The homebuilding industry has been among the most volatile this year. The beginning of the year saw stellar performance for the industry as new home permits rose to highs. In March, COVID introduced an extreme shock that caused the homebuilder ETF (ITB) to lose half of its value as investors expected another 2008-like real estate market crash. Most surprisingly, that did not occur and most homebuilders are actually trading at YTD highs.
Before the crash in January, I covered one of my favorite builders Century Communities (CCS) in “Century Communities Is A Stellar ‘Growth At A Reasonable Price’ Homebuilder.” I was bullish on the stock due to its extremely low valuation and high growth rate. Most importantly, the company is focusing on new home buyers in growing millennial markets which I believe represents the best growth opportunity this decade. Put shortly, millennials have been slow to leave urban environments and buy homes but that trend has begun to shift. Since COVID has forced many young workers to work from home and cut consumption spending (i.e bars), this trend has only accelerated over the past few months.
This is a major reason why CCS’s stock price initially fell by 66% and subsequently rallied a staggering 260% from its March lows. Despite the crash, the stock is currently 30% higher than it was in January when I covered it. See below its performance below compared to that of ITB:
No doubt this has been a wild roller coaster for CCS/homebuilder investors, but despite the circumstances, the company is perfectly holding up to my original expectations.
Will Homebuilder Stocks Continue to Outperform?
Now, the company’s forward outlook is quite a bit different than it was pre-COVID. The long-term catalyst of growing millennial entry-level home demand persists, but the short term is dicey considering the U.S economy has been turned upside down by the situation.
Despite the recession, the homebuilding market has been very strong. Permits and pending sales took an initial dip when the crisis began, but have since made full rebounds and are actually sitting around highs. Additionally, home price-to-income valuations remain at extreme lows meaning homes are very cheap in most of the United States. See below:
The U.S housing market is objectively very strong today. This highlights today’s strange economic reality. The economy is certainly in a difficult position with unemployment at a persistent high and many small businesses struggling to survive. However, certain sectors that are usually extremely cyclical like homebuilding are actually thriving.
I believe there are logical reasons for this. Most Americans are not spending money on vacations, restaurants, and other activities which has caused savings rates to rise dramatically. Additionally, since there is little to do outside of the home, it makes it worthwhile to invest in a larger nicer home. This is particularly true for young people who have left big city apartments for suburbia and it is very unclear if they will return. This is good for all homebuilders, but Century Communities more than others due to its many entry-level construction projects.
As you can see below, this has enabled CCS to achieve near-record revenue and profits in Q2:
Looking forward, we must consider whether or not this trend will continue over the coming year. U.S. personal incomes have declined from their ‘stimulus spike’ level and spending has increased as some COVID lockdowns are lifted. Mortgage rates remain extremely low, but it is worth pointing out that FHA mortgage delinquencies are at a record of 16%. FHA is a key source of funding for entry-level buyers, so this is a potential bearish forward-looking indicator.
The fact is that not everything is as rosy as home sales and permit data suggest. Houses are cheap, but with unemployment this high and mortgage delinquencies on the rise, it is likely that sales will slow down over the coming year as Americans tighten their belts. Despite this, I still believe CCS is a fundamentally undervalued company.
A Closer Look at Century Communities’ Valuation
CCS is a very cheap stock, particularly given its extremely high revenue/EPS growth rate of 20-30% per year. Century Communities currently trades at an extremely low forward “P/E” of 8.7X. That said, earnings over the coming year may be lower than is currently anticipated by analysts due to expected mean-reversion in home sales.
As noted in the Q2 transcript, the bulk of the company’s upcoming sales will be weighted toward the fourth quarter due to delays in Q1-Q2. This is possibly problematic because home sales and prices usually slow down over Winter (though the impact is generally lower in the warmer climates where CCS is currently building). The company has been reinvesting profits into new projects and the upcoming sales season will be key for Century Communities’ future. CCS will be hurt if the positive surprise in COVID home sales results in a negative shock over Q3-Q1 2021.
This possibility makes me cautious, but I still believe CCS is an undervalued company. It has a cleaner balance sheet than most homebuilders with total liabilities to assets of 55% and trades at a single-digit “P/E” multiple. Most importantly, its management team understands the trend toward entry-level buyers and created its “Century Complete” brand which offers all-inclusive online buying for homes in the $100-$200K range.
This brand essentially mimics LGI Homes’ (LGIH) business model which has enabled LGI to be the fastest-growing builder for years. The key difference between CCS and LGIH is that the former trades at a significantly lower valuation. I’ve liked both companies for a long time, but I would say CCS has recently demonstrated a greater aggressive push than LGIH. In other words, CCS has a lower valuation and greater expected growth than its most similar competitor.
The Bottom Line
Overall, I remain bullish on CCS but am more cautious than in the past. The company is undervalued and I expect it to continue to achieve strong revenue growth over the coming years as urban renters become suburban home buyers. This gives CCS a significant possible upside that may easily be well over 100% from its current price.
That said, I believe investors are overly convinced that the coast is clear regarding COVID lockdown’s impact. The lockdowns harmed the company’s production temporarily, but the negative economic impact has persisted. Century Communities and many other builders posted strong sales in Q2, but it may be a mirage due to workers leaving large cities and/or consumers having more free cash to spend. This source of buying will likely end if it has not already.
This means new home sales may slump over the coming year and new home prices will likely decline too. I do not believe it will be as substantial as 2008 due to the market’s strong long-run fundamentals, but CCS has a lot of money on the line at what I believe to be a highly inopportune time.
Again, I believe CCS is the best builder in the market and has great long-run potential, but I personally would not buy the stock until it has a moderate pullback which discounts these economic risks.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CCS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Looking for 10-20% pullback before purchase.