DR Horton: Potential for ‘value trap’ as mortgage rates rise (NYSE: DHI)
The housing market has been on a frantic ride over the past couple of years. House prices have risen dramatically about 33% as demand accelerated with ultra-low mortgage rates. Today, the positive impact of low interest rates is now decline as mortgages became much more expensive. Last July, the average American 30-year-old the mortgage rate was 2.8%, today it’s around 4.7%, making today’s homes less affordable than they were just a few months ago. Already, this trend has resulted in a sharp decline in total pending home sales in the United States, although there has been a continued increase in building permits. See below:
Following the huge upside shock to the housing market, the stock of existing homes is still relatively low. As a result, residential construction companies such as DR Horton (NYSE: DHI) have been in a gold loop environment of high demand and high affordability. However, the affordability factor has now deteriorated with rising mortgage rates, which could upset selling prices. Construction costs continue to rise as wood price and other crucial construction products have not faltered, which could reduce profits for builders on both sides.
Still, homebuilder stocks are generally cheap today based on traditional valuations. DR Horton has a forward P/E of just 4.8X and has lost about a third of its value since December as the potential impact of rising mortgage rates is priced in. Overall, the situation has placed DHI, and most other homebuilder stocks, in a very tight position with high “value trap” potential. To fully understand the dynamics at play, we need to consider the macroeconomic situation and its likely impact on DR Horton and his peers.
Will rising rates hamper home sales?
Large national residential construction companies like DR Horton basically run on the run of the economy. Builders can make efforts to develop homes in certain regions and particular types of homes with higher sales demand. Today, that generally means smaller “entry-level” homes in more affordable areas such as the Southeast and South-Central regions. In general, both younger, newer buyers and older “downsizing” buyers have changed their preference for smaller homes. Additionally, many people are move out of expensive parts of the country, like California, to improve lifestyle affordability.
These trends bode well for DR Horton, which has focused its efforts operations to adapt to these trends. Importantly, this shields the business from macro factors, as the sharp rise in mortgage rates is likely to prove much more detrimental in expensive areas than in cheaper ones. Unsurprisingly, most of the less affordable West Coast states also have unemployment rate todaywhich increases the downside risk given the negative economic impact of rising rates.
Yet, although there is plenty of evidence to suggest that higher mortgage rates will significantly hamper home sales, much of the US housing market is technically booming. Home inventories remain around record highs and data suggests that very few buyers are in default. In addition, residential property construction spending has increased at a record pace:
Undoubtedly, the real estate market situation today is quite different from what it was in 2006-2008, but with some similarities. House price-to-income ratios are then close to the same levels, although this had a minor impact, as mortgage rates were much lower than in the 2000s. However, now that they are back to almost 5%, many new home buyers increase their incomes to the same extent. Banks have been less lenient on subprime and floating rate loans, so the higher rate shock will likely impact new home sales (and therefore DR Horton), but not necessarily more owners like in the 2000s. Yet with soaring inflation, real hourly earnings are falling and savings rates have fallen below pre-COVID levels, implying that many people could soon find it difficult to meet their payment obligations as they pay more for groceries and gas. See below:
In my view, this does not bode well for much of the US housing market. While most of the problems that plagued the market in the 2000s do not exist, other stresses, such as falling real incomes and savings, can lead to the same net result. The result is lower home sale prices and a potential increase in foreclosures as some struggle to meet mortgage payments. contrary to the shock of 2020, homeowners can no longer refinance and extend mortgages at lower rates to avoid defaults as they did in the past. More broadly, due to unchecked inflation, the US Federal Reserve is unlikely to be able to bail out the mortgage market again (via MBS QE purchases) to avoid a systemic shock.
Overall, it is still unclear what impact the sharp rise in mortgage rates will have on new home sales. While the housing market is still “strong” on paper, much of that is based on peak pre-mortgage data. Indeed, I wouldn’t be surprised if many of today’s pending home sales don’t close as homebuyers are shocked by the steep increases in mortgage interest charges. While it appears the market impact will be weaker in DR Horton’s high inventory regions, the company will likely experience a sharp drop in sales as its construction activity ramps up over the course of the year at to come. Fundamentally, the critical risk facing DR Horton is that mortgage rates are now “high,” but the rate at which they have risen on a continuing rise could be quite shocking.
Is DR Horton cheap, despite the slowdown?
Based on TTM metrics, DR Horton is very cheap. However, TTM measures are potentially poor indicators of future earnings, as the rapid change in the macroeconomic situation can render the company unprofitable very soon. On a TTM basis, DHI trades at a P/E of 6.1X and an EV/EBITDA of 5.1X, both of which are approximately 50% below the industry median. DR Horton also experienced robust earnings growth. Based on the views of other analysts, its earnings are expected to continue to rise, giving DHI an extremely attractive position. cheeky “P/E” of 4.8X. That said, investing based on future earnings estimates can be a bad decision for highly cyclical companies like DR Horton.
On the one hand, DR Horton has impressive EPS growth from $4 pre-COVID to $12.50 today, with strong gross margin increases despite rising construction costs (wood, labor, transportation, etc). Additionally, the company’s inventory nearly doubled to $18.2 billion. See below:
This trend is undoubtedly impressive, but it should be noted that the company has not realized most of these gains. DR Horton’s annual operating cash flow was $612 million TTM last quarter (or just $1.60 per share), compared to $1.4 billion in mid-2020. This is mainly because the company reinvested almost all of its profits in new housing development projects, thus causing immense increases in its modification stocks. While this may mean that DR Horton’s operating cash flow is skyrocketing over the next year, it may also indicate that the company has been too aggressive in pursuing growth and has maybe too extensive. While cash flow may be less critical for homebuilders in good times, liquidity is usually king when the economy is turning. Of course, with soaring inflation, it may be better to own inventory than cash, even in a recession.
Overall, there’s a lot to like about DR Horton, and there’s a bit to be skeptical about. First, his assessment should be taken with a grain of salt, as preliminary evidence suggests that rising mortgage rates lead to lower new home sales. Since DR Horton has reinvested most of its income in major new development projects, it could soon find itself with many assets and very little cash and find it difficult to sell homes at the expected prices. At the same time, the company’s financial debt ratio is much lower than it was, giving it some protection in the event of a storm. Additionally, while its true “P/E” valuation going forward will likely turn out to be well above 4.8X, the stock is only around 30-40% above its pre-COVID levels despite immense earnings growth, so it’s definitely not in a bubble (as I think most stocks are).
The current tangible book value per share of DHI is $44. Today, its price-to-book ratio is almost exactly in the middle range it has maintained over the past few decades. So while it is certainly possible that DHI will continue to decline, the stock does not look overvalued or undervalued. Investors who have a bull long-term vision of the housing market can still find value in DR Horton. However, given how quickly mortgage rates have risen, I still believe the stock is best avoided, as a continued rise in rates could eventually lead to a credit market freeze, putting DR Horton in dire financial straits. So while I’m not as bearish on DHI as I am on most stocks today, I see little value in the stock at its current price.