2023-08-17 09:32:08 ET
Summary
- The homebuilding sector has performed well, with Builders FirstSource stock rising 116% in the past year, driven by potential momentum speculation and stock buybacks.
- BLDR's forward P/E valuation remains relatively normal, but its price-to-sales is exceptionally high, indicating significant risk if its margins fall to pre-COVID levels.
- The US housing market is slowing, with high home prices and low affordability, but the Southeast region shows potential for growth.
- Construction spending and home prices have likely peaked, although the reversal's depth is unclear due to low home inventories and high rent growth.
- I believe BLDR is a short opportunity as its momentum finally fades, creating potential for a sharp reversal.
Despite the significant increase in interest rates, the homebuilding sector has generally fared well over the past year. Key homebuilding stocks, like Builders FirstSource (BLDR), have risen by a staggering 116% over the past twelve months. BLDR has risen by over 8X over the past five years and is trading at roughly 5X its pre-COVID value. BLDR's stellar performance has caused increased speculation on the stock, with many investors seeing it as a perfect "growth at a reasonable price" opportunity.
Despite its significant performance, BLDR's forward "P/E" valuation remains at 11.3X, a relatively low range, even for a cyclical company. The company's revenue and income have risen rapidly, with its total sales doubling over the past three years and its EPS increasing by ~6X. The company has a firm positioning for the macroeconomic environment. Indeed, BLDR is among the few to grow sales rapidly and its gross margin over this tumultuous period.
In light of such strong returns, I believe investors would be wise to consider the macroeconomic conditions impacting the company. Its performance can not be entirely chalked up to more robust building demand, but it is a significant factor affecting the firm. Secondly, we must consider the company's managerial decisions that promote its growth outside macroeconomic conditions. Ideally, a clearer picture of these conditions will better inform us regarding BLDR's ability to generate strong EPS growth.
The Building Boom is Slowing, Albeit Slowly
In the US, home price-to-median income ratios are currently nearing 8X, well above the peak ~6.8X level reached in 2006 at the height of the property bubble. Home valuations, as a function of affordability, are even lower due to the sharp increases in mortgage rates to 7%. Meager mortgage rates in early 2020 initially fueled the home price boom; however, prices have remained high despite a massive decline in affordability, chiefly due to low inventory levels. See below:
In the US, homes have never been as unaffordable as they are today, but there are not enough on the market to offset high prices. Further, rents are also at peak levels compared to inflation, meaning many people may still save money by buying a home despite terribly low affordability. Still, the total US urban home price index has likely peaked, with the Case-Shiller top 20 city composite index falling by nearly 2% YoY. Of course, there is a notably large gap between Western real estate and Southeastern. See below:
Home valuations are generally much lower in the Southeast. The Southeast has also seen an increase in higher-paying job opportunities, with many companies and people flocking from West to East, breaking a long-set pattern east-to-west. This is important for Builders FirstSource because it has operations across the US, with an exceptionally high concentration in the Southeastern region where home demands, and shortages, are becoming most extreme.
Of course, falling real wages and general business strains have fueled weaker consumer and business sentiments, as indicated by the sentiment index and the manufacturing PMI. Unsurprisingly, pending home sales are meager, as fewer people are able or interested in moving or buying a new home. Pending home sales, the manufacturing PMI, and consumer sentiment are all floating around the lowest levels since 2007-2011, excluding the significant temporary declines in 2020. See below:
Of course, home sales are partly low due to a lack of inventory; however, we must consider that many people cannot sell their homes even if they wish because they cannot afford to buy in the current market. Accordingly, low home inventories and sales are not necessarily a sign that more homes must be built but that the property market has become highly illiquid. The home market is primarily supported by (typically) older cash-buyers who sold a large home and downsized without needing a significant mortgage. The share of new home buyers has been around record low levels due to the record increase in borrowing costs. Existing student debt issues amongst would-be new buyers are likely a significant factor in delaying or halting the potential for new market entrants. Thus, the total size of the homeowning market appears to be shrinking.
