By David Urani
One of the bigger players in the homebuilding sector, Lennar Corp (LEN), reported its fiscal third quarter earnings on Monday and overtook the consensus estimates on revenue and earnings. Housing stocks, and the market as a whole, seemed to take the results as a positive, and perhaps even saw it as a beginning in the housing recovery. And it only seems natural for the market to act as such, because if one looks at the chart of any given homebuilder, one sees a lot of value to be regained; investors these days have itchy trigger fingers, especially when it comes to the housing sector. The way I see it, though, this Miami homebuilder is going to stay beached for a while longer.
Let's look at the numbers:
- Revenue $825.0 million (+14.5% y/y; $777.5 million consensus)
- EPS $0.16 (vs. -$0.97 3Q09; $0.11 consensus)
- 2,950 homes closed (+10% y/y; +1% q/q)
- 2,624 homes ordered (-15% y/y; -18% q/q)
- Gross margin 21.1% (vs. 7.8% ex. charges 3Q09 and 20.6% 2Q10)
- Rialto investment arm added $38.0 million revenue, $7.7 million earnings ($0.04 per share)
The first thing to look at is the Rialto investment arm, which picked up a large batch of troubled mortgages from the FDIC. This turned out to be a good investment, but it's separate from the Company's core homebuilding operations. Without Rialto, Lennar generated sales of just under $800 million and EPS of approximately $0.12. Otherwise, homebuilding operations still posted strengthened sales and gross margin which were stronger but that was not a big surprise considering the quarter included leftover sales from the federal homebuyers' tax credit (it typically takes a couple of months for ordered homes to close). As we all know, nationwide housing demand plunged after the tax credit expired, so really the fact that Lennar posted decent results in its 3Q is somewhat of a moot point; when we analyze we need to constantly be looking forward.
So then, when we do look forward we don't see a whole lot to be excited about. The big figure to look at is the 18% sequential drop in new orders which does in fact reflect that thumping tax credit hangover. Consequentially, it is clear that sales will be well lower in the fourth quarter, and in fact they are likely to stay subdued as we enter the seasonal winter slowness. When it comes down to it, the macroeconomics just aren't looking good. We've written pages about this before (here and here) but in a nutshell, a huge plunge in demand post-tax credit, combined with record high levels of bank repossessions of foreclosed homes (and the ensuing increase in supply), equals an inevitable decline in prices. On top of that, we suspect many home sellers had simply notched prices higher just to compensate for the tax credit discount.
Lennar holds $3.8 billion of inventory, which was approximately 15.9 months worth at the fiscal 3Q10 sales rate, and one of the highest in the industry. The problem with having a relatively large amount of inventory is that it makes you more exposed to the potential drop in prices. As we saw from 2007 through 2009, homebuilders who get caught with a lot of inventory outstanding while home prices are falling take big hits to gross margin through asset impairment charges. Additionally, selling prices obviously go down and the homebuilders are also inclined to offer more incentives to get deals done. We suspect that will be the case in the coming months. It's not going to be the sheer terror we saw in 2007-2009 as the majority of the housing devaluation already occurred during that stretch. However, another 5% to 10% drop in prices is realistic and we do not see current share values as reflective of that risk.