Homebuilding sector downgraded at Credit Suisse: What you need to know - Toll Brothers (NYSE:TOL), PulteGroup (NYSE:PHM)

Lackluster demand and declining gross margins are the two main points that Daniel Oppenheim, research analyst at

Credit Suisse,

emphasized in a note to clients in which three names in the homebuilding sector were downgraded.

PulteGroupPHM

Toll Brothers TOL and William Lyon Homes WLH were all downgraded from Outperform to Neutral. Lackluster demand A Credit Suisse survey of real estate agents led Oppenheim to conclude that there is a continuous weakness in demand in the real estate market as buyer traffic is lower sequentially and year over year. The Credit Suisse “buyer traffic index” derived from the monthly survey of real estate agents fell two points in February to 36 from 38 in January. This compares unfavorably to a reading of 65 in February 2013 and 62 in February 2012. February's reading of 36 marks the lowest reading for a February since 2009. Expectations for February is a reading of 50. February's data point is not the only sign that demand is soft. In January, the survey increased only three points to 38 from December 2013, well below the average eight point increase from December 2013 to January 2013. The survey points could indicate that homebuilders may need to increase incentives to finalize sales which will naturally impact the bottom line. Investors could accurately point out that commentary from homebuilders are positive and the stocks have reflected this optimism. Oppenheim acknowledges the general positive sentiment in the market but cautioned investors that valuations are at risk given the soft demand seen in the monthly survey. “We expect the stocks to reflect these observations as macro housing data and homebuilder orders and gross margins come in short of expectations,” Oppenheim argued while citing the fact that the monthly surveys has demonstrated a “strong ability” to predict inflection points in stocks. Oppenheim noted that an increase in mortgage rates to 7.00 percent by 2017 would have little effect on demand as the market could still absorb a three percent annual price appreciation. Upticks in rates will not derail the housing market but could contribute to an extended pause in activity. Gross margins under pressure in 2015 and 2016 In 2014, homebuilders' gross margins should continue to benefit from early cycle land purchases that were made in 2008 and 2009. As a result, Oppenheim is projecting gross margins for the sector to improve on average by 70 bps to 21.7 percent from 21.0 percent in 2013. Investors should understand that as homebuilders run through the lower cost supply, gross margins should decrease on average to 21.4 percent in 2015, if not sooner. “The appetite for land has become increasingly fierce since the recovery began,” noted Oppenheim while suggesting that the price of land has driven higher at the expense of gross margins. Gross margin levels are projected to fall to 21.2 percent by 2016. Interestingly enough, despite these declines, the projected gross margin rate is in line with the group's historical average of 21.4 from 2001 to 2003 and above the historical ten year average of 19.6 percent. Price targets PulteGroup is Neutral rated with a price target established at $20. Toll Brothers is Neutral rated with a price target established at $39. William Lyon Homes is Neutral rated with a price target raised to $30 from a previous $28.

Market News and Data brought to you by Benzinga APIs