Lennar and The Housing Market - A Closer Look (NYSE:LEN) | Seeking Alpha

2022-06-25 00:30:23 By : Ms. Sally Feng

Joe Raedle/Getty Images News

Joe Raedle/Getty Images News

A lot has happened in the second quarter. Interest rates have continued to fly as the Federal Reserve is aggressively hiking rates to combat inflation - even if economic growth is weakening. On top of that, various industries like homebuilding continue to struggle with supply chain issues, making it hard to turn backlog into deliveries. Moreover, because of challenging market conditions, homebuilding sentiment is weakening. So far, this has led to zero building permit growth, and falling housing starts.

Lennar Corporation (NYSE:LEN ), one of America's largest homebuilders, just reported its earnings. The company confirmed the macro case as it struggles with demand for the first time since the pandemic started. However, the company still performed well despite challenges, making it an interesting buy on weakness.

With that said, let us look at the details.

One of the most important graphs can be seen below. The 30-year fixed-rate mortgage rate average in the United States has worked its way up to the high 5% range - coming dangerously close to 6% in a move that exceeds prior peaks by a relatively wide margin.

According to the Wall Street Journal:

Recent data suggest the U.S. economy is starting to slow under the combined weight of soaring inflation and climbing interest rates - including the highest mortgage rates since 2008.

Economists have slashed their projections for second-quarter output growth in recent days. One closely watched model - the Federal Reserve Bank of Atlanta's GDPNow tracker - estimates that gross domestic product is on track to remain unchanged at an annual rate over the three months through June 30. Output fell at a 1.5% annual rate in the first quarter.

As a result, building permits were just 0.2% higher compared to prior-year levels. Housing starts contracted.

According to the National Association of Home Builders ("NAHB"):

Overall housing starts fell 14.4% to a seasonally adjusted annual rate of 1.55 million units in May from an upwardly revised reading the previous month, according to a report from the U.S. Department of Housing and Urban Development and the U.S. Census Bureau.

With regard to these numbers, demand is just one driver. The other driver is supply chain constraints. According to the same NAHB report:

"Single-family home building is slowing as the impacts of higher interest rates reduce housing affordability," said Jerry Konter, chairman of the National Association of Home Builders (NAHB) and a home builder and developer from Savannah, Ga. "Moreover, construction costs continue to rise, with residential construction materials up 19% from a year ago. As the market weakens due to cyclical factors, the long-term housing deficit will persist and continue to frustrate prospective renters and home buyers."

On June 15, more than 600 NAHB members urged Congress to implement measures to ease the housing affordability crisis.

Issues include volatile building materials prices, supply chain disruptions, diminishing housing affordability, burdensome federal, state, and local building regulations, high inflation, interest rates, and chronic construction labor shortages.

That's quite a list and the reason why the NAHB Housing Market Index fell to a new 52-week low in May. The index has now erased the entire "post-pandemic" rally that was fueled by panic real estate buying and affordable rates.

Now, we're at a point where home prices remain despite a surge in rates, making it even harder for people to afford homes.

The average monthly mortgage payment based on median existing home prices is now at more than $1,800. That's up from roughly $1,000 prior to the pandemic. Needless to say, that's a huge deal for almost every single potential homebuyer/homeowner.

With that being said, Lennar just reported its 2Q22 earnings, which included a load of useful data and comments.

Lennar finally caught a break after reporting earnings on June 21. The company's stock rose by 1.6%. That's good news, as it breaks a steep downtrend. The bad news is that the S&P 500 rose almost 3% on that day and that Lennar closed well below its highs.

Let's look at some numbers.

In the quarter, the company delivered 16,549 homes. That's an increase of 14%. Total new orders were somewhat slow at 17,992 homes. That's an increase of 4%. The dollar value of these orders rose by 20% to $9.1 billion thanks to strong pricing.

As a result, the backlog increased by 16% to 28,624 homes. A dollar increase of 33% to $14.7 billion.

One of the company's comments hit the nail on the head, as it addressed the Fed's actions and the implications this has for homebuilders (emphasis added):

"The Fed's stated determination to curtail inflation through interest rate increases and quantitative tightening have begun to have the desired effect of slowing sales in some markets and stalling price increases across the country. While we believe that there remains a significant shortage of dwellings, and especially workforce housing, in the United States, the relationship between price and interest rates is going through a rebalance."

So, what does this mean for the company? It means that affordability and making as much money on existing backlog are more important than "ever."

