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Morningstar | Lennar's 1Q New Order Growth Tells Us Spring Selling Season Is Off to Strong Start

Shares of Lennar traded higher March 27 after the no-moat-rated homebuilder reported fiscal first-quarter results that mostly beat management's guidance. Most notably, Lennar reported 10,463 new sales orders during the quarter versus guidance of 9,700-10,000 orders (we had been expecting approximately 9,900). The better-than-expected order activity tells us that the all-important spring selling season, which started on Super Bowl Sunday, is off to a strong start. Recent mortgage application activity points to the same conclusion. According to data from the Mortgage Bankers Association, week-over-week mortgage applications have increased for three consecutive weeks as the average 30-year fixed mortgage rate has hit a one-year low of below 4.3%.

Lennar's incentives as a percentage of home sales increased 40 basis points year over year and 20 basis points sequentially to 5.8%. Even so, this increase in incentives seems reasonable to us relative to recent housing market conditions. We don't believe Lennar is becoming overly aggressive on price reductions to push sales. Indeed, the average selling price of home deliveries during the first quarter ($410,000) was in line with management's guidance, and the ASP of new orders ($397,300) was only $1,100 lower compared with the first quarter of 2018.

We're maintaining our $70 fair value estimate, and we continue to believe that Lennar and D.R. Horton are best positioned to benefit from a growing need for housing in the United States, especially from the large millennial cohort.

While Lennar's first-quarter revenue and EPS both missed consensus estimates, we're not concerned because the lighter-than-expected top- and bottom-line performance was mostly caused by weather-related delivery delays. Indeed, the firm's first-quarter backlog conversion rate of 57% was uncharacteristically low (average is closer to 70%-75%). However, we expect any delayed home closings will be delivered during the second quarter.

During the earnings call, CFO Diane Bessette issued fiscal second-quarter and preliminary full-year 2019 guidance. The full-year guidance is notable because at this point, no other public homebuilder has offered a full-year outlook due to previous housing market uncertainty. However, Bessette noted that the market is now "a bit less uncertain and on solid ground." We expect other homebuilders will follow Lennar's lead as the first-quarter earnings season unfolds.

We were generally pleased with both second-quarter and full-year guidance. Lennar's second-quarter demand outlook is about in line with the second quarter of 2018 (14,000-14,300 new orders compared with 14,440 last year and 11,700-12,000 deliveries versus 12,095 last year), which benefited from a strong spring selling season. Management also expects delivery ASP of $400,000-$405,000, home sales gross margin of 20%-20.5%, and a selling, general, and administrative expense ratio of 8.5%-8.6% compared with a $413,000 delivery ASP, a 21.6% gross margin, and an 8.7% SG&A ratio last year.

For the full year, management expects to deliver 50,000-51,000 homes (compared with 45,627 in 2018) at an average selling price of $400,000-$405,000 ($413,300 in 2018) with an average gross margin of 20.5%-21% (21.8% in 2018 excluding CalAtlantic-related purchase accounting). While an uptick in incentives is a headwind for near-term gross margins, management expects to reduce incentives as 2019 progresses, assuming demand plays out like management expects.

As widely reported by the press, the Federal Housing Administration, which insures first-time mortgages, recently announced tighter lending standards. The FHA told The Wall Street Journal that about 40,000-50,000 loans a year could be affected, which equates to 4%-5% of annual FHA-insured mortgages. To put FHA mortgage volume into perspective, according to the U.S. Department of Housing and Urban Development, through the first three quarters of 2018 (latest available data), FHA mortgages represented just over 12% of total mortgage volume. During Lennar's earnings call, CEO Rick Beckwitt said this change has an "insignificant" impact on Lennar, noting that less than 1% of total loans would have been affected over the last five quarters.

In both our December 2018 Industrials Observer, "Can Beaten-Down Homebuilders Build Profits in Your Portfolio?," and our "U.S. Housing Outlook: First Quarter 2019" report, we named D.R. Horton and Lennar as our top homebuilder picks. As of this writing, on a year-to-date basis, D.R. Horton's stock price has increased 23% (11% outperformance relative to the S&P 500) and Lennar's stock price has increased 32% (20% outperformance). While D.R. Horton has now moved into 3-star territory, Lennar is still trading at an approximate 25% discount to our $70 fair value estimate.

Lennar's board of directors authorized the company to repurchase the lesser of $1 billion or 25 million shares over an unspecified period. Lennar repurchased 1 million shares for $47 million during the first quarter. Given that Lennar's stock trades below our estimate of the firm's intrinsic value, we think buybacks are a prudent use of capital.