Lennar- A Case Study In Crisis Management But Fairly Valued Now

Mar.21.13 | About: Lennar Corporation (LEN)

While I believe that economic optimism outweighs reality to a large extent, the housing market's improvement and future prospects, is something that I believe offsets many of the other issues. While all homebuilders faced unprecedented pressures from the Great Recession, in what was already a highly cyclical industry, Lennar Corporation's (NYSE:LEN) highs and lows have been truly fascinating to watch. The company had to deal with over 270 joint ventures in which many of its partners went belly-up, and the liabilities were recourse to Lennar. This obviously pressured the balance sheet and at its depths, the stock traded below $3.50 per share. Lennar's seasoned management team right-sized the balance sheet, raised equity capital and refinanced its debt as opportunities arose, significantly improving the company's liquidity. Unlike many other smaller and large builders, Lennar also managed to invest aggressively, buying land at rock-bottom prices, and capitalized on distressed and work-out loans with its Rialto investments unit. As housing bottomed and has since begun recovering, I'd argue that no homebuilder is better positioned for the rebound than Lennar. Due to no fault of the company, I believe that the stock offers very little margin of safety at current prices, but I believe that management's actions during the Great Recession should be a case study taught in business schools of how cyclical businesses can survive and prosper in the most distressed of circumstances.

While homebuilders know that their business is cyclical in nature, the last six years served as the ultimate stress test scenario. In a perfect world, a builder would do into that type of recession with very little debt or inventory. This was not the case for Lennar, which carried about $3.7 billion of debt versus equity of $5.7 billion into 2007. Of course that equity value proved to be highly inflated forcing write-downs, and the company ended 2007 with about $3 billion in debt, and roughly $3.8 billion of equity capital. To combat market pressures, the company managed its inventory by reducing starts and used below market financing and incentives to sell homes and reduce cancellations. Lennar aggressively paired down its joint venture exposure and recourse liability despite terrible market conditions, and the company moved quickly to reengineer its product to fewer floor plans, reducing design costs.

Lennar matched housing starts to housing sales, which reduced working capital requirement. Fortunately, the company prior years' profitability enabled the company and other builders to receive much needed cash from tax refunds on its losses. In fiscal 2008, despite frozen capital markets, Lennar issued $225MM in stock under its $275MM equity draw down program, and found a way to extend its debt maturities, while also retiring debt. In 2008 and 2009 the company began opportunistically purchasing new land to set the stage for future growth, at incredible prices when there were very few big buyers. In fiscal 2010, Lennar's Rialto Investments unit acquired in partnership with the FDIC, distressed residential and commercial real estate loans. It also acquired bank portfolios and invested in the AllianceBernstein (NYSE:AB) PPIP fund. These initiatives made Lennar profitable far earlier than the majority of its competition, and set the stage for further growth measures. In fiscal 2011 Rialto began raising 3rd party money, which in addition to Lennar's seed investment, would further leverage the unit's ability to navigate the distressed real estate markets.

Fiscal 2012 and early in 2013, the improvement in the real estate market is much more national. Housing prices are extremely attractive relative to rental rates, largely due to reduced prices, and historically low interest rates. Housing starts bottomed at about 550,000 units, which just offsets the amount that are removed from the market due to obsolescence, have rebounded sharply and there is a supply shortage of new homes in many key markets. A generation of perspective buyers that in many cases were forced to live at home much longer than previous generations, are starting to venture off of the nest to create households of their own. As one of the few companies that was able to invest reasonably aggressively in the downturn, Lennar has large projects in these key markets that are perfectly suited to meet this demand at attractive margins. The company also has expanded into multi-family developments where it seeks to introduce the Lennar name into the households of prospective home buyers prior to their first purchase.