Homebuilder sentiment, which was extremely strong over the 2020-2022, has rapidly cooled in recent months. Mortgage rates are one major factor, but also a lack of construction workers, an absence of buildable lots, and materials shortages. The materials shortage is excellent for Builders FirstSource because that has dramatically improved its pricing power. However, if its high prices are pricing builders out of the market, it will eventually lose sales. Indeed, there has been a notable decline in residential construction spending and an even more significant drop in building permits and contracts. See below:
Based on the above data, it is clear to me that Builders FirstSource has reached a macroeconomic peak. The company can no longer rely on extreme external conditions. Years ago, those conditions included significant homebuying demand (ended in 2021), exceptional building activity (completed in 2022), and materials storage, which persists today. The materials and equipment shortage has benefited FirstSource's profit margins, while the other macroeconomic factors have boosted its sales growth. Should building activity decline sufficiently, FirstSource will no longer benefit from the equipment and materials shortage.
While a peak appears to be in, it remains unclear how long the drop will be to BLDR's trough. Based on TTM metrics, the company is not trading at an exceptionally high valuation, so a slight decline in sales and EPS would not necessarily harm the stock's value. Higher home demand in the Southeast compared to inventories and rental shortages may imply the trough will not be too far below current levels. In my view, the company is headed for a cyclical decline, but it should not be as bad as in 2008 unless other factors cause a significant increase in unemployment over the coming two to three years.
What is BLDR Worth Today?
While BLDR's price has risen dramatically over recent years, its valuation metrics have mostly been stable. Its "P/E" and "EV/EBITDA" are currently at a typical level for the past five years. However, both figures have risen dramatically throughout 2023 as the company's EPS has waned slightly despite a significant share-price increase. Furthermore, the firm's price-to-sales ratio has grown exceptionally quickly over the past five years, currently resting roughly twice its five-year average. See below:
Since BLDR's bottom-line-based valuation metrics have remained generally normal, while its price-to-sales ratio has risen significantly, the company's most significant risk is likely a reversal in its profit margins since that is the primary determining factor of its valuation growth. BLDR's gross margins have risen exceptionally quickly over the past two years to a staggering ~35% today, roughly 50% above its typical pre-COVID range. In reality, this increase is not driven entirely by an effort of the company to decrease costs, but a massive increase in materials prices, associated with a substantial materials shortage. See below:
The company's primary products are roughly an even mix of specialty items, lumber, manufactured goods, and windows and doors, most of which go toward single-family residential properties. Accordingly, the company has diversified exposure to many materials across the construction supply chain, meaning its most significant risk is a decline in materials prices. Today, materials prices are no longer increasing faster than the broader PPI, indicating that BLDR is unlikely to continue to see an increase in its gross margin. See below:
This is an essential ratio because its trend indicates the likely trend in BLDR's margins. The company's costs, such as labor and others, are likely most associated with the broader PPI index, while its sales are correlated to construction materials prices. The ratio has declined over the past year in the same pattern as the drop in construction spending and building permits, indicating that BLDR's gross margins could return to normal levels if the construction boom continues to slow.
We must remember that homebuilders will likely pull back quite quickly should home prices decline, given the sharp increase in construction costs over the past three years. Indeed, that is well validated in the homebuilder sentiment trend, being weighed down by construction costs and slowing sales volumes. Looking forward, I expect BLDR will face a decline in both sales and margins as falling construction activity also causes the materials shortage to evaporate.
