Due to interest rate-related concerns, almost all major homebuilding and building product companies’ stock prices have corrected significantly in recent months. Taylor Morrison Home Corporation (NYSE:TMHC) is no exception to this and the company’s stock price has decreased ~20% from its 52-week highs and is now trading at $28.66 which is only a slight premium to its Q1 2022 ending Tangible Book Value (TBV) per share of $27.30. The consensus EPS estimate for FY2022 is $9.21, which implies the company’s TBV per share will reach ~$35 by the end of FY2022. So, there is a substantial upside if the stock even trades near its tangible book value by the year-end.
Apart from its cheap valuations, TMHC’s business fundamentals look promising as well. The company’s nationwide roll-out of rationalized floor plans, as well as the full implementation of the canvas design package, should help the company to streamline processes and improve margins. Furthermore, increased digitization effort should help in cost reduction as well. On the capital allocation front, management is focusing on increasing capital efficiency through a land-light investment strategy which should help the company in delivering better returns with lesser risk.
While rapidly rising rates are a major cause for concern, significant undersupply of homes from 2008 to 2019 and strong homebuyer profiles should partly offset shocks related to rate hikes. So, I believe the company is a good bargain at current levels.
Last Quarter Earnings Analysis
In late April, TMHC reported better than expected Q1 2022 results. Total revenue stood at $1.7bn (up 20% Y/Y) exceeding the consensus estimate of $1.6bn. The increased total revenue was primarily driven by a 23% Y/Y rise in ASP to $594k whereas home deliveries declined slightly to 2768 (or down 2% Y/Y) putting a slight drag on total revenue. The decline in the number of homes closed was a result of ongoing building product and labour shortages. Despite this, the company posted a gross margin of 23.1%, a 450bps Y/Y improvement which was its highest gross margin since going public in 2013. The company also recorded its best SG&A expense (as a percentage of home closing revenue) figures which improved 120bps Y/Y to 9.6%. Improved gross margin and SG&A cost as a percentage of revenue resulted in a 92% Y/Y rise in EPS to $1.44, beating the consensus estimates of $1.26.
While demand remained healthy, net new orders declined 32% to 3054 due to tougher comparisons from last year and management’s decision to strategically restrict sales to keep up with production delays. As a result, the backlog declined 7% to 9400 homes.
Margin Improvement Prospects
Since its listing in 2013, the company had been on an acquisition spree. The company first acquired small regional players from 2013 to 2016. Later on, the company acquired AV Homes for ~$963mn (including debt) in 2018 and William Lyon Homes for ~$2.5bn (including debt) in 2020.
While these acquisitions helped the company increase its geographic footprint and become a national player they also created operational complexity. The company’s Florida market, where it had been less acquisitive in recent years, uses shared architecture, floor plan repetition, and option rationalization to save cost. When compared to the West Coast operations, which were impacted by the recent acquisitions, the company’s Florida markets have 300bps higher gross margins and one month lower cycle time. Looking forward, management has diverted its focus from acquisition and plans to implement initiatives such as floorplan rationalization, across all geographies.
Furthermore, the company aims to rationalize its SKUs to improve the procurement process and reduce cost and timeline to overcome material shortages. The main pillar in rationalizing SKU count is the Canvas design package which is an option pallet of standardized design packages. It provides prospective buyers with an option to choose from pre-bundled interiors. This eliminates the complex process of sourcing different choices of prospective buyers which was a major bottleneck in the traditional design centre model.
Lastly from a sales and marketing perspective, TMHC is pioneering the digitization of the home buying experience. Over the last two years, the company has introduced industry-leading capabilities to reserve inventory homes online with 3D self-guided virtual tours where prospective homebuyers can visit new homes virtually and design a model home according to their need via the Canvas design package. This had resulted in an increased conversion rate and lower SG&A expenses for the company.
Looking forward, I expect that once floor plan and design option rationalization are fully implemented across geographies it could lead to further operational streamlining and should yield better gross margins. For instance, only 15% of homes closed in last year’s second half implemented the canvas design model. Now management aims to scale the Canvas design model to all homes. Moreover, as more communities will be added to the company’s digital homebuying platform, it should reduce SG&A expense as a percentage of home closing revenue which should further enhance margins.
ROE Improvement Prospects
In addition to margin improvement, management is also focusing on improving TMHC’s return on equity.
After the acquisition of Lyon Homes, TMHC shifted its capital allocation strategy from being high debt less capital efficient to low debt, and more capital-efficient.
For TMHC the land light investment strategy is a key pillar in increasing capital efficiency. Following the acquisition of William Lyon, the company began to focus more on land acquisition via option purchase mechanisms rather than buying it outright. When compared to traditional land buying, controlling land via option requires less upfront payment (5-20% of the land price). If the demand is good, the company can purchase the land, else they could forfeit the upfront payment. This mechanism allows the company to manage a large land inventory while spending less money and taking on less risk by holding less land inventory on the balance sheet. In 2019, the company had a 15% optioned land pipeline, which has now increased to 39%, and management plans to increase it to 45% by the FY22 end.
Following the acquisitions of AV Homes and William Lyon, TMHC’s net debt to capital ratio had risen to the high 40s. Management is now concentrating on lowering the net debt to capital ratio by targeting the mid-20s level for the current year-end.
I believe management can easily achieve this target thanks to its strong profitability and land light strategy which means less cash should now be tied up with the land.
Rate Hike Worries
Inflation is rising at the fastest pace in the last 40 years and this has resulted in expectations of significant federal fund rate hikes this year and next year. The expectation of rate hikes had led to a spike in 30Y mortgage rates which rose ~220bps from ~3% to ~5.2% in the last six months. Moreover, home prices have also risen 20% YoY within the last 12 months. These two factors combined have resulted in a considerable decrease in affordability.
Despite some moderation versus very strong 2020 and 2021 due to these factors, demand continues to remain at healthy levels. On average TMHC homebuyers have a credit score of 752 and an average down payment of 24%. According to management, homebuyers whose homes got delivered in Q1 would have qualified at rates 650bps higher than their actual rates. Presently, the backlog contains 82% of homebuyers with similar qualifications while 16% of the homebuyers have a rate cushion of almost 370bps. This provides some downward cushion in case of a demand slowdown.
Looking forward, I expect rate hikes to put pressure on housing demand. However, as described in one of my previous articles, there has been a significant undersupply of new homes from 2008 to 2020. So, the supply condition remains tight and I am not expecting a 2008-like housing crisis. New housing starts have averaged 984k homes between 2008 and 2020 whereas the historical average was around 1.43 mn from 1959 to 2007. This denotes ~446k fewer new homes built every year from 2008 to 2020. So if a downturn is triggered by a significant hike in interest rates, its impact may not be as severe as we saw in prior recessions due to tight supply-demand dynamics. This undersupply of homes should partly offset demand reduction due to rising rates. Moreover, the company’s strong homebuyers profile should cushion some of the downsides.
Valuation and Conclusion
TMHC’s tangible book value at the end of Q1 2022 was $27.30. The consensus EPS estimate for FY22 is $9.21. I don’t see much risk to the 2022 consensus number as most of this year’s deliveries are already in the backlog. Using these numbers we get the company’s FY22 year-end tangible book value to be around ~$35. So, I see a substantial upside even if we assume the stock to trade in line with its TBV by this year-end. Hence I have a buy rating on the stock.