jetcityimage Introduction It’s time to talk about home builders – one home builder in particular. The Lennar Corporation (NYSE:LEN) is America’s second-largest home builder and one of the best-performing S&P 500 (SP500) stocks over the past five years. Going back to 2019, LEN shares have more than tripled, outperforming the S&P 500 by more than 100 points. Data by YCharts This surge was supported by massive housing shortages. Even elevated rates could not keep home builders from flying, which was simply because many people had locked in extremely low rates before mortgage rates started to fly. The New York Times Because people with attractive mortgages did not sell, the supply of homes was low, which met rising demand from people moving from urban areas to suburban areas and mass immigration. My biggest problem was being too careful. My most recent article on Lennar was written on August 16, shortly after it became public that Warren Buffett had acquired a stake in the company. As much as I like both LEN and DHR, the companies are in a tricky spot. They can only continue the current growth streak if the housing supply remains low. Since then, Lennar shares are up 20%, which includes a 13% drop from the company’s all-time high. As the company just released its earnings, I will use this article to take a closer look at the home builder and explain why I believe I wasn’t wrong in August when I disliked the risk/reward. So, let’s get to it! Why The Good Times May Be Over On March 26, Bloomberg published an op-ed titled “A Dream Run For Homebuilders Is Ending.” This was almost the exact day LEN shares peaked. Conor Sen, who wrote the article, noted the same developments that I have highlighted since 2022, which is that low housing inventories are a big problem for the housing market – and great news for home builders. Home builders consistently ramped up construction and benefitted from high margins – especially when the rate of inflation came down. Unfortunately, the good news may be ending. I added emphasis to the quote below: There’s growing evidence that we’re about to see the most significant increase in resale housing inventory since the financial crisis of 2008, making the prospect for price gains this year tenuous. […] Resale inventory levels are still very low, but they’re now up meaningfully from early 2022. […] America will still have an overall housing deficit of somewhere between two million and six million homes, depending on the source, but prices are set on the margin. It took a historic inventory shortage to cause a historic affordability problem, so a somewhat less acute inventory shortage should chip away at prices, particularly if mortgage rates remain onerous. – Bloomberg So far, his call is right. Using the latest data, we see pressure on pricing, lower new home sales, and rising inventories. All of which are bearish. As reported by Wells Fargo last month: New home sales dropped 4.7% during April. Although a pullback was expected, the drop was a bit sharper than anticipated. The weakness in new home sales can largely be explained by early April’s spurt higher in mortgage rates. Rising inventory levels in the resale market appears to be another factor weighing on sales. – Wells Fargo. Looking at the chart below, we see home builders are increasing incentives and cutting prices to increase sales. Wells Fargo Meanwhile, the supply of new homes for sale is at nine months, roughly 50% above average 2012–2022 levels. Wells Fargo While none of this screams “recession,” it shows highly favorable tailwinds for home builders are quickly fading. It also does not help that persistently elevated mortgage rates pressure the economy, which resulted in the first NAHB Home Builders sentiment decline since November 2023. The market has slowed down since mortgage rates increased and this has pushed many potential buyers back to the sidelines. A lack of progress on reducing inflation pushed long-term interest rates higher in the first quarter and this is acting as a drag on builder sentiment. The last leg in the inflation fight is to reduce shelter inflation, and this can only occur if builders are able to construct more attainable, affordable housing. – NAHB. Data by YCharts To me, it appears that the longer rates remain elevated, the more likely it is that weakening credit conditions and economic growth trigger an event of lower demand, falling prices, higher housing inventory, and much lower margins/demand for home builders. Again, I’m not predicting a Great Financial Crisis here. I’m just assessing a less favorable risk/reward for home builders. What’s Up With Lennar? As I wrote in my prior article, Lennar is in a great position to capture growth in attractive markets. Before