Lennar Corporation (LEN), a residential construction company established in 1954 and headquartered in Miami, FL has experienced similar profits the rest of the real-estate market has felt over the 2012 fiscal year, but we are not optimistic about this company sustaining those profits. Our price target analysis projects the 2013 stock price at $36 giving us a Buy/Sell range from $28 on the low end and $40 on the high end. Since LEN is currently priced around $41, we rate this company at Sell. Looking at its past fiscal year performance and its current valuation we believe the future value of the stock is already priced in at these elevated levels. The company also recently announced its plans to offer additional senior notes, a move that can further dilute current share value. Its Rialto Investment segment operated on a loss during Q3 of this past fiscal year, another indicator that all is not well. Overall, we see 2013 as a step back for LEN stock value after being overvalued due to increased revenue in 2012 like much of the real-estate market.
LEN's current PE is 12.8, much lower than the industry average at 31.0. Its future PE is 17.8. In comparison to competitors, which we will flesh out later in the article, LEN is towards the lowest stockholders are willing to pay for residential construction investment.
CEO Stuart Miller of LEN, in the company's latest earnings press release, seems optimistic in the improvement of the residential housing market in general during 2012, as well as for this company in specific. Miller states, "Overall, our third quarter reflects excellent overall results and strengthens the financial position of our company, as we grow volume and drive profitability in a recovering market." LEN saw a 33% increase in Q3 earnings YoY up from $700.6M to $932.8M in 2012. These increased revenues are due to a 28% rise in the number of home deliveries. LEN did have to increase costs in order to see these profits. Selling, general and administrative expenses increased during Q3 from $100.3M to $112.2M. Corporate and general administrative expenses in 2011 were 2.8% of Q3 total revenues while in 2012 they increased to 2.9%. While we see an increase in home sales and revenue coming in from these sales, LEN is still seeing losses, especially its Rialto Investments segment that saw a $5.7M loss in operating earnings for Q3. Competitor Ryland Group, Inc. (RYL) saw even more impressive increases of 68.3% in revenues YoY. Its selling, general and administrative expenses including corporate decreased from 16.4 in 2011 to 13.4 in 2012. Where RYL was seeing losses in 2011, it has been turned to profits in 2012. Another competitor DR Horton Inc. (DHI) saw 180% increases in revenue YoY 100.1 million. During the 2012 fiscal year DHI saw a 13% increase in closed homes: 18,890 homes in 2012 compared to 16,695 homes in 2011. Again we see that this company, having seen losses in the 2011 fiscal year, as turned those numbers positive. Compared to close competitors, LEN is the only company still operating in part at a loss.
Key ratios like ROA, ROE, and ROIC equal the playing field so companies are more comparable. Let's look at how LEN compares to the same competitors. LEN reports ROE at 22.2% while DHI reports 31.8% and RYL at 2.3%. Here LEN lands in the middle of these two competitors though DHI has a much higher return on equity ratio. For ROA, LEN reports 7.0%, DHI 15.7%, and RYL 8.5%. This time LEN is the lowest while DHI still reports the highest ratio. Lastly, LEN reports ROIC at 8.3%, DHI at 18.5%, and RYL at 1.7%. Like ROE, LEN is between DHI and RYL. LEN is competitive in its market but is not the strongest.
What we are seeing is that LEN is improving its numbers like much of the market, but there are still weak points in the company. The Rialto Investments segment operated at a loss during the 2012 Q3 and while LEN saw increases in revenues and home sales, its percentage increases were not the highest in the market. While this company is showing profits in areas, the weakness in its investment segment is troubling and contributes to our "Sell" rating.
The major catalysts for LEN in 2013 include can the housing recovery continue, will LEN move to greater profits, and will the company be able to turn around negative assets like its investment arm. First off, housing data will be a big catalyst for LEN throughout the year. If housing data does not continue to suggest a bottom is in for housing, LEN could fall apart. Another important point will be if LEN can grow profits higher. One recent issue could be some share dilution and increase in equity for the company. LEN is planning to sell senior notes that will mature 4.125% in 2018, and another set that will mature at 4.750% in 2022. It will sell 275 million principal of its 4.125% senior notes at a price of 99.98% and 175 million principal of its 4.750% senior notes at a price of 98.073% to total an outstanding principal amount of its 4.750% senior notes due 2022 to 525 million. The company plans to issue these senior notes and use the proceeds towards working capital and general corporate purposes, which may include the repayment or repurchase of some of its outstanding senior notes.
