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Home Affordability And New Home Sales To Drive Lennar Higher – Lennar Corporation (NYSE:LEN)

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Via SeekingAlpha.com

While many are touting the coronavirus related stock market slump as the first recession since 2008, fear, and not mortgages, are driving the decline. So why are home-builders’ stocks – Lennar (LEN), KB Home (KBH), D.R. Horton (DHI), and PulteGroup (PHM) – getting hammered as well? People will still need homes and existing demand had just been growing at its highest rate, yet the next few months are expected to see a large drop in home sales. Of the four, Lennar, although having a relatively weak quarter in comparison to its norm, has proven itself to be the strongest in terms of income generation per expenses, and the best in producing revenue on lower expenses.

New residential home sales for February were estimated at 757K, and actual new residential sales were reported 1.05% higher at 765K, still representing a 4.4% decrease from January’s 800K figure. Existing home sales rose at their fastest pace since 2007, hitting 5.77 million in sales for February in a 6.5% increase from January adjusted annually, and 7.2% year over year.

Although home sales rose for February, unreleased economic data for March is expected to reverse this trend. With millions of workers out of jobs both temporarily and permanently, and stay-at-home orders increasing around the country, home sales are expected to decrease to 5 million on an annual basis, a 13.34% decline from the February report. Non-seasonally adjusted home sales have decreased by around 36% since May 2019.

The Home-Buying Market

Although new residences only totaled 13% of existing home sales, the market for new home construction will not disappear even if overall home sales decline. The 30-year fixed mortgage rate currently sits at 3.65%, and is up from around 3.3% at its low. With mortgage rates below last year’s levels, and zero-rate interest rates, the attractiveness of cheaper mortgages could drive home sales higher following the stay-at-home orders, as the housing affordability index has risen, and could potentially rise more as new, lower fixed and refinanced interest rates lock in within the next quarter or two.

Of the four home-builders, Lennar generates the highest annual revenues on deliveries and new orders totaling almost 23,000 homes. From their earnings report, Lennar reported $4.5 billion in revenues, with 71.4% of deliveries and 69.4% of new orders in the East and West regions. Only four of the twelve states (NJ/PA/CA/WA) have endured sudden halts to life due to coronavirus, while the rest (FL/NC/SC/AZ/CO/NV/OR/UT) are less affected.

Lennar’s primary model of home-building is pre-fabricated, cookie-cutter style customizable homes that are built quickly, but allow a touch of personalization in each case. Homes go together like a jigsaw puzzle with large pieces – roofing units and shingles in large pieces that fit into place with ease, and walls and frames up within just a few days. Most of Lennar’s homes follow floor plan models, so individual homes are likely to be similar based on room size and layout. Homes internally are equipped with modern, smart devices, and externally range with many colors and styles to give buyers exactly what they want.

A Look at the Numbers

all numbers in M

Lennar

KB Home

PulteGroup

D.R. Horton

Homebuilding Rev.

4,172.12

1,553.34

2,947.12

4,020.70

Operating Expenses

378.89

140.3

261.55

455.80

as a % of Rev.

9.08%

9.03%

8.87%

11.34%

Net Income

398.45

123.17

299.89

431.30

Net Profit Margin

9.55%

7.93%

10.18%

10.73%

NI per $1 of Op. Exp.

$1.05

$0.88

$1.15

$0.95

EPS

$1.27

$1.31

$1.22

$1.16

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Data taken from companies’ 8-k, linked in names above

Let’s take a quick look at the four builders based on their most-recent quarter financials. Lennar generated the highest home-building revenues of the quarter ($4,505m including other business segments), only $150m ahead of D.R. Horton. For profit margins, KB Home lagged the group, 1.62% behind Lennar, and 2.80% behind D.R. Horton. Even though D.R. Horton has a higher net profit margin, they generate less net income per dollar of operating expenses than Lennar ($0.95 v $1.05) since operating expenses accounted for a higher percentage of revenue. Quarterly data does not show much of a difference between the four; annual TTM data does.

all numbers in M

Lennar

KB Home

PulteGroup

D.R. Horton

Home-building Rev.

