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Morningstar | Lennar’s 2Q Beat and Order Growth Weren't Enough to Assuage Fears of a Housing Slowdown

Lennar released better-than-expected fiscal second-quarter results on June 25 that featured year-over-year order growth. The no-moat-rated homebuilder’s consolidated revenue ($5.6 billion) and diluted EPS ($1.30) handily beat consensus estimates of $5.1 billion and $1.14, respectively. Lennar’s homebuilding operations, which accounted for 92% of the firm’s second-quarter pretax earnings before corporate expenses, were the primary reason for the solid results. Home sales grew almost 4% year over year to $5.2 billion, driven entirely by volume (up 5%), as the average selling price of delivered homes declined about 1% compared with the prior-year quarter. Home sales gross margin came in at 20.1% versus an adjusted 21.6% during the year-ago quarter due to higher construction costs and sales incentives. However, Lennar’s lower gross margin was somewhat offset by better selling, general, and administrative expense leverage; SG&A as a percentage of home sales declined 30 basis points year over year to 8.4% (a record second-quarter low for Lennar). Lennar’s home sale operating margin contracted 130 basis points to 11.6%.

All eyes were on Lennar’s orders and guidance. Orders were stronger than management had anticipated (up 1% year over year to 14,518 compared with guidance of 14,000 to 14,300). However, we think concerns about Lennar’s use of incentives to increase orders and the underwhelming third-quarter guidance, which culminated in an expected EPS of $1.25 to $1.35—below even the low consensus estimate of $1.40 (average was $1.51), caused Lennar’s stock to sell off 6% on June 25 despite bullish premarket trading.

Still, Lennar’s updated full-year guidance remained mostly unchanged, and management still expects to deliver up to 51,000 homes in 2019 (an increase of 12% year over year). Our long-term outlook remains intact, so we’ve maintained our $70 per share fair value estimate. In our view, the June 25 sell-off was overdone.

While 1% order growth seems unimpressive at first, it’s important to consider that orders for Lennar were particularly strong during the second quarter of 2018, up about 10% year over year by our estimate (on a pro forma basis adjusting for the CalAtlantic merger). Lennar’s order growth came on a flat active community count, too. By community, Lennar signed 11 orders per community during the quarter compared with 10.9 last year during what was widely viewed as a strong spring selling season.

Incentives ticked up to 6.1% of sales during the quarter versus 5.3% during the year-ago quarter and 5.8% during the first quarter of 2019. We suspect this disclosure caused some investors to question whether Lennar has been using aggressive pricing to drive growth, but that’s not our take. In fact, incentives as a percentage of sales were near 6% as recent as 2017, which was the same year homebuilder stocks surged on growing housing optimism. Furthermore, management said they expect improving home sales gross profit margins over the balance of 2019, due in part to reduced incentives amid a “solidifying” housing market.

Some investors might also have taken issue with Lennar’s falling average selling prices. The ASP of delivered homes fell 1% to $408,000; the ASP of new orders fell 4% to $399,000; and the ASP of homes in backlog fell 7% to $405,000. While increased use of incentives explains some of the drop, we think Lennar’s declining ASP is more the result of a mix shift to Lennar’s lower-price products. Indeed, during the earnings call, CEO Rick Beckwitt used the Texas market as an example, saying that over the past 18 months, 75% of the land that Lennar purchased there will be developed as entry-level communities. While we continue to believe D.R. Horton has a stronger entry-level position, we expect Lennar to perform well with this type of buyer, as well.

May new-home sales data from the U.S. Census Bureau, which was also released on June 25, didn’t help Lennar’s case, either. New-home sales declined about 4% year over year to 626,000 units (seasonally adjusted annual rate). However, year to date, new-home sales were up 4% relative to the first five months of 2018.

Management’s mention of tariff headwinds likely influenced the sell-off, too. We were perplexed why this topic even came up on the call given that we don’t think U.S. homebuilders are all that exposed to Chinese tariffs. Case in point, management said the tariff impact on Lennar is just $500 per home, which is not even close material, in our view, and not worth unprompted commentary from management. Nevertheless, at the time of this writing, we’ve seen some news headlines where Lennar’s sell-off and tariffs are mentioned in the same breath.

Lennar’s involvement in building single-family rental homes was a new and interesting development during the earnings call. Management said it’s currently working with a third party in Florida that is purchasing the homes from Lennar for rental purposes. Lennar is exploring similar opportunities elsewhere, but management was quick to point out that it’s looking to roll out this strategy in markets where the firm otherwise wouldn’t build, so we’re not worried about cannibalization of Lennar’s sales. Given that Lennar won’t own the land it’s building these rental homes on, these projects should deliver strong returns on invested capital with lower risk.