- A leading homebuilder on sale
- Bull Case Points:
- Bear Case Points:
- Growth and Margins.
- Balance Sheet Strength.
- Share buybacks continue.
- Macro: Housing Stock Continues to Fall
- Macro: Lumber prices are easing
- Macro: Rising rents show remote working has lifted housing demand to crazy highs.
- Macro: Mortgage quality isn’t a concern, yet.
- LEN: Is clearly a value stock
- Now for the bear case – Mortgage rates are rising
- A recession might be coming (probably not)
- Labor shortages will crimp Lennar’s growth.
- The trend isn’t your friend, yet.
A leading homebuilder on sale
Lennar (NYSE:LEN), alongside D.R. Horton (DHI), competes for the title of largest US homebuilder. Despite strong earnings and fundamentals Lennar has fallen 30%+ this year alongside all homebuilders. This isn’t just a general market downdraft (although that’s true too), but because homebuilders fall when mortgage rates rise. But are those falls overdone?
Bull Case Points:
- Good growth and margins.
- Strong balance sheet.
- Increasing share buybacks.
- Housing stock remains close to historical lows.
- Lumber prices are easing.
- Rising rents show remote working has lifted housing demand.
- Mortgage quality is not an issue, yet.
- Lennar is exceptional value right now.
The market is not wrong: mortgage rates are rising, and that WILL impact the housing market. But this isn’t 2007 all over again. Homebuilders were never expensive and are now very cheap. The housing market continues to be very tight and demand will be steady, but won’t drive off a cliff.
Bear Case Points:
- Rising mortgage rates reduce affordability.
- A recession is coming (probably not).
- Labor shortages will crimp growth.
- The trend isn’t your friend, yet.
The key point might be the battle between a clear lack of supply and continued firm demand against rising mortgage rates driving down affordability. But here are all the main points.
Growth and Margins.
The revenue growth trend is quite firm and steady.
Earnings per share – EPS – are also trending up strongly due to good fundamental earnings and continued share buybacks. More on that shortly.
We adjusted to remove the positive and negative effects of Lennar’s technology investments that have clouded performance slightly in recent years. Lennar will likely spin these investments off later in 2022.
Gross margins are strong and steady, which is another sign of a well run company and leader in its field.
Balance Sheet Strength.
Homebuilders can achieve growth artificially via buying smaller rivals. That can raise debt levels dangerously. Debt to total capital of 18% is conservative.
Lennar’s debt levels continue to fall and are at record lows. Liquidity is excellent with $1.5 billion in cash and an undrawn $2.5 billion of line of credit.
Low leverage provides options to Lennar. Soon it will be better to invest in growth or in increasing buybacks than push leverage to zero.
Lennar has been an increasing buyer of its own shares recently apart from the 2020 COVID uncertainty.
At the recent Q1 2022 earnings Lennar announced that a further $2 billion in stock repurchases had been approved. That’s enough to retire just shy of 10% of stock at current prices.
A growing dividend, currently yielding about 2% at current market prices, is a little extra cream for investors who plan to hold long term.
Macro: Housing Stock Continues to Fall
The supply of houses available for sale is close to all time lows at just 2 months. Of course, this means the only way is up. However there are numerous reports of contractors turning away work. This means there is considerable pent up demand. A return to 5-6 months of supply won’t be quick.
Macro: Lumber prices are easing
Lumber prices have declined, helping margins, although there is scope for prices to fall further as supply continues to recover.
Already more than half of building materials suppliers say inventories have returned to normal.
Macro: Rising rents show remote working has lifted housing demand to crazy highs.
Explaining the jump in property prices is easy: historically low interest rates.
Rents are a better judge of fundamental housing demand because there is no investment component. So why have they jumped so outrageously? Where are the people and demand coming from?
We have a theory, but first the evidence.
Is the rental surge due to migration to the US or natural increase?
Neither. In fact population growth is at record lows.
Given that net international migration to the US has never been this low, it should actually be a drag on housing demand over the baseline. Is that Trump’s fault or achievement? Or is it COVID? I’ll leave that to you to decide. But migrants really aren’t stealing your rental property.
It is probably those city slickers, moving to the country.
Unlike most property booms, this one truly is everywhere. If we head back to the rental crisis, the cause becomes clearer still.
As the Atlantic describes, “remote work has snipped the tether between home and office”. Early in the pandemic this meant people fled cities, but now rental rates for apartments have quickly rebounded. Buy why are rents spiking if a bunch of people are avoiding the office?
Here’s our theory on what’s happening: Many people taking dual residences.
Now that remote work is possible, we think a few percent of the working population have decided to have dual residences. A few percent doesn’t sound like much but 5-10 million people suddenly buying, or renting, a second property is a very big deal. That’s 2-3 years of demand right there, assuming 2-3 occupants per household.
It takes properties off the rental and purchase markets. This explains the rental and property price explosion everywhere even as rates have risen. It explains why office visits are still down yet city rents are back rising again.
The rise of remote work might represent a permanent jump in housing demand for the upper white collar workers. This demand will eventually be met, but given the size, it could take years.
Do we have direct statistical evidence of this? No. If you have direct evidence, either for and against this argument, please leave it in the comments. But it is the only theory we can find that fits the circumstantial evidence.
