A Play on Mainstream America

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

Do you believe in mainstream America? Do you believe that though times have been tough that the middle class will rise again? If so, I have the perfect stock for you!

Sorry to sound like a late night infomercial, but sometimes a stock is such a perfect play on a segment of the economy that I can't help but get excited about its prospects. If you believe as I do that the economy is slowly but surely turning around, Lennar (NYSE: LEN) seems the perfect way to play this recovery.

Lennar is a well known homebuilder, and for some investors, just the idea of buying anything related to housing seems crazy. Lennar started looking like a decent buy several months ago, as I read their earnings report and saw positive comments from their competition about the improving housing market. It's one thing for a single company to say business is getting better, but it's something else when most companies in the industry are reporting a positive outlook.

What makes the homebuilders' talk about improvements meaningful is that the data backs up what they are saying. Consider for a moment that Lennar reported the average sale price of homes delivered increased from $243,000 to $261,000 on a year-over-year basis. Now add to Lennar's positive numbers the fact that KB Home (NYSE: KBH) recently reported their average selling price rose by 14% year-over-year. If you want more proof, Toll Brothers (NYSE: TOL) said their average selling price increased 3% versus a year ago. Between the three companies, investors are being told that in different areas of the country, homes priced from around $200,000 to well over $500,000 are selling well. The turnaround in housing is more than just a rumor -- it has already begun.

If you want proof that buyers are going to Lennar in droves, consider their recent earnings. The company saw revenue increase 42% and diluted EPS jumped by 250%. This alone should be enough to get Lennar serious consideration, but beyond the headlines, the company is doing exceptionally well. Lennar saw home deliveries up 32% and new orders up 32% as well. When you compare this to KB Home's new order growth in the single digits, and Toll's new order growth of 75%, you can see that Lennar shows impressive growth, though they weren't able to match Toll's new order growth.

Where Lennar was able to beat Toll Brothers was in backlog growth in the current quarter. Lennar saw its backlog dollar value jump by 107% on a year-over-year basis. Toll reported impressive growth as well at 70% growth, and KB Home fell far behind at 35% growth. If there was one thing conspicuously absent from Lennar's recent earnings it was the lack of a number regarding their cancellation rate.

Lennar didn't provide a specific cancellation number, but we can get some guidance from their peers and the company's own history. Toll Brothers leads the industry with a 4.6% cancellation rate. KB Home has been the industry laggard for a while, and recently reported a 35% cancellation rate. Falling somewhere in the middle is PulteGroup with a cancellation rate of 14%. Last quarter, Lennar reported a cancellation rate of 16%. It's highly likely that their rate in the current quarter was somewhere close to their last quarter rate. Compared to their peers, Lennar hasn't had the lowest rate or the highest, but instead fell in the middle of the pack.

Where Lennar isn't going to be in the middle of the pack is future growth, and I'm not ashamed to say I think analysts are being too conservative with estimates. For the next few years, analysts are calling for just 6% EPS growth at Lennar. I believe this number will be significantly higher. The company's massive backlog growth suggests that, at least near-term, growth will be very good.

In addition, the company said that not only did the average price of homes delivered increase, but they did so with fewer incentives. Specifically, incentives dropped from nearly $34,000 last year to $25,800 this year, down 23.89%. The company's gross margin also improved to 23.5%, which puts Lennar second only to Toll Brothers. If analysts expect Toll Brothers to grow EPS by nearly 25% in the next few years, it is very likely that Lennar may do better than 6%.

While it's true that Lennar caters to the middle class, and Toll caters to higher-end homebuyers, this is exactly my point. As the economy improves, it's likely the middle class that will step forward to buy relatively more homes than the higher-end segment. If Lennar can continue growing its backlog, it will take a while for all of these homes to be built and completed. Though the company will face difficult EPS growth comparisons, I think 6% growth is too low of a bar. The fact that Lennar absolutely crushed expectations by over 310% in the last four quarters is yet another reason the company may do better than analysts think.

Investors looking for a play on the growth of the middle class should put Lennar at the top of their Watchlist. The company had a fantastic 2012, and it looks like their business is built to post significant growth in the next several years.

MHenage 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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