The Downgrade
Zelman & Associates gut-punched home builder stocks with a major downgrade of the sector on June 10th. Zelman used a survey of builders to conclude that soaring housing prices are reducing demand. The survey also revealed “a fourth straight month of weaker-than-seasonal order activity in May”. (I have covered this dynamic as “normalization” in several housing market reviews). Zelman slapped sell ratings on Beazer Homes USA (BZH), Century Communities (CCS), and Dream Finders Homes (DFH). NVR, Inc. (NVR) received a downgrade to Hold. Zelman left M/I Homes (MHO) unscathed with a buy rating.
Since Zelman’s bearish call, NVR is the only stock of the group to recover its losses. Even MHO remains down 10.6% in the wake of the downgrade. The downgrade originally dropped iShares U.S. Home Construction ETF (ITB) to a 2.6% loss. However, last week, ITB finished a recovery from that loss partially thanks to the recent strength in Lennar Corp (LEN).
Lennar Corp to the Rescue
Zelman is well-known for its coverage of home builders. I see Zelman analysts participate in every builder earnings conference call that I follow. Accordingly, the collateral damage from Zelman’s downgrade makes sense. LEN stock also lost 2.9% that day. However, Lennar got a quick opportunity to refute Zelman’s claims in its earnings report the very next week. Indeed, LEN jumped 3.6% post-earnings. Last week, LEN confirmed a 50DMA breakout even as ITB failed at its 50DMA resistance. LEN may once again lead the sector into extending the seasonal trade on home builders. Lennar came to the rescue in March when the company announced its Upward America Venture to extend single family housing options to renters.
Zelman downgraded LEN to hold on October 26, 2020. LEN is up 36% since then, so I expected Zelman to ask extremely critical questions in the Lennar earnings conference call. After all, a mistimed and as yet unrepentant bearish call was at stake. Instead, Zelman only asked for clarification on production guidance, information on the affordability ceiling, and clarification on Lennar’s rental strategy. Lennar deftly responded. One claim stood out in particular because it suggested that housing prices could rise higher and longer than many might otherwise expect. From the Seeking Alpha transcript:
“…the home is the hub of people’s life, very different than it was in the past. So it’s not just where they live. It’s where they work. It’s where they educate. It’s where they recreate. And post pandemic, that’s still going to be the case for the large part, and therefore, people view the home as more valuable and will put a larger portion of their income towards that more important asset in the home.”
In other words, households are now willing to pay more than usual for the benefits of home ownership.
The rest of the earnings call delivered valuable nuggets for understanding the current state of the housing market in addition to the company’s overall financial strength and business performance. While I still see gradual normalization in the housing market, Lennar announced full steam ahead.
A Housing Market In the Best of Times
Lennar boldly described the current housing market as “…the best of times.” The company recounted all the familiar macro factors that have persisted for years: constrained housing supply, labor shortages, land limits, a persistent construction deficit, and strong demand. The coronavirus pandemic exacerbated some of these issues as well as added new supply chain logjams. As a result, Lennar is not worried about demand, which has experienced a “mild cooling” from “extremely, extremely hot to extremely hot.” Housing demand continues to overwhelm supply in all of Lennar’s markets and across all product categories (entry-level, move-up, and active adult). In numerical terms, Lennar “sold 17,000-plus homes during the quarter, and the variability between the months was plus or minus 100 homes. So [they have] seen no impact associated with the cooling.” Moreover, cancellation rates are at a historic low of 8.6%. Austin, TX is Lennar’s strongest market.
Demand is so strong that Lennar decided to sell homes later in the construction cycle as a way to further improve pricing and margins. Lennar started 2500 more homes than it sold in the quarter even though the company could have sold every single construction start. Clearly, LEN expects prices to continue moving higher in the near future. This strategy also allows LEN to recover more of its rising material and labor costs.
Lennar effectively admitted that home prices are stretching out of reach. The company already announced its rental joint venture as one of the solutions for people who can afford the monthly payment but cannot yet come up with the down payment for a home. Of course, implicit in relieving people of the down payment pressure is the potential for savings to migrate toward paying ever higher rental costs. From Lennar:
“When you can make single-family lifestyle available to our workforce, and that workforce starts with a rental and can earn into owning it, it just creates a stepping stone, and it enables that workforce to afford that higher-priced home. Now where is the top? It’s certainly going to plateau at some point.”
