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Morningstar | D.R. Horton Reports New Order Growth in 1Q Despite Housing Market Slowdown; Shares Undervalued. See Updated Analyst Note from 25 Jan 2019

By now, it's well known that housing demand slowed in the waning months of 2018. Prior to D.R. Horton's fiscal first-quarter (ended December) earnings release, five peers all reported a year-over-year decline in new orders during their respective fiscal fourth quarters. Toll Brothers' orders fell 13%, Hovnanian's and KB Home's orders both declined 12%, NVR's orders were down 11%, and Lennar's pro forma orders were 2% lower than last year (adjusting for the CalAtantic merger). So, while D.R. Horton's 3% uptick in orders versus the year-ago quarter (2% excluding acquisitions) was underwhelming relative to recent performance, we were pleasantly surprised that the firm gained market share during a difficult environment. However, D.R. Horton's share gains came at the expense of its gross margin; the firm noted that higher sales incentives, which are used to stimulate orders, were one factor that contributed to an 80-basis-point year-over-year decline in home sales gross margin to 20%. Management noted that rising costs, decreased pricing power, and purchase accounting were other factors.

D.R. Horton's stock traded higher briefly following its earnings release, but then sold off over the course of the Jan. 25 trading session. We think the sell-off was likely in response to the company's disappointing gross margin outlook. D.R. Horton expects second-quarter gross margin to range between 19.0% to 19.5% versus 20.8% in the second quarter of 2018 due to the same factors mentioned above. Management noted that this depressed gross margin range could persist throughout 2019. Still, we think a 19%-plus gross margin will likely beat many of D.R. Horton's peers in 2019, and we note that over the past 20 years, D.R. Horton's home sales gross margin has averaged 19.2%, so the firm's outlook is not unusually pessimistic, in our view.

We're maintaining our $47 per share fair value estimate and no-moat rating for D.R. Horton as our long-term outlook has not materially changed.

Price versus sales pace is a balancing act all homebuilders try to optimize to generate the best possible return on invested capital. D.R. Horton's 2019 outlook shows the firm is willing to sacrifice some margin in order to improve sales absorption pace and its inventory efficiency. In our view, this is a good strategy because faster turning inventory (note that inventory accounts for most of D.R. Horton's invested capital) can more than offset less robust margins to drive better returns. Indeed, D.R. Horton's trailing 12-month return on inventory (as calculated by the company) improved 230 basis points year over year to 19.3%.

While management acknowledged the recent housing slowdown, the trend in D.R. Horton's sales activity is a reason to remain optimistic as the firm enters the all-important spring selling season. We say "all-important" because the spring selling season can make or break a homebuilder's year. Management noted that year-over-year sales were down in October, but sales returned to year-over-year growth trajectory in November and December, and so far, January is looking good, too. VP of Investors Relations Jessica Hansen noted during the earnings call that "the very early signs for spring are good."

We continue to believe that D.R. Horton's focus on building affordable homes and its ample and geographically diverse supply of land position the firm to deliver the strongest organic home delivery growth among the homebuilders we cover over the next decade. Given D.R. Horton's affordable price point and the fact that the 30-year average fixed rate mortgage has fallen to 4.45% (from a cycle high of 4.94%), which is about in line with prevailing mortgage rates during last year's spring selling season when demand for new homes was strong, we think this spring selling season could surprise to the upside. If that happens, and factoring in significantly lower lumber costs that will begin flowing through D.R. Horton's cost of goods sold in earnest during the second half of 2019, we think the firm's home sales gross margins could also come in better than expected.