the pandemic hit, it sold more than half of its homes in Florida, Texas, and the Southwest. Lennar Corp. In the second quarter of its 2024 fiscal year, the company did well, as it started roughly 21,400 homes, sold 21,300 homes, and delivered 19,700 homes. It is now on track to deliver 80,000 homes this year. To put things in perspective, that’s enough to provide every household in Springfield, Missouri, with a new home. With that said, total sales growth was 19%, with a 15% increase in deliveries on a year-over-year basis. The company also improved its sales pace from 4.8 to 5.7 homes per community. Total orders increased by 19% to 21,293 homes. The dollar value of these homes rose by 12%, which indicates lower average pricing. The good news is that despite some pressure on pricing, Lennar is maintaining high margins, as it reported a gross margin of 22.6% in the second quarter, up from 21.8% in the previous quarter. Going forward, it expects to achieve a gross margin of roughly 23% in the third quarter. Moreover, the company holds $3.6 billion in cash and has a low home building debt-to-total capital ratio of 7.7%. This provides fertile ground for shareholder distributions, as the company has bought back 10% of its shares over the past three years, with an accelerating trend since the start of 2023. Data by YCharts In general, the company is expected to become more streamlined, as it is looking to spin off between $6 and $8 billion worth of land into a new company with no associated debt. The goal is to accelerate its land life strategy and allow for off-balance sheet treatment of its land assets. Unfortunately, the company did not comment on it further during its earnings call, as it is limited to what it can make public at this stage of the spin-off. So, that’s something to keep an eye on in the weeks and months ahead. The company did comment on the housing market, which is similar to what we discussed in the prior part of this article, as it sees some factors pressuring the housing market. […] the chronic supply shortage, the impact of interest rates on affordability as well as persistent and stubborn inflation have moderated housing market strength. We have also continued working on additional product approaches to help build a more healthy housing market. We have intensified our focus on build-to-rent community scale and single-family for rent scattered homes across markets. We believe that we can and need to build additional production for professionally owned housing that can fill an important additional need. – LEN 2Q24 Earnings Call (Emphasis added). In general, while the company’s quarter was good, it wasn’t good enough, which may be another sign that high expectations may have to come down a bit. The company expects Q3 new orders of 20,500-21,000 vs. Bloomberg consensus of 21,095, deliveries of 20,500-21,000 vs. consensus of 21,004, average sales price of $420K-$425K, and gross margin on home sales of ~23.0% vs. consensus of 24%. – Seeking Alpha. As a result, shares are down roughly 5% after earnings. Valuation Despite its stellar performance, LEN is not overvalued. Using the FactSet data in the chart below, LEN trades at a blended P/E ratio of roughly 11x, which is below its normalized P/E ratio of 12.8x. FAST Graphs Analysts expect the following EPS growth rates: Year EPS Growth 2024E 6% 2025E 13% 2026E 5% Click to enlarge The reason LEN is selling off despite these numbers is increased uncertainty. If current macroeconomic developments continue, these rosy analyst expectations are on very thin ice. Given how cyclical home builders are, it makes sense that we’re seeing some profit-taking at these levels. Over the past ten years, LEN has been through three sell-offs of more than 40%. Just one of these was during a recession. It has been through two additional >20% sell-offs. Data by YCharts All things considered, I maintain a Hold rating, as I do not believe that LEN shares offer a good risk/reward at these levels. Going forward, I’ll continue to monitor housing inventory and new home sales, as I believe we could see a deterioration in both indicators. Takeaway Lennar has seen tremendous growth, but the future looks challenging. Despite a strong performance and solid fundamentals, the housing market’s dynamics are shifting. Elevated mortgage rates, rising resale inventory, and potential economic slowdowns present significant risks. Although Lennar is well-positioned in attractive markets and maintains healthy margins, the broader market’s tailwinds are clearly fading. While current Lennar Corporation stock valuations remain fair, I believe it’s prudent to be cautious, which is why I stick to a Hold rating.
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