• November 1, 2013, 1:33 PM ET

Home Builders Have Marginal Concern for 2014

Bloomberg News
Investors are worried about builders’ profit margins as home-price growth slows and costs rise.

As if there isn’t enough to fret about in the new-home market, home builders have provided investors with another concern: the potential for declining profit margins.

Roughly half way through earnings season for home builders, margins have become the new focal point of investor angst. The concern is that builders’ profit margins might start to dwindle as early as next year if, as many expect, price appreciation for new homes loses more momentum than the rising cost of building homes.

Such jitters can reverberate for investors because the home-building industry is quite cyclical. Investors constantly scan for the latest sign that the market is gaining steam, plateauing or starting to decline.

“If builders say the trajectory of margins is beginning to peak, then in a cyclical business, people tend to go from thinking the best to thinking the worst,” said Stephen Kim, an analyst who tracks home-builder stocks for Barclays.

No one is predicting that the housing cycle will turn negative this early. Still, investors are nervous that this might be a sign that the home-building industry’s recovery will be more rocky or drawn out than initially expected.

Home-builder stocks already have fared relatively poorly in recent months amid a slowdown in sales of new homes. The Dow Jones U.S. Home Construction Index of home-builder stocks closed Thursday 21% below its 2013 high, set May 14.

The margin concerns surfaced during builder Meritage Homes Corp.’s third-quarter conference call with investors on Oct. 23. Meritage Chairman and Chief Executive Steven Hilton said the builder’s gross margin rose to 22.8% in the third quarter from 18.6% a year earlier. What drew attention was his next statement, that Meritage’s margins likely would rise or stay flat for two or three quarters before starting to decline next year toward 20% or 21%.

“The biggest impact for us, our margins, going forward is going to be land cost,” Mr. Hilton said on the call. “Particularly in the California, it’s going to be difficult for us to replace (at economical prices) some of that land that we got at really good prices” in past years.

Of the many tricky things about land for builders is that they buy land two to three years before they start selling completed homes on it. Land prices were fairly cheap in 2011 before they started rising in 2012 and then spiking in 2013. That means that homes sold today are on land bought for relatively affordable prices in 2011 or thereabouts.

However, homes sold in 2014 and 2015 will be built on land bought at significantly higher prices last year and this year.

As the Journal reported, land-price gains recently began to slow. But smaller price increases still are increases. If home-price appreciation doesn’t outpace that rise in costs, you get a margin squeeze. And that, at some point, leads to a selloff of the industry’s stocks.

Richard Dugas, chairman, president and CEO of PulteGroup Inc., said during the builder’s Oct. 24 call with investors that rising land prices will have a “push-down effect” on margins within an unspecified timeframe. Pulte logged a third-quarter gross margin of 20.9%, up from 17% a year earlier.

Another national builder, Ryland Group Inc., reported a third-quarter gross margin of 20.6%, up from 19.1% a year earlier. Ryland President and CEO Larry Nicholson said Tuesday on the builder’s call with investors that its margins will increase in the fourth quarter. But he didn’t give a definitive outlook for Ryland’s margins next year.

“Margins are approaching the 21% to 22% range, and we’ve always said that we thought normalized margins were around 22%,” he said. “So there’s not a lot of room for it to grow. But for now, we see improvement out over the headlights.”

What does this mean for home-builder stocks? Well, stocks typically are valued in relation to earnings. “People might have overly aggressive earnings assumptions” in light of the potential margin squeeze, said David Goldberg, an analyst who tracks home-builder stocks for UBS. “Therein lies the problem.”

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