It also leaves the question.
What happens when/if international migration starts to bounce back?
Macro: Mortgage quality isn’t a concern, yet.
We’ve all seen the property crash forecasters on the message boards and comments. They warn of disaster because they’ve seen this movie before, and it all turned to hell. So are shady mortgages back again? Not yet.
Non-agency mortgage backed security issuance with poor lending standards were at the heart of the crisis last time. As the figure above shows, we are no-where near 2002-2007 levels yet, although issuance in 2021 did rise firmly.
In even better news, almost everyone has locked in super low mortgage rates for 30 years. We aren’t seeing the adjustable rate surge like 2002-2007.
LEN: Is clearly a value stock
The strongest argument for buying Lennar is that it is very cheap. Homebuilder valuations never go insane. These companies are for investors who like the steady 10-15% growth of these companies. They usually have a price-earnings ratio range of 9-13 in normal times. Right now the market expects earnings to halve from current levels.
We have used earnings from 2020 and 2019 on the current price to see what a pullback in demand might look like for valuations.
A few quick points:
- A PE below 10 is usually cheap.
- A PE ratio of 4-5 is very cheap.
- Other leading builders are priced at similar levels.
- At a PE of 5 you should always beware of value traps.
- Normalizing earnings to 2019 gives a conservative guess of what 5% mortgage rates might look like.
- Using 2019 earnings to estimate the PE based on the price today is conservative because LEN is bigger now, with less debt, house sale prices are higher yet margins are roughly the same, and the share count is far lower and still falling fast.
- Price to tangible book value close to 1 is also conservative.
Now for the bear case – Mortgage rates are rising
The biggest determinant on the cost of a house purchase is the mortgage interest rate. This is by far, the strongest argument of the bears. Rising rates have pushed mortgage rates very quickly from below 3% last year to more than 5% and rising quickly.
Higher mortgage rates are probably necessary to cool an overheated market. Prices are rising too fast and this combined with higher mortgage rates has changed the affordability dynamic. But where is the peak for mortgage rates? Rates were in the 5-8% range from 2000 to 2010 – aka, not that long ago.
Mortgage payments are rising far faster than earnings.
This has meant that affordability has collapsed to 2007 levels.
To be sure, a sales slowdown hasn’t shown up yet in homebuilders reports. However if rates get to 6% or above, then this could change quickly.
A recession might be coming (probably not)
Some worry a big recession is coming. Some worry every year, but this year has a better argument than most. Blame the rapid increase in interest rates, cost of living pressures from a spike in gas and energy prices hurting consumption. Not to mention fractured supply chains from Russia’s invasion of Ukraine and China’s lockdowns.
However forecasts of recession are far from universal. Counterpoints include:
- Very low unemployment rate.
- Rising wages, particularly for the bottom quartile of workers.
- Infrastructure spending will continue throughout this year.
- Business finances are strong.
- Business investment to rebuild supply chains will be needed.
- Household finances are also strong like early in the cycle.
This isn’t an economics essay, but without a massive 1980s’ style spike in interest rates the economy shouldn’t collapse. Based on present employment trends, even a normal recession looks unlikely currently.
Labor shortages will crimp Lennar’s growth.
Yes Lennar could grow faster if it could find the staff. But this point also supports the bull case in a macro sense.
The bullish part is we don’t expect a sudden surge in construction to quickly return housing inventory to previous levels.
The trend isn’t your friend, yet.
The angle of decline this year is very consistent. A trend you might say. A downtrend trend is not an investor’s friend. If mortgage rates keep rising, then it is likely homebuilders will keep falling.
Lennar is a high quality company, conservatively financed, and like other homebuilders, cheap. The macro headwinds almost offset each other. Pent up demand and a constrained supply on the bull side fighting the rapidly spiking mortgage rates on the bear side. We *do* think rate rises will cool the market, but pent up demand will keep prices firm and prevent a collapse in home sales. So what to do?
In the current market here is our strategy, although it requires patience.
1. Buy small at around $70-71 and close your eyes for a while. You are buying a great company at a cheap price. Demand at this level seem sustainable long term. Yet mortgage rates will spike short term, so it might not be the bottom.
2. Plan to buy further at $60 and $45 per share if the price falls that far. If mortgage rates keep rising we might get there, at least briefly. In 2020 Lennar’s stock price briefly touched $38, before running hard. We don’t see long term stock malaise on the cards given housing market fundamentals.
Most of the bad news is baked into the price now. But that doesn’t mean the market declines won’t continue. Once the market realizes a cooling housing market isn’t a disaster for sales and mortgage rates start to stabilize, which might take a quarter or two, then the floor will be in the stock price. The approved $2 billion in stock buybacks will support prices also.
It doesn’t feel like it right now, but it helps to remember that eventually we will get good news. It always feels terrible when it is the right time to buy, which is why we have valuations to help guide us.
Perhaps easing China lockdowns will likely be first (our bet is not until mid June at the earliest though) or easing inflation pressures. Eventually we might hopefully see good news in Ukraine. But the wheel always turns.
Lennar is at a very good price to buy, but you’ll need patience to be fully rewarded.