Description

Note: See katana’s May2020 LGIH post for a vibrant VIC message board re: homebuilders.

Punch Line: The market is pricing in significant write-downs of homebuilder land and inventory.  Unlike the GFC however, we enter this housing cycle with structural housing undersupply and much lower financial leverage at homebuilders.  We like TPH at 0.67x book, with one of the best vintages of land on their BS (i.e. oldest, and therefore less subject to impairment).

Summary

Tri Pointe (TPH) is a mid-cap home builder with concentrations in California (43%), Texas (17%), Arizona (11%), Carolinas (10%) as well as mid-single digit exposure to Nevada, Colorado and DC with average home prices of ~$670k. 

The setup for housing while the Fed is raising rates is bad.  Affordability has been reduced on the back of 1) post-covid home price appreciation, and 2) mortgage rates roughly doubling since the beginning of 2022.  That said, we believe valuation has become extreme and prices in severe impairments that are unlikely to occur given the backdrop of housing supply, current gross margins, and underlying demand.  TPH is extremely cheap with 50% upside to book value.  The market is presenting a rare opportunity to purchase a quality homebuilder at distressed levels in the absence of distress.

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Setting the stage

There is a housing shortage in the US.  Homebuilders, Timber REITs, and others estimate a 3-5mm unit shortfall.  The shortage is the result of the aftermath of the Global Financial Crisis in 2008-2009 where the following decade experienced housing production well below levels needed to sustain population growth, household formations and obsolescence.  This is nicely illustrated by a FRED chart on single family starts and the Census chart of home units under construction. 

The graphs show housing starts from 2008-2019 was at levels mostly below the period from 1983-2007 and substantially below 1999-2006.  The end result has been aggregate underbuilding of single-family homes to the tune of 3-5 million homes. 

At the same time, demographics have shifted in the US where the millennial generation, a larger cohort, is in the prime home buying stage of life.  The demographic increases through 2030 which will exacerbate the shortfall of homes needed to support this large cohort’s household formation and need for a single family home. 

A knock-on effect of the housing shortage is an increase in the age of the US housing stock. This is a more subtle supply impact but overtime the obsolescence of the stock should accelerate as the average home is now estimated to be ~40 years old whereas it was 31 years old in 2005. It is estimated that close to 40% of housing stock is older than 50 years. 

The housing shock we are experiencing in today’s market is not due to an over-supply issue, unlike what we saw in the GFC.  The supply chain issues that created elongated delivery times for home builds were ultimately a gift that did not allow supply to build.  Further, existing homes inventory is currently at the lowest level in 20+yrs.

Homebuilders do not have a supply problem nor a demographic demand problem…they have an affordability problem.  Mortgage rates have doubled from ~3% to ~6% in the past year and home purchases have stalled.  This creates a weak setup for homebuilders where pricing and margins will compress.

We believe gross margin contraction will be less severe than prior periods of distress and not result in material writedowns.

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This time is different

In 2021 and 2022 housing construction started to ramp to meet high demand from post-covid Urban flight, as shown in the Census graph displayed above.  However, new supply was limited by labor and supply chain disruption.  As a consequence, we did not see the over-supply we have typically seen in other housing cycles.  Instead, we saw homebuilder gross margins and Return on Equity “ROE” hit historically high levels.  E.g. TPH gross margins have expanded from a history of mid-teens to 27%.  Many peers in the homebuilding sector have low 30s gross margins and all companies are operating at historic margins.

Further, credit fundamentals of the mortgage market never got frothy due in part to the absence of sub-prime lending.  The average credit score this cycle starts with a “7” and not a “5”, and LTVs are much higher than in the GFC.

This housing market slowdown is not caused by credit contraction, or an irrational supply response. We think this cycle will manifest through price concessions driving a decline in margins and ROEs.  At the peak, homebuilders were generating 30+% GMs and 30+% ROEs, growing book 6-9% per quarter.  Those days are over.  ROE and gross margins will come down, but we expect that this can occur without writing down land and inventory.

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How much can prices come down before book values are impaired?

