Description

The shares of the homebuilders seem to be compellingly attractive.  I believe that, a few years from now, most of the homebuilders should be worth roughly twice their current share price.  Of the dozen or so homebuilders that are publicly traded, Lennar is our favorite. Lennar is a strong company with excellent management – and yet its shares are trading at only 4-5 X our projection of the company’s FY 2020 earnings.

We have four key theses: 

1. The sales of new homes will grow at a relatively high rate over the next few years as demand returns to normal, even if house prices and mortgage rates increase materially from present levels.  Importantly, the construction of new homes materially lagged demand during the 2008-2017 period.  As a result, there currently is a shortage of homes in many parts of the country – and the shortage is increasing because current annual production of new homes is materially lagging the 1,500,000 new housing units required to satisfy the growth in population and the number of houses that are torn down (because of age, fires, floods, etc.)   Importantly, people have to live somewhere, even if housing affordability is less attractive than it is now – and there are many advantages to owning a home vs. renting an apartment.  Thus, even if affordability declines due to increasing interest rates, the demand for new homes should be favorable.  We note that, during the 20-year period 1980-1999, 30-year mortgage rates averaged 10.4%. Housing affordability during the period was materially less favorable than it is now, and yet the sales of new homes was 34% higher than in 2017 relative to the population of the United States.  During the 2002-2006 period, rising prices for new homes reduced the affordability of homes.  The National Association of Realtors’ housing affordability index fell from about 128 in 2002 to less than 110 in 2006.  Ironically, the increasing prices incentivized many families to purchase a home quickly before prices increased further.  The result was an abnormally large demand for new homes, which caused a period of boom-bust – and the housing crisis.  We hope that the present prospect of rising interest rates does not result in an abnormally large demand for homes – and another period of boom-bust.
2. The homebuilding industry is undergoing a systemic change for the better.  Until a few years ago, most homebuilders reinvested the bulk of their net earnings in 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 the priority. One builder, NVR, was an exception to the rule.  NVR typically purchases developed lots just before the company starts to build on the lots. Thus, the company’s investment in land is relatively light.  While most other builders historically lacked material free cash flows to return to shareholders, NVR, with its “asset light” strategy, has been able to return a large percentage of its net earnings to shareholders through share repurchases.  It is apparent that NVR’s strategy is superior to the historical strategy of the other homebuilders. And, the superior strategy was recognized by the investment community.  During the four-year period 2013-2017, NVR’s shares sold at an average PE ratio of 17.2 at a time when Horton’s shares sold at an average of 13.3 X earnings and Lennar’s at 13.5 X.  Importantly, most of the larger homebuilders currently are adopting asset lighter strategies that will lead to larger free cash flows, material share repurchases, higher per share earnings, and higher ROE’s. The homebuilders are becoming asset lighter by owning less land.  Lennar has stated that it is heading towards owning only a 2-3 year supply of land – and most of the other public builders also are reducing the amount of land they own.  At the end of 2017, Pulte owned 89,253 lots, down from 95,212 four years earlier.  And, during the same period, D.R. Horton reduced its owned lots to about 125,000 from about 126,000.  I note that these reductions are occurring at a time when the demand for new homes is increasing at about a 10% CAGR. As a result of the reduced expenditures for land, most of the homebuilders are generating sizable amounts of free cash flows.  These cash flows are being used to reduce debt, finance acquisitions, and repurchase shares.  Given the new metrics of the business, the homebuilders deserve to sell at higher PE ratios than previously.  Logically, their PE ratios should come closer to NVR’s.
3. The homebuilding industry is consolidating, partially due to acquisitions and partially due to attrition as smaller, less efficient, and less well capitalized builders shrink or leave the business.  Thus, the larger builders have been growing much faster than their industry.  In 2018, Horton is expected to sell about 51,000 homes vs. 24,155 five years earlier and Lennar is expected to sell about 47,500 vs. 18,290 five years earlier.  Thus, when the growth in the homebuilding industry returns to normal, the largest builders likely still will be able to grow at a reasonable rate.  Furthermore, the large builders enjoy important efficiencies of scale that should increase over time – and that should lead to somewhat improved margins.
4. The homebuilders should enjoy a tight market for new homes for the foreseeable future.  At a time when there is a large demand for new homes, several constraints will dampen supply.  The asset lighter strategy of the homebuilders has the effect of restricting the supply of developed lots.  Increasing difficulties obtaining development and building permits also are restricting supply.  Additionally, there is a general shortage of labor.  Logically, the tight market should lead to increased pricing power and margins.  When projecting earnings for the homebuilders, I build two models.  The first model assumes that the prices of new houses only increase sufficiently to offset cost increases.  The second model assumes that prices increase by 1% more than costs in 2019 and again in 2020.

At the present time, Lennar is our favorite homebuilder.  Lennar was founded in 1956 by Leonard Miller.  The Miller family maintains control of the company through ownership of super voting class B shares – and Leonard’s son Stuart is the company’s Chairman of the Board and guiding executive. Stuart worked part time at Lennar as a teenager and joined the company full time after receiving a BA degree from Harvard and a law degree from the University of Miami (the Miller family is from Miami).  With the caveat that it is very difficult to judge the quality of management, in my opinion, Stuart Miller is one of the best executives I have ever come to know.  He is smart, self-motivated, creative, entrepreneurial, and both aggressive and risk averse – and he appears to have great people skills.

