Merrill Lynch Sees Huge Upside in Builders as Spring Selling Seasons Nears

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After the huge housing and mortgage-related crash in 2008, the home-building industry went into hibernation as headlines screamed in the media that the “American Dream” of owning a home was over forever. Needless to say, 10 years later it is a far different story, as unemployment has dropped to the lowest levels in generations and the economy is growing the fastest in years. The American Dream of owning a home is indeed alive and well.

In a new research report from John Lovallo, who covers homebuilders at Merrill Lynch, he makes the case that the industry is on sale as the group was hammered recently over fears of rising interest rates. Lovallo feels that 2018 is lining up well despite the probability of rising rates, and he feels the pullback in the top stocks is providing a huge opportunity, especially for the firm’s top picks.

These four stock are rated Buy, and the two top picks could have as much as 50% upside potential from current trading levels.

D.R. Horton

This is one of the highest volume builders in the United States and a top pick at Merrill Lynch. D.R. Horton Inc. (NYSE: DHI) is the largest public builder by closings in the country and is positioned in 78 metropolitan markets in six major regions. It develops single-family homes primarily for first-time and move-up buyers.

Approximately 80% of revenue is derived from the Southeast, South Central and West regions, all of which continue to see very solid growth. D.R. Horton also provides mortgage financing and title agency services to homebuyers.

Shareholders are paid a 1.12% dividend. The Merrill Lynch price target for the stock is $71, and the Wall Street consensus target is $56.80. The shares closed Thursday at $44.55.

Lennar

This is the other top pick at Merrill Lynch, and it is well set in the entry-level market. Lennar Corp. (NYSE: LEN) is the second largest public homebuilder by closings in the United States, delivering over 29,000 homes in 2017.

The company is well positioned in 18 states in four major regions targeting first-time, move-up and active adult buyers. Lennar has diversified its core homebuilding operations with the addition of real estate investment and management, multifamily and single-family and commercial real estate development in California. The company also owns a financial services business.

In addition the company also announced last year that it would merge with CalAtlantic group, which it will acquire for $51.34 a share. The company expects to fund the acquisition with a combination of 80% stock and 20% cash.

Lennar investors are paid just a 0.29% dividend. The $90 Merrill Lynch price target is well above the posted consensus target of $78.06. The stock closed Thursday at $59.11.

PulteGroup

This is another top company with a wide product portfolio. PulteGroup Inc. (NYSE: PHM) is one of the largest public homebuilders in the United States, delivering over 21,000 homes in 2017. The company is also well-positioned in approximately 50 markets in 26 states, targeting the first-time, move-up and active adult buyer groups.

PulteGroup primarily builds single-family detached homes, although it also constructs townhouses, condominiums and duplexes. The company owns a captive financial services business that provides mortgage financing, title, insurance and closing services.

Merrill Lynch was positive on fourth-quarter results:

Following a solid fourth quarter, we slightly lower our 2018e earnings and to reflect a higher expected tax rate, However, we raise 2019e EPS from $3.70 to $3.85 given the company’s continued execution, while introducing a 2020e of $4.35. We view Pulte’s 2018 financial outlook as conservative, particularly deliveries, and expect upside as the year continues.

Investors receive a 1.26% dividend. Merrill Lynch has a $42 price objective, while the consensus price target is $35.75. shares closed Thursday at $28.67.

Toll Brothers

This company is more focused on the higher end of the market, and business remains good. Toll Brothers Inc. (NYSE: TOL) is a leading U.S. homebuilder with a focus on luxury suburban and urban markets. It operates in four distinct geographic segments, building homes catering to move-up, empty-nester, active-adult and second-home buyers.

Toll Brothers has entered into various joint ventures to develop land or high-rise construction projects. More than 45% of the company’s sales are attributable to the Northeast and Mid-Atlantic regions.

Shareholders receive a 0.73% dividend. The Merrill Lynch price target is $60. The consensus target is $54.11, and shares closed Thursday at $43.75.

These four stocks have big upside to the Merrill Lynch targets. With the mortgage interest deductions levels raised in the new tax reform plan, the great majority of the homes sold by these companies will be eligible for the deduction. In addition, even if rates rise, mortgages will still remain at very reasonable levels, especially for 30-year paper.