Description

It is exciting when an investor sees a positive change in a company or industry that can drive the price of a company’s shares. In the case of homebuilder Lennar, we see five positive changes.

Lennar is the second largest homebuilder in terms of units and the largest in terms of revenue.  The company was founded in 1956 by Leonard Miller and currently is run by his son Stuart.  Of importance, we are extremely impressed by Stuart Miller and his team.  In our opinion, Stuart is smart, motivated, experienced, and a leader.  We rate him among the best executives we have come across.

Here are the positive changes that we believe will drive Lennar’s stock:

- The homebuilding industry is transitioning from an asset heavy (land heavy) business model to an asset light (land light) model.    Until recently, most homebuilders reinvested most of their cash flows into land and land development because they desired to own increasing amounts of developed land so that they could grow rapidly and increase their market shares.  Rapid growth was a strategic priority.  Importantly, one builder, NVR, adopted a different strategy.  NVR typically purchases developed land just before the company starts to build on the land. Thus, the company’s investment in land is relatively small.  While most other builders historically lacked material free cash flows to return to shareholders, NVR, with its “asset light” strategy, has been returning a large percentage of its net earnings to shareholders through share repurchases.  In recent years, it became clear to Lennar and most other larger builders that NVR’s strategy is superior to their asset heavy strategies.  And, the superiority was reflected in the relative prices of the shares.  During the fiver-year period 2015-2019, NVR’s shares sold at an average PE ratio of 16.3x at a time Lennar’s A shares sold at an average of 11.5x.  Now, Lennar and  most of the larger homebuilders are rapidly adopting asset light strategies that are leading to higher free cash flows, higher ROEs, stronger balance sheets, reduced risks (of land impairments during periods of weakness), and large share repurchases.   Lennar’s goal for the end of its FY 2021 is to own outright only a three-year supply of land – and to control another three-year supply under options.  Currently, Lennar is already generating large amounts of free cash flow.  Twenty years ago, Lennar was a strong company in a fair to middling industry.  Now it is a strong company in a very good industry.

- Lennar and DR Horton (the largest builder by units) have gained substantial efficiencies of scale that will permit them to gain market share at the expense of smaller, higher cost builders.  Lennar and Horton have purchasing power when buying materials (lumber, wallboard, cement, appliances, etc.), often can negotiate lower labor costs because they can offer labor steadier work (because they build more houses in an area), and have lower architecture, advertising, and corporate costs per house sold.  Many smaller builders do not have the cost structure to compete in the long-run with Lennar and Horton and are either going out of business or are selling to the larger builders.  As a result, the homebuilding industry is in a continuing gradual roll up which permits Lennar and Horton to gain market share organically or through favorably priced acquisitions.

- As many others have written, over the past decade the housing industry has underbuilt relative to underlying demand (which is a function of population growth and, to a lesser extent, the number of aged homes that are torn down).  The sales of new housing units can vary from year to year, but over the longer-term, every family needs a place to live – and thus the longer-term demand for housing units (multi-family apartments plus single-family homes) is relatively predictable at about 1.5 million units.  Of interest, as a result of COVID, there appears to be a mix shift away from urban apartments and towards single-family homes in suburbs.  There are two factors at work.  Some who will be working more at home desire a den or other separate room in a single-family house that can be their office (single family houses tend to have more rooms than apartments).  Also, some found that their apartments are confining during sheltering in place and now are seeking a larger living space with a private yard located in a less crowded neighborhood.  As a result of these trends (and of low mortgage rates), the demand for new single-family houses has turned surprisingly strong in recent weeks.

- Lennar has been designing software that will lead to increased profits (and competitive advantages over its competitors).  For example, “dynamic pricing” software permits the company to continually adjust prices on its houses based on comparable sales in comparable communities.  Also, software that permits prospective buyers to “see” a house virtually over the internet permits Lennar to sell more houses directly without paying commissions to real estate brokers.

- In addition to building single-family houses, Lennar has a smaller business of building and renting out multi-family apartments.  This multi-family business (heavily done with third party equity) is highly successful (Lennar seems to be successful in just about everything it does).  Stuart Miller has publicly stated that Lennar will sell its multi-family business over the next few years and become a pure builder of houses.  The sale of multi-family should generate a sizable profit and will simplify the analysis of the company.

We believe that the housing industry will reach a normal level of demand and sales within a few years.  At a normal level, we project that Lennar will sell about 64,000 homes a year at an average sales price of about $400,000.  In FY 2019, Lennar’s profit margins from building homes was 12.2%.  We project that normal margins in FY 2022 will be about 13.5%.  The increase in margins will be due to: positive leverage over fixed costs, a greater percentage of houses sold without commissions paid to brokers, lower debt and therefore lower capitalized interest expense (which is expensed through cost of goods sold),  purchasing power, and dynamic pricing.  We also estimate that Lennar’s financial service subsidiary will earn about $270 million in FY 2022 (it provides mortgages to purchasers of new homes and then packages and sells the mortgages to third parties without material recourse).  The company also earns about $50 million per year from selling land, etc.  Based on these estimates, a 25.5% effective tax rate, and a 300 million diluted share count, Lennar would earn about $8.00 per share.  We have been conservatively valuing Lennar at 14 X earnings, but secretly believe there is no reason the shares should not sell at NVR’s historical PE ratio of 16 plus X.

Lennar has two classes of shares: “A” shares and “B” shares.  The “B” shares have super-majority voting powers and are 57.8% owned by Stuart Miller.  Both classes have an equal economic interest in the company and its dividends.  Logically, the “B” shares should sell at a premium to the “A” shares because of their voting power.  However, likely because of marketability, the “B”  shares currently are selling at a 25% discount to the “A” shares.  We believe that the “A” shares are compellingly attractive and that the “B” shares are even more compellingly attractive.

DISCLAIMER: This is intended for information purposes only (not investment advice) and should not be relied upon solely as a basis for investment. The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Catalyst

Transition to asset/land light model, market share gains, increased use of technology, and recovery of single-family housing market.