MKM Partners - Homebuilder Update & 2 Top Picks

On Thursday, MKM Partners managing director Megan McGrath, published a comprehensive report updating guidances and the homebuilding sector following Q1 earnings reports.

McGrath compiled data from both the builders and Fact Set, which highlights key industry trends for investors to digest in order to assist with buy, sell or hold decisions moving forward.

MKM's top picks include one builder currently trading at a premium and one builder arguably trading at a discount to book value.

Here's The Lineup

Here's The Pitch

While luxury builder Toll Brothers Inc TOL may be a name on many watch lists for investors who follow this sector, McGrath's other top pick, KB Home KBH, has been out of favor with some analysts. However, KB Home is an MKM value pick for sector "comeback player" of the year.

Tale Of The Tape: 2015 YTD

MKM Partners–KB Home: Buy Rated, $20 PT

Based on MKM's $20 price target, shares of KB Home represent a potential upside of approximately 39 percent from Thursday's closing price of $14.40 per share.

McGrath's KB Home thesis is fairly straightforward: if KBH can put together a couple of good quarters in a row, the valuation discount versus sector peers should begin to close.

However, many Wall Street firms do not share McGrath's optimism, with both Morgan Stanley and Barclays rating KB Home at Underweight with a $14 target price, and JMP Securities at Market Outperform with an $18 target price.

Related Link: Morgan Stanley Homebuilders At Mercy Of Rising Interest

Notably, Morgan Stanley recently calculated that approximately $9 of KB Home's book value was attributed to a deferred tax asset (DTA), which they value at a discount.

MKM Partners–Toll Brothers: Buy Rated, $44 PT

Based upon MKM's $44 price target, shares of Toll Brothers represent a potential upside of approximately 19.8 percent from Thursday's closing price of $36.72 per share.

Related Link: These Pros Love Toll Brothers And KB Home

MKM believes Toll Brothers is well positioned for FY 2016, "with improved margins and pricing, in part due to a growing City Living presence and continued strong performance in California."

Homebuilders' Bigger Picture

Despite the recent pullback in homebuilder share prices across the board, MKM remains "relatively Neutral on the space."

Builder Performance YTD

MKM noted the top performing homebuilder YTD has been Meritage Homes Corp MTH, at approximately 20 percent, although MKM noted that "it was the second worst performer on the MKM list in 2014."

The worst performing homebuilder stock YTD has been Hovnanian Enterprises, Inc. HOV, down 27 percent, which follows on the heels of 2014 where Hovnanian was the poorest performer on the MKM Partners list.

Beating Estimates Not Enough

"Seven of the 11 builders profiled in this report beat earnings estimates in the quarter – most by a few pennies. However, these positive surprises did not necessarily dictate performance," MKM reported.

Margin Concerns

McGrath pointed out that one concern was, "Despite stronger order growth in 1Q and an incentive and pricing environment that appeared to be at least stable, homebuilders generally maintained their gross margin guidance for the full-year."

Unfortunately, "this calls for 2015 gross margins to be flat to down roughly 100 bps (depending on the homebuilder)," McGrath concluded.

The Bottom Line

MKM believes "that more bullish investors had been hoping that a strong start to the spring selling season would result in improved gross margin guidance for the year.

"In addition, it appears that sensitivity of builder stocks to mortgage rates has returned and could create near-term volatility."

However, the firm is not bearish on housing and believes "that additional weakness in the stocks could create some buying opportunities over the next few months."

McGrath sees this as a time for investors to "remain patient and selective."