D.R. Horton: Positioned For Success In Evolving U.S. Housing Market (NYSE:DHI)

Investment thesis

My initial “Strong Buy” rating for D.R. Horton (NYSE:DHI), which I shared in early September, aged exceptionally well because the stock has rallied by 35% since then. To add context, the S&P 500 appreciated 6.5% over the same period. Today, I briefly summarize recent developments and share my FQ1 2024 earnings preview. Overall, I am optimistic about the company’s prospects, given the solid secular tailwinds behind DHI’s back multiplied by the exceptional execution of the management. The valuation is still very attractive even despite the robust recent rally. All in all, I reiterate my “Strong Buy” rating for DHI.

Recent developments

DHI released its latest quarterly earnings on November 7, when the company confidently surpassed consensus estimates. Even though revenue grew by 9% YoY, the adjusted EPS narrowed from $4.67 to $4.45. The EPS decrease was mostly due to the shrinking of the gross margin, which suffered both due to the cost of revenue growth and decreased average selling prices. I consider this to be a temporary issue due to the unfavorable macroenvironment.

Despite the headwinds for the gross margin, the company generated a robust $1.7 billion in levered free cash flow [FCF]. This enabled DHI to enhance its already strong financial standing. As of September 30, the company held $3.7 billion in cash, supported by solid liquidity ratios. The leverage remains low and inconsequential compared to the company’s market capitalization. In summary, I evaluate DHI’s financial position as exceptionally strong, providing the company with a strategic advantage.

Now, I want to emphasize the company’s upcoming earnings release, which is scheduled for January 23. Consensus estimates forecast FQ1 revenue at $7.58 billion, a 4.4% YoY growth. The adjusted EPS is projected to demonstrate positive dynamics by expanding YoY from $2.76 to $2.89. It is important to emphasize that there were 13 EPS upgrades over the last 90 days, which is a bullish sign.

When we speak about the expectations around the upcoming earnings release, it is important to understand the macro environment because the management’s guidance revision plays a crucial role for investors. Interest rates are still high, but mortgage rates are moderate, and this trend is expected to persist into 2024. Moderating mortgage rates is good information for DHI since sky-high interest rates make it very expensive for first-time buyers to purchase property. That said, this could serve as a compelling basis for DHI’s management to offer a more optimistic outlook for FY 2024.

Another reason I do not expect any negative surprises during this week’s DHI earnings release is the overall stance of the U.S. housing market from a secular perspective. I have already discussed in my previous thesis the massive shortage of houses in the U.S. due to several factors, which include the massive undersupply of new houses after the Great Recession and the massive demographic factor of millennials, the largest population group in the U.S., entering the housing market. This trend is secular, and balancing the supply and demand in such an industry as homebuilding with long cycles will be a long process, which will be good for DHI. Furthermore, despite mortgage rates being at their multidecade highs in 2022-2023, home prices in the U.S. continue breaking records. In addition to the substantial supply shortage, I attribute this trend to the fact that numerous homeowners who secured fixed-rate mortgages during the period of record-low Fed rates are reluctant to lose this cheap financing. I regard this as another significant positive factor bolstering high prices.

Amid all these favorable trends for the home building industry, it is also important to highlight that DHI mostly targets homes below $400k, i.e., affordable houses, which is crucial in the environment of rising prices coupled with still high mortgage rates. It is also essential to understand that the supply shortage is the hardest in the affordable housing segment, which is also favorable for DHI. Given DHI’s dominant market position across multiple geographies, the company will likely be one of the major beneficiaries of all the strong tailwinds I have described above.

In general, my outlook for DHI’s revenue growth is highly optimistic, considering the substantial positive trends in the market, the company’s dominant position, and its impressive track record of success. Beyond the promising potential for revenue expansion, it’s crucial to highlight the management’s commitment to maintaining strict financial discipline and balanced capital allocation, as emphasized in the latest earnings call. The combination of favorable revenue prospects and a management team dedicated to cost oversight and responsible reinvestment forms a powerful blend for creating sustainable value for shareholders.

Valuation update

DHI rallied almost 60% over the last 12 months, significantly outperforming the broader U.S. stock market. The start of 2024 has been calm, with +0.36% stock price appreciation YTD. Seeking Alpha Quant assigns the stock with an average “C+” valuation grade, meaning the stock is approximately fairly valued. The current multiples are notably higher than historical averages across the board, which might indicate overvaluation. However I would prefer not to rely solely on ratios analysis and will proceed with the dividend discount model [DDM] further.

I use the same 9% WACC as during my previous DHI valuation analysis. This looks fairly conservative to me, especially given the Fed’s expected interest rate cuts in 2024. Given the solid financial performance in recent quarters, there was a boost for consensus dividend estimates, which increased to $1.20 for FY 2024. DHI has a stellar “A” dividend growth grade from Seeking Alpha, but I have to remain more conservative and will use the sector median 8.38% dividend growth.

Based on the DDM analysis, DHI’s fair price is $194 per share. This means the stock is around 27% undervalued from the DDM perspective. Multiples indicate overvaluation, while DDM indicates undervaluation. Therefore, I think I also need to expand my valuation analysis with the discounted cash flow (“DCF”) simulation.

The same 9% WACC will be used to run a DCF model. Consensus expects revenue to compound at a 5% CAGR over the next five years, which I consider fair given all the industry tailwinds I have described in the previous section. For the years beyond, I implement a 2% revenue CAGR, in line with the Fed’s inflation target. I use the flat 8.2% TTM FCF ex-SBC margin, which I consider fair to use given that it is the current level and the topline is expected to grow.

All these assumptions return to the business’s fair value at $66 billion, which is 31% higher than the current market cap. That said, the stock is substantially undervalued at current share price levels. To sum up the valuation, I assign my target price for DHI as a range between $194 and $200, which are the midpoint of the outcomes of the DDM and DCF approaches.

Risks update

The homebuilding industry currently faces cyclical headwinds due to the Fed’s tight monetary policy, which adversely affects the demand for mortgages. The Fed’s approach to interest rates is cyclical, and there apparently will be periods of much lower mortgage rates, but the critical uncertainty here is timing. The U.S. economy’s impressive resilience is a key support for homebuilders; however, interest rates remain higher compared to the relatively lower rates experienced for over a decade before 2022. This continues to act as a constraint, limiting the ability to unlock the full growth potential of the U.S. homebuilding industry.

In addition to the prominent macroenvironmental risk, homebuilders like D.R. Horton face various inherent business risks. The company’s operations involve intricate processes such as land selection and acquisition, raw materials procurement, construction planning and design, and actual construction. Each stage demands consistently exceptional execution for the company to operate successfully without facing financial or reputational harm. For example, supply chain disruptions can increase idle time, and labor safety issues may significantly damage the company’s reputation.

Bottom line

To sum up, DHI is still a “Strong Buy”. The valuation is very attractive, both based on the DCF and DDM. I see favorable industry tailwinds for homebuilders, and DHI is apparently a high-quality business poised to absorb positive secular shifts. The management sustains a healthy balance sheet and demonstrates strict financial discipline as well, crucial factors for creating sustainable value for shareholders. I am optimistic about the upcoming earnings release and expect DHI to deliver a strong quarter and demonstrate confidence in the near-term outlook.