2023-07-19 07:06:53 ET
Summary
- The economic environment in the home building industry has stabilized, with customers adjusting to higher interest rates and supply chain disruptions normalizing.
- The U.S. housing market has witnessed a remarkable surge in new home sales, reaching a 13-month high in April.
- Amid the return of strong demand for housing, adjusted prices and incentives have made housing more affordable for customers who were previously deterred by high prices.
- Lennar stock seems cheaply valued at a forward P/E of 10, but there is more than what meets the eye.
Lennar Corporation ( LEN ) is one of the leading home construction companies in the United States, founded in 1954. The company operates in 21 states and offers affordable, move-up, and active adult homes for various lifestyles. The company also has investments in multifamily and single-family residential rental properties and property technology companies. Lennar is known for its Everything's Included® program, which provides features and upgrades at no additional cost to the buyer. The company has also partnered with Opendoor Labs to make it easier for customers to sell their current homes and buy new ones. As customers adjust to higher interest rates and supply chain disruptions begin to normalize, housing market trends are beginning to normalize, paving the way for Lennar to thrive. Investors, however, will have to keep a close eye on Lennar's market valuation although the company seems cheaply valued.
Housing Market Prospects In The Current Economic Environment
The economic environment in the home building industry has stabilized, with customers adjusting to higher interest rates and supply chain disruptions normalizing. Limited housing supply across the country has resulted in a new normal in the market. The U.S. housing market has witnessed a remarkable surge in new home sales, reaching a 13-month high in April. A Commerce Department report revealed that new home sales increased by 4.1% to a seasonally adjusted annual rate of 683,000 units, marking the highest level since March 2022. Sales of new single?family houses in May were at a seasonally adjusted annual rate of 763,000 units.
Exhibit 1: Seasonally adjusted new residential sales
U.S. Census Bureau
Amid the return of strong demand for housing adjusted prices and incentives have made housing more affordable for customers who were previously deterred by high prices. While interest rates and affordability were initial challenges, the chronic housing supply shortage has played a significant role in keeping inventory levels low. This has led customers to stretch their finances to secure housing, encouraged by price reductions, interest rate buy-downs, and other incentives. The report showed an 11.8% year-over-year rebound in new home sales, accompanied by an 8.2% drop in the median new house price compared to the previous year. Sales in April were concentrated in the price range of $300,000 to $499,000. In May, the median sales price of new houses was $416,300 while the average was $487,300.
Lennar's focus on pricing to market and meeting demand with affordable pricing and incentives resulted in a positive performance in the second quarter of Fiscal 2023 , leading to total revenue for the quarter amounting to $8 billion. Lennar delivered 17,074 homes during the quarter, representing a 3% increase compared to the previous year. Additionally, the company received new orders for 17,885 homes, valued at $8.2 billion. The backlog of homes reached 20,214, with a dollar value of $9.5 billion. Although the average sales price per home delivered in the second quarter decreased to $449,000 from the peak of nearly $500,000 the previous year, the company recorded positive growth in home deliveries.
During the second quarter, Lennar Corporation utilized its digital marketing platform and dynamic pricing model, known as the Lennar Machine, to drive sales volume at market pricing. This approach aimed to maintain consistent production levels and improve inventory turnover. The company achieved a 1% increase in new order volume, exceeding the previous year's results. Cancellations normalized to approximately 13.5%, allowing for higher deliveries, which increased by 3% compared to the previous year. Looking ahead, Lennar anticipates delivering between 17,750 and 18,250 homes in the third quarter, with gross margin projected to range between 23.5% and 24%. For the full year 2023, the company expects to deliver between 68,000 and 70,000 homes, ahead of its previous guidance.
Market Performance
The company divides its markets into three categories based on their performance and the level of pricing adjustments and incentives required to maintain sales targets. Lennar reported that during the second quarter and in June, the company had 14 markets that were performing exceptionally well. These markets included Southwest Florida, Southeast Florida, Tampa, Palm Atlantic, New Jersey, the Philly metro area, Charlie, Raleigh, Charlotte, Raleigh, Coastal Carolinas, Indianapolis, Dallas, Houston, Phoenix, and San Diego. These markets were benefiting from factors such as low inventory, strong local economies, employment growth, and migration.