Lennar uses affordability to rationalize the professionally owned and managed single-family rental business. “The single-family for rent participants are making a single-family home lifestyle accessible to more families, to working families.” Lennar went on to insist that the industry should allocate a greater share of a growing housing supply to this rental market. In fact, “this is simply a social equity program that enables better housing for more families and more diverse families without weakening the mortgage market.”
Whenever housing demand and prices top, the milestone could create a shock for an industry that has grown accustomed to charging ever higher prices to ever more eager buyers.
Guidance
The strong state of the housing market allowed Lennar to stand by strong guidance for the coming quarters. None of Zelman’s fears appear in the guidance. Lennar even nudged up guidance on average sales price which in turn increased revenue guidance.
The third quarter (Q3) guidance below includes the sequential percentage changes given the easy year-over-year comps (also see the earnings release):
- New orders: 16,000 to 16,300 homes (midpoint -5.9% from Q2) – this decline aligns with seasonal expectations
- Deliveries: 15,800 to 16,100 homes (midpoint +10.1% from Q2)
- Average sales price: $420,000 to $425,000 (midpoint +2.1% from Q2)
- Gross margin: 27% to 27.5% (up from 26.1% for Q2)
- SG&A: 7.3% to 7.4% of revenue (down from 7.6% in Q2)
The full year fiscal 2021 guidance includes the changes from previous full-year guidance.
- Deliveries: 62,000 to 64,000 homes (no change)
- Gross margin guidance of 26.5% to 27% for the year (up from 25%) – exceeds peak margins from 2005
- SG&A: 7.3% to 7.5% of revenue (down from 7.6% to 7.8%)
- Average sales price: about $420,000 (up 5%)
- Community count: up 10% year-over-year by year-end (no change)
- Financial Services earnings: $460K to $470K (up from $445K to $460K)
Importantly, Lennar did not ramp up delivery promises in the face of persistently strong demand. Instead, the company anchored delivery targets for the year to avoid further stressing the supply chain. For the larger industry as a whole, this decision implies new home sales have a tight ceiling for the year. Supply chain disruptions have already added two weeks to Lennar’s production cycle time.
Strong Financial Performance
Lennar’s strong financial performance drove other milestones and accomplishments. For example, S&P joined the other two rating agencies in upgrading Lennar’s debt to investment grade. Lennar accomplished 50% owned versus controlled land two quarters earlier than expected. The company also reduced land supply to 3.3 from 3.9 years. These items further improved cash flow generation. Lennar now has a 23.1% debt-to-capital ratio and nearly $2.6B cash on hand.
Lennar also gobbled up shares in repurchase activity. In Q2, Lennar bought back 1M shares for $98M and plans to buy the dips: “So as there are dips in the stock, then we can take advantage of those dips because we have the cash to do so”.
Lumber
The soaring price of lumber made many headlines. Lennar claimed that it did not believe the recent heights were sustainable. The current pullback apparently occurred partially because of the do-it-yourself (DIY) market postponing projects. I was starting to suspect that lumber’s tumble came from contracting demand from home builders. I remain wary.
Lennar expects its August starts to benefit from today’s declining costs. The company saves about $1,700 per average-sized home for every 10% drop in random lengths lumber. The same pricing dynamics apply to OSB (oriented strand board), but those prices have not yet started to slide.
The Trade
LEN’s 50DMA breakout makes the stock a buy even though I already declared an end to the seasonal trade on home builders. Indeed, I bought a July $101/$106 call spread as a low risk bet on a continuation of the breakout over the next two weeks. However, given the likely ceiling on new home sales, margins already at historic highs, and the drag of lower-performing home builders, I doubt in the near-term that Lennar will make material progress above its all-time high in May. Thus, I expect my current trade to end LEN purchases until the seasonal trade officially picks up again in October or November.
Be careful out there!
Full disclosure: long LEN call spread, long DFH