Why I'm Sitting Out Homebuilder Speculation

Merger mania continues this week with a number of deals being announced. CVS Health (CVS) will buy Target's (TGT) pharmacy business for $1.9 billion. Cox Automotive is buying DealerTrack Technologies (TRAK) for $4 billion in cash. Coty (COTY) will acquire the Max Factor, CoverGirl and Wella beauty products and fragrance lines from Procter & Gamble (PG) for approximately $12 billion. The one that caught my eye, however, was the announced merger between high-end homebuilder Standard Pacific (SPF) and Ryland Group (RYL), another homebuilder. The $5.2 billion transaction will create the fourth-largest U.S. homebuilder behind D.R. Horton (DHI), Lennar (LEN) and PulteGroup (PHM), with the new company offering products across 17 states and a variety of price points. In many ways the merger makes sense -- a more diverse product offering, greater geographic coverage, a larger mortgage finance business, and, of course, the purported synergies. Still, one question that I tend to ask myself when these deals occur is, why now? There is always the argument of greater scale, but if we trace through homebuilder comments from the March-quarter reporting season we find that many are contending with the fallout of spec homebuilding over the prior months. Faced with excessive inventory, homebuilders have ratcheted up the use of selling incentives and concessions to convert prospects to buyers. Arguably, the best example of this came at Hovnanian Enterprises (HOV), which delivered 1% fewer homes in the March quarter, but saw its gross margins drop more than 400 basis points. The cause? Incentives and concessions to move excessive spec housing that was built up during the second half of 2014. And Hovnanian wasn't alone -- Meritage Homes (MTH), M.D.C. Holdings (MDC), Standard Pacific, D.R. Horton, and PulteGroup all saw margins affected by these practices. Like any company that is looking to move product fast, it's the net value to the consumer that matters. What's always been funny to me is how the homebuilders discuss deliveries and price when it comes to revenues, but concessions and incentives hit margins. Why not use net pricing or would that tip their hand when it comes to aggressive enticements? Can't have that -- it might signal other issues. So some of this could be explained by the desire to stabilize prices and therefore margins. Part of the problem is there are simply too many publicly traded homebuilders. A recent count shows more than 20, and outside of the banks/financials I think many would be hard pressed to find an industry with as many players. We've seen waves of consolidation among the homebuilders and a quick Googling of the words homebuilder and consolidation delivers articles that seem to call for such activity nearly every year. Last year saw 15 M&A deals (13 among publicly traded builders), the most since 2005, and Builder Advisor Group (BAG) expects 2015 to be at least as active as 2014 for homebuilder M&A. With the Fed jawboning for an interest rate hike later this year, homebuilders, just like all those other buyback-happy companies (e.g., Apple (AAPL)), might look to tap the low-interest rate market before such a transaction becomes even more expensive. Those notions helped homebuilder stocks gap up on the Standard Pacific-Ryland news as that union could signal the beginning of another mini-merger wave among homebuilders. As traders speculate on which puzzle piece fits with another, it can be a challenging time for the longer-term investor, particularly given the at best mixed housing market, due to job creation, wages, and other demographic factors. If I were eyeing a homebuilder stock I would want that company to have a presence in markets seeing strong job creation and upward wages, such as the Mid-Atlantic region or Northern California. In these merger speculation waves, it's important to think like an acquirer. Which potential partner has the best geographic presence, little overlap with either my existing footprint, price point or both? Just like with the recently announced media and telecom mergers, the last thing you want is to be partnered with a name that is among the last players standing. Most of the attractive ones are scooped up early. Being an investor, I may miss out on some profits by sitting out the homebuilder speculation, but as I've talked about over the last week, recent industrial data point to a slower than previously expected economy. Demographic data, such as the fact that nearly 30% of Americans have no retirement savings and the preference among Millennials to rent rather than own, make me wonder if there is more to 2015's slide in household formation than just the weather. Findings from the recent Business Roundtable report that found CEOs have planned less spending and hiring amid reduced expectations for sales during the next six months certainly doesn't help. Even though we may see a seasonal bump in housing data, those findings tell me that homebuilders (and their margins) are likely to continue to be affected by the use of incentives and concessions to move product. I'd rather wait on the sidelines for better fundamentals, better stock prices or both.

Why I'm Sitting Out Homebuilder Speculation

Margins continue to be hurt by incentives and concessions.

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