M/I Homes: Affordability Headwinds Dampen Stock Sentiment

Despite the recent increase in mortgage rates, M/I Homes (MHO) has achieved significant success, with the stock reaching an all-time high in September, surpassing the $100 mark, delivering impressive returns of 76.64% year-to-date and beating EPS expectations for the previous six consecutive quarters. However, the stock has experienced an 11.56% decline in the past month. Since my last article, negative sentiment has increased, with short interest in M/I Homes nearly doubling to 5.02%. As we await the Q3 earnings report, it is crucial to highlight that home sales in August hit a record low for the year. Furthermore, with the winter season approaching, we typically see a seasonal dip in sales.

M/I Homes has effectively targeted entry-level buyers, achieving robust financial performance and maintaining a solid balance sheet. Nevertheless, with the stock exhibiting a downward trend as we enter the seasonally subdued Winter sales period and affordability challenges, including elevated mortgage rates, creating added stress for potential homebuyers, the demand outlook appears uncertain. Given the current circumstances, I recommend maintaining a hold rating on this stock.

Company updates and growth potential

Although M/I Homes is a minor player in the housebuilding industry, it has increased its presence and offers homes in 195 communities across 16 markets that span ten states. Recently, M/I Homes extended its reach into the Nashville, TN, and Fort Myers/Naples, FL markets. Active construction is underway, and sales are anticipated in Nashville this year, targeting 300 to 500 homes annually in the coming years. M/I Homes has a run rate of approximately 8,000 homes within its existing markets, intending to reach up to 14,000 homes in the future.

Entry-level target market growth

M/I Homes has been successful in catering to the needs of entry-level and first-time buyers, who accounted for 58% of its Q2 2023 orders, up from 55% in Q2 2022. The company's Smart Series offerings have played a significant role in tapping into the robust demand within this buyer segment, which is expected to remain strong. However, it's important to note that these buyers are susceptible to affordability concerns. The rising mortgage rates have put affordability under pressure, resulting in an 18% increase in the monthly payment for the median-priced home over the past year.

Financials

M/I Homes has demonstrated strong financial performance in recent years, achieving top-line revenue and bottom-line profit growth. The company has exceeded EPS expectations for the past five consecutive quarters. However, it is worth noting that in the first half of 2023, although the number of new contracts has increased, there has been a decline in the number of homes delivered. As a result, there has been a decrease in revenue and income in the latest quarter.

Looking at M/H Homes' balance sheet as of Q2 2023, we can see that the company has $667.4 million in unrestricted cash and has access to $568.8 million through its $650 million revolving credit facility. This facility has no outstanding borrowings and will mature in December 2026. This level of liquidity provides ample support for the company's near-term working capital requirements. Additionally, MHO's debt maturity schedule is well-extended, with no significant maturities until 2028, when $400 million of senior notes becomes due.

M/I Homes cash flow generation has benefitted from its land-light strategy, although we can see that it has not been consistently upward trending over the years. 2022, the company reported a positive levered free cash flow of $46.7 million. This was due to reduced land and development expenditures, increased revenue and improved margins. In 2021, M/I Homes found itself in a negative cash flow position. In 2020, the company achieved a positive levered free cash flow of $146.5 million, benefiting from solid profitability and a temporary reduction in land acquisitions during the initial stages of the pandemic. Levered free cash flow is $495.34 million TTM. The company's positive levered cash flow, combined with its strong balance sheet allows the company to reinvest into its operations and repurchase stock.

The stock has seen impressive growth over the past year, with a 128.06% return for investors. However, recent trends show a decline, particularly over the last month. This can be attributed to factors such as a slowdown in housing sales and persistently high-interest rates, which have affected consumer demand. Despite a promising FWD price-to-earnings ratio of 4.98, it's worth noting that year-over-year revenue and earnings per share growth are lower than its three-year CAGR. Moreover, the stock has been receiving more negative sentiment, as indicated by the elevated short interest of 5.02%. Although the company has good long-term growth prospects, it faces challenges in the current market environment, which could impact its performance in FY2023.

Risks

Investing in M/I Homes comes with significant risks tied to the real estate market's ups and downs, rising interest rates, and economic downturns. The company's fortunes closely follow the housing market's fluctuations, leaving it vulnerable to market downturns that can reduce homebuyer demand and earnings. As interest rates climb, it can also make homes less affordable, potentially reducing demand and squeezing M/I Homes' profits. Economic downturns can lead to less consumer spending and lower home sales, adding another layer of uncertainty.

Final thoughts

M/I Homes operates in the dynamic and cyclical residential real estate market, offering homes across various markets and regions. While the company has successfully targeted entry-level buyers and demonstrated a healthy balance sheet, it faces significant risks associated with market sensitivity, rising interest rates, and economic downturns. The potential impact of these risks on affordability and homebuyer demand must be carefully considered. In light of these challenges in the near term, I suggest maintaining a hold rating on this stock.