Stephen Kim has been following the home building sector in some capacity for nearly three decades, both as an analyst and an investor. His career has spanned several home building cycles, giving him a unique perspective on the industry and the publicly traded home builders. He is the lead home building analyst at Evercore ISI and has been voted the top-rated analyst in the space in each of the past five years, according to a survey of investors conducted by Institutional Investor magazine.

I spoke with Kim to get his thoughts on the stocks ahead of first quarter earnings, the types of investors that are investing in the builders, and what he’s focusing on in terms of operational performance and outlook. Below are some of the highlights from the interview.

Mackintosh: What do you think is top of the mind for investors heading into first quarter earnings?

Kim: Normally, home building investors focus on year-over-year order growth, almost to the exclusion of earnings, since orders are the most leading indicator. However, for the last nine months, we have been telling people that these are not normal times and that order trends are not the best metric to watch. Indeed, builders across the industry are deliberately limiting their sales because demand is outstripping their production capacity and raising prices at a rapid rate. In this environment, what really matters for the builders now isn’t orders, but rather margins.

Mackintosh: You’re probably the most bullish analyst on the Street, with Buy ratings across the sector and above-consensus earnings estimates. What are the red flags you’re looking for that could potentially change your view?

Kim: Yes, our FY21 estimates are about 20% higher than the Street consensus, and our FY22 estimates are 35% higher, on average. That’s an unusually large gap, and, amazingly, this was true six months ago, as well. The Street has consistently underestimated the durability of housing’s strong selling conditions broadly, and the home builders’ ability to drive profitability specifically. As to the industry backdrop, the current inventory shortage cannot be alleviated quickly, because production constraints and government forbearance programs are limiting the addition of homes for sale, while first-time buying and second-home buying are reducing inventory further. So supply will stay tight for a long time. Then, on the demand side, the current strength is rooted in a decade of pent-up household formations now driving the low end of the market and a paradigm shift in the desire for more space and second homes supporting the higher end. These are trends that will play out over years, not months.

So what could go wrong? Near term, the primary risks we see are rates and the supply chain. An abrupt rise in mortgage rates above 4% this year (from 3.13% now) would probably induce a buyer’s strike. Meanwhile, constraints on materials and land development brings the potential for production shortfalls or declining community counts at the builders. These would likely be temporary hiccups, but the stocks wouldn’t like it. I am less worried about higher lumber costs, although a lot of people ask me about it. I’d point out that builders have a long history of raising prices enough to more than cover lumber cost spikes, and, thus far, it looks like it’s playing out this way once again.

Mackintosh: Have you seen any change in the types of investors looking at the home building stocks over the last year or so?

Kim: The home builder stocks are an interesting subset of the market because nobody has to own them. Even though housing is a very large segment of the economy, their combined market caps are relatively small. So what you have are investors who go out of benchmark to buy the builders from time to time. These investors usually cover Financials, Industrials, Consumer Discretionary, or Real Estate (REITs). Sometimes, however, you see generalist investors get more active in the home builders. These folks tend to be highly thematic in their investing style and look for secular change stories or cyclical inflections. We would argue that the housing sector offers both right now, and we have definitely seen an increase in interest from the generalist community over the past six months.

Mackintosh: Are there any themes or home builders that you expect to outperform this earnings season?

Kim: We have had an Outperform rating on every home builder under our coverage since September, which is rather unusual. But when across the board, I see our estimates so far above the Street, we believe such a stance is warranted. Relative P/E valuations have almost never been lower than they are now, and so the stocks are being driven by upward estimate revisions.

In terms of themes, there are two that we highlight. One is that the build-to-order (BTO) builders like Pulte, NVR, and MDC will register a bigger uptick in gross margins than the spec builders over the next couple of quarters. The big margin inflection that the spec builders reported last quarter should logically benefit the BTO builders three to six months later, but the Street has curiously not modeled this lag correctly. As a result, we see more upside to margin expectations for the BTO builders from here.

The second theme relates to cash flow and share repurchases, which favors the largest builders in the industry—DHI, LEN, NVR, and PHM. These four have high margins relative to their smaller peers, very low levels of leverage, and are seeking to minimize land spend in order to pursue an asset-light business model. What that means is that they will generate significant cash flow, which will lead to an unprecedented degree of share buybacks. Longer term, we believe this will allow DHI, LEN, and PHM to trade primarily on a price/earnings basis, rather than on price/book, following in the footsteps of NVR.

Two builders that sit at the intersection of both themes are Pulte and NVR, so those would be names to focus on this earning season.

Company Coverage and Required Disclosures:

Ticker; Company

AWI; Armstrong World Industries, Inc.: Evercore ISI or an affiliate expects to receive or intends to seek compensation for investment banking services from this subject company Armstrong World Industries, Inc., within the next three months.
DHI; D.R. Horton, Inc.
FPH; Five Point Holdings, LLC: Evercore ISI or an affiliate expects to receive or intends to seek compensation for investment banking services from this subject company Five Point Holdings, LLC, within the next three months.
FBHS; Fortune Brands Home & Security: Evercore ISI or an affiliate expects to receive or intends to seek compensation for investment banking services from this subject company Fortune Brands Home & Security within the next three months.
IBP; Installed Building Products, Inc.
KBH; KB Home: Evercore ISI or an affiliate expects to receive or intends to seek compensation for investment banking services from this subject company KB Home within the next three months.
LEN; Lennar Corp.: Evercore ISI or an affiliate expects to receive or intends to seek compensation for investment banking services from this subject company Lennar Corp. within the next three months.
MDC; MDC Holdings Inc.
MAS; Masco Corp.: Evercore ISI or an affiliate expects to receive or intends to seek compensation for investment banking services from this subject company Masco Corp. within the next three months.
MTH; Meritage Homes Corp.
MHK; Mohawk Industries, Inc.
NVR; NVR, Inc.: Evercore ISI or an affiliate expects to receive or intends to seek compensation for investment banking services from this subject company NVR, Inc., within the next three months.
OC; Owens Corning: Evercore ISI or an affiliate expects to receive or intends to seek compensation for investment banking services from this subject company Owens Corning within the next three months.
PHM; PulteGroup, Inc.: Evercore ISI or an affiliate expects to receive or intends to seek compensation for investment banking services from this subject company PulteGroup, Inc., within the next three months.
Evercore ISI or an affiliate has received compensation from this subject company PulteGroup, Inc., for investment banking services in the last 12 months.
RLGY; Realogy Holdings Corp.
TOL; Toll Brothers, Inc.
BLD; TopBuild Corp.: Evercore ISI or an affiliate expects to receive or intends to seek compensation for investment banking services from this subject company TopBuild Corp. within the next three months.
TPH; TRI Pointe Group, Inc.