Lennar Corp'A' : (LEN)

INVESTMENT THESIS This week's Focus Stock of the Week is Lennar Corporation Class A shares (LEN: $15), which carry Standard&Poor's highest investment recommendation of 5-STARS, or Strong Buy. We expect this U.S. homebuilder to benefit from its diversified geography for selling new homes and other real estate-related investments, despite high unemployment rates, increased foreclosures and tightening credit standards. In our opinion, the U.S. housing market is beginning to stabilize and homebuyers can take advantage of increased affordability resulting from declining home prices, a large supply of inventory and historically low interest rates for home mortgages.

In the last two quarters, LEN has realized positive growth in net new orders and contract backlog, with the latter increasing to $655 million at May 31, 2010 from $455 million at the end of FY 09 (Nov.). This is the company's highest level for backlog since August 2008. Backlog in some ways is a good indicator of a company's likely sales and earnings for the next several quarters, as it is derived by subtracting current-period closings from the sum of all existing orders that have not yet been closed.

We believe LEN can achieve profitability with reduced sales incentives and lower construction costs on new scaled-down homes coming to market. We expect the company to be opportunistic in new land purchases or option land contracts, with abundant land coming to market from banks that took possession of distressed or bankrupt private homebuilders. As of May 31, 2010, LEN had in excess of $1.1 billion of cash and cash equivalents to support its working capital and debt obligations, as well as new land acquisitions. By our analysis, LEN should be able to meet its working capital and debt requirements and still have available funds to invest in new land acquisitions in order to build new communities. BUSINESS PROFILE Lennar Corp., the third largest homebuilder in the U.S. (based on the Builder Magazine 2010 survey of U.S. home closings), constructs homes for first-time, move-up and active adult buyers, and also provides various financial services. It takes part in all phases of planning and building, and subcontracts nearly all development and construction work. LEN sells homes primarily from models it has designed and constructed. The company was founded as a local Miami homebuilder in 1954, and it completed an initial public offering in 1971. During the 1980s and 1990s, LEN entered and expanded operations in some of its current major homebuilding markets, including California, Florida and Texas, through both organic growth and acquisitions. In 2000, the company acquired US Home Corporation, which expanded its operations into New Jersey, Maryland, Virginia, Minnesota and Colorado and strengthened its position in other states. From 2002 through 2005, LEN acquired several regional homebuilders, which brought it into new markets and strengthened its position in several existing markets. LEN's strategy has been to focus on the basics of its homebuilding operations as management repositions the company for a potential return to profitability in 2010. To adjust to changing market conditions, LEN was able change its product offering to smaller homes, reduce the number of floor plans and target more first-time and value-oriented homebuyers. These more efficient product offerings have significantly reduced the company's construction costs to meet changing customer demands. In addition, the cost savings from scaled-down houses, combined with reduced sales incentives has improved gross margins in the last several quarters. With lower sales volumes, LEN has also reduced SG&A expenses by right-sizing its overhead levels, which we believe will allow for leveraging additional volume when the housing market recovers. Like other homebuilders, LEN has certain obligations related to post-construction warranties and defects for closed homes. Through May 31, 2010, the company accrued $80.7 million of warranty reserves related to homes confirmed as having defective Chinese drywall, as well as an estimate for homes not yet inspected that may contain Chinese drywall. For the same period, the warranty reserve, net of payments, was $37.3 million. The company is seeking reimbursement from its subcontractors, insurers and others for costs it has incurred or expects to incur on defective Chinese drywall issues.

LEN's newly formed Rialto Investments unit tries to generate above-average, risk-adjusted returns by focusing on commercial and residential real estate opportunities arising from dislocations in the U.S. real estate market. In the first six months of FY 10, Rialto contributed $34.6 million in revenues and $13.8 million in operating earnings. INDUSTRY OUTLOOK Assuming sharp decreases in housing prices ease to 7%-9% declines in 2010, we believe most publicly traded builders are in a solid competitive position after reducing costs, retiring debt and increasing cash positions. We think the housing market is beginning to stabilize and is poised for future growth as inventory in most markets levels off after steep increases in the last two years. Following the expiration of the federal housing credit, sales of new single-family homes in May 2010 plunged 32.7% compared to April 2010, and were down 18.3% from a year earlier. The decline was greater than we had expected, and we believe this leads to a weaker near-term sales outlook for homebuilders. However, despite weak demand, we are beginning to see homebuilders acquire improved or developed land for future communities. Our neutral fundamental view of the homebuilding industry is dependent on the housing market's ability over time to continue to reduce existing home inventory, which stood at 8.3 months at the end of May 2010, still above normalized levels of 6 months. We believe normalized levels may not be realized until late 2011 if more foreclosed homes come to market.

