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Bobby Raines's Analyst Insights

Options Analyst Writer
Bobby Raines
Author Bio

July 22, 2013- Pulte Group's Valuation is Built on Shaky Ground

The housing sector has seen a significant improvement since its central role in the Financial Crisis. Home prices have recovered from their lows and while they haven't regained the highs they hit before the collapse, those highs were never based in reality.

Housing-related sectors have also recovered; financial institutions and homebuilders are both well above their post-crisis lows and banks have been reporting better-than-expected quarterly results so far this earnings season.

Recovery doesn't mean the picture is all rosy though. Interest rates have been moving higher, which is likely to slow the rise in home prices.  This may not have a big impact on the number of new homes that homebuilders can sell. The population is growing and new people need new places to live after all. What it does mean is that margins may be tighter. Higher interest rates means a larger share of a homebuyer's payment goes to interest. Since most home sales are financed, homebuyers buy a house based not on overall price, but on how much the monthly payment will be. If the interest part of the monthly payment goes up, the part of the payment that goes toward the house has to go down.

The homebuilders most-likely to feel the impact of this are at the lower end of the spectrum. Toll Brothers (TOL) which specializes in high-end homes has said that as many as 20% of its sales are cash sales, which won't be impacted at all by higher interest rates.  Home buyers in this category are also more likely to be able to make a higher monthly payment, allowing prices to keep rising even as interest rates climb

It is at the lower-end where higher-interest rates are going to have the biggest impact. The low-end home buyer is much less likely to be able to afford to afford a larger monthly payment. In some cases, the buyers at this end of the spectrum may be forced to continue renting and not make a purchase at all.

One company particularly vulnerable to rising rates is Pulte Group (PHM) the company builds houses across the spectrum, but has recently put particular emphasis on what the industry calls "affordable" homes (the low-end) and homes for mature buyers (those 55 and over).

Analysts don't seem to have particularly high hopes for the second quarter. Earnings are expected to improve to 30-cents per share from five cents in the year-ago period, but the company earned 31 cents per share in the fourth quarter and 15 in the first quarter, so there's still some volatility there.

The revenue line is less volatile, but not much more encouraging. Revenue was $1.07 billion in the year-ago quarter and analysts expect $1.62 billion for the recently completed quarter.

Volatile earnings are one knock against the company, but the current stock price is another. Pulte Group currently has a price-to-earnings ratio of more than 24, giving it the highest multiple in the industry. I don?t since the company doesn't have the best growth prospects in the industry, I believe there are much better options out there.

Traders who share my negative outlook on PHM could consider an October 23/26 bear-call spread. This position yields a credit of 29 cents per share. That's a return of 10.7%, or 57.44% on an annualized basis. This position will return a full credit so long as the stock is below $23 at October expiration, giving it 20.4% downside protection.

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