22,896.82

4,552.75

10,212.96

18,094.60

Operating Expenses

727.51

501.68

1,058.54

1,851.20

as a % of Rev.

3.18%

11.02%

10.36%

10.23%

Net Income

2,007.59

268.78

1,016.70

1,762.60

NI per $1 of Op. Exp.

$2.76

$ 0.54

$ 0.96

$ 0.95

TTM data

When looking at TTM data, D.R. Horton’s quarterly net income per dollar figure shows no variance, so we can deduce their average to be about $0.95 net income generated per dollar of expenses. KB Home’s income per dollar is shockingly poor, netting just over a half-dollar of income per dollar of operating expenses – yet they do have the highest percentage of operating expenses in regards to total revenues. Lennar, on the other hand, is the out and out best performer in the TTM. Operating expenses account for a meager 3.18% of revenue, giving them the highest net income per dollar of expenses for the group, at $2.76 per dollar. Previous data from FY17, FY18, and FY19 showed Lennar generating, at its best, $4-$5.50 of net income per dollar of expenses; even with such a relatively higher figure than its peers, Lennar lies relatively below its past net income per dollar ratio.

TTM

FY19

FY18

FY17

FY16

NI per $1 of Op. Exp.

$2.76

$5.42

$4.93

$2.84

$ 3.92

I believe that much of Lennar’s net income generating efficiency comes from its cookie-cutter, pre-fabricated model of home-building and construction on-site. By having large portions of the house pre-built offsite, and moved to the site at once, a few workers can install a full first-floor frame or full roof within one day. This speed allows them to minimize their operating expenses to a minimum, allowing them to generate a high net income in proportion to those expenses. However, Lennar’s net income will not be too much higher, since the cost of building homes is about 85% of total revenue, on average. Building a home will never be cheap, and the margins between the cost of building and the sale price will never be high, or customers will not purchase those homes.

Lennar’s Risks

Even with Lennar’s dominance in income generation of the group, their TTM income per dollar of expenses has dropped to FY17 levels. Should Lennar struggle in the next quarter, their net income generation, and therefore EPS, could decline by double-digit percentages. Even with only four states in its East and West development region currently have stay-at-home orders and large quarantines (and now possibly FL as a fifth), those four states (CA/WA/NJ/PA) have large populations, and therefore a hit to deliveries and new orders could decline sharply, with the two regions accounting for nearly 70% of both.

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In addition, with those four states and others possibly following suit in the coming days or weeks, should Lennar not be deemed a vital business and forced to suspend operations for the short term could affect the delivery and construction time, and cause Lennar to defer new construction until possibly almost the middle of the quarter. Lennar’s average home sale price of $401,000 could also cause issues with new orders — with unemployment claims jumping to 3.28 million on March 26, the housing affordability index could fall and demand for expensive new homes could drop too.

So What Happens if Home Sales Fall?

Home sales are already expected to decline although the expected number is unknown. The industry in itself is cyclical, and this year is showing the potential to be a cyclically low year. Lennar’s TTM data shown previously shows them operating almost in par with FY17’s income efficiency. Using Lennar’s quarterly and TTM data, we can paint a picture for FY20 by extrapolating data for the next three quarters. Revenue forecasts will be generated using Q1 data of 10,321 homes delivered at an average sale price of $401,000 per home. Revenue for Q2 will be estimated with 5-20% declines at every 5% interval. Q3 will be estimated at -5 to 5% Q/Q2 in 2.5% intervals, while Q4 will be estimated at -1.5% or 1.5% Q/Q3.

Revenue declines for Q2 were weighted equally at .25 each in the average calculation, since the effect on home-building and homes sales is unknown. Q3 revenues were weighted at .17 for -2.5% and 2.5%, and .33 for 5% and 7.5%, as home-building should pick up again once stay-at-home orders end, and if mortgage rates stay lower. Q4 was weighted equally at .5. Overall this would point to a nearly $7B decrease in revenue, which I think is highly unlikely given the current mortgage rate situation and home affordability index rising for a few months. Even with a revenue decline of that percentage, operating income (calculated using 4% of sales, a bit higher than FY19) and net income (calculated using Lennar’s average net profit margin of 9%) would be lower than FY19, but not by much – pointing to only a 22% decline in EPS in this estimated scenario.

