Homebuilding sector may be affected by seasonality: Analyst

Wedbush Securities downgraded multiple homebuilding stocks including Lennar (LEN), D.R. Horton (DHI), and LGI Homes (LGIH), claiming they could see seasonal price declines. Despite the downgrade, they maintained their price targets for all five stocks.

Wedbush Securities Equity Research SVP Jay McCanless — the analyst behind the call — joins Market Domination to break down the reasoning and take a look at the homebuilding sector and how it may play out going forward.

In terms of which of the stocks he downgraded might stand above the rest, McCanless claims: "Not on the homebuilder side but we are favorable on the product side for a company called Builders FirstSource (BLDR). They are the market leader right now in terms of lumber and building product sales, and we think that unit volumes of single-family homes, whether for rent or for sale, are going to be up in '24 versus '23 and we think Builders FirstSource is positioned to meet that demand. We also think they're going to be growing in the repair and remodel category which we have a favorable outlook for that space too."

For more expert insight and the latest market action, click here to watch this full episode of Market Domination.

Editor's note: This article was written by Nicholas Jacobino

Video transcript

JOSH LIPTON: Wedbush downgrading multiple homebuilder stocks today, including Lennar and D. R. Horton. For more, we are now turning to the man behind that note, Wedbush Securities SVP of Equity Research, Jay McCanless. Jay, thanks for joining us.

Downgrade a number of names from neutral to underperform. Jay, lower price targets, too. In part, Jay, what you're saying is investors should be expecting here, some kind of normal seasonal stock price declines heading into summer.

JAY MCCANLESS: Yeah. And thank you for having me on. That's part of what we're expecting. Typically, this time of year, demand begins to slow, especially as we get closer to summer.

And typically with the seasonal trade that we talk about in, you tend to see the stock prices-- the gains that they had earlier in the spring trade, in the fall, and early winter tend to typically fade as you go get closer to summer. So that's part of it.

Part of it also is we've been making an out of consensus call around mortgage rates. We do think they stay around these levels, which could pressure we think affordability and potentially sales volumes and earnings estimates going into the back half of the year.

And so that's interesting. Why don't you think that the mortgage rates are going to be coming down maybe as much as some of your peers do?

So we think it's a couple of things. One, with mortgage rates now sitting at 7% plus, if a bank or non-bank goes out to write a mortgage, they're burying some pretty high refinance risk, especially if mortgage rates were to move down quickly. So we think that's part of the reason they're keeping the rates high and the spreads high relative to the 10-year Treasury.

We think the other thing and we talk about this in the note, mortgage credit availability is back to 2013 levels. So even if you've saved up the down payment and pre-COVID, you could have qualified for a home. That mortgage credit availability tightening up.

We think that's also restricting some people's ability to get a mortgage. And we think is the higher rates are part of that in terms of people not being able to qualify.

And Jay, it sounds like part of your thesis, too, it's a margin story that home builders, they're competing with one another price cuts, incentives, that's pressuring margins. And you see that continuing.

JAY MCCANLESS: Yeah, we do. It's especially at in an environment where demand is certainly strong. But available product on the existing side is stayed low. We think new Homebuilding at least for this spring season is really the only game in town.

But now that we're starting to see more product come out of the ground, some of the cycle time and supply chain headwinds, that the industry faced in '21 and '22, those have largely dissipated now. So there's a lot more supply we think, coming on to market. But to move that supply it's still requiring incentives mortgage rate buy downs, things like that that are all gross margin negative.

JULIE HYMAN: You downgraded everybody I think pretty much or a big group of stocks in your coverage. Are there any that you think are going to get weather this a little bit better than the others?

JAY MCCANLESS: So not on the homebuilder side. But we are favorable on the product side for a company called builders firstsource, BLDR. They're the market leader right now in terms of lumber and building product sales. And we think that unit volumes of single family homes whether for rent or for sale are going to be up in '24 versus '23.

And we think builders firstsource is positioned to meet that demand. We also think they're going to be growing in the repair and remodel category, which we have a favorable outlook for that space, too.

JOSH LIPTON: And, Jay, I'm just curious, broadly. Did valuation factor into your call at all?

JAY MCCANLESS: No, this is more about what we've seen the last couple of years, especially in the back half of the year where the homebuilders need to meet their volume targets. And they all become a little more aggressive about selling homes. And that's resulted in gross margins missing the last two fourth quarters of the year.

And we think might be on the same trajectory this time around. So this to us is more about seeing a similar playbook in what we saw in '22 and '23 in terms of the industry kind of beating itself up in the back half of the year to meet those sales targets. The valuations we think were a little rich on a couple of the names.

But by and large, this was more about what we think is going to happen to earnings and maybe the consensus estimates being a little too high relative to what we were expecting.

JOSH LIPTON: Jay, thanks so much. Really interesting call. Appreciate it.

JAY MCCANLESS: Thank you.