Is the Market Wrong About Lennar's Earnings?

Adam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

One of the best performing sectors of 2012, by far, was homebuilders. The iShares Dow Jones Home Construction ETF increased 75% over the course of the year, and those that bet big on housing won big. Tuesday morning, the largest U.S. homebuilder by market cap, Lennar Corp (NYSE: LEN), reported its Q4 earnings. Despite fantastic results, the stock price moved down more than 2% as investors are wary over future business.

In fact, analysts felt the earnings report was bad enough to indicate weakness in the future of homebuilders in general, causing KB Homes (NYSE: KBH) and DR Horton (NYSE: DHI) to fall about 1% in price as well. I believe this is a case where the market is overreacting to small negative details in the housing market, and ignoring the big wins and positives in Lennar’s earnings report.

What’s Wrong With Housing Now?

Lennar reported new orders for the fourth quarter of 3,983. That number is a 32% improvement over the same period a year ago, but still falls below analysts’ high estimates. As orders are the primary indicator of future earnings, analysts were compelled to sell out of at least part of their position.

One reason for lower than expected orders may be the recent climb in the 30-year mortgage rate. Last week, mortgage rates rose to an 8-week high at 3.4% APR. However, this shouldn’t cause pause for investors for a couple reasons.

First, the 3.4% mortgage rate is still nearly 0.5% below where that mark was last year. After watching the Home Construction ETF rise more than 10% last January, this mark shouldn’t worry too many investors.

Second, the Market Composite Index, a measure of loan application volume, rose 11.7% last week. That is to say, more people are applying for loans, and not just to refinance as that mark stayed steady at 82% of loan applications. These applicants indicate the increasing demand for homes in the United States is still going strong. I believe this trend will continue throughout the year, much to the benefit of Lennar and its investors.

What’s more, Lennar’s contract backlog, another indicator of future sales grew 87%. This ought to mitigate the lower than expected new orders number.

So Much to Like in Lennar

The year-over-year figures from Lennar’s earnings report are ridiculous. Fourth quarter earnings rose a paltry 310% from 2011 at $0.56 per share. That’s a 27% upside surprise on analysts’ estimates, and only the highest estimate expected that much. Revenues climbed 42% to $1.35 billion beating analysts estimates on that mark as well.

However, what I found most impressive is Lennar’s ability to improve its industry leading margins. Gross margins improved 410 basis points over last year to 23.5%, as the average selling price climbed to $261,000 from $243,000. Operating margin improved 660 basis points over the fourth quarter of 2011 to 12.2%, indicating overhead costs have declined, and the company is operating more efficiently.

The company keeps its margins high by focusing its efforts in areas where high demand drives home sales and not low pricing. As more metropolitan areas see increased home buyer demand in 2013, Lennar’s strategy should result in good growth on the top and bottom lines.

Housing Outlook

Lennar’s earnings report makes me confident that housing will continue to do well in 2013. Its margins indicate increasing pricing leverage for homebuilders, which is a trend I expect to continue for a couple reasons. First, as I touched on earlier, mortgage applications are increasing as consumers buy up homes while the prices are still relatively low. Second, the number of foreclosures and mortgage defaults are falling precipitously. In November, foreclosures fell 23% from the year prior, and 6% from October. With fewer foreclosed homes on the market, supply will go down, resulting in a void for homebuilders to fill.

Another positive for homebuilders and their margins is that housing prices are on the rise. In a self-fulfilling prophecy, consumers’ expectations of continued rising housing prices, ought to cause housing prices to continue climbing. As renters look to get out of the high priced renting market and into a house before prices climb too high, demand increases causing prices to rise. Couple that with very low mortgage rates, and homebuilders should have plenty of demand to fill even as prices rise through 2013.

While I like Lennar to continue to perform well in this positive environment, I also like the prospects for Toll Brothers (NYSE: TOL). In its third quarter, Toll reported a 75% increase in the number of newly signed contracts to build homes worth more than $684 million. The number of units increased 70% to 1,098. Most importantly, profits grew from just $15 million in 2011 to $411.4 million in 2012 for the quarter ended Oct. 31. While the company trades near 33 times forward earnings, the company’s profit growth and the positive outlook for homebuilders in 2013 ought to justify the high price. I’ll be looking forward to its earnings report from its latest quarter next month. I expect to find more positives.

adamlevy has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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