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The bear market of 2022 has been quite merciless, dragging down most sectors materially, as pessimistic projections outweigh strong financial performance. The dichotomy between current results and an uncertain future is most clearly seen in cyclical stocks such as commodities and homebuilders. I believe Mr. Market has overreacted with the selloff that we’ve seen in the common stock of Lennar (NYSE:LEN), creating an attractive entry-point for long-term investors to buy this top-tier homebuilder at a bargain price. Certainly, there are headwinds, such as inflation, higher interest rates, and a potential recession, but I believe those fears are more than priced into the current valuation.
Q2 Results
On June 21st, Lennar reported another very strong quarter on high demand and limited supply, posting non-GAAP EPS of $4.69, on revenue of $8.36B. Net earnings were up 59% to $1.3B. Deliveries increased 14% to 16,549 homes, while the backlog increased 16% to 28,624 homes. Homebuilding operating earnings increased to $1.9B from $1.1B a year ago. Financial services operating income of $104MM was slightly above the high end of guidance despite mortgage operating earnings being $74MM, down from $92MM a year ago. Title operating earnings were $30MM, up from $24MM, as a result of higher premiums driven by an increase in the average sales price per transaction. Lennar’s Other segment produced an operating loss of $108MM, primarily resulting from non-cash mark to market losses on public company technology investments, which totaled $78MM. The remainder of the loss was related to other strategic investments.
Margins
Gross and net margin were 29.5% and 23.4%, respectively. SG&A of 6.1% was a 150-basis point improvement over last year, and Lennar generated a return on equity of 21.4%, which was a 260-basis improvement YoY. New orders were up 4% YoY, although the company reported signs of weakening in the overall market. The sales pace per community increased from 4.8 to 5 sales per month, as the company is continuing its practice of selling homes later in the construction cycle to maximize prices, while offsetting potential cost increases. Sales increased YoY each month of the quarter, despite sales incentives on new orders being down 10 basis points YoY. The cancellation rate totaled 11.8%, which was up sequentially, but far below the long-term average.
Strong Demand vs Rapidly Rising Rates
The housing market is weakening because of the Fed’s aggressive rate hiking in a belated attempt to slow inflation. The 30-year mortgage rate has basically doubled, combined with the stunning home price appreciation over the last two years, making for major affordability issues for many families. Household formation continues to rise, driving demand, and while home prices are up, so are rents, which many would-be homebuyers are seeking to avoid paying by buying a house. The major difference between the current environment and 2007-2008 is that there has simply been way too little supply being built in the years following the Financial Crisis, compared to the oversupply that existed prior. Lennar points to the production of dwellings over the last decade lagging household formation by as many as 5 million homes. Despite solid underlying demand, higher rates and negative headlines are starting to show up in worsening sales conditions, and these trends are unlikely to improve much in the short-term.
Management Commentary
Management said that 19 markets continue to perform well including the six Florida markets, New Jersey, Maryland, Charlotte, Indianapolis, Chicago, Dallas, Houston, San Antonio, Phoenix, San Diego, Orange County, and the Inland Empire. Commonalities between these markets are low inventory and strong local economies. 10 markets are modestly softening including Atlanta, Colorado, Charleston, Middle Beach, Nashville, Philadelphia, Virginia, the Bay Area, Reno, and Salt Lake City. These markets have seen slowing traffic and increased cancellations. Despite limited inventory, Lennar is having to offer more aggressive financing programs and targeted price reductions. More significant weakening is occurring in 7 markets, including Raleigh, Minnesota, Austin, Los Angeles, the Central Valley, Sacramento, and Seattle. These markets are going to face more pricing pressure and aggressive mortgage buydown programs. Sticker shock is a real thing and paying 6% for a mortgage when 6 months ago, you’d have paid 3% is a nasty deterrent, but one still needs to find housing one way or the other. Direct construction costs were up 1.6% sequentially in Q2, and 20% YoY. Most of the recent increase was related to labor, but lumber and other costs are also still up from pre-pandemic pricing as well. Fortunately, the company has been able to pass on these cost increases to customers, so it will be interesting to track margins in this lower demand environment.