1Q

Revenues

$ 4,172.12

Avg. Estimated Revenue

$ 4,172.12

Operating Expenses

$ 166.88

Net Income

$ 375.49

NI per $1 of Op. Exp.

2Q

Revenue Change Q/Q

-5%

-10%

-15%

-20%

Revenues

$ 3,963.51

$3,754.91

$ 3,546.30

$3,337.70

Avg. Estimated Revenue

$ 3,650.61

Operating Expenses

$ 146.02

Net Income

$ 328.55

3Q

Revenue Change Q/Q

-2.5%

2.5%

5.0%

7.5%

Revenues

$ 3,559.34

$3,741.87

$ 3,833.14

$3,924.40

Avg. Estimated Revenue

$ 3,801.19

Operating Expenses

$ 152.05

Net Income

$ 342.11

4Q

Revenue Change Q/Q

1.50%

3.00%

Revenues

$ 3,858.21

$3,915.23

Avg. Estimated Revenue

$ 3,886.72

Operating Expenses

$ 155.47

Net Income

$ 349.80

FY20

Estimated Revenue

$15,510.64

Operating Expenses

$ 620.43

Net Income

$ 1,395.96

NI per $1 of Op. Exp.

$ 2.25

FY20 EPS

$ 4.49

Current EPS

$ 5.74

EPS % Change YoY

-21.86%

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What Do These Numbers Mean?

This is only a model; all values are hypothetical. Assuming the housing market contracts as the market has, and home sales decline in the low double-digit percentages for Q2, and make a high single-digit return in and slow by Q4, Lennar could see a potential 32% decrease in revenue. However, I believe that this is highly unlikely, even if the housing market declines, since FY19’s previous quarters saw revenues in the $5-6.5B; for Lennar to have three consecutive quarters of sub-$4B revenues, I think that the housing market would have to slump similar to the beginning of the 2008 crisis.

In addition, Lennar’s net income efficiency, even for FY19, is significantly below previous years. A prediction for FY20 would show another decline, yet this gives Lennar a significant upside potential to either decrease their operating expenses in regards to lower revenues, or generate a larger stream of net income, which therefore boosts their FY EPS. With Lennar currently trading at a P/E ratio of ~7 and a P/B of .8 (based on their current book value of 51.52), this is significantly lower than the S&P multiple and even a fair valuation. I think that the current expected decrease in home sales is only a slight setback for Lennar, and a 25% upside (at least) to book value and higher could be possible with a virus containment by May.

Note that much of the assessment of the future FY and quarterly numbers was made by a model, but there is still a strong case for Lennar trading at an undervalued price due to its relatively low P/E compared to the S&P and its P/B at .69, giving it upside potential of $15+/share to trade at fair value and higher.

Conclusion

Lennar could face a tougher year than expected, should lock downs persist in major states in its East and West regions. With their current valuation around .8 of book value, Lennar seems to be undervalued as it typically trades at a P/B around 1.2. Lennar has much room for growth back to its past valuation multiples, and with a hypothetical model-predicted 22% decline in EPS, could have potential 10-15% downside in the short term. Even so, Lennar generates the most revenue on the lowest operating expenses, and therefore cost-cutting measures to preserve net income generation are not needed, since it would be nearly impossible to cut operating expenses below its current 3% of revenue. Overall, I believe Lennar to currently be undervalued along with the other three home-builders, but I think that Lennar’s strong operating efficiency gives it the best position should home sales fall for the quarter, and also provides them large upside to return to previous net income efficiency of $5 per $1 of operating expenses. Should Lennar return to that efficiency in FY21, boosting its EPS higher, I believe Lennar could easily return to the high-$60 range.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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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