Builders FirstSource could also face some financial pressures if its macroeconomic prospects reverse. The company has benefited tremendously in the current market by making accretive acquisitions of smaller materials companies. In doing so, the company's total liabilities have increased substantially. At the same time, BLDR has pursued relatively large share buybacks since 2022. To me, it is not necessarily good when a company is both borrowing and buying back shares at the same time, as that can increase share prices without necessarily improving fundamental value. Its free cash flow is significant, but it could make acquisitions with its FCF and not by borrowing money, particularly at today's elevated corporate interest rates. Additionally, before COVID, the company's financial situation was relatively poor, with a meager FCF-to-debt ratio. See below:
These data indicate that Builders FirstSource is acting like the strong economic cycle will never reverse. Usually, a cyclical company would use its high cash flows to build a solid capital base to prepare it for a potential recession. In the homebuilding industry, cyclical reversals are inevitable; although they are not always as large as in 2008, the company would still be wise to prepare by deleveraging its balance sheet. Debt-to-income ratios are unimportant for a highly cyclical firm because income is extremely volatile. Should BLDR face a significant income decline, it could return to a poor financial position due to its overly aggressive leveraged expansion in recent years.
Overall, I believe BLDR is considerably overvalued today. It should trade at a price-to-sales ratio closer to its historical average, or around 0.6x to 0.7X, resulting in a share price target of roughly $97. The company was trading at that price just three months ago, so a 33%+ decline does not seem unreasonable, given the substantial increase in its valuation. I believe this valuation target does not account for a sizeable potential recession but a normalization of its gross margins. To me, that is extremely likely, given the peak has passed for total construction spending and home prices.
Should construction spending continue to decline, BLDR could fall much lower since its sales and margins would reduce together, potentially bringing its income back toward pre-COVID levels. Further, a sufficiently large recession that dramatically increases unemployment and lowers home prices could likely be disastrous for BLDR due to its rapid debt-laden acquisitions in recent years. In my opinion, the company does not have large enough reserves to meet costs should its cash flows turn negative again.
The Bottom Line
Admittedly, I was slightly bearish on BLDR at the end of last year due to the strong signals that a cyclical peak was reached in the residential housing market. However, at that time, I was opposed to betting against the stock because it seemed its valuation remained in a sensible range. Since then, the stock has more than doubled in value, while the macroeconomic outlook has continued to turn against the firm. Its EPS has also begun to decline with a notable negative consensus outlook . Indeed, if not for its massive share buyback program and potential momentum in-flows from speculators, I doubt its price would be relatively as high as it is today.
BLDR's "P/E" valuation may seem low, but if its profit margins (~10% today) were to return to standard levels (2-3%), requiring a slowdown or end to the acute materials shortage, its EPS would fall by around two-thirds. Of course, its EPS would be even lower if its sales declined and potentially negative in a true recession. Thus, while the stock may seem cheap, it is likely costly, given that its income is based upon a cyclical peak. Of course, BLDR's cyclical peak is also particularly high due to various trends created in 2020 that led to shortages and a sharp increase in home prices. Now that those factors are much more minimal, it isn't easy to justify its current valuation.
In my view, BLDR is a solid short opportunity today, mainly because the stock has lost momentum over the past three weeks, along with the S&P 500. If it loses sufficient momentum, then momentum-driven ETFs and trend-following speculators should mechanically sell the stock, likely driving it much lower. Of course, its bullish trend has not entirely broken yet, so there is considerable risk that BLDR continues to rise in value; however, at its current position, I believe its downside potential is significantly more significant than its upside due to the trend reversal in its EPS, market fundamentals, and its excessive valuation.
Very few are currently betting against BLDR, so its short-selling cost is minimal . The stock's implied volatility is also extremely low at 35%, the 20th percentile rank for its normal range, indicating that few option speculators are betting on a volatility increase. There has also been a slight increase in IV over recent weeks, showing a solid potential setup for put option buyers. Put options are also particularly attractive in BLDR's case due to the decent probability that my negative outlook remains too early. To me, the negative cyclical view for BLDR is very likely. Still, as we've seen in the year that began, that will not necessarily stop excessive speculation benefiting the stock, particularly if BLDR continues repurchasing shares. Still, at its current position, BLDR is one of my favorite short opportunities today, not due to any company-specific issues but macroeconomic conditions and excessive investor expectations.
For further details see:
Builders FirstSource: Short Opportunity As Homebuilder Momentum Fades