Lennar: Hold Rating For The Near Term

Overview

For Lennar Corporation (NYSE:LEN.B) to succeed in generating returns in the coming years, I believe it must maintain its momentum toward an asset-light business model. LEN.B's size, operational discipline, and healthy balance sheet are three of the most important fundamental factors that will drive growth, in my opinion. The most crucial of these three factors, in my view, is operational discipline. Lennar continues to prioritize volume growth and the use of targeted investments to generate cash in a choppy economic climate over pursuit of profit. In my opinion, this is a good turn of events because it provides more financial leeway despite the hazy nature of the business environment. Management mentioned during the call that they have reduced land costs and there is about one finished spec in each community. In addition, a record-high 68% of lots have been optioned as LEN.B pursues longer-term growth opportunities while remaining asset-light. Moreover, it was a pleasure to learn that LEN.B has successfully stabilized its base price in various regions thanks to the application of incentives of varying intensities. In FY23, when working capital is expected to return to normal levels, I expect free cash flow to be robust enough to fund both strategic investments and shareholder returns. Short-term, however, margins and ROE are expected to decline in FY23, so the outlook is not as bright. I recommend a hold rating on LEN stock for now (near-term), and would consider upgrading to a buy after FY23 if nothing major goes wrong.

1Q23 results summary

LEN exceeded expectations with its operating earnings per share of $2.12 for 1Q23, surpassing both its own guidance of $1.40 to $1.70 and the consensus estimate of $1.55. The EPS beat was driven mainly by higher revenues and lower SG&A costs. Improved gross margins, increased income from financial services, and decreased income taxes also played a role in the positive results. Although 1Q orders declined by 10% year over year, the decrease was much less than the anticipated 14-24% decline. Looking ahead to the near term, management provided 2Q23 guidance that forecasts a 4-10% drop in orders and gross margins in the range of 21.0-21.5%. However, the FY23 guidance was slightly raised to 62-66K orders.

Demand doing fine

Listening to the call, it was heartening to hear that management had noticed an increase in traffic and sales each month of the quarter, in line with the change in rates, with the cancellation rate reaching a quarter-low of 14% in February, compared to 21% for 1Q23. In that same month, sales averaged 4.7, down just 0.1 from the previous year. Affordability is only one factor; I think the successes also reflect the advantages of LEN.B's dynamic pricing model, incentives, and a focus on digital marketing. It's noteworthy that March cancellation rates have remained stable despite some incentives being loosened here and there on a case-by-case basis, with these changes occurring on a weekly basis at the local level. The fact that formerly under-performing MSAs have shown improvement in performance suggests to me that management is executing well. When we step back, we can also see that the 29 markets that management has pinpointed show a positive response to pricing. All in all, I think Lennar's strategy will bring more consistent volumes, despite the fact that the uncertainties regarding mortgage rates and demand.

Margins outlook

As lower lumber prices were partially offset by increases in other material inputs, direct construction costs for the quarter fell by 1% sequentially but rose by 13% year over year. It's encouraging to see management keeping up productive relationships with their trade partners and remaining confident in their ability to save customers $14,000 on average per home, which should become apparent in the financials beginning in 2H23. In light of the possibility of a summertime increase in the price of lumber and the ongoing challenges posed by the price of aggregates and concrete, I feel it's important to point out that this is a significant achievement (if well executed). However, although front-end processes have decreased by 2 weeks, cycle times have increased by 8 days sequentially, highlighting an area for improvement. Since the peak of December 2020 single-family starts has passed, I anticipate a gradual return to normalcy over the next few quarters as supply chains gain incremental capacity and LEN inventories are depleted. Overall, I see no surprises to gross margin cadence for FY23 and should be within the same band that management forecast for 1Q23. In terms of FY24, I anticipate gross margins to face minor headwinds from sellers that are seeking to readjust to the operating environment, which includes lower land prices. However, I think LEN.B's digital marketing efforts will pay off in the long run and help increase through-cycle margins.

Financials

In general, I anticipate that the fundamentals of the market will begin to stabilize in 2023, with a potentially steady or slightly reduced interest rate environment. Because of this, I believe that investors will be more open to a recovery of normal gross margins and sales pace, and that a new cycle for the construction industry may begin in the coming years. Valuation-wise, I believe that LEN.B is currently trading at a fair multiple from a PE perspective, as it is trading at 10 times the forward price-to-earnings ratio, which is its average. However, in terms of book value, LEN.B appears to be trading at a slightly lower than average multiple of 1.2 times book value, which I believe is due to the lower expected return on equity, which is reasonable given the near-term margin outlook.

Conclusion

LEN.B has clearly shown strength in maintaining its momentum towards an asset-light business model, driven by its size, operational discipline, and healthy balance sheet. The 1Q23 results showed positive growth, exceeding expectations with higher revenues and lower SG&A costs, and the demand for Lennar's homes is doing well, with increased traffic and sales. Despite uncertainties regarding mortgage rates and demand, Lennar's dynamic pricing model, incentives, and digital marketing focus are expected to bring more consistent volumes. In terms of financials, the company appears to be trading at a fair multiple from a P/E perspective, but a slightly lower multiple from a book value perspective due to the lower expected return on equity. Overall, I recommend a hold rating for now, with potential for an upgrade to a buy after FY23 if nothing major goes wrong.