Balance Sheet
Lennar’s balance sheet is a major source of confidence with $1.3 billion of cash, nothing drawn on its revolver, and a 17.7% debt-to-total capitalization rate ratio, down from 23.1% last year. The company is planning to pay down another $575MM of debt later this year, as it comes due, which will further strengthen this position. A strong balance sheet is imperative for a homebuilder, particularly when the economy slows down in this cyclical industry. Attractive land deals or acquisitions might come around in a recession, and historically Lennar has been a savvy investor. Expect the company to really focus on driving cash flow and prudently allocating capital, via stock and debt repurchases at attractive prices. In the 2nd quarter, LEN repurchased another 4.1MM shares of stock for approximately $320MM, while paying dividends of $111MM. There are no debt maturities in fiscal 2023 and book value per share increased to $72.12.
Lennar has pursued a land-light strategy, increasing its controlled homesite percentage to 62% from 50% at the same time last year. This is an area that caused major problems during the Great Recession as the company was burdened with owning too much land, as opposed to having flexibility with options. The years of supply of owned homesites is down to 3.1 years from 3.3 years at the same time last year. Lennar has used its soon-to-be spun-out asset management company to cycle through $10 billion of land and land development from owned to controlled. Less outright land purchases save the company a tremendous amount of money and keeps the balance sheet nimble. The company owns 193,000 homesites and controls 319,000 for a total of 512,000. By year-end the company plans to reach its goal of 2.75 years of supply and 65% home sites controlled.
Asset Management Spinoff
Lennar is planning to spin-off its asset management company into the public markets by year-end, along with billions of dollars of assets under management that has previously been held on Lennar’s books. The company will be called Quarterra and trade under the stock symbol Q. This spinoff will reduce Lennar’s asset base by an estimated $2.5B, which should improve the ROA and ROE, without materially reducing the bottom line or earnings per share.
Q3 Guidance
Lennar’s management is being very cautious with guidance for Q3 acknowledging the rapidly changing environment. New orders are expected to be between 16,000 to 18,000 homes, while deliveries should be between 17,000 and 18,500. The average sales price should be slightly higher than the Q2 average of $483,000. Gross margins should be between 28.5% to 29.5%, while SG&A should be between 6-6.5%. Guidance should produce an EPS range between $4.55 to $5.45 per share in Q3. The bear case likely believes 2008 will repeat itself and Lennar and other builders might be exposed to land impairment risk. When asked about this, here was Stuart Miller’s response: “I think it’s important to recognize, we have virtually no land impairment risk in our backlog. Our margins remain healthy. We remain focused on recognizing that prices are going to move around a little bit, and we’ll continue to build efficiencies in the way that we create value for our customers. But our land acquisition model has been rock solid and I think the market is going to have to fall an awful lot for us to start talking about impairments once again.” Part of this confidence is likely due to the different land strategy and the fact that due to low inventory, there are buyers to replace those looking to cancel their orders.
Valuation
At a recent price of $65.65, LEN trades at just 91% of book value. The forward P/E is a paltry 3.7x, for an earnings yield in the high 20% range. I fully understand that earnings are susceptible to a downturn if the economy goes into a major recession, and/or if interest rates keep rising. With that said, Lennar is positioned to keep reporting strong profits, and grow its book value per share via retained earnings and accretive stock buybacks. The balance sheet, strong management team, and underlying supply/demand economics of the industry should provide enough of a tailwind for shareholders to do quite well at current prices. The reality is that there is still unmet demand for homes and Lennar is poised to meet it. If margins contract a bit, that is unfortunate, but it is more than priced in based on current prices, as the stock trades at the lowest valuations in the last decade on just about every metric. Just a 5x earnings multiple on $16 of EPS gets you to a $90 share price, which doesn’t seem like too heroic of an assumption. Even if earnings were to go down by 50%, which I don’t expect to happen, you’d have a stock trading at right around 11x trough earnings, with a stellar balance sheet. Investing is about probabilities, and I believe that the odds are stacked in your favor at the current share price.
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