Lennar Rebuilding, But Valuation Overbuilt

By Stephen D. Simpson, CFA | September 24, 2012 AAA

Homebuilders have already had a heck of a run over the last year, with names like Toll Brothers (NYSE:TOL), DR Horton (NYSE:DHI) and Lennar (NYSE:LEN) all up more than 125% over the last year and up many times over from the lows in the late fall of 2008. What concerns me is whether these moves have already discounted a lot of the early gains from the nascent housing recovery - setting up the possibility that housing activity (and prices) could continue to improve without necessarily taking the homebuilder stocks with them.

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Solid Q3 Results
Lennar certainly delivered a respectable third quarter result, adding support to the idea that the new housing market really has turned the corner. Reported revenue rose 34%, with a 33% improvement on home sale revenue. This growth was fueled by a 28% increase in deliveries, with a roughly 4% improvement in realized prices as well. Lennar also saw strong order activity, with orders jumping 44% (more than most analysts expected) and backlog increasing 79%.

Lennar also seems to be doing well with its profit structure. The company has spent the last few years streamlining and improving operations. Gross margin (including interest) improved 70 basis points sequentially and 200 basis points from last year, and management sounded confident that this is sustainable. Lumber, drywall and concrete prices are rising a bit, but the company is offsetting this with lower incentives. At the bottom line, Lennar delivered a double-digit core operating margin of just over 11%.

SEE: A Look At Corporate Profit Margins

Could Prices Head Higher?
While I don't think anybody will argue that the housing market has not come roaring back, it does seem to be getting better. What I wonder, though, is whether the market is going to start seeing higher price appreciation based on quality. What I mean is this - there have been a lot of houses out there sitting vacant or with residents going through a long-term foreclosure process and having little-to-no incentive (or ability) to reinvest in that house. Look at the statements from Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) management prior to this spring, on the remodeling/maintenance trends. So I wonder whether there's an increasingly sharp distinction between high-quality houses on the market and under-maintained (if not dilapidated) houses. If that is the case, that could lead to some strong price action in the quality houses available for sale.

Lennar Has Gotten Itself Back Into Shape
If housing is on the way back, it'll be good for DR Horton, PulteGroup (NYSE:PHM), KB Homes (NYSE:KBH) and most of the sector participants - a rising tide that lifts all of the boats. I do think that Lennar management has done a lot of heavy lifting over the past three to four years to get this company back into shape. Management cut the number of off-balance sheet JVs, reorganized its land bank, and pursued cost improvements like standardizing designs and centralizing purchasing. At the same time, the company sits with a strong land bank in what should be desirable areas. Now it seems like those movements are translating into solid gross margins and order rates relative to the industry.

The Bottom Line
When it comes to valuing these shares, good luck. It will likely be a couple of years before this company posts positive free cash flow, and homebuilders often have erratic cash flow patterns. Likewise, the company's P/E and EV/EBITDA look higher than should be sustainable as the company's earnings recover from an abnormally low base.

Trading at around two times book value, Lennar is near the valuation level that this sector enjoyed during the good times. Although that may superficially suggest that the shares are already fully recovered, I'd argue that that book value ought to grow pretty well over the next couple of years. When it is all said and done, I don't think Lennar is much of a bargain, and I think the homebuilders may be vulnerable to some profit-taking, but it's hard to argue that this sector/industry isn't getting better.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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