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Sterne Agee: The bull and bear case for housing stocks

PulteGroup listed as a buy

While inventory is tight and homebuilders are rushing to keep pace with demand, there are still a handful of factors that need to come together in order to be successful.

A recent homebuilding and furnishing stock report from Sterne Agee CRT analyst Jay McCanless said, “Better-than-expected order volume was a common theme in the March quarter reports. We believe this trend could continue into calendar second quarter 2015, but we fear rising interest rates could outweigh improving demand trends.” 

McCanless explained homebuilder stocks could be under great pressure if rates rise further.

“In spite of the demand growth and backlog pricing growth we saw in the recent earnings reports, homebuilders may underperform the broader market in a rising interest rate environment,” the report stated.

Here are is the bull and bear case McCanless (his quotes in italics) makes for homebuilding and furnishing stock:

Bull case:

1. Mortgage applications coming back to life 

The index that tracks applications for purchase mortgages has been up by double-digit percentages Y/Y in four of the last five weeks and has comped positively for most of 2015. We view this as a sign of improving demand, and we believe the recent round of order reports from our builder coverage confirms that view.

2. Order volumes well ahead of expectations

The average order growth for our coverage was 54.1% versus our 34.0% forecast and the consensus estimate of 37.6%. The average backlog growth also exceeded our 33.8% Y/Y forecast and the Consensus estimate of 35.6% with an average comparison of 41.2%.

3. Valuations relatively tame

On a FY15 price-to-book-value basis (P/B), our 16 covered builders have an average multiple of 1.5x and excluding NVR the average drops to 1.3x. Our coverage’s multiple compares to a 1.9x forward P/B multiple for the homebuilder ETF ITB. On a P/E basis excluding AV Homes, our coverage is trading at an average FY15 multiple of 14.3x and has a 12.4x multiple for FY16. Assuming the homebuilders and the housing industry are still in the middle of the cycle, we view the P/E multiples as in line with historical averages.

Bear case:

1. Looming interest rate hike from the Federal Reserve

Theoretically, an increase in the Fed Funds rate shouldn’t have a meaningful impact on mortgage rates. Practically, we don’t believe that is the case, and we believe clients are very nervous about builders in a rising rate environment.

2. Affordability lower than last year

According to the National Association of Realtors' housing affordability index, the median-priced single family home is less affordable on a national basis than last year. This index typically has not been a reliable demand indicator, but from a high level view, it may deter new investors to the space.

While the report cautioned to be patient with new money, it still included PulteGroup (PHM) as a buy-rated name.

PulteGroup’s first-quarter profits surprisingly slid after home sales fell 28% in the pricey U.S. Northeast due to construction delays.

Home sales revenue, which excludes land sale and financial services revenue, was flat at $1.09 billion, while total revenue rose 1.3% to $1.13 billion.

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