"An improving homebuilding environment, increasing community count and TOL's recent acquisition of California's Shapell Homes set the stage for gross margin and EPS growth in FY2014 and beyond," the analysts wrote in a note Thursday. "Catalysts include growing high-end demographics, gross margins expansion from high-end market exposure and a higher quality mix and long land position."
Home prices rose strongly in 2013, but it was not a great year for homebuilder stocks. The Merrill Lynch Homebuilding Index declined 15% on a relative basis in 2013.
An acute shortage of homes for sale and better demand drove prices of new homes higher, helping homebuilders increase gross margins by 300 to 400 basis points.
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However, rising home prices and higher interest rates hurt demand for new homes in the latter part of the year, forcing homebuilders to cut back on prices.
Homebuilders have struggled to ramp up construction amid rising costs of land and labor. Household formations also remain well below their peak, which has added to their caution.
So while housing has recovered, housing starts remains one of those metrics that continue to underperform. Merrill Lynch senior economist Michelle Meyer's original forecast for housing starts was 975,000 for 2013 but dropped to 925,000 by the end of the year.
Still, a team of analysts led by Michael Roxland said in a note Thursday that 2014 would likely be a better year for the sector and are forecasting a 15% to 35% upside for the homebuilders under coverage.
"Ultimately, our thesis is still on track that housing is on an upward trajectory over a multi-year period. Specifically, we expect to see continued improvement in housing starts and better consumer confidence as consumer expectations have likely adjusted now to higher prices and rates," they wrote.
Recent data that showed November starts approaching an annualized rate of 1.1 million appear to have inspired confidence. A steadily improving job market and the fact that rates still remain relatively low compared to historical norms also bodes well for housing demand, according to the analysts.
-- Written by Shanthi Bharatwaj in New York.