Description

Background

Taylor Morrison (Ticker: TMHC) is the 8th largest public homebuilder with a geographic focus on TX, FL, CA and AZ that make up over 50% of home closings. The company has grown to be a top 10 builder through four major acquisitions since 2015 with the two largest being AV Homes in Oct 2018 and William Lyons in Feb 2020. 

However, due to the acquisitions, TMHC generated below industry gross margins as they sold through lower margin communities from the acquisitions. Between 2016 through 2020, TMHC’s margins lagged their peers by 300-500 bps, where TMHC had generated inline to above industry gross margins prior to 2014. The chart below illustrates the gross margin profile of TMHC vs peers from 2010 to 2021.

In addition to accelerated community closeouts and lower margins, TMHC also had a relatively lower land lot position which raised questions about TMHC’s growth opportunities in the future. The combination of all the above factors led TMHC to underperform their homebuilding peers on a YTD basis by 25% and trade at a price to book value of around 1.0x.

Thesis

I believe TMHC is a cheap way to gain exposure to the multi-year housing cycle that is underpinned by a significant lack of housing inventory while also investing in an early innings turnaround story. TMHC’s discount valuation provides a 4-1 risk reward ratio and limited downside relative to the potential upside. 

Over the next 6 months, TMHC will have completely cycled through lower margin acquired communities and begin to capitalize on new communities developed on the acquired land. There were several significant developments in the most recent quarter that give me confidence in the following thesis points: 

1) In the next 6-12 months, I believe that TMHC will close the gross margin gap to peers and exceed their preliminary 2022 gross margin and ROE guidance to earn $7.45 EPS in 2022.

2) TMHC is embarking on floorplan standardization which is a proven strategy and recently hired a key person to lead it, which could lead to further margin improvement vs their stated 2022 goal

Thesis Point #1. In the next 6-12 months, I believe that TMHC will close the gross margin gap to peers and exceed their preliminary 2022 gross margin and ROE guidance to earn $7.45 EPS in 2022. 

There are no structural impediments to TMHC achieving gross margins that are inline with the industry once they open communities on land from acquisitions and reap the benefits of synergies.

Furthermore, analyzing TMHC’s division profitability reveal that legacy TMHC divisions, primarily in the East division, generated margins 200bps higher than divisions integrated into TMHC from the acquisitions (primarily West division and parts of Central). In the last quarter, legacy TMHC divisions generated margins 330bps higher. The table below illustrates the gross margins by divisions and provides evidence that TMHC can achieve market level profitability.

Furthermore, I believe that TMHC will begin to realize the synergies of the acquisitions through scale of procurement and marketing, while also embarking on a significant standardization plan which should significantly increase margins (part of my second thesis point).

Other important details from the 2Q21 release give me more confidence on TMHC’s future growth prospects that contribute to my above consensus growth, gross margin and EPS for 2022. TMHC's owned and controlled lots for future development grew to 76k which is about 5.5 years, catching up to the industry average of 6 years vs their average of 3.8 years in 2019 and 2020.

Lastly, during the last quarter, TMHC repurchased $107m of stock (3% of market cap), the largest cadence in the last 3 years indicating confidence in the balance sheet having de-levered significantly since the acquisitions. The share repurchases are another lever to increase EPS and ROE.

Thesis Point #2. TMHC is embarking on floorplan standardization which is a proven strategy and recently hired Brian Juedes to lead it, which should lead to further margin improvement vs their stated 2022 goals.

Brian Juedes is a 35-year industry veteran architect and is credited to having helped turnaround Meritage Home's operations from 19% gross margins in 2016 to 27% in 2021 by engaging in floorplan standardization and value engineering.

Brian's core expertise is home design and standardization to create procurement and building efficiencies without sacrificing design and appeal. Under his leadership, TMHC will standardize and simplify their construction, design and procurement process (i.e., instead of having 40 window designs and SKUs, simplify it to 15, while retaining design flexibility).

In addition to the turnaround at Meritage Homes, a similar standardization process was done at Pulte Group between 2012 to 2014 where margins expanded from 16% to 28%. Meritage and Pulte's turnarounds provide proof of concept and Meritage's chief architect is now at TMHC leading the effort. (Note the chart on page 1 will illustrate the gross margin trajectories of both Pulte and Meritage). 

I am confident that with Brian leading the charge, it increases the likelihood of success which should yield better gross margins vs the industry. Better design also makes the homes more appealing relative to competition increasing home premiums and sale cadence.

