Strategic trade
Trade view / 29 September 2017 at 11:48 GMT

DR Horton attractive as US housing boom continues - #SaxoStrats

Head of Equity Strategy / Saxo Bank
Instrument: DHI:xnys
Price target: 50
Market price: 38.98
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KB Home has just reported third-quarter results beating estimates, and the outlook remains bullish. The S&P Homebuilder Index is up 373%, or 19.8% annualised, since the bottom in February 2009, but our conclusion is that this housing boom has more legs.

S&P Homebuilder Index
Annual housing permits in the US are around 1.27 million, which is around 15% the long-term average since 1960. If we factor in the rising population and drag on family formation since the Great Financial Crisis, the upside is probably 20-25% before the boom ends. Rising interest rates in the US are not a problem either as this early rate cycle will only continue against the backdrop of a stronger economy, including higher wage growth offsetting the drag from rising mortgage rates.

There are two ways to invest in North America home builders. Either through an industry exchange-traded fund or go selective among single stocks. In this trade idea, we recommend the stock we believe is most undervalued against current fundamentals.

The scatter plot below shows all North America home builders with a market value above $1 billion. On the y-axis is enterprise value to invested capital, and on the x-axis the return on invested capital to weighted average cost of capital. Only three home builders deliver a return on invested capital above the cost of capital which not a healthy sign. However, momentum is still strong in US housing so we expect fundamentals to improve over the coming years.
North America home builders valuation
Source: Bloomberg and Saxo Bank 

Among home builders, we prefer DR Horton. Their valuation is low relative to the fundamentals and that's before factoring in improvements over the coming year when margin expansion will be the key driver of profitability. 12-month trailing revenue growth was 18% in Q2, and margins expanded at a healthy clip. The financial leverage is low and manageable so we see few drags on the stock price apart from concerns over how rising mortgage rates will affect home builders.

Based on growth projections and current ROIC, the EV/IC multiple should be closer 2.1x, up from current 1.67x. For this to happen the market value/share price needs to climb 28%, which would take it to $50 per share.

DR Horton weekly share price since 2012
DR Horton share price Source: Saxo Bank 

Management and risk description

There are some risks to this trade idea:
  • The Fed gets caught off guard by unexpected higher inflation and is forced to accelerate rate hikes
  • Mortgage rates are pushed significantly higher, capping housing demand as the Fed's quantitative tapering starts in agency bonds (MBS etc.)
  • Slowdown in US economic fundamentals although right now the trajectory in leading indicators is now upward
  • Worse-than-expected earnings/outlook. Key date is November 9 when DR Horton releases Q3 earnings


Entry: we buy DR Horton shares at the open. Depending on one's urgency, it can be done with a market order before the open, which will then be filled at the opening auction price, or place a limit order before or after the open at one's desired entry level.

Stop: $33 per share, which is just below the 200-day moving average.

Target: $50 per share, translating into a 28% upside from current levels.

Time horizon: long term as it could take up to 12 months to reach the target level.

— Edited by John Acher

Non-independent investment research disclaimer applies. Read more
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