Deutsche Bank Turns Cautious On Homebuilders, But Upgrades Lennar, Meritage

Homebuilding stocks as a group are down more than 30 percent since the start of 2018 due to multiple concerns, and the Street's 2019 outlook appears to be overly optimistic, according to Deutsche Bank.

The Analyst

Analyst Nishu Sood made the following rating changes:

• Lennar Corporation LEN from Hold to Buy, price target from $58 to $51.
• Meritage Homes Corp MTH from Hold to Buy, unchanged $47 price target
• PulteGroup, Inc. PHM from Buy to Hold, price target from $34 to $24.
• Toll Brothers Inc TOL from Buy to Hold, price target from $51 to $29.
• Taylor Morrison Home Corp TMHC from Buy to Hold, price target from $25 to $14.

The Thesis

The weakness in homebuilders can be attributed to a slowdown in the housing market along with price-cost fears, Sood said in an industrywide research report. (See his track record here.) 

Mortgage lending standards coupled with debt-to-income ratios contributed to the housing market's strength into 2018 — but also to the slowdown that started in the middle of the year, the analyst said. 

A closer look at DTI trends suggest the housing market is not only at the end of the "affordability rope," but could see downside if interest rates continue to move higher, Sood said. This outlook is inconsistent with Street estimates that call for 8-percent order growth and flat gross margins in 2019, he said. 

Not only are these assumptions are unlikely to play out, but for the first time in modern history, affordability constraints managed to stop the housing momentum at a time when it would otherwise be considered midcycle, Sood said.

Fifty-seven percent of FHA purchase borrowers are now sitting on debt-to-income ratios that are above the "extreme level" of 43 percent, according to Deutsche Bank. 

What To Buy, Avoid

Despite a cautious outlook, there are still opportunities for investors in the homebuilding sector, Sood said. Investors should look for companies with exposure to entry-level homes and a management team with a reputation of executing well, he said. 

Investors should avoid companies with exposure to luxury homes and even "move-up" homes that lack a floor for demand, the analyst said. 

Price Action

At the time of publication Monday: 

• Lennar shares were down more than 2 percent at $40.
• Meritage shares were down more than 1 percent at $32.72. 
• PulteGroup shares were down 1.67 percent at $21.22.
• Toll Brothers shares were down 2.87 percent at $29.15. 
• Taylor Morrison shares were down 2.59 percent at $15.04. 

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