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Morningstar | Lennar's 3Q Results Beat Wall Street Estimates; Management Expects 15% Delivery Growth in 2019

No-moat-rated Lennar reported strong fiscal third-quarter results that easily beat management's and Wall Street's earnings expectations. Adjusted EPS of $1.61 topped management's guidance of $1.40 to $1.45 and the consensus estimate of $1.42. Lennar's homebuilding operations outperformed management's expectations; home sales revenue of $5.2 billion beat guidance by about 2%; adjusted home sales gross margin came in at 21.9% versus guidance of 21.5% to 21.75%; and selling, general, and administrative expenses as a percentage of home sales was 8.6% versus management's expectations of 8.7%.

While management slightly lowered its fourth-quarter 2018 guidance for home deliveries and orders because of "Hurricane Florence…and a bit of sluggishness in today's markets," Lennar's strong third-quarter results and fiscal 2019 guidance are hardly reflective of a housing recovery that has run its course. Indeed, pro forma new order volume increased 11% year over year, and management expects to deliver 53,000 homes in fiscal 2019, a 15% increase over 2018 home delivery guidance.

Lennar has been executing upon its "soft pivot" land strategy, which calls for moderate growth and a lighter land acquisition program, for several years now. However, Lennar appears positioned to double down on this strategy. Approximately 22% of Lennar's lot position is controlled through options or joint ventures. Management expects to increase this metric to 40% in a few years. We had not been modeling as aggressive of a shift to optioned land, which tends to generate lower gross profit margins but higher returns on invested capital, so this disclosure has a valuation impact. We lowered our 10-year average gross margin assumption to 22.6% (from 24% previously), and we now expect average inventory as a percentage of home sales to improve to about 70% over our 10-year forecast (versus 80% previously). As a result of these changes, our fair value estimate declined about 1.5% to $68 per share.

It will be quite a milestone if Lennar can achieve its desired lot mix in a few years since Lennar's controlled lot position as a percentage of total lots has not been greater than 40% since fiscal 2008. During the earnings call, management disclosed that the company has entered into agreements with three of its large regional land developers that will give Lennar exclusive access to these developers' future land pipeline. These relationships should certainly help Lennar grow its optioned lot count. While management wouldn't disclose the terms of these agreements, we didn't get any indication that it's anything like what D.R. Horton did with Forestar (taking a 75% ownership stake which required consolidation), so we think Lennar will be able to keep land from these developers off its books until it executes land options. In addition to potentially improving Lennar's ROICs, a more option-heavy land mix will help Lennar derisk its balance sheet.

During the earnings call, management noted that it's "consider[ing] the repurchase of our stock opportunistically." This statement marks a change in capital allocation strategy, in our view, because Lennar has not repurchased a noteworthy amount of stock since fiscal 2006 when the firm spent $320 million to repurchase 6.2 million shares. Given that Lennar's stock trades at over a 30% discount to our fair value estimate, we think share repurchases are a good use of shareholder capital.