Why Lennar Is a Good Pick for Value Investors
- By Dilantha De Silva
In 2018, Lennar Corporation (NYSE:LEN) acquired CalAtlantics Homes for $9.3 billion, making it the largest homebuilding company in the United States. Being the leading real estate company in the country, Lennar has a good opportunity of growing its earnings in the coming years as home buyers are likely to be active in the market when the American economy finally recovers from the economic downturn.
The real estate sector is under-supplied compared to current demand, which is exerting upward pressure on home prices. This is good news for Lennar as its existing inventory can be sold for a higher-than-expected value, leading to strong earnings growth.
The outlook for the housing industry
The economic recession created doubts in potential homebuyers in the first quarter of 2020, and many Americans were waiting for a drop in property prices similar to what was experienced during the global financial crisis of 2008. However, things took a different turn along with the trillion-dollar stimulus packages introduced by the Federal government to revive business activities in the country. The emergency rate cut delivered by the Federal Reserve in March 2020 pushed mortgage rates to record lows as well, and this played an important role in creating substantial demand for new and existing homes.
According to Wall Street experts, the housing market is predicted to continue to grow in 2021 due to many reasons, including the ultra low interest rate environment and the fiscal stimulus. The expected recovery in the job market will also be a driver of the demand for new homes. New housing constructions, on the other hand, are expected to remain low due to increasing cost burdens, longer delivery times for building materials and a shortage in labor. This skews the odds in favor of demand, which is likely to push home deliveries down but also push prices to new highs in 2021.
The rise in the number of people working remotely and the low mortgage rates are also expected to increase home sales this year. Dave Ramsey projects existing home sales to increase 9% this year, while new home sales are projected to grow 21% year-over-year.
Based on the Realtors Confidence Index Survey in 2020, there was a high rate of buyers looking to buy houses in almost all the states except Iowa and Vermont in the last year. The number of houses that were listed to sell, however, was down 22%, creating a significant undersupply in the market. The only states that had a high number of houses to sell were Arkansas, Wyoming, Kansas, New Mexico and Connecticut. The survey also shows that houses in most states are likely to be sold within 16-30 days this year, which is a testament to the demand and supply mismatch in the U.S. housing market.
This will create great competition among homebuyers, which gives companies like Lennar the opportunity to sell houses at higher prices. Even though there's a possibility of mortgage rates increasing gradually along with the expected uptick in inflation and other factors, rates are likely to remain close to historic lows at least through the end of 2022 according to data from the Federal Reserve. The chief economist at realtor.com, Danielle Hale, expects home sales to increase in both 2021 and 2022 as the economic recovery gathers momentum.
Financial performance and dividend safety
While many companies struggled to make ends meet last year, Lennar was able to grow revenue and earnings as a result of favorable macroeconomic developments for the homebuilding industry. Lennar reported a net profit of $2.46 billion for fiscal 2020, which was a significant improvement from the $1.84 billion in profits generated the previous year. As illustrated below, the revenue of the company has increased steadily over the last decade thanks to the strengthening U.S. economy and the timely, value accretive acquisitions completed by Lennar in a bid to expand its horizons.
Source: GuruFocus
Lennar is a cash-rich business as well, and its operating cash flow has grown in every financial year since 2016. This is good news for dividend investors as higher cash flows will enable Lennar to distribute more wealth to shareholders in the future. The company has covered dividends with free cash flow in the last five years as well, which adds a degree of safety for income-oriented investors. The quarterly dividend of 25 cents translates to a yield of just over 1% at the market price of $94.64 per share on March 19, and the expected bump in earnings will have a positive impact on distributions in the coming years.
Lennar is a stable business
Earlier this year, fitch ratings upgraded the rating of Lennar including the issuer default rating to "BBB" from "BBB-," indicating that the company has a strong balance sheet that is continuing to improve as a result of stellar financial performance. Some of the key rating drivers that have contributed to this decision were Lennar's solid credit metrics, historical growth, significant scale and diversity, strong cash flow generation, diversified real estate activities and the favorable housing market dynamics expected throughout this year. Fitch Ratings further mentioned that the company has been able to reduce debt by $4.4 billion since February 2018, including $1.8 billion in 2020, which is a testament to the management's focus on improving Lennar's balance sheet strength.
Takeaway
The shortage of inventory and the pent-up demand is keeping the housing market strong and steady, which creates a very lucrative opportunity for Lennar. Even after a very strong run in the market that saw Lennar shares appreciate more than 200% in the last 12 months, the stock is still trading at a forward price-earnings ratio of just 9.35, which is well below historical averages and the industry multiple.
There seems to be an anomaly between the financial performance of the company and its market value. Despite the fact that a low price-earnings ratio can actually be a red flag for cyclical companies like Lennar, I believe the strong outlook for the housing industry is likely to act as a catalyst in helping Lennar stock continue running higher in the next 12 months.
Disclosure: The author does not own any shares mentioned in this article.
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This article first appeared on GuruFocus.
