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www.jpmorganmarkets.com

North America Equity Research

08 January 2019

Homebuilding

Nine Questions for 2019; We Maintain Our Cautious

Stance; Top Pick = LEN

Homebuilders & Building Products

Michael Rehaut, CFA

(1-212) 622-6696

[email protected]

Bloomberg JPMA REHAUT <GO>

Elad Hillman

(1-212) 622-6435

[email protected]

Maggie Wellborn

(1-212) 622-5909

[email protected]

J.P. Morgan Securities LLC

See page 69 for analyst certification and important disclosures.

J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aw

are that

the firm may have a conflict of interest that could aff

ect the objectivity of this report. Investors should consider this report as only a single

factor in making their investment decision.

Table

: J.P. Morgan Coverage Universe

Homebuilders

Ticker

Rating

Larger

Cap

D.R. Horton

DHI

Lennar

LEN

NVR, Inc.

NVR

PulteGroup

PHM

Toll

Brothers

TOL

Smaller-Cap

Beazer Homes

BZH

KB Home

KBH

MDC Holdings

MDC

Meritage Homes

MTH

Taylor Morrison

TMHC

Higher Growth Smaller Caps

Century Communities

CCS

Green Brick Partners

GRBK

LGI Homes

LGIH

William Lyon

Homes

WLH

Land Development Cos.

Five Point Holdings

FPH

Building Products

Ticker

Rating

Beacon Roofing Supply

BECN

Caesarstone

CSTE

Fortune Brands

FBHS

Griffon Corporation

GFF

Jeld

Wen

JELD

Masco

MAS

Masonite

DOOR

Mohawk

MHK

Owens Corning

PGT Innovations

PGTI

Stanley Black & Decker

SWK

Whirlpool

WHR

Source: J.P. Morgan.

Looking into the upcoming year, we offer our views on nine key questions on the

homebuilding sector that are among the most commonly asked by investors.

Regarding our sector view, following our Sector Update on 9/21/18 in which we

became more cautious and downgraded five builders, we maintain our cautious

approach to the builders, as we believe potentially higher rates, a maturing macro

cycle, rising inventory levels and downside risk to gross margins should hold

valuation multiples at current levels and hence limit upside in the stocks. Moreover,

despite already likely being reflected in the stocks’ valuations and buyside

expectations, we believe the Street’s 2019 and 2020 EPS remain aggressive, and

hence, following continued softer order trends in 4Q, we lower our 4Q, 2019 and 2020

estimates for several builders, resulting in our 2019 and 2020 EPS estimates now

being 6% and 4% below the Street (ex-higher growth small-caps), respectively, vs.

previously being in-line and 2% above. The nine questions discussed in this report

include the drivers of 2018’s performance; our 2019 outlook for housing starts (up low

single-digits) and home prices (up 1-3% at most); our outlook for the homebuilders’

growth and margins; the impact of rising rates; evaluating builders from a risk

standpoint; where are builders’ profits most exposed geographically; strongest/weakest

markets; valuation and top picks. Regarding stock selection, amid our cautious

approach, we remain limited in our Overweight-rated names and focus mainly on

compelling relative valuation opportunities. Our top pick for 2019 is Overweight-rated

LEN, while we also highlight OW-rated LGIH and WLH among the higher growth

small-cap builders. By contrast, we maintain our relative Underweight ratings on

PHM, KBH and MDC. Please join us for a conference call today at 11:00 AM ET to

discuss this report. Contact us or your J.P. Morgan salesperson for details.

 Question 1: What drove 2018’s weak performance? Following 2017 being one

of our homebuilder universe’s best performances over the last 15 years, up 65%

(S&P 500: 19%), 2018 witnessed the worst performance for our sector since 2007,

with our universe down 36% (S&P: -6%). Interestingly, in contrast to last year’s

outperformance being more driven by non-fundamental and one-time items, in our

view (i.e., a market sector rotation and corporate tax reform), this year’s

underperformance was largely driven by fundamental drivers and concerns.

Specifically, during 1H18, investors focused on a nearly 50 bps increase in 10-year

Treasury yield, while during 2H18, order trends softened materially as consumer

demand finally began to more assertively react to a combination of higher rates and

home price appreciation over the last several years.

On January 3, 2018, MIFID II came into effect. Therefore, you may only be eligible to participate in this event if you have the appropriate

level of access to J.P. Morgan research. Please check your eligibility before participating/accessing.

North America

Equity Research

08 January 2019

Michael Rehaut, CFA

(1-212) 622-6696

[email protected]

 Question 2: What will housing starts and home prices do in 2019? We believe both

single-family housing starts and new home sales will continue to grow at 2018’s low

single-digit pace in 2019 – please see our Housing Forecast report also published today

– as we expect higher rates, a more mixed set of coincident demand drivers (job growth,

consumer confidence and affordability) and higher inventory levels to result in

continued tepid growth for the housing industry. Additionally, we expect home price

appreciation to moderate more significantly in 2019 to only 1-3% at most (if not

potentially being flattish) following a roughly 5% gain in 2018 (in turn a slight

deceleration from 2017’s 6% rate), driven by an increased focus on affordability and

the resulting shift towards entry-level product along with our outlook for a more mixed

set of demand drivers and higher inventory levels.