Economic Moat -
LEN has a weak economic moat in that the company has little differentiation from competition. At the same time, residential construction companies were able to build decent moats during the housing crisis as competition folded and companies like LEN bought lots of land. Overall, though, we do not see any sort of strong contender for an economic moat for LEN, another negative factor that leaves no barriers to entry against competitors.
Revenue and EPS Outlook -
The price target analysis for LEN breaks down what we predict for the next five fiscal years in terms of income and growth, and secondly what that means for the stock price in 2013. Reflected in our first table is the 2012 operating income and then the decrease in 2013. The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices. We anticipate a 20.6% decrease in operating income YoY, after which the company will start to see growth. We expect LEN's current EPS of 3.11 to drop to 2.23 by Q3 of 2013. Interesting enough DHI is predicted to fall as well from its current EPS at 2.68 to 1.50 by Q3 of 2013. On the contrary RYL is predicted to increase its EPS from 0.84 in 2012 to 2.94 in 2013.
Price Target Analysis
The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.
Here is how to calculate price targets using discounted cash flow analysis:
(all figures in millions)
Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.
Available Cash Flow
Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).
WACC for LEN: 8.44%
PV Factor of WACC
PV of Available Cash Flow
For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate. Cap Rate for LEN: 3.44%
Available Cash Flow
Divided by Cap Rate
Multiply by 2016 PV Factor
PV of Residual Value
Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:
Sum of Available Cash Flows
PV of Residual Value
Interest Bearing Debt
Divide equity value by shares outstanding:
Profit/Value Industry Comparisons
Q1 - Q3 2011
Return on Equity
LEN has shown either increased or maintained its profitability margins YoY. Lenner increased its operating margin from 6.2% to 8.5%. LEN's gross margin maintained itself at 11.0%. The largest increase in profit margin was in ROE from 3.5% to 22.2%. How do these numbers compare to competitors?
DHI saw increases YoY in profit margins across the board. Its operating margin increased form 3.3% to 8.7%. Gross margin increased from 16.9% to 18.8%. Again ROE was the largest increase from 2.7% to 30.8%. NVR, Inc. (NVR) also saw profitability increase in operating margin from 7.1% to 8.0%, gross margin from 19.5% to 20.1%, and again the largest increase was ROE from 8.3% to 12.7%. Meritage Homes Corporation (MTH) saw profitability ratios increase in operating margin from 5.0% to 6.6%, gross margin from 16.4% to 18.3%, and ROE again the largest increase from -4.3% to 17.8%. Lastly RYL sees profitability ratios increase in operating margin from 5.3% to 6.8%, gross margin from 21.4% to 22.3%, and ROE's large increase from -10.7% to 8.5%. All competitors in the residential construction market saw increases in profitability margins confirming the notion that the market is improving. LEN is the only company that merely maintained its gross margin instead of increasing. LEN mostly follows the trends for profitability in the market but is the weakest company especially when looking at gross margin YoY.
Let's compare PE and future PE to the competitors. As discussed briefly earlier, LEN is showing a 12.8 PE and an increase in future PE with 17.8. Compared to the industry average LEN is low, though we see that future growth and profits are already valued into the current PE. DHI has an 8.3 PE and a 15.5 future PE. NVR has a 29.2 PE and a 13.5 future PE. MTH has a 14.0 PE and a 13.6 future PE. Finally, RYL has a 44.0 PE and a 12.6 future PE. While companies like NVR and RYL have high PEs and are overvalued, LEN's valuation accounts for current and future profits, so the increase seen in the future PE indicates that the company will lose money YoY.
What could go wrong in our argument? There is a chance that LEN will see increased profits in 2013 and the secular housing recovery will lift all boats. LEN has stated that it plans to use the revenue from the new senior notes as working capital, for corporate expenses, and may be used in the repayment or repurchase of other outstanding senior notes. If used wisely, this could give LEN the capital to boost revenues, manage those revenues efficiently on the corporate end, and settle outstanding senior notes, freeing up the company to turn larger profits this fiscal year. This new capital help them counterbalance the overvaluation in its current stock and justify this overvaluation.
The Bottom Line
In conclusion, we see that LEN has followed the market trend and increased revenues in 2012 but we believe that the current stock value already reflects future profits and will drop in value over the course of the year as a result of this overvaluation. The Rialto Investments segment of LEN is not operating at a profit and the company has recently announced its plans to offer hundreds of millions of dollars of additional senior notes on top of those outstanding. Our price target analysis projects a depreciation in LEN's stock price for 2013 and we believe that this company is best rated at Sell.