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Lennar (NYSE:LEN), one of the nation's largest homebuilders, reports its fiscal 3rd quarter, 2013 financial results on Tuesday morning, September 24, 2013, before the opening bell.

Analyst consensus, as it stands currently, is looking for $0.45 in earnings per share (EPS) on $1.56 billion in revenue, for expected year-over-year growth of 12.5% and 42%, respectively.

Some of the air has come out of the homebuilding stocks since the 10-year and 30-year Treasuries bottomed in early May '13.

Our sale of homebuilders in mid to late May '13 was one of our best sales this year in terms of keeping clients out of trouble, but we did it for reasons that weren't obvious and had little to do with interest rates:

1.) Despite the steady rise in national residential housing values over the last year, the homebuilders aren't generating any cash-flow from operations (NASDAQ:CFO). In the 8 quarters ended November 2012, LEN had one quarter of positive CFO and that was q4 '12. So far in fiscal '13, LEN has added two additional quarters of negative CFO. Obviously, this means there is little free-cash-flow (FCF) being generated. Cash-flow is a metric we pay close attention to for all of our holdings and as the housing recovery progressed, the fact that the homebuilders seemed unable to generate cash made me nervous, particularly given the valuations.

2.) Dilution: as we will show shortly, and given our above link to the May '13 article, homebuilder shareholders are being steadily diluted, which is common amongst most homebuilders stocks, not just Lennar.

3.) The "deferred tax asset" (DTA) in our opinion has inflated homebuilder earnings the last 12 months, and thus overstates earnings for the last 4-6 quarters. With the pricey P/Es and overvaluation on the overstated earnings, we felt that we needed to be a better seller in May, despite the macro improvement in housing data.

4.) Sentiment was universally bullish around the stocks, and according to recent homebuilder sentiment releases, still remains so.

5.) A tough admission to make in a public forum, but given the negative cash-flow, the joint venture balance sheets, and very complex accounting, I felt like I didn't understand the homebuilder financial statements as well as I liked, so I punted the stocks and booked the gains. We are big cash-flow and free-cash-flow investors as a safety net for client holdings. I have a tough time figuring out "capex" for the homebuilders, and started using just the change in inventory values quarter-to-quarter to arrive at capex and free-cash-flow, which is very different from the capex that shows up on the cash-flow statement.

Here is an example of LEN's operating income and effective tax rate since 2010, both what is actually reported, and then adjusting for a "normalized" tax rate:

LEN's NOPAT, after adjusting for DTA

Oper

Income

eff tax

rate

NOPAT Op Inc

pro-forma

tax rate

NOPAT
8/13 (est)
5/13$196.110%

$176.6

$196.135%

$127.5

2/13$84.64%$81 $84.635%$55
11/12$144.013%$125.4 $144.035%$93.6
8/12$90.914%$78 $90.935%$59
5/12$81.26%$76.7 $81.235%$52.3
2/12$33.3-5%$34.8 $33.335%$21.6
11/11$40.3-34%$54 $40.335%$26.2
8/11$46.91%$46.3 $46.935%$30.5
5/11$46.42%$45.4 $46.435%$30
2/11$59.6-4%$62.0 $59.635%$38.7
11/10$63.8-6%$67.6 $63.835%$98
8/10$63.41%$63 $63.435%$41.2
5/10$57.8 ml-19%$69 $57.835%$37.6

* Source:LEN financials and 10-Q's

* NOPAT: net operating profit after tax (term usually found in return-on-invested-capital calculations)

Without considering EPS, just the difference in NOPAT between the actual reported and what would be pro-forma NOPAT is roughly $270 million or -- using the May '13 outstanding shares -- of $1.19 per share.

That calculation is probably a little unfair to LEN though, since this doesn't include income or losses from minority owned interests that are reported after-tax on LEN's P/L, and thus outside this calculation.

Last quarter's results:

Last quarter, May '13's fiscal 2nd quarter, LEN reported 53% revenue growth, and 190% EPS growth, against the last weak comparisons from the 2008 housing depression. LEN's reported EPS was $0.63, while operating EPS (per one source) was closer to $0.43, thanks to the $0.20 tax reversal.

Still $0.43 was 100% year-over-year growth versus the $0.21 a year prior.

Gross margins of 24% and operating margins of 13% were both better than expected. Revenue growth was driven by an 11% average selling price (ASP) increase and backlog conversion.

Valuation:

Historically, homebuilders are valued based on a price-to-adjusted-tangible book value metric, with the adjustment being tied to the value of the deferred-tax asset. If we used the traditional static analysis of adjusted-tangible book value for LEN, "intrinsic value" would be close to the high teens or low $20s for the prime homebuilder. However, I don't think this valuation metric gives the sector credit for the earnings rebound currently being seen across the sector.

At $35 per share LEN is trading at 18(x)-19(x) expected fiscal 2013 EPS of $1.90-$1.91 and 14(x)-15(x) fiscal 2014 EPS of $2.48, for expected year-over-year growth of 54% and 30% currently.

Our internal "intrinsic value" model puts a fair value on LEN of close to $50, which is an earnings-based valuation model.

The tough aspect to valuing LEN is deciphering what are "true, core earnings per share," which we estimate are between $2-$3 per share on a normal effective tax rate, what "real" cash-flow looks like.

If we do what we normally do, and split the difference between our internal model and the traditional adjusted book value model, LEN seems fairly valued near $35, which is exactly where it closed on Friday, September 20th.

Conclusion:

To be clear this is no way an indictment of LEN's accounting or financial reporting. We could have done the exact same analysis on Toll Brothers (NYSE:TOL) or any number of homebuilders. The key takeaway from this for readers is that with the deferred tax asset (DTA), and since the recovery in residential home values, the tax-loss carry-forward has led to (in our opinion) an overstatement of homebuilder sector earnings, and with valuation looking stretched even with reported results, the sector's "true" valuation is likely lower than where the stocks are trading currently.

The other issue is that with the tax laws around homebuilders and real estate, the reporting of financial results seems (in my opinion) very complex already, which is further complicated by the many joint ventures and minority interests (usually with their own financing or debt covenants)

Finally, determining "core earnings per share" for the homebuilders is a tough calculus at this point in time, and since we are a small advisor and I can't become a 100% full-time homebuilder analyst at the exclusion of trading, following our other holdings, and doing other functions necessary at a small RIA.

In our opinion as of late September 2013, LEN is NOT selling at significant enough discount to intrinsic value to warrant us owning the homebuilder in quantity in client accounts.

We are still long one core position in LEN with a price of $22 per share from January 2012, which is held in a tax-sensitive taxable account for a long-term client.

We start getting a lot more interested in LEN and TOL in the $20s.

Source: Lennar Earnings Preview: We Like It Better In The $20s, Preferably The Mid-$20s