2023-07-20 11:43:11 ET
Summary
- I maintain a hold rating for LEN due to a potential weak FY23 and FY24 and an unattractive upside based on my DCF model.
- Despite stronger than expected 2Q23 results, I believe high interest rates will continue to affect consumer demand for housing.
- I think that LEN's strategy of maintaining a supply-demand gap and a land-light business model could improve FCF conversion.
Summary
This article is following my coverage of Lennar Corporation ( LEN ), where I recommended a hold rating in the near term due to my expectation that margins and ROE will decline in FY23 . This is an update on my thoughts on the business and stock. I reiterate my hold rating for LEN as I continue to see FY23 and FY24 as difficult years. Based on my DCF model, the potential upside is not attractive either.
Investment thesis
LEN's 2Q23 results were stronger than expected. Both total revenues ($8 billion) and homebuilding revenues ($7.6 billion) fell by 4% year over year. Although LEN's total number of closed homes increased by 3% year over year, the company's average sale price fell by 7% to $449,000. Positives include a $9.5bn backlog at the end of the quarter for 20,214 homes, an increase of 1% year over year, and an increase in net new orders of 1% to 17,885 (above management's guidance of 16,000 to 17,000). Home sales gross margin was around 22%, which is also above management's target range of 21% to 21.5%. Moving down the P&L statement, SG&A expenses as a percentage of revenue were also better than expected at 6.7%, rising only 60bps vs last year. Finally, LEN's balance sheet is also in much better shape now than it was at the beginning of the quarter, where net debt is lower now vs 1Q23.
Management now anticipates closings in the 68-70K range, up from the previous 62-66K. In particular, management anticipates 17,750-18,250 closings for the 3Q23, with ASPs anticipated to be roughly flat sequentially. Management also anticipates orders between 18K and 19K, an increase of 25 to 32%. However, gross margins are predicted to range from 23.5 to 24%, down 520 to 570bps year over year but up 100 to 150bps sequentially.
As demand appears to be holding ahead of seasonal norms, I think there is a chance that LEN will continue performing strongly like 1Q23. As customers adjust to higher interest rates and available stock drops to record lows, management has seen an uptick in quarterly orders. Early in the month of June, sales and cancellation rates mirrored those of 2Q23, setting the stage for a stronger than expected 3Q23.
Consequently, 14 markets, including significant parts of Florida, the Northeast, the Carolinas, Dallas, Houston, and Phoenix, are performing favorably due to balanced incentives in response to demand. On the other hand, 26 markets, like Austin, Colorado, and Northern California, continue to need higher-than-average adjustments to encourage activity. Despite the uncertain future of interest rates, I anticipate that these remaining 26 markets will eventually catch up, leading to increased growth in orders.
In sum, I believe that LEN is carrying out its cash and returns focused strategy, utilizing a constant starts and sales pace to drive greater operational and financial efficiencies (such as inventory turns) while maintaining a supply-demand gap. In my opinion, this will make it easier to see progress and maintain quality, as well as to more efficiently recruit from a small pool of construction workers. I believe this will help them remain cost-effective despite the rise in interest rates, giving LEN the ability to keep prices stable to gain share in the current macro climate. Together, I think these initiatives and a land-light business model can help the company become more nimble and support shareholder returns by increasing the percentage of net income that is converted into free cash flow.
Valuation
I believe the fair value for LEN based on my DCF model is $142. My model assumptions are that LEN will see a weak FY23 given the high interest rate, which hurts consumer demand for housing as mortgages are hard to service. Staying in the conservative camp, I would assume FY24 will remain a flat year as consumers remain wary about the economy. Post FY24, I expect LEN to grow at the same rate in the mid-single digits, mirroring the GDP growth rate with a slight premium as it catches up on growth. In the terminal years, I expect growth to slowly normalize to 2% (inflation levels). I note that this growth is lower than global real estate growth , which is fair as the US is much more developed.
Author’s DCF model
LEN trades at 10x forward PE today, which is in line with other homebuilding businesses in North America. For instance, LGI Homes ( LGIH ), NVR ( NVR ), Dream Finders Homes ( DFH ), M.D.C. Holdings ( MDC ), etc. I believe the entire sector is going through the same pain and expected growth, as such, LEN should also follow how the industry trades.
Bloomberg
Risk
In my opinion, the key short-term risk is higher interest rates, which will hinder affordability for customers. Other risk also includes a mis-execution in LEN current strategy to lean, which might impact its ability to capture a recovery in demand as it lacks manpower.
Conclusion
I maintain a neutral stance on LEN stock due to the unattractive valuation and the potential challenges in the near term. While the 2Q23 results showed some positives, such as increased closed homes and net new orders, higher interest rates pose a risk to customer affordability. However, a strong performance in 3Q23, fueled by ongoing demand and a favorable market outlook in certain regions, could turn near-term sentiment positive for the stock.
For further details see:
Lennar Corporation: Remain Neutral On The Stock As Valuation Is Not Attractive