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By Philip Guziec, CFA | 07-12-2010 04:14 AM

A Homebuilder With Options

Morningstar's Eric Landry thinks Lennar has plenty of ways to profit from a normalization of the housing market.

Securities mentioned in this video
LEN Lennar Corp

Philip Guziec: Hi, I am Phil Guziec, Co-Editor and Portfolio Manager of Morningstar's OptionInvestor research service and I'm here with Eric Landry, Associate Director of our Industrial's research team and our analyst covering the housing industry and homebuilders.

Eric Landry: Hi, Phil.

Guziec: So we spent some time in a recent video talking about the homebuilding industry in general and you're decidedly bullish and you think we're rounding the corner right about now. In making an investment in that space, let's talk about Lennar which I know you're very fond of and we have a position in our Pay-Me-Later OptionInvesting portfolio.

Landry: Sure.

Guziec: So, give us the history on Lennar. What happened to them during the downturn?

Landry: You know Phil, Lennar is a very interesting homebuilder because they've always been sort of on the leading edge of innovation in the land market. If you go back to sort of the bubble of the crazy days, '03 to '05, they were the innovators in the off-balance sheet housing of their inventory of land. So they've formed these joint ventures; they load them up with that house and land off-balance sheet, so it wouldn't affect their asset turns as much if a more traditional builder that would house this on balance sheet. And investors by and large were onboard with this when things were going well.

Of course, when the cycle turned and land prices plummeted, Lennar was similarly reviled for these risky off-balance sheet entities that they carried, so the stock got crushed. It would always trade at a discount to the rest of the group because people were terrified of this off-balance sheet exposure through these joint ventures.

Through all of this management has done, what I consider, pretty good job of eliminating or greatly reducing this risk of these off-balance sheet entities blowing up. Their exposure was about $1 billion several years ago. They whittled that down to less than $250 million, even if all the partners go belly-up and they're stuck everything. So, the Company was on a leading edge; they were reviled for a while and now I think they are clawing their way back to respectability and there's also a lot of other good things going on in the company right now.

Guziec: Yeah, let's talk about that. You think they're particularly well-positioned to profit from the coming swing or even just normalization in housing demand?

Landry: Yeah.

Guziec: What have they done?

Landry: Well, Lennar is a member of the group of large national builders that are absolutely flushed with cash right now. And what's happening now, as you've got a bifurcated market, you've got the – what's left of the little builders on one side that are starved of cash, not likely to get much liquidity in the next couple of years because the financing is right there. On the other hand, you've got a small number of large builders that are absolutely very liquid, ready to invest.

On top of this, you've had the management at Lennar working extremely diligently. They cut off going to conferences and what not, talking to investors, touting themselves for a couple of years actually while they got their house in order. So, while many other builders, large and small, were focused almost exclusively on getting rid of their land inventory, Lennar was getting rid of the bad stuff simultaneously restocking with the cheaper, better located land. So, as a result of that, they are not – last quarter they were profitable, and as ahead of most other builders, and a lot of that is due to very strong gross margins for the industry because they're running this new land through the income statement right now.

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