 Question 3: What are JPM’s builder growth and margin outlooks for 2019 and

2020? Following a stark deceleration in order trends during 2018 – which has

continued in 4Q18, and hence we further lower our 4Q18, 2019 and 2020 order growth

and/or EPS estimates for several builders – we estimate order growth will continue to

slow in 2019, along with a moderate amount of gross and operating margin contraction.

As a result, we estimate average order growth for our universe (ex-higher growth small

caps, or HGSCs) of 1% (previously 4%), which follows 4% in 2018 and 10% in 2017.

We also estimate EPS growth of only 2% in 2019 (previously 7%) as well as for ROEs

to contract by 160 bps to 13.1%.

 Question 4: How will a rising rate backdrop impact the stocks and the industry?

As the Fed currently remains within a tightening cycle, we include our analyses of how

the stocks and builder fundamentals have been impacted by both Fed tightening cycles

as well as, more broadly, rising rate cycles. Overall, while we found mixed results in

terms of stock performance during the last five major Fed funds tightening cycles, by

contrast, a more consistent pattern of declines emerged during rising interest rate cycles

(specifically, the 10-year Treasury). However, following the end of both Fed tightening

cycles and rising rate periods, the stocks have demonstrated a more consistent pattern of

outperformance. Lastly, while gross margins and EPS growth did not exhibit consistent

patterns around both Fed tightening cycles and rising rate periods, order growth was

more consistently impacted during these events.

 Question 5: How can the builders be evaluated from a risk standpoint during

periods of industry stress? We believe there are three key areas of investor focus, in

terms of analyzing builders from a risk standpoint, that occur when the housing industry

is perceived to either about to encounter stress or is in the midst of a slowdown. First,

buyer profiles, and more specifically, first-time or entry-level buyer exposures, are

considered by investors as they relate to a homebuilder’s customers’ sensitivity to

interest rates. Second, a builder’s land position, specifically total and owned years

supply of lots, are among the first metrics looked at in the context of asset risk against

an industry slowdown. Lastly, balance sheet leverage is likely the most important

factor in terms of relative stock performance when the industry faces high levels of

stress, as builders with high leverage during the last downturn materially

underperformed their peers due to concerns around survivability and the refinancing

ability of more heavily indebted builders.

 Question 6: How concentrated are builders’ profits and where are they most

exposed geographically? Following our regional profitability analysis, based on

company filings and our estimates, we view the larger-cap builders’ profits as generally

– but not always – having a greater degree of geographic dispersion, as compared to the

smaller-cap and higher growth small-cap (HGSC) builders typically being more heavily

North America

Equity Research

08 January 2019

Michael Rehaut, CFA

(1-212) 622-6696

[email protected]

concentrated in one or two regions. Among the larger-cap builders, we found DHI and

PHM’s profits to have the greatest geographic dispersion, while among the smaller-

caps and HGSCs, BZH, MTH and TMHC’s profits have the greatest amount of

geographic dispersion, in our view. Lastly, in terms of regions, Texas, the Southeast

(incl. Florida) and California typically represent the largest drivers of builders’ profits.

 Question 7: Which markets look to be the strongest / weakest entering 2019?

Based on our regional market analysis, Phoenix, Raleigh and to a lesser extent Charlotte

currently appear to have the strongest fundamentals across job growth, affordability

metrics and inventory levels on a relative basis as compared to national averages. By

contrast, Los Angeles, Denver, Las Vegas, Dallas and San Diego have the weakest

fundamentals on a relative basis, most of which demonstrate weaker metrics relative to

the national averages across both affordability and inventory levels, followed by

Houston, San Antonio and Sacramento.

 Question 8: Are homebuilder valuations inexpensive, reasonable or expensive?

While our homebuilder universe (ex-higher growth small-caps) trading at 7.8x our

2019E EPS – which includes our larger-cap builders trading at roughly 8x (ex-NVR)

compared to longer term mid-cycle current and forward multiples of 9-10x and 8-9x,

respectively – may appear inexpensive relative to housing starts remaining solidly

below their long term averages, at the same time, we believe the stocks’ multiples will

likely remain under pressure over the near to medium term due to a combination of

potentially higher rates, a maturing macro cycle, rising inventory levels and downside

risk to gross margins. Similarly, on a P/B basis, while we also view valuations as

generally inexpensive, as our larger-caps are trading at roughly 1.4x current P/B on

average, which compares to a historical range of mostly 1-2x and a mid-cycle multiple

of roughly 1.5x, we believe the same headwinds limiting P/E multiples should also

restrain P/B valuations.

 Question 9: What are your top picks for 2019? Our top pick for 2019 is

Overweight-rated LEN, as we believe the stock’s valuation discount to its larger-cap

peers is unwarranted and does not reflect our outlook for above average order growth,

gross and operating margins as well as the company’s improved market position

following its acquisition and integration of CAA. Additionally, among the higher

growth small-cap builders, we highlight OW-rated LGIH and WLH, as we continue to

point to LGIH’s strong track record of growth as well as its above average margins and

ROE, while for WLH, highlight its highly attractive relative valuation. By contrast, we

maintain our relative Underweight ratings on PHM among the larger-caps and KBH

and MDC among the smaller-caps, as we continue to see PHM as having above average

downside risk to its gross and operating margins, while we view KBH and MDC’s

premium valuations versus their peers as expensive relative to our fundamental

outlooks for these names in 2019.

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