Lennar is the second largest builder in the United States – a close second to Horton – and about twice as large as number three (Pulte).  In addition to building homes, Lennar opportunistically and temporarily entered the businesses of securitizing commercial mortgages (the subsidiary is called Rialto) and of building large rental apartment buildings.  Both of these non-core businesses were successful and will be sold (Rialto this year and the apartment business likely in 2019 or 2020).  Rialto and the apartment buildings are examples of Stuart Miller’s ability to see and seize on unusual real estate related money-making opportunities.  Stuart emphasizes the Lennar normally will be a pure play homebuilder, but from time to time will invest in unusually attractive opportunities in which it has expertise.

In 2017, Lennar acquired WCI and, this past February, acquired CalAtlantic.  Stuart Miller strongly believes that scale is a major advantage in the homebuilding business – and the acquisitions gave Lennar considerable scale.

The success of Lennar as an investment will be a function of the company’s EPS and its PE ratio.  We project Lennar’s 2020 EPS as follows.

• This year (actually, the fiscal year that ends on November 30), Lennar will sell about 45,750 homes.  The 45,750 does not include the homes sold by CalAtlantic between December 1, 2017 and February 12, 2018 (the date CalAtlantic was acquired).  On a pro forma basis, Lennar’s sales in FY 2018 would have been about 49,000.
• We project that Lennar’s unit sales will grow at a 9% CAGR over the next two years, reaching 58,000 in FY 2020.  This growth likely will somewhat lag Horton’s because Lennar is emphasizing profitability and cash flow over growth.
• This year, the average price of a house sold by Lennar will be an estimated $402,500.  We project that prices will increase at a 3% CAGR to $427,000 in 2020.  The 3% CAGR assumes that prices increase sufficiently to offset costs.  Should a tight market permit annual price increases of 4%, then prices in 2020 would average about $435,000.
• Thus Lennar’s 2020 homebuilding revenues are projected at $24,765 million if prices increase at a 3% CAGR and at $25,230 million if prices increase at a 4% CAGR.
• Lennar’s homebuilding margins before the acquisition of CalAtlantic were 12.9% and CalAtlantic’s margins were 9.5%. Lennar sold about twice as many homes as CalAtlantic,  Thus, before synergies, the weighted average pro forma margin of the combined companies was 11.8%.  Lennar seems highly confident of achieving synergistic savings of at least $365 million.  Most of CalAtlantic’s overhead is being eliminated and best practices are being adopted with respect to house designs, building techniques, and the purchase of supplies and labor.  The $365 million of synergies would increase homebuilding margins by about 1.5% to 13.3%.  There are several reasons why Lennar’s margins should be higher than 13.3% by 2020: the company will benefit from leverage over fixed costs, the company is using the internet to sell homes (thus reducing sales commissions paid to outside brokers), and the company is increasingly using dynamic pricing to achieve more optimum pricing and higher margins.  My best guess is that Lennar’s operating margins from the sale of new homes will be 13.5-14.0% if price increases merely offset costs increases – and  15.5-16.0% if price increases exceed cost increases by 1% per year.
• Thus, we project that Lennar’s pre-tax profits from homebuilding in 2020 will be roughly $3,345-3,465 million if prices increase with costs and $3,910-4,035 million if prices increase by 1% more per year than costs.  

We project that Lennar will have the following other pre-tax profits and expenses in 2020:

• $225 million of profits from its financial services subsidiary;
• $50 million of profits from its land joint ventures;
• $410 million of corporate overhead expenses.

• Thus, we project that Lennar’s pre-tax profits in 2020 will be $3,210-3,330 million if price increases just offset costs – and $3,775-3,900 million if price increases exceed cost increases by 1% per year.
• Lennar’s effective tax rate is 25%.
• Lennar’s diluted share count currently is 329 million.  The company expects to have a very large free cash flow this year (roughly $2 billion) that will be used to reduce debt.  Stuart Millar has stated that Lennar, largely because of its asset lighter strategy, will have large free cash flows in 2019 and 2020 – and that some of the free cash flow will be used to repurchase shares.  My best conservative estimate is the Lennar’s diluted share count in 2020 will be 325 million – although this number could prove to be too high.
• Based on our estimates for pre-tax earnings, the effective tax rate, and the diluted share count, we estimate that Lennar will earn $7.30-7.70 per share in 2020 (I will use the single point $7.50) if price increases offset cost increases and will earn $8.70-9.00 per share (I will use $8.75) if prices increase by 1% more per year than costs.

Lennar is an extremely well managed and well positioned company that benefits from efficiencies of scale. While I believe that the company’s shares are worth close to the market multiple of 16 X earnings, I will conservatively value the shares at 14 X earnings. Therefore, I believe that Lennar’s shares will be worth $105 if the fundamentals of the homebuilding do not lead to increased pricing power – and will be worth roughly $125 if the adoption of asset lighter strategies leads to increased pricing disciplines and to price increases that exceed cost increase by 1% per year.  I note that the above earnings estimates assume that the housing market is at normal levels in 2020 – as opposed to above normal levels.

Catalyst

Continuing improvement in housing market and move to asset lighter strategy