- Lennar is a well-respected major homebuilder.
- It has a dual-class share structure that provides opportunity to those who know how to take advantage.
- A greater than 20% spread creates a wide arbitrage.
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Lennar (NYSE:LEN) has become quite a controversial stock with the wild swings in the housing market. Bulls are attracted to its deep value at a discount to book and extremely high earnings yield, while bears point to the significant cooling seen already this year as mortgage rates soared. I fall on the bullish side of the debate as I think the long-run fundamentals for housing are strong even if there are near-term issues.
This article, however, will highlight an arbitrage which provides ample profit potential regardless of which way LEN moves. In such an arbitrage, bankruptcy is just as profitable as LEN getting bought out at $100 per share. We will also discuss risks to the arbitrage.
The arbitrage play
Arbitrage is not suitable for everyone, but it can be interesting and potentially lucrative for those who understand what they are getting into. Here are the involved securities.
This arbitrage can be scaled up or down depending on the size of one's account and how large of an exposure one feels comfortable taking, but for the sake of easy math, lets choose round numbers such as buying and selling 1000 shares. More specifically, here are the legs of the hypothetical arbitrage.
- Long 1000 shares of LEN.B at $62.81
- Short 1000 shares of LEN at $79.28
A spread of $16.47 between the market prices of the two classes of common shares results in proceeds from the pair. The long position costs $62,810 while the short position nets $79,280 resulting in $16,470 of net proceeds.
The basic premise is that LEN and LEN.B are almost exactly the same thing which makes this akin to a true arbitrage in which one is buying and selling the same thing at different prices on different markets to net the spread.
So in this instance, one is getting $16,470 in "profits" while being left with functionally zero exposure to LEN. If it works, it is essentially free money, but as you know there are always complications. Let's dive into the specifics.
Nearly identical securities
Lennar Class B common stock (NYSE:LEN.B) is pari passu with class A Lennar (LEN). Each share of LEN.B is entitled to the same dividend and same liquidation preference as each share of LEN. Thus, in terms of direct financial value they should be worth the same. Here are the vital details of LEN.B.
The quarterly dividend rate, ex-dividend date and par value are all the same as LEN Class A shown below.
However, there are two minor differences which can have an indirect impact on the value of the securities.
- LEN.B gets 10X the votes. Both shares get to vote, but LEN.B gets 10 votes per share while LEN only gets one vote.
- LEN.B is smaller and less liquid with a market cap of $2.3B compared to $20B of LEN class A.
The first difference is unequivocally a positive to LEN.B over LEN.A so I think it is the second which causes them to trade at a spread. More than half of the Class B shares are owned by Stuart Miller or related entities as per the 10-K:
"As of November 30, 2021, Stuart Miller, the Company's Executive Chairman, directly owned, or controlled through family-owned entities, shares of Class A and Class B common stock, which represented approximately 35% voting power of the Company's stock."
Most of his voting power is concentrated in the class B shares because those vote 10X.
With his large and static ownership, the actual float of LEN.B is smaller than one would anticipate for a $2.3B security which results in an even greater liquidity disparity between the issues. As you can see below LEN has an average daily volume of 2.7 million shares while LEN.B trades just 100K shares per day on the NYSE.
Further exacerbating the liquidity differential is the fact that LEN is in the S&P 500 index while LEN.B is not. Since so much of the market trading volume is through ETFs that passively follow major indices like the S&P 500, LEN.B is missing out on all those trades.
All of these factors influence the price at which LEN.B trades relative to the price at which LEN trades, but they do not actually impact the financial value of LEN.B which should be the same as LEN.
That is the arbitrage. We have the opportunity to take advantage of the market's inefficiency to buy the same thing for 21% less which provides 26% upside to LEN.B shares if and when they close the gap.
Are they really the same thing?
While I think most would agree that the market can be inefficient, a gap of this magnitude based simply on LEN being more liquid seems a bit extreme. I was skeptical, so I dug through Lennar's SEC filings to verify that they are in fact pari passu.
From the annual report:
"Liquidation Rights- We currently have no outstanding preferred stock or participating preferred stock. While that continues to be the case, if we are liquidated, the holders of our Class A and Class B common stock will be entitled to share equally on a per share basis, without regard to class, in the assets available for distribution after we have satisfied our debts and liabilities.
If we are liquidated at a time when there are outstanding shares of preferred stock, but not of participating preferred stock, the holders of our Class A and Class B common stock will be entitled to share equally on a per share basis, without regard to class, in the assets available for distribution after we have satisfied our debts and liabilities and made any distributions we are required to make with regard to the preferred stock."
That legal mumbo jumbo basically just says the common shares are below the debt and preferred in the waterfall and that LEN and LEN.B get the same proceeds as each other.
That is great, but sometimes management tries to pull the wool over the eyes of one class of shareholders to benefit the other. I find that unlikely to go against the B for three reasons:
- The Class B shares have a disproportionate voting power
- The chairman has a massive financial interest in LEN.B
- LEN.B shareholders can convert their shares to LEN at any time by majority vote.
Again from the 10-K:
"Termination of Class Rights and Powers If at any time (i) the number of outstanding shares of our Class B common stock is less than 10% of the number of outstanding shares of Class A common stock and Class B common stock taken together, or (ii) the holders of a majority of the outstanding shares of Class B common stock vote to cause all the Class B common stock to be converted into Class A common stock, the Class B common stock will automatically be converted into, and become for all purposes, shares of Class A common stock, and we will no longer be authorized to issue Class B common stock."
