Lennar's Pricing Concessions Will Hurt Margins in 2023, but We Expect Outsize Cash Flow

Sector Director

Brian Bernard

Revenue segments as reported by the company.

Homebuilding

Financial Services

Multifamily 

Lennar Other

Revenue Segments

Revenue is the money generated from normal business operations. Gross Profit is revenue minus cost of goods sold. Operating Income is revenue minus cost of goods sold and other operating expenses.

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Gross Profit, Operating Income, and Net Income as a percentage of Revenue

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Lennar Other realized and unrealized gain (loss)

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United States homebuilders enjoyed a robust demand environment from 2020-22 despite the COVID-19 pandemic. We believe several factors explain the pandemic-era housing surge, including increased suburban and cross-state migration (due in part to the rise of flexible work arrangements), government stimulus (which bolstered household savings), and record-low mortgage rates (which supported affordability despite rising home prices). However, home sales activity began to decline in 2022 as rising mortgage rates and high home prices reduced homeownership affordability.

We project housing starts to decrease 22% year over year in 2023 to 1.220 million units. However, we expect affordability will improve over the next two years as both mortgage rates and home prices decline. We project starts will rebound to around 1.55 million units by 2026-27 and average roughly 1.45 million-1.5 million units toward the end of the decade.

We expect first-time buyers will be a key driver of future housing demand, and Lennar is well positioned to capture these potential buyers with its increased mix of entry-level homes. Lennar controls an ample land supply, which affords the company the ability to meet future demand while focusing on improving cash flows and maintaining a strong balance sheet. The company has shifted to a lighter land acquisition strategy, which seeks to reduce the amount of capital tied up in land by purchasing smaller land parcels and relying more on land options to acquire land on a just-in-time basis. We think this strategy should help the company realize better returns on invested capital and cash flows over the housing cycle. 

Lennar’s investments in ancillary businesses, such as its multifamily business and technology startups, distinguishes the company from many other homebuilders. Management announced plans to spin off its multifamily, single-family for rent, and land businesses but the spinoff transaction has been delayed. In our view, the separation of these ancillary businesses, which tend to generate lumpier earnings, should dampen Lennar's earnings volatility.

Business Strategy & Outlook

As one of the nation’s largest builders, Lennar enjoys certain benefits from its scale that some smaller builders may find difficult to replicate. Furthermore, the company has been able to generate above average margins among public peers over the past several years. Still, the fragmented homebuilding industry is very competitive, capital-intensive, and cyclical. Moreover, we believe there are few barriers preventing homebuilders from replicating successful strategies and entering new markets. These structural forces have made it difficult for homebuilders to earn consistent, positive economic profits over the business cycle. As such, we assign Lennar a no moat rating.

Lennar’s construction efficiencies have been a source of the company's strong gross margin performance. Lennar’s "Everything’s Included" product strategy, reduced floor plan offerings, and centralized purchasing have simplified the construction process, reducing construction costs and cycle times. Lennar’s building efficiency strategy is not arcane, as other homebuilders have implemented similar strategies with beneficial results. While we think Lennar’s scale and industry reputation have helped build strong relationships with subcontractors and land developers, we don't think the company is able to negotiate meaningful long-term price concessions, especially given the tightness of the current construction labor market and land supply. If anything, we think bargaining power can shift to the suppliers of land and labor in a strengthening housing market. Overall, we think Lennar's gross margins will converge closer to the industry average over the coming years as the company exhausts its lower-cost land supply, increasingly relies on more-capital-friendly but lower margin optioned land, and as peers replicate successful marketing and building efficiency strategies. 

Lennar faces significant competition that can act irrationally at times. The fragmented homebuilding industry features at least 17 public homebuilders and many more private regional and local homebuilders. All of these builders compete for land, materials, labor, and of course customers. Irrational behavior, such as aggressively pushing incentives to drive better community absorption rates or overbidding on land deals, can have adverse repercussions for the entire industry. Competitors can also enter new markets and replicate successful product and land acquisition strategies with relative ease, potentially diminishing returns for incumbents. Historically, homebuilders have used mergers and acquisitions as a means of entering new markets, as acquiring an existing builder grants immediate access to the new market with less risk than a greenfield startup operation. We see few barriers preventing builders from replicating successful product and land acquisition strategies, especially for public companies with the scale, experience, and capital availability to do so.

