Description
The report of particularly and surprisingly strong earnings usually has been followed by a sharp appreciation in the price of a homebuilder’s shares. For example, Toll’s shares appreciated 22% in the week following its December 9th announcement of very strong earnings. During the three months that followed KBH’s September 20th announcement that its Q3 earnings rose more than expected, the price of the company’s shares appreciated 36%. And, Pulte’s shares appreciated by 25% in the two months that followed its July 26th announcement that its Q2 earnings were up 46%.
For a homebuilder, the relative earnings strength in any particular quarter is largely a function of the number of homes delivered (which can vary due to weather, random fluctuations, etc.) and, importantly, the geographic mix of homes delivered. Because of general supply constraints on both the Atlantic and Pacific coasts (due to the difficulty of obtaining building permits in relatively built up areas), margins on both coasts generally are much higher than margins in the middle of the country (margins in Texas, Denver, and many Midwest states currently are quite low). While the mix of homes sold often is quite steady, sometimes there is a random fluctuation. For example, in the first and second fiscal quarters of its current year (which ends on March 31), Centex’s delivered a disproportionately large number of homes in its less profitable Midwest and Southwest regions. Specifically, in the September quarter, while 33% of revenues were from the Midwest and Southwest, at the end of the quarter only 25% of the Centex’s backlog (in terms of dollars) was from these two regions. Largely because of this adverse mix, Centex’s EPS only increased by 15% in the first half of its fiscal year.
It typically takes about six months from the time an order for a house is received until the house is delivered (and revenues are booked). Therefore, we know that the bulk of Centex’s September 30 backlog will be delivered in the December and March quarters. By studying the timing of orders, one can conclude that the mix of sales in the December quarter was much improved and that the mix in the March quarter should be particularly favorable. More specifically, Centex’s backlog (in units) in its two less profitable regions was down 3% on September 30, 2004 vs. the year earlier date while its backlog in its three very profitable regions was up 31% from 8,459 homes to 11,130 homes.
Based on our projection of expected deliveries, we expect that Centex’s earnings increased roughly 30% in the most recent (December) quarter and that earnings will increase close to 50% in the March quarter. We believe there is a good chance that Centex’s shares will appreciate sharply once investors become aware of the expected sharp earnings gains. Based on this analysis, we have two alternative recommendations. Those who believe that the consolidation taking place in the homebuilding industry is the dominant force (and that interest rates only are a secondary force) should purchase Centex. On the other hand, those who are more concerned that rising interest rates will dampen the demand for houses and will be the primary force, should execute a paired trade: purchasing Centex and shorting another homebuilder (Toll for example) that already has appreciated sharply due to an earnings surprise that likely is non-recurring in nature.
Catalyst
Centex should report particularly and surprisingly strong earnings for its March quarter.