TMHC - Taylor Morrison Home: Moving To Neutral Post The Recent Run-Up (Rating Downgrade)

2023-06-16 13:03:00 ET

Summary

• Taylor Morrison Home's stock price has increased by 65% since last year, outperforming expectations despite a slowdown in the housing market.
• Housing demand is expected to remain strong for several years, compensating for the underbuilding of new homes after the 2008 recession, and TMHC's margins should stabilize at higher levels compared to the pre-pandemic period.
• However, I am moving to a neutral rating on TMHC stock as it is reasonably valued after the recent run-up and already reflects the company's long-term prospects.

Taylor Morrison Home Corporation ( TMHC ) has experienced a solid 65% increase in its stock price since my contrarian buy rating last year. Despite the market's bearish sentiment towards TMHC and other homebuilders/building product stocks due to rising interest rates, I recognized the stock as being undervalued and did not agree with the prevailing view that we can see a market crash similar to the one in 2008. I was also impressed by the company's efforts to enhance return on equity and reduce debt. The outcome of the call aligned with my expectations, and although the housing market slowed down somewhat, there were no significant write-offs of land inventory as seen during the great recession. TMHC performed well, with a 500 basis point improvement year-over-year in return on equity, reaching 24% last quarter. Additionally, the company's net debt-to-capital ratio decreased to 21% at the end of the last quarter, compared to 35.7% at the end of Q1 last year. Consequently, the stock outperformed. While I am optimistic about the company's long-term growth outlook, I believe the stock is reasonably valued post the recent run-up, and am hence moving it to a neutral rating.

Revenue Outlook

Despite high-interest rates, homebuilders are observing a good spring selling season. TMHC reported resilient customer demand in the previous quarter, even amidst the banking crisis in March. Management highlighted positive leading indicators such as sales traffic, mortgage prequalification, and digital home reservations. Of particular interest is the company's decision to reduce incentives and raise prices, which reflects management's confidence in the sustainability of homebuyer demand. Similar sentiments have been expressed by other homebuilders who also noted good demand from homebuyers during this spring season despite macro headwinds.

There appears to be a significant gap between homebuilder supply and demand due to the significant underbuilding of homes over the past decade following the 2008 recession. I have previously discussed this phenomenon in an article, emphasizing that housing starts between 2008 and 2019 averaged less than a million homes per year, compared to the historical average of 1.5 million homes per year. Many homebuyers who postponed their purchases for over a decade are now returning to the market post-Covid, which sustains housing demand despite rising interest rates. Looking ahead to the medium and long term, I expect housing demand to remain strong for several years, compensating for the loss of demand and the underbuilding of new homes after the great recession.

In the near term, while rising interest rates have slowed net new home orders year-over-year in recent quarters, there has been sequential improvement, and net new orders per community per month were higher in Q1 2023 at 2.9 compared to 1.9 in Q4 2022. The second quarter is expected to show further improvement due to seasonality. I anticipate 2023 to mark the bottom of the current housing downcycle in terms of new orders. Since it takes a couple of quarters from receiving orders to finally delivering them and booking them in sales, FY24 should likely mark the bottom in terms of the company's revenues and TMHC should resume growth from FY25 onwards.

Margins Should Normalize But Still Remain Above Pre-Pandemic Levels

Regarding margins, the company experienced significant expansion post-Covid. This was primarily driven by the shortage of new homes in comparison to demand, resulting in notable increases in home prices. Most of the homes the company sold in 2021 and 2022 were built on land purchased prior to the pandemic, when real estate prices were low. As land and home prices appreciated significantly post-Covid, the company was able to generate healthy profits. As housing demand normalizes and the company begins selling homes on land acquired at higher post-pandemic prices, margins are expected to normalize.

Nevertheless, I believe margins should stabilize at higher levels compared to the pandemic period. The company has made significant operational enhancements and improved productivity over the past couple of years, which should be beneficial. Furthermore, the company's transition towards a land-light strategy minimizes the risk of significant write-downs. Currently, approximately 60% of the company's sales come from speculative inventory (homes started before receiving a firm order from customers), while 40% are from built-to-order homes. Built-to-order homes typically yield higher margins, and the company plans to increase its sales mix in the coming year. Additionally, TMHC is expected to benefit from the easing of supply chain constraints, which should reduce homebuilding cycle time and improve productivity.

Before the pandemic, the company's adjusted gross margin was ~18.2% in FY 2019. Last year, the company reported ~25.2% gross margins. For the current year, management has guided gross margins of ~23%. I believe gross margins should eventually stabilize in the low 20s. Similarly, SG&A as a percentage of home building revenues was 10.4% in FY 2019. For the current year, management is expecting it to be in the high nine-percent range. I expect it to remain lower than the pre-pandemic level as well. So, while we may see some pressure on margins in the near term due to difficult comps from the last couple of years, it should also bottom sometime next year.

Moving To Sidelines

In general, this slowdown hasn't been as tough on homebuilders as what we saw during the great recession. I believe investors were panicking about the possibility of significant write-downs last year but when it didn't materialize, the homebuilder stocks posted a swift recovery. TMHC has also posted a meaningful appreciation in the stock price. The company ended last quarter with a tangible book value of $38 and the stock is currently trading at price to tangible book value of ~1.24x. While I still like the company's long-term prospects and housing fundamentals, I believe TMHC stock is already reflecting those prospects to a good extent. Hence, I am moving to a neutral rating on the stock.

For further details see: