Description

Executive Summary

The stock of Lennar Corporation (LEN), a homebuilder, presents a highly attractive long opportunity for both industry reasons (beta) and stock-specific reasons (alpha).

For the US homebuilding industry as a whole the fundamental outlook is strong, driven by a combination of supportive macroeconomic forces, including (i) low interest rates, (ii) low unemployment, (iii) wage growth, and (iv) high consumer confidence.  On top of these factors, the rate of US household formations has been outpacing the rate of US housing starts for several years, creating a supply/demand imbalance which should further support industry growth.

For LEN specifically the Company is progressing through a strategy shift which should cause its stock to outperform the homebuilding industry as a whole.  The Company is pivoting to a “land lighter” strategy which should (i) reduce its asset base, thereby unlocking sizeable amounts of additional free cash flow to the benefit of shareholders and (ii) increase the Company’s return on equity which should drive a higher valuation multiple.  Essentially, LEN is becoming more like its competitor NVR, Inc. (NVR) which already uses a “land light” strategy and which the market rewards with a significantly higher valuation multiple.

Currently my 2020 and 2021 EPS projections for LEN (November FY End) are ahead of consensus estimates.  A contributing reason for the variant view is my projection that the Company directs its additional cash flow generation from its “land lighter” strategy toward share repurchases.  I’m at $6.41 in EPS for 2020 and $7.27 for 2021 vs. consensus at $6.24 and $6.67, respectively.  Based on these estimates, LEN is trading at 10.4x and 9.2x 2020 and 2021 EPS.  NVR is currently trading at 17.6x and 16.8x 2020 and 2021 PE, respectively (December FY End).  While LEN will likely not be rewarded with a full NVR valuation multiple, even if it appreciates to a reasonable ~13.0x PE multiple LEN’s stock could reach $95/share, >40% upside from current levels.

Please note that LEN’s pivot to a “land lighter” strategy was noted in the LEN write-up posted on VIC on 5/2/18 by lordbeaverbrook.

Company Description

LEN is one of the largest homebuilders in the US and has three reporting segments:

Homebuilding (93% of Revenues, 90% of Operating Earnings) – The Homebuilding operations include the construction and sale of single-family attached and detached homes as well as the purchase, development and sale of residential land.  Homebuilding reports results the following categories:

East – Florida, New Jersey, North Carolina, South Carolina

Central – Georgia, Illinois, Indiana, Maryland, Minnesota, Tennessee and Virginia

Texas – Texas

West – Arizona, California, Colorado, Nevada, Oregon, Utah and Washington

Other – Urban divisions and other homebuilding related investments

Financial Services (4% of Revenues, 8% of Operating Earnings) – The Financial Services operations offer conforming conventional, FHA-insured and VA-guaranteed residential mortgage loan products and other home mortgage products primarily to buyers of LEN homes through the Company’s financial services subsidiary, Eagle Home Mortgage, LLC.  In 2018, Financial Services provided loans to 73% of LEN’s homebuyers who obtained mortgage financing.

Multifamily (3% of Revenues, 1% of Operating Earnings) – The Multifamily operations are involved in the development, construction and property management of multifamily rental properties.  The segment is one of the largest developers of apartment communities across the US.  Originally, the Multifamily segment focused on building multifamily properties and selling them shortly after they were completed.  However, more recently LEN has focused on creating and participating in ventures that build multifamily properties with the intention of retaining them after they are completed.

Investment Thesis

LEN’s stock price should be driven upwards by the following:

Strong Homebuilding Fundamentals Driven by Macroeconomic Forces – For the US homebuilding industry as a whole the fundamental outlook is strong, driven by a combination of supportive macroeconomic forces.  These include:

Low Interest Rates – Low interest rates greatly increase the affordability of buying a home, thus supporting demand.  Currently, US interest rates are very low with the 10-Year Treasury yielding ~1.69% (USGG10YR on Bloomberg).  The yield is up from its recent low of ~1.50% in August/September of 2019 but still very low on an absolute level.  The last period of time the yield was this low was in 2016 and prior to that in 2012.  Commensurately, the rate on 3-year fixed mortgages in the US is also very low and is currently 3.87% as of 1/17/20 (MB30 on Bloomberg).  The last time rates were this low was in 2016 and prior to that in 2012.  While things may change, the Fed’s most recent commentary indicates that it intends to keep rates low for the remainder of 2020.  The next Fed rate decision is scheduled for 1/29/20.

Low Unemployment – With low unemployment and greater workforce participation, consumers’ level of disposable income is not only greater but more stable, thereby increasing the affordability of purchasing a home.  US Unemployment (USURTOT on Bloomberg) is currently 3.5%, down from 9.9% at the end of 2009.  The last time US unemployment was this low was in 1969.  The next release date for US Unemployment is 2/7/20.

Wage Growth – Wage growth also increases the affordability of a home for buyers, supporting demand.  US Hourly Earnings (AHE YOY% on Bloomberg) have not only been steadily growing since 2010 but have been growing at an accelerating rate.  The next release date for US Hourly Earnings is 2/7/20.

High Consumer Confidence – Coinciding with low unemployment and wage growth, US Consumer Confidence as measured by the University of Michigan Consumer Sentiment Index (CONSSENT on Bloomberg) is very high with its latest reading of 99.1.  The index has steadily moved upwards from its most recent low of 56.2 in August 2011.  The next release date for the index is 1/31/20.