Based on the above reasons, I think LEN.B is financially worth the same amount as LEN.
Getting back to the math of the arbitrage.
In buying 1000 shares of LEN.B and shorting 1000 shares of LEN at today's pricing one nets $16,470 in proceeds. The dividends on the B are the same as on the A so there is no dividend cost to carry.
While one does get the $16,470 up front, they do have to maintain their positions in the two securities continuously. Thus, this $16,470 only becomes a true profit if and when one can close out the positions at the same price.
Pathways to realizing the arbitrage
Here are some ways in which the pricing gap between LEN and LEN.B could close.
- Natural closing of gap in market price
- Conversion by voluntary vote
- Conversion by governance encouraged vote
- Sale of company
- Bankruptcy of Lennar
I am of the believe that the gap should close naturally because the securities entitle one to the same assets and cashflows. However, the market can stay irrational for a very long time and given that the gap has been roughly this large for 10 years, I don't see it as particularly likely that it will naturally close.
Conversion by voluntary vote
This is cleanest and easiest way to realize the arbitrage profit. If the majority of LEN.B shareholders vote for conversion each share of LEN.B becomes a share of LEN so instead of having + 1000 shares of LEN.B and -1000 shares of LEN the arbitrageur would be netted out to just not have any shares. The $16,470 would be theirs to keep and there would no longer be a need to hold positions.
The impediment to this happening is that the majority of shares are held by Stuart Miller. Presumably he is maintaining the super voting shares rather than converting so that he can have greater control of Lennar which he has been with for decades.
Such insider control via dual share classes is popular among tech companies, but occasionally it is seen outside of tech as well.
Perhaps one day Stuart Miller will decide he wants to fully retire and just take the massive profit that comes with conversion of his shares to LEN class A, but I would not hold my breath.
He is 64 years old and has recently transitioned to be chairman rather than CEO. Chairman is a much less active role allowing someone to semi-retire while still being important. It is not uncommon to see people stay as chairman well into their 80s.
I have absolutely no access to his medical records but the man looks fit and healthy so he can hold onto those shares for a long time.
This brings me to the next possible means of realizing the arbitrage:
Conversion by involuntary vote
Governance is becoming a bigger and bigger focus of Wall Street and dual class share structures are increasingly frowned upon.
So far, Lennar has gotten away with its dual class structure without much criticism because it has had stellar performance. Investors are not so averse to management hoarding voting rights when management uses those rights to make good decisions that increase long term value.
Since inception in 1986, LEN has returned 3531% to shareholders.
Happy shareholders don't make a fuss over votes.
More recent performance, however, has been less impressive with Lennar down 30% year to date.
In my opinion, the decline is entirely macro related with mortgage rates causing a slowdown in housing, but it may be enough to make shareholders a bit unhappy.
At some point, it may be perceived that the dual class structure is hurting Lennar and pressure could mount to convert to single class.
To assuage the third party governance hawks, it might make sense for Mr. Miller to vote for a conversion. I think his preference is to keep the class B shares, at least for now, but given the financial benefit he would personally receive along with all the other holders of LEN.B, it may not be that hard to convince him to up the corporate governance scores of Lennar.
External resolutions to the pricing gap
Many industries are experiencing substantial consolidation in which even very large companies are getting bought out. If private equity or some other homebuilder were to purchase Lennar, both LEN and LEN.B would get the same buyout price. For the sake of the arbitrage, it wouldn't matter if the buyout price is $50 or $100 per share. Either way the positions get closed out and one gets to keep their proceeds from the initial pricing delta.
On the more negative side, a bankruptcy of the company would also close out the arbitrage (successfully from the perspective of the arbitrageur). Note that I do not see a bankruptcy as likely given Lennar's healthy financial conditions and long-standing success.
Risks to the arbitrage
While the pair trade aspect nets out the short exposure, there are still some challenges that come with shorting.
As of today, LEN has a just under 5% short interest which is quite normal so I don't think there would be a cost to borrow and the size of the company should make the shares easy to find. However, the holding period of the arbitrage could be rather long as it is unknown how long it will take for the valuation gap to close. At some point over the holding period short interest could rise or some other event could make Lennar harder to borrow which could introduce a cost to carry.
There is also the possibility of the spread widening which could result in increasing the leverage of one's account despite the actual stocks being paired out. Such a widening could result in margin interest expense depending on how close one was to fully invested upon entering the trade.
How I'm playing it
Those who follow my work know that I am long LEN.B. At this time, I have not elected to take on the other leg of the arbitrage (shorting LEN). I prefer just the long leg because I happen to be fundamentally bullish on homebuilders.
In the arbitrage one's upside is capped at the 21% or 26% spread depending on whether you measure top down or bottom up.
Given the extremely cheap valuation at which Lennar trades today at 5.4X trailing earnings, I think it will go up significantly more than that as housing fundamentals rebound. The arbitrage would be my preferred play if I were agnostic to housing.
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This article was written by
Dane Bowler is the Chief Investment Officer and a registered investment adviser at the 2nd Market Capital Advisory Corporation. He has over a decade of experience running a proprietary portfolio with a specialization in REITs. On-site property tours and critical analysis of REIT management help inform his selection process.
Dane leads the investing group Portfolio Income Solutions along with Simon and Ross Bowler. Features of the service include: a diversified high-yield REIT portfolio, data tables on every REIT, tax guidance, macro analysis, fair value estimates, and quick updates via chat on breaking news. Learn More.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of LEN.B either through stock ownership, options, or other derivatives. 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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