According to April data, the inventory of pre-owned homes remained 44% below pre-pandemic levels, intensifying the competition among buyers. As a result, prospective buyers are turning to new homes as an alternative. Despite concerns about tightening credit conditions due to the Federal Reserve's interest rate hikes, there are currently no signs of a slowdown in the housing market. Additionally, the surge in new home sales was primarily observed in the Midwest and South regions, while the Northeast and West experienced a slight decline.
Exhibit 2: New home sales
While the majority of markets showed improvements compared to the first quarter, Lennar identified 26 markets in the second quarter that fell into a second category. These markets required higher pricing adjustments and incentives than the category-one markets but were still meeting the company's sales targets. Category-two markets included Jacksonville, Ocala, Orlando, Gulf Coast, Northern Alabama, Atlanta, Virginia and Maryland, Chicago, Minneapolis, Nashville, Austin, San Antonio, Colorado, Tucson, Las Vegas, Cal Coastal, the Inland Empire, the Bay Area, Central Valley, Sacramento, Portland, Seattle, Utah, Reno, and Boise.
A report from Realtor indicates that the number of homes available for sale in the 50 largest metro areas in the U.S. experienced a significant increase in May compared to the previous year. However, inventory in these metro areas remains below pre-pandemic levels, indicating ongoing supply constraints in the housing market. According to Realtor's June report , the inventory of homes available for sale in the 50 largest metro areas was 47% below pre-pandemic levels. On the other hand, the total listing count declined by 4.6% in June, confirming that inventory is not growing fast enough to meet the housing demand.
Exhibit 3: Total listing count in June
Realtor
The Southern region stands out as the primary driver of inventory growth, with a notable 54.4% increase in the number of homes for sale compared to May 2022 followed by a 24.1% YoY increase in June. However, despite this growth, home inventory in the South is still 41% below pre-pandemic levels, indicating a persistent shortage of available homes.
Large metro areas in other regions experienced slower or declining annual growth in active inventory. In the Midwest, inventory grew by a mere 1.5% year-over-year in May and declined by 5.5% in June. The West saw an inventory decline of 5.2% in May followed by a staggering 21% decline in June, ending the second quarter inventory levels 42% below pre-pandemic levels. Meanwhile, the Northeast witnessed an 8.5% year-over-year decline in inventory in May and another 13.4% decline in June.
These numbers highlight the ongoing supply-demand imbalance in the housing market, with supply struggling to catch up with strong demand. While the Southern region has seen some positive inventory growth, other regions are experiencing limited inventory growth or even declines. The persistent shortage of available homes is likely to continue, putting upward pressure on prices and triggering intensifying competition among buyers.
Exhibit 4: Regional housing stats
Amid the limited inventory in these markets, Lennar implemented strategies to maintain sales momentum. This included offering mortgage rate buy-downs, base price reductions, closing cost assistance, and other incentives. The size and nature of these adjustments varied on a community-by-community basis and were often limited to specific homes each week. The company, with Lennar Mortgage, is creating attractive and cost-efficient financing packages, ensuring competitive purchase prices for customers, allowing Lennar to sell homes quickly and avoid excess finished inventory.
Market Strategy And Construction Efficiency
Lennar's market strategy revolves around pricing homes competitively to ensure the smooth operation of its construction machine without interruptions. By aligning home prices with market conditions, Lennar aims to minimize disruptions and reduce direct construction costs. This approach has yielded the expected results, leading to an improvement in gross margins.
The company's focus on pricing homes appropriately has allowed it to minimize excess finished inventory, enabling the company to maintain a balanced level of inventory per community. This strategy not only helps control costs but also ensures that homes are sold before completion. Lennar's quarterly starts and sales pace have been carefully managed, with 5.3 homes started and 4.8 homes sold per community.