In addition to the macroeconomic forces above, the US homebuilding industry should also be supported by the fact that housing demand has been outpacing housing supply for the past several years.  Specifically, US Household Formations (USHRFORM on Bloomberg) have averaged ~1.3mm over the past 5 years.  Adding to this housing demand is the loss of ~300,000 housing units per year on average due to weather, natural disasters, fires, etc. as well as the additional need of another ~100,000 housing units per year on average for second home purchasers.  Accordingly, demand for US housing has been averaging ~1.7mm units for the past 5 years.  However, US Housing Starts (NHSPSTOT on Bloomberg) have averaged ~1.2mm units for the past 5 years.  This has created a cumulative housing deficit of ~2.5mm units during this timeframe.  US Housing Starts will have to substantially increase and stay >1.7mm units for years to come in order to satisfy demand.  The trend in this direction is starting to take place as US Housing Starts have significantly increased from 1.204mm units in July 2019 to 1.608mm units in December 2019.

Transition to a “Land Lighter” Strategy, Driving Additional Cash Flow and Increasing Return on Equity – LEN is in the process of transitioning to a “land lighter” strategy which should (i) reduce its asset base, thereby unlocking sizeable amounts of additional free cash flow to the benefit of shareholders and (ii) increase the Company’s return on equity which should drive a higher valuation multiple.  Management stated on their 4Q19 earnings call that if they achieve their two-year goal of reducing their owned supply of homesites, discussed below, it would reduce their on-balance sheet land position by ~$3.0 billion by the end of FY2021.  This additional $3.0 billion in cash release could be used toward share buybacks, M&A, etc.  Given that LEN’s market capitalization is ~$21bn, this cash release equates to an additional 14% FCF yield over the next two years on top of the normal level of FCF LEN generates.

Historically, LEN purchased land well in advance to assure that it had a stable supply with which to develop properties.  This because there is strong competition among homebuilders for land that is suitable for residential development.  The future availability of developed lots and undeveloped land that meet a homebuilder’s criteria includes land availability in general, competition with other homebuilders and land buyers for desirable property, inflation in land prices, zoning, allowable housing density and other regulatory requirements.  However, owning significant amounts of land (i) requires significant capital investment and (ii) carries with it inherent risks.  Specifically, if housing demand declines, a homebuilder may own land they acquired at costs they will not fully recover or on which they cannot build and sell homes profitably.  The homebuilder may have to sell homes for lower than anticipated profit margins or record inventory impairment charges with regard to the land.

LEN is pivoting to a “land lighter” strategy in which management is (i) reducing its years of owned supply of homesites and (ii) increasing the percentage of land controlled through options.  As shown in the table below, LEN has been steadily changing the composition of its homesite portfolio.  At the end of 2018, the Company’s homesite portfolio was 74.6% owned, 25.4% under option.  At the end of 3Q19, the homesite portfolio was 70.1% owned, 29.9% under option.  While LEN has not yet published its 2019 10-K, management noted on the 4Q19 earnings call that the Company’s homesite portfolio at the end of FY2019 was 67% owned, 33% under option.  Management has stated their two-year goal is to have 50% of their homesite portfolio under option by the end of FY2021.

Concurrently, management is also reducing its years owned supply of homesites.  At the end of FY2018, the Company had 4.4 years of owned supply of homesites.  Again, LEN has not yet published its 2019 10-K but management noted on the 4Q19 earnings call that the Company ended FY2019 with 4.1 years of owned supply of homesites.  Management has stated that their two-year goal is to reduce their years owned supply of homesites to 3.0 by the end of FY2021.

Financials

Below is a summary version of my financial model for LEN.  Please note that the model is largely reflective of the detailed guidance management presented on the 4Q19 earnings call (see pg. 7 of the Bloomberg transcript) for deliveries, avg. selling price, gross margin, tax rate, etc.  Again, I am projecting that LEN directs the excess cash flow it will generate from its “land lighter” strategy to repurchasing stock.

Valuation and Risk/Reward Profile

Based on the projections above, LEN is currently trading at 9.2x 2021 earnings.  With the Company’s pivot to a “land lighter” strategy and associated increase in ROE, it’s reasonable to opine that the valuation multiple placed on LEN should increase.  For reference and before LEN completed the acquisition of CalAtlantic Group in February 2018 (just to use clean numbers), the Company ended FY2016 with a book equity balance of $7.2bn.  Net income in FY2017 was $0.8bn, equating to an ROE of ~11%.  By my projections, LEN will have a book equity balance of ~$16.3bn at the end of FY2021 and will generate $2.2bn in net income in 2022.  This equates to an ROE of ~13.5%, or ~250bps of improvement.  For LEN’s PE valuation multiple to increase to 13.0x is not unreasonable.  Applying this to 2021E EPS of $7.27 equates to a stock price of ~$95/share, or >40% upside from current levels.

During 2013-2015 LEN traded at a 1-year forward PE multiple of ~13.0x and then traded back up to that valuation multiple again in late 2017.  So, there’s sizeable history of the Company trading at that multiple (and even higher), and nothing to indicate it can’t reach that multiple again.

If LEN’s valuation multiple does NOT appreciate but stays at 10.4x 1-Year forward and the Company achieves my 2021E EPS of $7.27, the stock will trade to $76/share, ~15% upside from current levels.  If LEN’s valuation multiple does NOT appreciate AND the Company only generates the consensus 2021E EPS of $6.67, the stock will trade at $69, ~5% up from current levels.  In a downside scenario where the Company only generates $6.00 in EPS in 2021, 10% below the consensus estimate, and trades at a compressed 9.0x 1-year forward multiple, the stock will trade to $54, down ~19%.  Based on the above, the risk/reward profile for LEN appears skewed to the upside.

Catalyst

Continued upward movement in US Housing Starts

Continued low-interest rate environment

Management execution on transitioning to a "land lighter" strategy and deploying excess cash flow toward shareholder-friendly purposes