Blue-chip builder DHI has estimated they won’t see any writedowns until GMs hit 15%, and no material write-downs until GMs are in the single-digit%s.  Mechanically, given 27-30+% current homebuilder GMs, that requires 20+% housing price declines before we see material writedowns.

But there is a further offset from abating cost inflation, which will support GMs. The most impactful example is lumber.  See the price of 1k board foot lumber on the graph below, which has come down ~65% from the recent highs.  Per UBS Lumber historically was ~20% of the cost of the home, and much higher during the post-covid period where lumber costs went up 2-5x.  As these costs abate, gross margins will have support, giving homebuilders further flexibility on pricing before any writedowns.

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What is in TPH’s book?

TPH has tangible book value of $2.5bn.  This reflects $3.5bn in real estate, less $1bn in net debt.

Their real estate comprises $2.1bn of inventories (think finished/semi-finished homes), $1.1bn of land, and $250m in options.

History suggests the existing inventories will be sold without problem.  In 2019, TPH did $3bn of home sales.  With a 20% GM, that implies they sold $2.4bn worth of inventory.  The $2.1bn on the books today is less than 1yr’s worth of inventory, with a GM that starts near 30%.  We think the sale of these inventories will likely be accretive to book value.

Options on the other hand are the riskiest part of book.  They will be the first to be written down.  However, this is just 10% of book, and noise relative to TPH’s current level of cheapness.

We think the fulcrum asset WRT write-downs is land.  TPH has the best vintage of land among the larger builders, with 62% of lots acquired prior to 2021, i.e. before the recent post-covid surge in prices.  Which gives them a bigger buffer for home price depreciation, before the land on their balance sheet becomes impaired.

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Valuation

TPH trades at 0.67x Price to TBV.  Buying homebuilders at < 1.0x TBV has been a successful strategy in normal times and <0.80x has been a successful strategy in times of stress/uncertainty so long as there are not widespread impairments like we saw in 2008-2009. 

We do not believe large impairments are on the horizon.  We expect homebuilder profitability to go lower, starts will slow significantly, but book values will hold up.  We enter this cycle with low, not high, supply.  Major differences between today’s housing environment vs the GFC period when builder book values collapsed 40-70%:

• Homebuilders entered the GFC with leverage levels (Net Debt to Equity) of 40-70% vs 10-40% today (TPH at 30%). The biggest driver of GFC book dilution was equity raises at trough stock prices.  Better balance sheets today, make that dilutive outcome less likely.

• Gross Margins entered the GFC in the low-20s% vs high-20s to 30+% today, giving us a higher buffer for home price depreciation before we see book impairment.

• Supply entered the GFC at extended/record levels.  Today, we think we are coming out of a 10+ year period of under-supply, including existing home inventory at multi-decade lows.

• Demographics are favorable with a record home-buying-age population.

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Summary

Homebuilders, and TPH in particular, are pricing in large impairments to book value, similar to what we saw in the GFC.   We think this is overly punitive, as 1) GMs start at record levels, providing a pricing buffer, 2) builder balance sheets are much stronger than entering the GFC, and 3) the mkt enters this downcycle in structural undersupply rather than oversupply.

At 0.67x book, we see +50% upside for TPH stock to return to book value.  One could make a similar case for owning other homebuilders.  We prefer TPH due to 1) relative cheapness, 2) best-in-class vintage of its land holdings.

Disclaimer:

This presentation is intended for informational purposes only and you, the reader, should not make any financial, investment, or trading decisions based upon the author's commentary. Although the information set forth above has been obtained or derived from sources believed to be reliable, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the above information serve as the basis of any investment decision. Before investing in a security, readers should carefully consider their financial positions and risk tolerances to determine if such a stock selection is appropriate. At any time, the author of this report may trade in or out of any securities that are mentioned in the report as long or short positions in his own personal portfolio or in client portfolios that he manages without disclosing this information.

This report’s estimated fundamental value only represents a best efforts estimate of the potential fundamental valuation of a specific security, and is not expressed as, or implied as, assessments of the quality of a security, a summary of past performance, or an actionable investment strategy for an investor. This is not an offer to sell or a solicitation of an offer to buy any security.

Catalyst

Lack of material impairments and growing Tangible Book value.

Mortgage rates peak.