A Homebuilder With Options

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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Guziec: And I think they're also doing some other things to buy and warehouse some high-quality land?

Landry: Right.

Guziec: Take advantage of the distress of some of the other builders?

Landry: Right. So, in the 90s Lennar had this arm called, LNR Properties, and its specialty was finding and buying and acquiring distressed real estate, working them out in some instances, foreclosing in others and what not, and they sort of acquired a skill at this. The business was subsequently spun-off and sold to private equity. But what happened was, a couple years ago, most of the management from LNR Property left LNR Property, came back to Lennar, and they're sort of restarting the band right now, and they started this back in 2007.

So what you see now is they are partners with the FDIC in some things, they are partners with other investors in other things, and they're starting this portfolio of distressed assets right now in what I feel is probably the perfect time to be doing that.

Guziec: So they're acting like great value investors?

Landry: They are. So, with Lennar, you've got multiple streams of value right now. This distress thing is probably 10% to 12%, 13% return on investment business here. So I think, there's a lot of sort of avenues where investors can win with Lennar going forward.

Guziec: Okay. Great. And then, you had some interesting comments about the local nature of the housing market.

Landry: Right.

Guziec: And how is Lennar positioned relative to that? Can you explain kind of the thesis behind it?

Landry: Well, sure. Let's talk big picture here. What you see now is a large amount of existing inventory, for sale inventory, and that's got a lot of people worried that there's going to be significant price pressure going forward. My take is, yes, that might happen, but you also have to consider the fact that real estate is not fungible, right? It's not like something you can put on a truck and ship it somewhere if there's demand, it's stuck.

So, what might happen is we may have a lot of sort of uneconomic homes sitting on the market in one area, let's call it Detroit, if you will, where there could be a shortage or an equilibrium in another more healthy market, let's call it D.C., where you and I both know that there's a perpetual demand for jobs and houses because of the growth of this monster called the Federal Government. So it might be that some analysts are fooled into thinking, we're going to have a sputtering market with significant inventory out there on a national level, whereas you've got local markets starting to equalize, and Lennar is well positioned in this, because they've got assets in areas where we think are likely to be good markets going forward.

Guziec: Okay. Great. And then, you think Lennar is worth $25, market thinks it's worth $14.

Landry: $14 today.

Guziec: Where's the big difference?

Landry: Well, the housing – the homebuilders sold off significantly when the new home sales number for May came out, there was an all-time low, and the reason is because much like 'Cash for Clunkers' with autos, you did have demand pull forward and this is a natural thing in my opinion. What a lot of people missed with homebuilders is that there is a deferred tax asset that sits off balance sheet right now that's likely to come back on balance sheet in the next year or so.

So if you look at Lennar, book value is somewhere around 13 and change, the stock doesn't look that cheap at a little bit over one times book, but when you add back $3.5 a share in deferred tax assets, it's coming back onto the balance sheet. It's still trading less than book value, and as you and I discussed earlier, there's multiple avenues for value creation in this homebuilder, which just doesn't exist in some others.

Guziec: Okay. Great. So what do you think the chances are that it's trading for less than $15, say, January 2012, the expiration of our option?

Landry: Well, you know my opinion about the market, so I think it's low. If you look at Lennar specifically, and homebuilders in general, you saw cratering of book value for the past three years. If you look over the past several quarters, the declines in book value have decreased significantly to where it's been flat, and in Lennar's case actually increased book value, because they made a profit in the latest quarter. Lot of these homebuilders are keeping inordinate amount of SG&A in place because they know there's an upturn coming and they want to be big beneficiaries of this.

So I guess, we could say that upturn never came. You're going to have more pressure on book value as they carry these large overheads and have to do more cuts and whatnot. There may be some impairments coming, but I think, Phil, honestly the odds of that are pretty low. I think, these homebuilders are in pretty good shape right now.

Guziec: Great. Good to hear. Thanks for taking the time.

Landry: Thanks.

Guziec: I am Philip Guziec, Co-Editor & Portfolio Manager of Morningstar OptionInvestor research service. Thanks for joining us.