In fiscal 2012, Lennar grew revenue by 33% to $4.1 billion. The company earned $679.1MM, or $3.11 per diluted share, which included a partial reversal of the deferred tax asset valuation allowance of $491.5MM, or $2.25 per share. Lennar's financial services division, which performed admirably in the downturn, generated $84.8MM of operating earnings, compared to $20.7MM the year before, as it was bolstered by the refi-boom. Rialto Investments had operating earnings of $26MM, compared to $34.6MM the year before, but its closing of 2 investment funds should set the stage for future growth. The company delivered 13,802 homes, which was up 27%. New orders grew 37%, to 15,684 homes. Average sales prices of homes delivered increased to $255,000, compared to $244,000 in 2011. Sales incentives were $28,300 per home delivered in 2012, or 10% of home sales revenue, compared to $33,700 per home delivered in the same period last year, or 12.1% of revenue. The backlog at the end of the year was 4,053 homes, which was up a whopping 87% from the prior year end. The backlog dollar value of $1.2 billion was up 107%. Lennar has led builders in gross margins on homes sold, and in 2012 the company's gross margin was 22.7%, compared to 19.9% in 2011. Lennar ended the year with 128,500 home sites. Homebuilding cash and cash equivalents at year end were $1.1 billion, while homebuilding debt to total capital, net of cash and equivalents, was 45.6%.

On March 20th, Lennar reported 1st quarter 2014 earnings that were quite strong. Revenues were up 37% to $989.9MM. Net earnings were $57.5MM or $.26 per diluted share, which was up from net earnings of $15MM, or $.08 per diluted share the prior year. The company delivered 3,186 homes, which was up 28%. New orders were up 35% to 4,055, while the cancellation rate was 15%. Lennar continues to grow its backlog, which stood at 4,922 homes, up 82%. The backlog dollar value was $1.5 billion, up 105% from the prior year. The company's gross margin on home sales improved 120 basis points to 22.1%, while SG&A expenses as a % of revenue from home sales improved 290 basis points to 12%. The operating margin on home sales was 10.1%, which was up 410 basis points. Lennar's homebuilding operating earnings of $67.1MM, were up from $20MM YoY. Lennar financial services had operating earnings of $16.1MM, compared to $8.3MM the year before. Rialto Investments' operating earnings totaled $1.7MM. Lennar ended the quarter with cash and cash equivalents of $1.1 billion, and had debt to total capital, net of cash and cash equivalents, of 49.3%. Importantly, the company was able to issue $275MM of 4.125% senior notes due 2018 and an additional $175MM of the 4.750% senior notes due 2022. Lennar is making real strides in reducing its financing costs, without having to withhold investments at the trough of the cycle. Moving forward I'd like to see management reduce the debt to total capital ratio as homebuilding profits continue to improve.

Lennar ended the quarter with $3.5 billion in shareholders' equity and homebuilding debt of roughly $4.5 billion. Shareholders' equity is likely to improve considerably over the next several years due to the benefit of significant earnings, and a continued reversal of net operating losses. Return on equity peaked in 2005 at just under 30% in the previous cycle, which I believe was clearly excessive in relation to normal cyclical upturns in housing. Lennar ended the 1st quarter with 226.017MM shares outstanding, so at a recent price of $42.40, the market capitalization is roughly $9.583 billion. The company also has $3.393 billion in net homebuilding debt, which puts the enterprise value around $13 billion. While I am very positive about the housing market, assuming Lennar could attain a 30% return on equity on current book value would put peak earnings at just over $1 billion. At just over 9.5 times peak earnings, Lennar would be fairly to slightly overvalued, due to its lack of a moat, and the industry's cyclicality. As I said before, book value is likely understated, but I also would be very surprised to see the company attain a return on equity around 30% in the current cycle. I certainly wouldn't short the stock, but homebuilding stocks tend to be early on the way up and the way down, and in this case I believe the valuation provides very little margin of safety.

If you are interested in buying undervalued businesses with excellent exposure to the real estate market, you need not look further than many of the large U.S. banks and insurance companies. Companies such as Bank of America (NYSE:BAC), Citigroup (NYSE:C), and American International Group (NYSE:AIG) can still be bought at slight to large discounts to tangible book value, with tremendous earnings power yet to be unlocked. Other companies such as Wells Fargo (NYSE:WFC) and JPMorgan (NYSE:JPM) are more fairly valued, to their better business performance, but they still trade at very cheap multiples to earnings, and offer a high likelihood of earnings and dividend growth. These large banks combined have hundreds of thousands of full-time and part-time employees dedicated to resolving problematic mortgages, and these costs will be declining rapidly moving forward. Capital and liquidity levels are better than they have ever been, providing huge protection even if the economy isn't as strong as some believe it to be. If the government and regulators actually realize that the global economy is still fragile and promoting economic growth is a good thing, then the upside could be that much greater. I'd look to buy Lennar on dips and most of the other homebuilders look more or less, fairly valued as well.

Disclosure: I am long LEN, C, BAC, JPM, AIG, WFC. 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.