"[...] we are laser focused on traffic, affordability, the quality of our backlog, along with cancellation rates and completed, unsold inventory levels which, to date, are both at low levels. Additionally, we are focused on balance sheet strength as we ended the quarter with $1.3 billion in cash, no borrowings on our $2.6 billion revolver and homebuilding debt to capital of 17.7%. Our balance sheet has never been in a stronger position than it is today."

These comments - so far - are backed by results as the company expects 3Q22 gross margins on home sales to be between 28.5% and 29.5%. The consensus was 27.8%. Given inflationary headwinds, that's a big deal - even if it's just an estimate for now. Moreover, Lennar expects between 16 to 18 thousand new orders. The consensus was 16.2 thousand. Expected deliveries are 17 to 18.5K, which is below the 18.6K consensus. However, this shows how strong the company's ability to maintain healthy margins is.

One of the reasons for better margins is the expectation that the drop in lumber prices will ease pricing pressure on deliveries in the second half of this year and new construction in early 2023.

With that said, challenges are mounting as the company mentioned one of its strongest markets: Seattle. This market has grown by 20% per year since 2020. Now things are changing (emphasis added):

The higher priced and highly sought after locations around Seattle has seen a significant pullback in sales in May and early June. This pullback is a result of both continued price appreciation in the first quarter, causing concern over home values being overpriced and stock market corrections, which have had a direct impact on employee stock compensation plans.

Looking at the bigger picture, the company is indeed excelling at growing EBITDA and improving balance sheet health. At the end of this fiscal year, the company could look at $4.4 billion in net debt, barely 0.6x EBITDA. Since 2019, the company is not expected to have a net debt ratio of more than 1.0x. If all goes right, the company could be looking at a long-term net leverage ratio of less than 0.50x.

Additionally, analysts expect that the company's ability to generate high EBITDA (and related financial indicators) will remain strong in the years ahead as demand remains strong.

Management is also bullish on its own stock as it repurchased 4.1 million of its own shares in the second quarter for roughly $320 million. That's 1.7% of its total market cap in a single quarter.

From a valuation point of view, we're dealing with a $19.0 billion market cap, $190 million in minority interest, and $1.5 billion in expected 2023 net debt. This gives the company an enterprise value of $20.7 billion, barely 3.3x next year's expected EBITDA.

Prior to the pandemic, LEN used to trade close to 10x LTM EBITDA. After the pandemic, the company was trading close to 6x NTM EBITDA. Right now, that would imply a lot of stock price upside.

Unfortunately, the market is saying "no way LEN achieves its expected results" - or something like that.

The stock is now down 43% year to date in one of the worst sell-offs in recent history.

Unless this becomes a second housing crisis, I think we've entered buying territory.

However, I do not suggest buying a big position. First of all, homebuilders are volatile in general. I would always keep homebuilding positions small. Also, it's hard to say how much more downside the stock may have.

Hence, start buying extremely small. Then, add over time. If the stock continues to decline, investors can average down. If the stock rebounds, investors have a foot in the door.

On a side note, in the months ahead, we will get more details of the company's spin-off called Quarterra.

Finally, we will conclude our long planned spin-off by year-end. As we have continued to refine the three verticals of our spin company, we will spin a mature asset management company into the public markets along with billions of dollars of assets under management that we previously held on Lennar's books. The final spin of our new company, which we will call Quarterra (PH) will trade under the stock symbol Q, and as we have noted before, will be an asset light asset management business that will have a limited balance sheet.

Although the company is reluctant to reveal a lot of details, it aims to reduce Lennar's asset base by another $2.5 billion, making Lennar a homebuilding-focused company with more efficient assets.

Homebuilders are in a tricky spot. Purely based on their expected financial results, they are huge buys. Lennar is expected to maintain high EBITDA and rapidly falling net debt. Hence, the company is trading at less than 4x FY2023 EBITDA. This would suggest at least 50-60% upside without getting anywhere to overvalued levels.

The problem is that homebuilders face headwinds. The Federal Reserve's aggressive hikes and high inflation are hurting demand and pricing. It is resulting in flat building permit growth, negative housing starts (also caused by supply chain problems), and falling homebuilding sentiment.

The Fed is clearly starting to succeed when it comes to fighting inflation by slowly damaging demand. The problem is that investors don't trust the homebuilding outlook anymore - hence Lennar is very cheap despite strong margins and quite impressive operating results.

"Luckily," the stock is in one of the worst drawdowns in recent history, suggesting that a lot has been priced in.

This market is now providing opportunities for contrarian investors as long as positions are kept very small to incorporate high market uncertainties.

(Dis)agree? Let me know in the comments!

This article was written by

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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