Lennar Reports Wednesday: What Is The 'Normalized Earnings' For The Homebuilder?

| About: Lennar Corporation (LEN)

One of the country's larger and more geographically-dispersed homebuilders reports second fiscal quarter earnings before the bell on Wednesday morning, June 27th, with analyst consensus expecting Lennar (NYSE:LEN) to report $0.17 in earnings per share (EPS) on $885.7 million revenue for expected year-over-year growth of 142% in EPS and 11% in revenues.

In last year's second quarter, Lennar reported $0.07 in EPS and $764.5 million in revenue.

Last quarter, for Q1 2012, Lennar reported 29% revenue growth (and a nice beat too) and $0.08 a share in EPS, along with home closings of 29% and a 3% average increase in price per home sold. (The national Case-Schiller housing price data is due out Tuesday morning, so it will be interesting to see if Lennar can extract price increases on new homes, even as the national price level index for housing continues to decline, albeit at a slowing rate.)

Other key stats from the first quarter, 2012:

  • Gross margin was a little better than expected at 20.9%
  • Q1 '12 new orders rose 33% y/y to a little over 3 ml
  • Q1 '12 backlog at the end of the quarter was 2.7 ml units or a 39% y/y increase
  • The Q1 '12 cancellation rate was a rather subdued 1%
  • Rialto generated about $5 ml in operating income, during the quarter

The homebuilders have had a monster move off the October '11 market lows, with Lennar up 116% (from $12 to $26) and Toll Brothers (NYSE:TOL) up 100%, from $13 to $26 as well.

So the big question for traders then - is the majority of the move for the homebuilders over?

While new housing starts were the lowest in 2011 since the data began being kept during the Kennedy Administration, thus I do believe new homes will continue to recover from the depression-like lows of 2010 and 2011, Lennar might be overbought here as we head into the second quarter earnings.

As a portfolio manager, I have two key concerns about homebuilders and Lennar in particular:

Obviously, the warm weather in the Midwest this winter pulled some housing activity forward into Q1 and then early Q2 '12, but we really haven't seen any change in margins at any of the homebuilders, even Lennar. You would think that with the horrific housing depression that we've seen since 2006, that homebuilders would have slashed expenses and payroll and then would get the benefit from the operating leverage that would be built up in the income statement, but I don't think we've seen that to any great degree. The first quarter 2012 gross margin of 20.9% was improvement, but just 90 bp's over the 20% gross margin from Q1 '11;

Lennar and a lot of the homebuilders are still cash-flow negative, which is putting pressure on the balance sheet. Lennar has about $3.5 billion of senior debt, and they haven't been cash-flow positive from an operations perspective since 2010. Here is how the numbers lay out in terms of cash-flow history:

February, 2012 - $132 ml cash-flow from operations deficit (last quarter reported)

November, 2011 - $259 ml cash-flow from operation deficit; (full year)

November, 2010 - $274 ml cash-flow from operations surplus; (full year)

November, 2009 - $421 ml cash-flow from operations surplus; (full year)

Id like to see Lennar generate some positive cash-flow this year to accompany the order and price growth.

The real question I am wondering about is what is the true earnings power of a homebuilder with a relatively decent balance sheet (Toll Brothers is thought to have the best balance sheet amongst the homebuilders) during this next up cycle for homebuilders?

A lot of folks thought we'd see a bankruptcy of a major public homebuilder, but it was the smaller, privately-held builders that suffered. The point being that I wonder how much capacity was lost (if any) during the housing depression.

If we assume that the 2005 - 2006 new single-family home sales were inflated by speculative activity at 1.2 ml - 1.4 ml new home sales per year, and the housing depression-like lows of the last few years of 200k - 250k were too low, is the current rate of seasonally-adjusted new home sales of 343k still below the long-run "new normal?" What is the longer-term run rate of new home sales - 800k a year?

Lennar is currently projected to earn $0.83 this year, almost double the $0.48 in EPS from last year, $1.36 for 2013, while current consensus is $1.90 in 2014 and $3.15 in 2015, leaving LEN trading today at 31(x) this year consensus and 19(x) next year's $1.36.

Homebuilders stocks tend to trade at low multiples near peak earnings as we saw in '05 and '06, when the stock were sporting 5(x) - 6(x) P/E ratios, so today's price of $26 and LEN's p/e of 31(x), might have all the good news already built into it.

If we assume that the "normalized earnings power" of LEN over time is $1.50 to $2 per share (with some allowance for a bounce off the depression like cyclical lows), and that the homebuilders' multiples compress as earnings accelerate, you could make a very good case that the upside on LEN should be limited to $22 - $25 per share.

However I think that may be a little too conservative.

We would look to add to LEN in client accounts certainly under $20, and in the high teens if we could get it, and above $30 I think the stock gets pricey, at least for now. LEN's all time high price was $68.05 in mid 2005. However we are now exiting the worst housing depression since the late 1970s when interest rates were at their century highs, so some allowance has to be made for the cycle.

Disclosure: I am long LEN, TOL.