Maintaining a steady level of starts is crucial for Lennar as it enables the company to secure the necessary labor and achieve its objectives of lowering construction costs, reducing cycle time, and achieving smooth production flow. Although Lennar experienced a decline in starts compared to the previous year in Q2, the industry as a whole faced an even greater decline, highlighting Lennar's resilience in maintaining starts across all communities and markets. This commitment to production has solidified Lennar as the preferred builder for trade partners, with Lennar representing a significant portion of their business, sometimes exceeding 70%.
During the second quarter, Lennar made notable progress in streamlining production by overcoming supply chain disruptions. The company's cycle time - the time taken to complete a home - decreased by four days compared to the previous quarter, and further reductions are expected in the coming quarters. These improvements in cycle time not only contribute to higher efficiency but also free up cash that would otherwise be tied up in inventory, strengthening Lennar's balance sheet.
Financial Services And Balance Sheet Strength
Lennar's financial services segment achieved operating earnings of $112 million in the second quarter. The mortgage division saw increased earnings, driven by higher secondary margins and lower loss volume. Similarly, the title division experienced higher earnings due to increased volume and improved cost efficiency through technology. The company's balance sheet remained strong, supported by a land strategy that facilitates progress in inventory management. Lennar increased its controlled homesite percentage to 70% and improved the supply of owned homesites to 1.7 years. This strategic approach, along with effective production management, resulted in a decline in cycle time and a focus on inventory management, as evidenced by approximately 1,300 completed, unsold homes at the end of the quarter.
The company ended the quarter with $4 billion in cash and no borrowing on its $2.6 billion revolving credit facility, providing a total of $6.6 billion in home-building liquidity. Lennar's focus on land efficiency is evident in the improvement of its homes metric and the increase in controlled home sites. With a portfolio of 387,000 home sites, Lennar is well-positioned to expand its market share in a capital-efficient manner.
Throughout the quarter, Lennar continued to generate cash by increasing production and turning inventory. The company also prioritized reducing debt and repurchasing senior notes at prices below par. These measures, combined with strong earnings, resulted in Lennar achieving its lowest-ever debt-to-total capital ratio of 13.3% in Q2.
Looking ahead, Lennar maintains a positive outlook for the third quarter, expecting new orders, deliveries, and average sales prices to remain favorable. With a strong balance sheet, ample liquidity, and low leverage, Lennar is well-prepared to navigate the challenges in the housing market and capitalize on opportunities in 2023 and beyond.
Valuation
Lennar is currently valued at a forward P/E of just 10.2 , which might give you the false impression that Lennar is very cheaply valued. It is normal to feel so given that many profitable growth companies are trading at more than double these valuation levels today. However, there is more to the story than what meets the eye.
As some of you may know, I am a huge fan of using cash flow models to estimate the intrinsic value of companies. However, I always look at historical trading multiples to gauge a measure of the average trading multiples of all companies in my coverage. Although this is a very underrated strategy, empirical evidence suggests there is a "normal" level of valuation range for every company. For instance, a company like Netflix, Inc. ( NFLX ) has almost always traded at P/E multiples of over 30. Combining this knowledge with a carefully built DCF model can prove to be handy in identifying lows for Netflix stock in a turbulent market. Coming back to Lennar, the company has almost always traded at cheap valuation multiples of below 10. In the last 5 years, Lennar has traded at an average P/E of 8.62, which makes the company fairly valued today in terms of a historical valuation perspective. I am not suggesting that an expansion in valuation multiples is not on the cards. However, given that we did not see an expansion in multiples over the last two years when the outlook for the housing market was in better shape than today, I see no reason for an expansion in multiples today. For this reason, I will remain on the sidelines although the company is performing well.
Takeaway
Lennar Corporation has capitalized on the surge in demand for new homes in a normalizing housing market. The company's strategic approach, partnerships, and affordability initiatives have resonated with buyers, leading to increased sales. Despite all the positives, the current valuation of the company does not allow me to take a long position in LEN stock today.
For further details see:
Lennar: The Cheap Valuation Is Deceptive