10% Upside For DR Horton, Lennar Too Risky

| About: D. R. (DHI)

With the macroeconomy still uncertain and skepticism surrounding the mortgage markets, homebuilders DR Horton (NYSE:DHI) and Lennar (NYSE:LEN) face substantial risks. Although both have rallied of late, outperforming broader indexes, I remain reserved on whether recent gains can hold. DR Horton is at a meaningful premium to sales and Lennar's high beta of 1.7, coupled with the low dividend yield of 0.7%, could spell disaster if the economy does tank.

From a multiples perspective, these companies are fairly expensive. DR Horton and Lennar trade at a respective 18.4x and 28.5x forward earnings. With KB Home (NYSE:KBH) offering a comparatively high dividend yield of 2.9% and trading at only 19.2x forward earnings, the two other homebuilders could have a hard time justifying the premium. With that said, as Southern Pacific (SOF) trades at 33.8x, the possibility of yet further multiples expansion is, I suppose, plausible.

At the fourth quarter earnings call, DR Horton's CEO, Don Tomnitz, noted the company's strategy:

"For the past several years, we have been focused on the basics of the Homebuilding business, with the singular goal of returning to profitability. We supplemented our existing land positions with newer, finished lot positions which enhanced our gross margin. We limited our investment in land and lot inventory, which benefited operational cash flow. We adjusted our overhead structure, which reduced our SG&A expenses, and we reduced our outstanding debt significantly, which improved our balance sheet leverage and resulted in less interest expense.

In fiscal 2011, we realized the benefits of these strategies and have achieved operational profitability, this time without a tax credit. We closed 16,695 homes, 8 fewer than 2 years ago in fiscal 2009. However, our bottom line results were greatly improved versus fiscal 2009, as our pretax income increased $569 million".

The main element that is attractive about DR Horton is its large national exposure, which offers investors greater certainty. Management has demonstrated solid operational skill with a discipline in SG&A. During the housing downturn, the company lost market share only to later regain it back. It now has around a twentieth of US new home sales and ranks within the top 3 in some of its core markets. As other homebuilders exit their site of operations, DR Horton is gaining improved pricing power. Note that foreclosures were down 3% sequentially in November.

Consensus estimates for DR Horton's EPS are that it will grow by 82.6% to $0.42 in 2012 and then by 85.7% and 48.7% more in the following two years. Assuming a multiple of 21x and a conservative 2012 EPS of $0.74, the rough intrinsic value of the stock is $15.54, implying 10% upside. This is not enough, in my view, to merit calling the investment a value play. Accordingly, I agree with the "hold" rating on the Street.

Lennar has slightly more, however insignificant, upside. The company entered the Seattle and Portland markets with Premier Communities gearing to take charge of the former. Lennar purchased distressed lots in 11 different communities in Portland Oregon. While this sounds impressive, one analyst models it only contributing as much as $0.02 to EPS if normal returns are realized.

Consensus estimates for Lennar's EPS are that it will grow by 60.4% to $0.77 in 2011 and then by 59.7% and 28.5% in the following two years. This deceleration gives me pause in light of a possible full recovery by 2013. Assuming a multiple of 21x and a conservative 2012 EPS of $1.19, the rough intrinsic value of the stock is $24.99, implying 12.3% upside. Analysts rate the stock a "buy".

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.