Lennar: Will it Profit from a Secular Tailwind?

An explosion of home building occurred in the 1970s as the Baby Boomers began buying their own accommodations. The Boomers were far more numerous than the preceding generation, and thus existing housing stocks were inadequate. As a result, home builders were kept busy for years.

Could we be on the cusp of another such boom? One respected voice suggests we might. Bill Smead of Smead Capital Management recently argued that history is about to repeat itself. In his recent GuruFocus article, “Net Present Value Bargains,” he wrote:

“The myopic media has preached that home buying will be determined by interest rates and affordability going forward. We believe it will be driven by a massive shortage created by horrifically low home building in the 2009 to 2019 period and an explosion of interest in the 90 million-person millennial age group, which will dominate the 30 to 45-year-old contingent over the next 10 years.”

The company

One of the companies that could profit nicely from another housing boom would be Lennar Corporation (NYSE:LEN)(NYSE:LEN.B). After merging with CalAtlantic Group, Inc. in 2018, it began calling itself America’s largest homebuilder based on consolidated revenues ($22.3 billion in 2019).

In addition to home building, it also generates revenue from residential and commercial mortgage loans, title insurance and closing services and as a developer of multifamily rental properties. Still, home building is by far the biggest contributor to revenue, with $20.8 billion of 2019’s total revenue of $22.3 billion.

Because of the CalAtlantic acquisition, Lennar’s revenues have grown quickly at an average of 14.5% per year over the past three years. Almost all of that increase dropped to the bottom line, with earnings per share (EPS) without non-recurring items (NRI) averaging 14.1% per year over the same period. Ebitda also grew at a slower rate of 10.7% per year on average.

With a dividend payout ratio of just 8% and a negative share buyback ratio over the past three years, it has plenty of free cash flow available for growth initiatives. For fiscal 2020, free cash flow totaled $3.8 billion.

Margins are also a factor; the operating margin is at a 10-year high of 13.88%. That’s significantly above the Homebuilding & Construction industry’s 10-year median of 7.27%. Similarly, its net margin of 10.96% is more than double its own 10-year median of 4.59%.

Behind the margins and other metrics is a management team with an eye on costs. For example, in its 10-K for 2019, Lennar reported:

“We are continuing our pivot to a land light operating model by controlling the timing of land purchases, reducing our years owned supply of homesites and increasing the percentage of land controlled through options or agreements versus owned land. We are focused on increasing the efficiencies in our building process and reducing selling, general and administrative expenses by using technology and innovative strategies to reduce customer acquisition costs.”

In its fourth-quarter and full-year 2020 results (its fiscal year ended on Nov. 30), the company noted it had reduced its supply of homesites from 4.1 years to 3.5 years. The company also reduced its debt by $2.1 billion, consequently reducing its interest expenses.

In commenting on the 2020 results, Lennar’s Co-CEO and Co-President Rick Beckwitt reflected:

“The confluence of Millennials starting families and creating households of their own, along with the pro-housing effects of the COVID-19 pandemic, has materially strengthened demand. This surge in demand for housing, combined with the market’s inability to produce sufficient homes to meet this demand, has exacerbated the already well-documented undersupply of new and existing homes for sale. Lennar is well positioned with its production-oriented, Everything’s Included® business model and strong land position to capitalize on this industry supply shortage.”

“Everything’s Included®” refers to one of its newer marketing tactics and branding strategies, which relies on using its purchasing power to allow it to include luxury features as standard items (it also simplifies homebuilding operations, according to the company).

Lennar gets a moderate GuruFocus rating for financial strength at 5 out of 10, presumably based on its debt position. However, we should note that companies in this industry must pay upfront for much of their land, development costs and homes under construction. So, it is no surprise that Lennar’s cash-to-debt ratio is in the same ballpark as its peers and competitors at 0.45.

Lennar’s competitors include D.R. Horton Inc (NYSE:DHI), NVR Inc (NYSE:NVR), PulteGroup Inc (NYSE:PHM) and Toll Brothers Inc (NYSE:TOL), among others. In terms of market capitalization, Lennar is roughly $2 billion larger than D.R. Horton ($22.5 billion versus $20.3 billion) and more than double the size of the other three listed above. Of course, these companies compete not only for homebuyers but also for land to develop.

Lennar believes it has several advantages in attracting home buyers, starting with its Everything Included program and innovative home designs, as well as the inclusion of Wi-Fi, solar power systems and advanced technology in many of its homes.

However, from an investor’s perspective, it offers few immediate rewards. It has a dividend yield of just 0.79% based on the current price and a three-year dividend growth rate of just 0.7%, and it has been issuing more shares than it has been buying back over the past three years.

Valuation

We have several intrinsic valuation metrics to choose from with regards to Lennar. The GuruFocus Value chart considers Lennar’s stock to be modestly overvalued, while the valuation rating is 8 out of 10, suggesting it is a good buy.

It has a price-earnings ratio of 10.11, which is below the industry’s 10-year median of 11.41 and below its own 10-year median of 14.81. More importantly, some would argue, is the PEG ratio, which is 0.97. The PEG’s importance comes from the context it provides to the price-earnings ratio, as it is calculated by dividing the price-earnings ratio by the five-year Ebitda growth rate. A ratio of 0.97 is just below the fair-value standard of 1.00.

As this 10-year chart shows, Lennar’s share price has recently pulled back from its all-time high:

Gurus

The gurus were enthusiastic about Lennar in the first and second calendar quarters of 2020, but have since been selling more shares than they have been buying:

Thirteen of the gurus followed by GuruFocus have positions in the company. The three largest, at the end of the third calendar quarter, were:

• Barrow, Hanley, Mewhinney & Strauss with 6,099,386 shares, good for a 1.95% stake in Lennar and 1.92% of its own assets under management after it reduced its holding by 4.44%
• Ken Fisher (Trades, Portfolio) of Fisher Asset Management with 1,052,553 shares after a reduction of 18.06% during the quarter
• Bill Smead of the Smead Value Fund (Trades, Portfolio), who added 1.79% to his position to finish the quarter with 914,210 shares

Conclusion

Could Lennar profit from a secular tailwind? The answer appears to be yes, in my view, as millennials are starting to buy their own homes in an already constrained market, driving up demand for new home construction.

Lennar is well-positioned to profit from that tailwind. As the largest company in the industry, it is using its economies of scale and its purchasing power to give itself a moat. In addition, it is paring down its costs and using new strategies and technologies to distinguish itself. Its financial strength and profitability are reasonably strong, and it has free cash flow to fund new growth.

I would argue it is fairly valued, based on its PEG ratio, which puts the price-earnings ratio into context with Ebitda growth. It has a modest following of gurus as well.

Value investors will find little of interest at current prices because there is no margin of safety. Growth investors may consider the tailwind and take an interest, while income investors will look elsewhere for dividends and other shareholder returns.

Disclosure: I do not own shares in any of the companies named in this article and do expect to buy any in the next 72 hours.

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