source of alpha for investors, delivering 2.7x the returns delivered by the S&P 500!

So far so good, but going forward, I would advise investors to tread with caution, as there’s been a shift in some key metrics, which in turn dampens the buy case.

Key Metrics

I’m not in a position to predict what the Fed is going to do with its policy rates this year, but there’s no denying that its actions in recent months have filtered through and upended the housing market. Even if one does get a pause in policy rates on account of potential systemic risks in the banking sector, the affordability quotient is unlikely to reverse and turn attractive overnight.

Recently, the 30-year fixed mortgage rate crossed the 7% threshold once again, and even before it hit that landmark, a lot of buyers were being priced out of the market. With MHO, one also needs to consider that the vast majority of buyers ( ~58% ), are first-time buyers who are typically very sensitive to these rates. These are not people with excess wealth and large net worths; rather, these are people who are more likely in the infancy of their careers and who can't afford to be overly emotional about their capital allocation priorities.

It’s fair to say that MHO is certainly feeling the pressure of dynamics in its end markets. Typically, this is a company that only witnesses cancellation rates of 10% on average, but in Q4, this shot up by 3x, hitting 30% !

Besides, the number of net contracts signed per quarter dropped below the 1000-unit mark for the first time in a long time, even as the YoY run-rate continues to worsen (-44% decline in Q4). Meanwhile, unsurprisingly MHO’s mortgage business too is originating a lower volume of loans (down - 18% in FY22, and -12% in Q4 alone).

Given a subdued end-market, it is reasonable to wonder if M/I Homes are carrying excess supply, and what they intend to do with it. The company currently has over 42000 lots, with over 40% of these lots (17049), giving them a certain flexibility, as they can choose not to exercise their option (these option agreements run through 2029 ).

However, I have concerns about the remaining 60% of their lots (which are owned) as it currently makes them oversupplied. Historically MHO has maintained its own lot inventory supply of over 2+ years, but with 42000 units you're looking at 3+ years of supply (as per MHO management’s estimates).

And don’t forget that MHO won’t be the only entity looking to dump more supply into the market. You already have a lot of these power buyers such as Ribbon Homes, and Orchard Technologies who are desperately trying to get rid-off some of their excess inventory.

This effectively means that the MHO will have to make more pronounced downward adjustments to its sales prices or engage in deeper financing and sales incentives, to get its supply position to more comfortable levels. This will no doubt reflect adversely on the gross margins of the firm for the foreseeable future. We’ve already seen the pressures of this play out in Q4 with MHO’s margins dropping to their lowest point (down 60bps YoY) since the post-pandemic era.

Closing Thoughts

When one shifts focus to the valuation and technical narratives of MHO, I don't feel too enthused either. After delivering 10% revenue growth in FY22 (Rev of 4.13bn), YCharts consensus expects MHO’s topline to slow by 16% in FY23, before bouncing back to $3.67m in FY24 (note that this is still lower than what was seen last year). The FY24 EPS ($12.24) too is poised to come in ~31% lower than what was seen in FY23 ($17.74).

In light of these unfavorable estimates, and considering the current share price, it’s no surprise to discover that the forward valuation picture doesn’t look too tantalizing. For clarity, taking the FY24 EPS number under consideration, the stock currently trades at 4.6x P/E; prima facie, no doubt a tantalizingly low number, but relative to the stock’s own 5-year forward P/E average of 3.8x , it comes across as quite bloated (21% premium).

If we look at MHO’s monthly chart, we can see that after the stock peaked at the sub $75 levels in May-2021, followed by a relentless downtrend till Sep-2022. After that, we've seen a comeback by the bulls but the momentum appears to have petered out over the last two months. The shape of the candles in Feb and this month (small candles with long wicks) suggest that additional supply is coming in at higher levels, dampening the prospect of outsized gains.

Finally, if we look at how MI Homes is positioned relative to its peers in the homebuilding segment (as represented by the SPDR S&P Homebuilders ETF) we can see that quite unlike 2012, and 2020, currently there is very limited incentive to rotate into MHO as the relative strength ratio no longer looks oversold and is not far away from its mid-point.

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