Valuation and Comparables

I believe that TMHC will meet or exceed their 22% gross margin target for 2022 which would be a catalyst for the stock to re-rate higher. I estimate TMHC EPS to be $7.45 in 2022 vs current consensus of $6.60, generating a FY22 ROE of 23.8%.

I also estimate that TMHC will grow communities in FY22 by at least 5% with upside to 10%, allowing closings to grow 5%-10% vs 2021 at normalized absorption pace. I am also assuming moderation of 3% off current price levels in 2022 as more supply comes into the market next spring.

A good valuation framework for homebuilders is typically ROE vs Price/Book Value. A consistently higher ROE usually warrants a higher book valuation. The table and chart below illustrates my valuation framework for homebuilders where my price target solves to be closer to the trend line. In the case of TMHC and a 23.8% ROE, I think that a fair value is 1.4x price book value which implies a $38.50 price target (40% upside).

In the event that TMHC's 22% gross margin target does not materialize either due to further operational mis-steps or a moderate housing slowdown, I believe a 20.7% gross margin is still achievable albeit on lower closings and ASPs. In such a scenario, I estimate $6.50 to be the downside EPS case for FY22, which is 2% below consensus, implying a 21.5% ROE. Typically, 0.95-1.0x price/book value is a floor valuation which implies 10% downside from current levels. This implies a 4-1 risk reward.

Brief Industry Overview and Outlook

The homebuilding market had a dramatic turnaround in the last 12 months. COVID has reinvigorated a generation of Millennials to seek out home-ownership where they have been slower to embrace it in the past for lifestyle and economic reasons. Remote work has also fueled out-migration from dense MSAs into the sun-belt states driving significant demand. The recent decline in US rates has led to lower mortgage rates has also helped spur demand.

The industry in the last 6 months have seen significant acceleration to earnings growth from this unprecedented demand, leading to record levels of home price appreciation and gross margin expansion, but also indicates how under-supplied the market is. While a key risk to the thesis is the health of the housing market, I believe that given the level of demand and under-supply, a moderate pull-back of home price appreciation is likely but not enough to derail the trajectory of earnings growth for most builders, with the exception of a handful that are facing tougher comps from 2020 and experiencing idiosyncratic development challenges due to a stretched supply chain.

Builders are also significantly better capitalized vs prior cycles allowing them to deploy significant share repurchases if and when the market slows down to keep earnings growth. Over 80% of public builders have substantial buyback strategies that they have deployed in the last 12 months.

Catalysts / Timing

I expect this thesis to play out in the next two quarters and would require TMHC to execute on their plan and exceed sales and gross margin expectations for 2022 and beyond.

In the current environment, I believe many homebuilders are still being valued based on sell-side consensus and TMHC beating and raising relative to sell-side consensus expectations is key to the thesis coming to fruition and the stock re-rating.

I also think the hiring of Brian Juede at TMHC is significantly under-appreciated. Management referred to him as a recent hire of a 35-year veteran on their last earnings call. I believe when there is a greater understanding and appreciation of the credentials of their new hire, there will be increased confidence in the turnaround narrative.

Risks / Mitigants

Risk #1. A sudden and sharp downturn in the housing market is a risk to the thesis, triggered either by a rapid increase in 10-year yields past 2.5% which would push mortgages rates past 4%, or a sharper than expected economic slow-down.

Mitigant - even though homebuilder orders moderated from very strong 1Q21 levels, the lack of housing inventory is likely to prevent a sharp housing down-turn. I conservatively estimate that the US housing market is about 2m homes under-supplied and more bullish estimates put that figure closer to 4-5m homes. At a housing starts pace of 1.6m per year, it would be at least 2 years before the housing market normalizes on supply/demand.

Risk #2. TMHC is over-indexed to the Phoenix MSA, with over 15% of closings tied to that market and Phoenix has historically seen more exaggerated cycles vs the national markets (higher highs and lower lows). Should price increases in the Phoenix market push the market too far, causing it to slow materially vs other markets, it would impede TMHC's ability to expand gross margins in the West division.

Mitigant - Phoenix in recent years have become more tied to the health of the CA housing market which continues to be robust due to the booming wealth generation in the state. As the largest destination for out-migration from CA, and the significant price gap between home prices in CA, I believe that the Phoenix market will be relatively well supported than in prior cycles.

Conclusion

I believe that TMHC is a value stock in the early innings of a turnaround with several self-help levers to get back to industry average gross margins. The stock has a 4-1 risk reward ratio and has fundamental downside support at a 0.95-1.0x price to book value ratio. The thesis is likely to take two quarters or more to play out but I have confidence with my upside view based on the points above. 

Catalyst

Earnings updates.