Lennar Corporation (LEN) is overvalued and the upside is limited. LEN, a residential construction company established in 1954 and headquartered in Miami, FL has experienced the profits that 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 $26 giving us a Buy/Sell range from $21 on the low end and $29 on the high end. Since LEN is currently priced around $42, we rate this company at Sell. Looking at its past fiscal year performance and its current valuation we believe LEN is undervalued, and without any real growth opportunity it will not be able to increase its value over the fiscal year. The housing market is projected to decline from the slight comeback they saw in 2012, partially due to increased costs of materials. LEN is not forecasted to grow during this decrease in the market. 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 was founded in 1954 and builds homes for different stages of life. Based out of Miami, FL, this company constructs homes in 18 states across the nation. They offer move-up and retirement homes in different types of communities including golf course, urban, active adult, and suburban neighborhoods. In construction LEN creates primarily single-family homes and also deals in the purchase and development of land. LEN provides financial services to its costumers such as mortgage financing, title insurance, and closing services. In the real estate domain LEN is involved in sourcing, underwriting, pricing, managing, and monetizing along with provision of real estate capital and asset management services. In November of 2012 LEN owned 107,138 home sites with 21,346 more sites accessible through option contracts.
LEN's current PE is 11.7, higher than the industry average at 0.0. Their future PE is 16.0. 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 thus is undervalued. In their fourth quarter presentation LEN reported a 313% increase in net earnings YoY for the quarter bringing them to $124.3 million, or $0.56 per diluted share. For the full 2012 fiscal year LEN reports a 33% increase in revenues to reach $4.1 billion. We do not see any evidence to believe that LEN will be able to maintain this level of growth and do not see the company appreciating in value over the forward fiscal year.
Key ratios like ROA, ROE, and ROIC level the playing field so companies are more comparable. Let's look at how LEN compares to the same competitors, DHI and RYL, in these areas. LEN reports ROE at 22.2% while DHI reports 30.8% and RYL at 8.5%. 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 15.2%, and RYL 2.3%. We see the same comparison here with LEN between competitors. Lastly, LEN reports ROIC at 8.5%, DHI at 15.2%, and RYL at 1.7%. Like ROE and ROA, LEN is between DHI and RYL while DHI has very good numbers. 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. At an 11.7 PE, this company is undervalued. The company is predicted to have -84% growth this quarter, with overall -45.3% growth for the fiscal year. Since LEN is already valued low and has negative growth expectations there is little change this company will be able to change their valuation. This combination of undervaluation with negative growth prospects merits our "Sell" rating.
Contrary to the progress the housing market made over 2012 the first three months of 2013 have not been as optimistic. While in many areas the demand for housing is there, Jerry Howard, CEO of the National Association of Home Builders explains the problem, "The home builders themselves are worried about their ability to provide the housing in a lot of instances". Why this worry? There is an overall lack of land, labor, and credit that are preventing homes to be built. Costs of materials, especially lumber, which have skyrocketed, are frustrating small and mid-sized builders that cannot keep up with these elevated prices. LEN finds itself in a market that is still not fully recovered and now has to battle rising material prices. Even though they have performed well during 2012 there is not enough opportunity for LEN to out perform the market.
Economic Moat -
Although this would not completely constitute an economic moat, the fact that LEN offers multiple services in one place for residential construction could be a unique factor. In fact, both DHI and RYL offer financial services and both of which see profits from those financial segments. The second strike against this possible economic moat, other than the fact that it is not exclusive, is that this is currently the weakest part of the company. As stated before the Rialto Investments segment of LEN is operating at a loss and could be a large part of why it needs to generate capital through senior notes. In a market where economic moats are not extremely easy to come by, 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 29.4% decrease in operating income YoY, after which the company will start to see growth. Going back to LEN's PE and future PE, we believe that these numbers are overestimating growth potential. A good PE range for a healthy company that is performing with the market is a 20-25 range. Currently LEN's EPS is 3.28. In order for LEN to reach this healthy range either the company's stock price would have to rise to approximately $66, from their current $42, or their EPS would have to drop to 2.1. Does this seem possible given the state of the company and its forecasted growth decreases? We do not see enough opportunity for LEN to achieve either of these possibilities, so we rate this company for the second time as a "Sell".
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: 8.10%
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: 3.10%
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 increased all of its profitability margins YoY. They increased the operating margin from 3.4% to 7.8%. Their gross margin increased f rom 6.4% to 11.0%. The largest increase in profit margin was in ROE from 3.5% to 22.2%.
DHI also saw increases YoY in profit margins across the board. Their operating margin increased form 0.3% to 5.6%. Gross margin increased from 16.9% to 19.8%. Again ROE was the largest increase from 2.7% to 30.8%. NVR, Inc. (NVR) also saw profitability increase in operating margin from 7.0% to 8.9%, gross margin from 18.7% to 19.3%, 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 0.2% to 4.6%, 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 -3.9% to 3.9%, gross margin from 13.8% to 21.5%, 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 their gross margin instead of increasing. LEN mostly follows the trends for profitability in the market but is the weakest.
Let's compare PE and future PE to the competitors. As discussed briefly earlier, LEN is showing an 11.7 PE and an increase in future PE with 16.0. LEN is undervalued with negative growth prospects. DHI has a 7.9 PE and a 14.5 future PE. NVR has a 28.7 PE and a 13.2 future PE. MTH has a 13.8 PE and a 13.5 future PE. Finally, RYL has a 44.6 PE and a 12.4 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.
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 their current stock and justify this overvalue.
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. Even though 2012 was a comeback year for the housing market analysts are already beginning to doubt is this market will sustain these improvements in 2013. Our price target analysis projects depreciation in LEN's stock price for 2013 and we believe that this company is best rated at a "Sell".