Lennar: Further Upside As Mortgage Rates Begin Their Decline (NYSE:LEN)

Introduction

Lennar (NYSE:LEN) has significantly outperformed the iShares U.S. Consumer Discretionary ETF (IYC) so far in 2024, delivering a circa 23% total return against the ~ 11% gain for the benchmark ETF:

I think the company has further upside, driven on the one hand by a sector-wide tailwind which will come from lower mortgage rates as the Fed normalizes policy, but also by an undemanding ~13x P/E multiple and a net cash position that provide a significant margin of safety if reported results do not improve as expected.

Company Overview

You can access all company results here. Lennar is the second largest US homebuilder, lagging only D.R. Horton (DHI). The company reports results in three main operating segments, namely Homebuilding, Financial Services, and Multifamily, with the remainder of results booked under Lennar Other. Homebuilding is the most important segment for Lennar, accounting for 95.6% of Q2 2024 revenue and 90% of EBIT:

Operational Overview

The company has a fiscal year ending in November, hence the Q2 2024 results cover the period that concluded in May 2024.

In Q2 2024 Lennar reported revenue growth of 9% Y/Y, driven by the Homebuilding segment. The gross margin on home sales stood at 22.6%, up 0.1% Y/Y on construction cost expense management, while the net margin stood at 15.1%, down 0.7% Y/Y on higher sales, general & administrative expenses.

The combined effect was earnings of $3.45/share, up 14.6% Y/Y, also helped by a 3.9% lower share count Y/Y.

Q3 2024 Outlook

In Q3 2024 the company expects to deliver some 20,750 homes with a gross margin of 23%, putting it on track to reach its 80,000 homes target for the full year, as well as a gross margin consistent with 2023:

Analyst consensus estimates put Q3 2024 EPS at about $3.62/share, which seems reasonable to me. Compared to Q2 2024, we are expected to see a marginally stronger gross margin and a smaller impact from sales, general and administrative expenses (down 0.1% Q/Q). Furthermore, EPS will benefit from share buybacks which I expect have continued throughout Q3 2024.

We should note Q2 2024 EPS included a $0.07/share benefit from a gain on the sale of a technology investment; hence I expect Lennar to show strong Q/Q EPS growth, although Y/Y comparisons will suffer from higher margins in the prior-year quarter.

Capital Structure

Lennar runs an extremely conservative capital structure, with the company ending Q2 2024 with a net cash position of ~ $1.4 billion, allowing it to focus on share repurchases – in Q2 2024 the company allocated $603 million for buybacks and $554 million for debt principal repayments (the company still has $2.2 billion in gross debt).

Prospects and valuation

Even before we factor in meaningful benefits from Fed rate cuts, I think it is reasonable to assume Lennar can deliver earnings of about $14/share annually, which would put the P/E multiple at 13x – a very undemanding valuation for a company with a net cash position. When we factor in inflation of 2% long-term, you are potentially looking at a high-single-digit return in the current economic climate.

I do expect the company to benefit from lower mortgage rates down the line, with data from Bankrate showing the national average 30-year fixed mortgage at 6.44%, well below the >7% readings we were accustomed to. You can clearly observe the trend for lower mortgage rates over the past six months:

While there is no guarantee we will see a return to the sub-5% mortgages that characterized the post-2010 period up until the recent cycle of Fed rate hikes, I would fully expect mortgage rates to drop further, potentially in the 5%-6% range which was the norm between the Dotcom bubble and the 2008 Global Financial Crisis:

This in turn is likely to provide a marginal boost to homebuilders, with Lennar one of the key beneficiaries. The company will potentially also benefit from Federal home assistance programs, which are likely to be strengthened irrespective of who wins the November 2024 presidential election.

Risks

The main risk facing Lennar is a continued rise in the unemployment rate, which would severely limit the propensity of people to purchase new homes, denting Lennar’s profits. This risk would be mitigated to an extent by larger-than-currently priced in decreases in the Fed funds rate, with the Federal Reserve increasingly attentive to weakness in the labor market.

The July 2024 pending home sales data was also weak, highlighting that even as mortgage rates have declined from their >7% levels in May/June 2024, the boost to the housing market may take longer to materialize. As such, while there is a correlation between the housing market and mortgage rates, it is not 1 to 1; hence there is no guarantee that lower mortgage rates will translate into more construction activity for Lennar.

Conclusion

Lennar reported strong revenue and EPS growth in Q2 2024, boosted by its core Homebuilding segment. I expect the robust performance to carry into Q3 2024 as well.

Lennar runs an extremely conservative net cash capital structure, limiting the company’s sensitivity to the ever-changing operational dynamics of the housing market. With mortgage rates on a clear downward trajectory, I expect the 30-year fixed mortgage to fall to at least 5%-6% in the medium term as the Fed normalizes policy.

Considering my forecast for a sector-wide tailwind from lower mortgage rates and a P/E multiple of only 13x, I reckon Lennar is worth a buy rating even after the company’s strong performance so far in 2024.

Thank you for reading.