The resiliency of the new-home market in 2023 has driven strong results for the majority of public builders. Citing strong underlying market fundamentals, limited resale inventory, the relative resilience of new-home demand, and the execution of strategic initiatives, public builders have been able to outperform Wall Street expectations for revenue and profits per share through the first three quarters of 2023.
“The market expected home builders to have a rough time because traditionally new homes are more expensive on average than existing homes. That has narrowed lately,” says Deidre Woollard, real estate analyst at The Motley Fool. “Over the last few months, as much as one-third of all homes for sale in some markets have been new homes. Home builders have been strategic about releasing supply and starting new construction because they are aware that things could change quickly.”
Sheraz Mian, director of research at Zacks Investment Research, says the strength of the labor market has benefited the sector. Mian says multidecade low unemployment rates and rising wages “kept the housing market afloat,” and the general resilience of macroeconomic conditions have been favorable for builders.
In the case of some builders, the outperformance has been significant. In the third quarter, Century Communities, LGI Homes, Meritage Homes, and NVR beat analyst projections for profits per share by more than $0.80.
Carl Reichardt, managing director of research and home building analyst for BTIG, says margins, delivery volume, and pricing have been “especially volatile” relative to past periods due to the effects of the COVID-19 pandemic.
“The last three-and-a-half years have probably been the most challenging period to actually model earnings that I’ve seen in my career,” says Reichardt, who has covered the home building sector for more than two decades.
To put together projections, analysts start with orders as an indicator of future revenue and attempt to forecast unit orders, absorption paces, and sales rates. Reichardt says forecasts attempt to determine what percentage of backlog that builders enter a quarter will be delivered in the upcoming quarter.
For Woollard, the most difficult aspect of projecting current earnings results is the uncertainty of “back-end” business operations.
“We can see overall reporting of new-home sales each month, but that is often volatile. Another thing that can be hard to determine in advance is the cancellation rate,” Woollard says. “That’s something that spiked when interest rates first began to shift. It has stabilized recently, but, as consumers face the pressure of paying for student loans, we could see that rise again. Builders can't necessarily change their prices dramatically so they rely on incentives if the market contracts. We want to make sure that using incentives doesn't become a crutch that eventually drags on margins.”
All the factors taken together, the volatility and variability of each line item can result in bottom-line results differing from projections.
“There’s a lot of variability in every line that we need to think through. Because home building is a low unit count, high dollar per unit business—especially when a company is small—a relatively small miss on our part on delivery volume can cascade through the rest of earnings,” Reichardt says. “In the most recent quarter, the most striking bit of outperformance was the gross margin. [There] was an expectation that a substantial number of builders would see incentives that would hurt gross margins.”
Woollard says homeowner purchasing ability is the biggest factor impacting public builder projections. While the job market is still strong and wages are growing, the rapid run-up in rates is still impacting buyers.
“Builders are focused on having enough inventory to satisfy demand without having a large and unmanageable backlog. A lot of builders felt the impact of a slower supply chain during the pandemic,” Woollard says. “After that eased, builders needed to make sure they are selling inventory and not getting caught with more homes on the books than they need.”
Weight of Consistent Overperformance or Underperformance
Mian, Reichardt, and Woollard agree that a company’s history of earnings surprises—either negative or positive—have a bearing on future projections for a particular company.
“History tells analysts how conservative or otherwise management has been in providing guidance to them,” Mian says. “Even if management doesn’t provide guidance, a history of outperformance shows that management has a good handle on managing expectations.”
Woollard says, in some cases, a company may “constantly set the bar low for itself in order to outperform its own expectations.”
“If a company does that consistently, then that has to factor into the projections,” says Woollard. “When there’s underperformance, it’s important to know what is driving it. Was there an external factor that contributed to it, and did it make sense for the management to be surprised by it? When we look at home builders, we want to see that they are planning for the future, which means taking into account the volatility of land and material prices as well as customer demand and interest rates.”
Despite the variability of performance, on balance, Reichardt says the guidance for the next quarter for a home builder should be fairly accurate because the company knows what is in backlog and the timeline to closing for those units.
“The variability tends to be when a builder takes an order and sells a house in the same quarter, because it’s not in backlog as reported. We had a lot of builders do that this past quarter,” Reichardt says. “In general, as the industry moved toward more of a spec model and more builders have focused on the low end and moving their spec inventory quicker, it becomes more difficult to model that because we don’t have visibility for that occurring during the quarter. The house is not in backlog if it is ordered and closed in the same quarter; that makes [projecting] more challenging.”
Looking Ahead
Coming out of the most recent earnings cycle, builders reported a normalization of build times, which Reichardt says will allow companies to “plan as opposed to living day to day” in 2024. He adds he is also interested in seeing what public builders do with the “significant amounts of free cash flow” that has been generated in 2023.
“Many [builders] have no net debt. What they do with this excess cash is a really interesting and important thing to think about,” Reichardt says. “Some of them will buy back stock, some will increase dividends, some will get more aggressive in the land market, [and] maybe some do mergers and acquisitions with their excess cash. How that’s deployed over the next year or so—because cash flow should return to its more normal level next year—is a really important question that I’m looking at.”
