DR Horton shares rise to new peak. Here’s why I’m doubling down

With the prospect of lower interest rates, housing stocks are rising. A beneficiary was Dr. Horton (DHI 1.02%)which recently saw its stock hit an all-time high. The largest US homebuilder enjoyed two months of momentum after impressive earnings results and encouraging macroeconomic data.

Some investors may be thinking of selling after recent gains, but there’s still a lot to love about this homebuilder. Here’s why.

The news has been good this summer

Home stocks surged in July after a stronger-than-expected earnings report. The company reported a 2% increase in sales and 5% higher earnings compared to the previous year. DR Horton’s new orders were relatively weak and it cut its sales forecast for the full year. However, investors were pleased with the overall outlook thanks to low housing inventories and the prospect of lower interest rates later this year.

Image source: Getty Images.

Interest rate speculation picked up steam in August. Fed Chairman Powell’s public comments indicated that a rate cut was on the way. Investors hope that lower borrowing costs will boost housing demand, sending DR Horton to a new all-time high.

Growth over business cycles

Home building activity is highly cyclical. It is influenced by many factors, including interest rates, employment, consumer sentiment and lending standards. There have been major distortions in the housing market over the past 20 years. DR Horton’s financial results have fluctuated over these macroeconomic cycles, but the company has delivered over the long term — achieving a compound annual sales growth rate (CASGR) of 6.8% since 2004.

DHI Revenue (TTM) data by YCharts.

Its result exceeded sales growth. Net profit, earnings per share and cash flow all expanded at a faster pace than revenue. Also, its dividends have been steadily increasing. DR Horton is not a dividend act; its dividend yield is below 1% and its payout ratio is less than 10%. However, it is important to recognize the company’s growing ability to return value to shareholders.

Competitive position

DR Horton operates in a highly competitive landscape. There are several home building companies with a national footprint. Its main competitors include:

• Lennar (NYSE: LEN)
• The Pulte Group (NYSE: PHM)
• Toll Brothers (NYSE: TOL)
• DVR (NYSE: NVR)
• Taylor Morrison (NYSE: TMHC)
• The merit (NYSE: MTH)

The industry also includes numerous smaller national or regional players, along with a large number of small businesses. Home building is a large and highly fragmented market.

DR Horton is the industry leader based on revenue. It closed more than 24,000 units in its most recent quarter, more than rival Lennar. The company has also diversified its revenue streams with a leasing and financial services segment that provides mortgages to its buyers. Leasing operations ensure more stable cash flows. Integrating mortgage services not only increases revenue, but also entices customers by simplifying the buying process.

Horton has gained market share in recent years, with its top line outperforming competitors. This can be attributed to several factors. Its broad geographic footprint and exposure to housing across the price spectrum means that DR Horton is not based on economic strength in a particular city, state or income level.

Diversifying the company provides a top drive along with a competitive advantage. DR Horton’s scale also gives it negotiating leverage over prices from suppliers and subcontractors, making it difficult for its rivals to compete on price.

DHI Revenue (TTM) data by YCharts.

The company also benefited from increased construction activity relative to total home sales. Newly built homes account for about a third of the total residential inventory. That number was about 15% before the global financial crisis and below 10% in the years after the housing crash. DR Horton has capitalized on this trend over the past decade, and demographics suggest demand for new construction should remain strong.

DR Horton cannot claim an economic moat based on a proprietary technology or network effect. As a result, some investors may feel justifiably skeptical about its ability to maintain its competitive advantages in the future. However, it’s hard to argue with the results; the company added market share while maintaining an attractive return on invested capital (ROIC). This is compelling evidence of strong competitive performance, pricing power and operational efficiency.

ASSESSMENT

DR Horton stock is currently somewhat expensive compared to its peers and historical averages, but the industry as a whole trades at modest valuations. The stock’s forward price-to-earnings (P/E) ratio is below 13, so there is no significant price speculation. If the economy enters uncertain periods of weakness, there is less room for the stock to fall even at this relatively high valuation.

DHI PE report data (before) by YCharts.

Cheap valuations often indicate operational or financial risk, but this is not apparent to DR Horton. Cyclicality creates problems, but should not surprise investors or company management. Crises are inevitable, and so are recoveries. DR Horton has sufficient liquidity based on its high current ratio. It also has a reasonable capital structure, so debt servicing should not cripple the company during the next economic downturn. Strong measures of financial health reduce macro risk for long-term investors.

DR Horton’s performance will depend on its ability to maintain its competitive position and the health of the housing sector. This is not the cheapest stock for exposure to housing or home building activity. Still, it’s a reasonable valuation for a market leader that boasts impressive operating performance and clear macroeconomic catalysts moving forward.