The Problem With Lennar And D.R. Horton

Includes: DHI, LEN
by: Takeover Analyst

After the subprime mortgage crisis, investors are naturally reserved when it comes to anything that relates to housing. Thus, homebuilders Lennar Corporation (NYSE:LEN) and D.R. Horton (NYSE:DHI) both offer value investors the opportunity for high risk-adjusted returns. However, I believe that these companies are more vulnerable to the negative effects of prolonged housing stagnation than to the positive effects of a shorter than expected housing recovery. Put differently, I am of the opinion that the risk outweighs the reward, especially in light of the high multiples that these companies trade at.

From a multiples perspective, both companies are expensive. Lennar has a respective PE and forward PE ratio of 35.6 and 21.6, while D.R. Horton has a respective PE and forward PE ratio of 49.1 and 14.5. The two also offer low dividend yields of around 1.1% while having betas solidly above 1. At the same time, costs remain high, limiting gross margins to around 12%. Analysts are currently more bullish about Lennar than they are about D.R Horton, rating shares around a "buy" and a "hold" respectively. In an earlier article, I highlighted why I recommend holding out in D.R. Horton; in this article, I will highlight why I also recommend holding out on its competitor.

Perhaps the greatest reason why I am reserved about Lennar is that I see its high-risk Rialto business almost as a symbolic suggestion of uncertainty in housing. Rialto holds the firm's distressed real estate assets and many investors have hailed it as a meaningful way to drive returns while the core homebuilding unit is stagnant. Yet I see more of the pessimistic side, namely, that it is a major hinderance to investor entrance when the housing market recovers. In addition, although the firm is ramping up staff in this segment, Rialto remains a small part of the whole and investors have given it more attention than it deserves. It is a bit of a wild card and catalyst that merits recognition, but should not obfuscate weightier issues. I am more concerned with how the firm is setting the stage to take away market share from competitors in its core homebuilding segment.

In the third quarter earnings call, Lennar's CEO, Stuart Miller, voiced his general optimism about a strong recovery:

In the context of what continues to be a challenging U.S. housing market, we're pleased to report our sixth consecutive quarter of profitability as we continue to position Lennar for future success. As noted in our press release, all of our business segments, Homebuilding, Financial Services and Rialto, were profitable in the quarter in spite of significant challenges…

Throughout our third quarter, we continued to see evidence that the consumer is beginning to return in earnest to the homebuilding market. Although sales price and pace are still under pressure, traffic trends have continued to improve and real, traditional primary purchasers with a real desire to purchase are showing up. The combination of home prices that have dropped to attractive levels across the country, together with interest rates on 30-year loans that are at historic lows, has made the prospect of home ownership both compelling and widely affordable.

To be sure, management does have a reasonable case that a housing recovery may occur sooner than what many appreciate. Rental rates are increasing, which will drive substitution towards housing. In addition, affordability has become somewhat of a bright spot to many first-time home owners.

However, poor access to credit and political scorn for the main mortgage financing units will limit demand - a point that management lamented during the call. Capital has consequentially been shifted towards Rialto, which has shown strong operational performance thus far. Management does not believe that "there's a silver bullet" to solve problems, but that Lennar has "positioned [itself] to remain profitable while the market corrects".

Lennar has cut costs, but I remain cautious whether or not they will materialize a meaningful effect before input pressures rise alongside weak demand. On the other hand, if demand takes off, Lennar may not have the capacity to maximize potential profits.

Consensus estimates for EPS are that it will remain flat at $0.51 in 2011 and then increase by 54.9% and 55.7% in the following two years. Assuming a multiple of 35.6x and a conservative 2012 EPS of $0.62, the rough intrinsic value of the stock is $22.07. This implies a 29.1% margin of safety - enough, in my view, to make it a value play. With that said, the risks are substantial and I would recommend holding out until a clearer picture can be made about the housing market and Lennar's position in it.

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