The company markets traditional homes and multifamily units under the Lennar brand name. While we believe brand recognition may drive increased foot traffic, our opinion is that location, pricing, design, and amenities are far more important than brand reputation for potential buyers. We don't think that the Lennar brand drives meaningful pricing power over similar competing offerings.

Homebuilders spend substantial time and effort completing due diligence before acquiring land and building communities. Still, land and communities can underperform initial expectations for myriad reasons, resulting in potential margin dilution and impairment charges, even in a healthy housing market. Land option contracts--which grant homebuilders the right, but generally not the obligation, to buy land at predetermined prices--can mitigate many of the risks associated with outright land purchases. An option contract strategy generally leads to lower average land inventory on the balance sheet and higher, more consistent returns on invested capital. NVR is an example of a homebuilder that has successfully executed this land-light strategy for years. While Lennar has done a commendable job shifting to a lighter land strategy, this strategy is not unique, in our view, as much of the industry has followed the same path to varying degrees of success. 

Economic conditions can have a profound impact on homebuilder profitability as witnessed during the housing downturn of 2006-09. Lennar went from earning $8.23 per diluted share in fiscal 2005 to losing $12.31 per diluted share in fiscal 2007 as the collapsing housing market resulted in drastic margin compression and large impairment charges. Between fiscal 2006 and 2009, Lennar recognized approximately $5.0 billion of inventory, goodwill, and other impairment charges. This downturn is an extreme example; however, it is typical for homebuilder profitability to ebb and flow throughout each housing cycle. Although we think the industry has learned from prior mistakes, the sheer capital intensity and cyclical nature of the homebuilding business make it difficult for most homebuilders to outearn their cost of capital over a full business cycle.

Lennar is exposed to several environmental, social, and governance risks, including product governance, carbon and other emissions, effluent and waste, and human capital. However, we don't believe these risks could result in material value destruction. Furthermore, these risks are already considered in our high uncertainty rating. 

Product quality issues do arise in the homebuilding industry (for example, construction defects); however, such incidences are generally confined to relatively few homes and are usually remedied via homebuilder, subcontractor, and/or manufacturer warranties. Warranties and prompt remediation can reduce reputational risk from such events, while insurance policies and contractor indemnification can limit financial losses.

Residential construction consumes a significant amount of energy to power construction equipment and transport building materials and construction and demolition waste. However, we're not concerned about the industry's ability to embrace more energy-efficient construction practices. As one of the largest homebuilders in the United States, we believe Lennar could be a leader in such efforts. It's also important to note that new homes have become increasingly energy-efficient (for example, installing solar roof panels or Energy Star-certified products). We believe these efforts help mitigate the environmental impact of homebuilding operations. 

Lennar is not immune to the human capital issue that has plagued the homebuilding industry. There's been a shortage of skilled construction labor for some time that has been exacerbated by an aging workforce. The labor shortage has increased labor costs for homebuilders and can extend the length of time it takes to build a home. That said, Lennar can leverage it superior scale to attract and retain subcontractors. We consider the financial impact of a persistent labor shortage in our base-case scenario.

None

Economic Moat

Lennar

Lennar Corp. is a homebuilder company which engages in the provision of real estate related financial and investment management services. It operates through the following segments: Homebuilding East, Central, Texas, and West, Financial Services, Multifamily, and Lennar Other. The Homebuilding East, Central, Texas, and West segment constructs and sells homes primarily for first-time, move-up, and active adult homebuyers primarily under the Lennar brand name. In addition, the company's homebuilding operations purchase, develop, and sell land to third parties. The Financial Services segment focuses on mortgage financing, title, and closing services for buyers. The Multifamily segment is involved in the development, construction, and property management of multifamily rental properties. The Lennar Other segment includes strategic investments in technology companies. The company was founded by Gene Fisher and Arnold Paul Rosen in 1954 and is headquartered in Miami, FL.

Earnings data Q1 2023

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Lennar Corp. engages in the provision of real estate related financial and investment management services. It operates through the following segments: Homebuilding East, Central, Texas, and West, Financial Services, Multifamily, and Lennar Other. The Homebuilding East, Central, Texas, and West segment constructs and sells homes primarily for first-time, move-up, and active adult homebuyers primarily under the Lennar brand name. In addition, the company's homebuilding operations purchase, develop, and sell land to third parties. The Financial Services segment focuses on mortgage financing, title, and closing services for buyers. The Multifamily segment is involved in the development, construction, and property management of multifamily rental properties. The Lennar Other segment includes strategic investments in technology companies. The company was founded in 1954 and is headquartered in Miami, FL.

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