We think the key factors to drive a stronger housing market are an increase in buyers' confidence with improving employment conditions, available mortgage credit from lenders, a better balance of new and existing homes available for sale, and an easing of increased foreclosed properties, which continues to put downward pressure on housing pricing. Monthly data from the Commerce Department on housing permits, starts and completions as well as new residential sales are a good indication whether the housing market begins to stabilize and recover, in our view. June 2010 single-family housing starts declined 4.6%, year over year, but were down only 0.7% compared to May 2010 after the April 30 expiration of the federal housing credit. Single-family housing permits declined only 3.4% in the same sequential months. In the next six months, we see modest growth in net orders, contract backlog and revenues, with wider margins leading to higher free cash flow, as demand stabilizes for new single-family homes. On July 19, 2010, the National Association of Home Builders had a more bullish view saying that low mortgage rates, affordable prices, and demographic trends will help revive consumer demand for new homes in the second half of 2010, and that new home sales will grow 10% in 2010 versus 2009. COMPANY OUTLOOK Competition for homebuyers continues to be intense with existing home foreclosures, and the selection of mortgage financing products remains limited with more restrictive underwriting standards. In FY 09, homes sold by the company had an average sales price of $234,000 compared to $270,000 in FY 08. Sales incentives were down slightly to $44,800 per home for FY 09. During the first half of FY 10, LEN's operations continued to be negatively impacted by a weak economy for housing, but the company did report positive quarterly sequential gains in revenue, net orders and contract backlog. The average sales price of homes delivered decreased to $240,000 in the fiscal second quarter of 2010 from $251,000 in the same period a year earlier, primarily due to product mix as fewer deliveries occurred in the company's homebuilding west segment. Sales incentives offered to homebuyers as a percentage of home sales revenue improved to 11.5% in the second quarter of FY 10, from 17.3% in the second quarter of FY 09 and 12.5% in the first quarter of FY 10. Contract backlog increased to $655 million at the end of the fiscal second quarter compared to $456 million at the end of FY 08 and $480 million at the end of FY 09.

Following an overall revenue decline of 33% in FY 09, we project that revenues will rebound 3.0% in FY 10, reflecting a slow but steady improvement in the housing market. With a higher contract backlog assumed, we forecast revenue growth of 15% in FY 11. Our financial model also assumes homebuilding gross margins will widen from an estimated 20.4% in FY 10 to 22.6% in FY 11 with increased home deliveries and stable pricing. Based on these assumptions, we estimate EPS of $0.50 in FY 10 and $1.00 in FY 11.

VALUATION Our 12-month target price of $21 is based on applying a price-to-book value multiple of slightly above 1.5X to our 12-month forward adjusted book value per share forecast of $13.50, which is above that of the company's homebuilding peers and toward the midpoint of LEN's historical range for the last housing cycle. We are also assuming a medium risk premium as we see the housing market stabilizing and beginning to show moderate improvement going into 2011.

We believe the shares should trade at a premium valuation given our view that the company has scale advantages over its peers, a diversified geographic presence, and $1.3 billion in cash to meet working capital needs and for potential real estate investments. CORPORATE GOVERNANCE We believe that LEN's corporate governance practices are in line relative to other homebuilders we follow.

Among the characteristics we view favorably are that the board of directors is controlled by a supermajority of independent directors greater than two-thirds, and it has committees to address governance issues. As of July 2010, the board of directors had nine directors and eight of them were independent directors. During FY 09, the board of directors met eleven times. Determinations regarding the eligibility of director candidates are made by the Nominating/Governance Committee, which considers the candidate's qualifications as to skills and experience in the context of the needs of the board of directors and stockholders. The Nominating/Governance Committee also evaluates and reports to the board of directors regarding the independence of each candidate. Generally, director qualifications require some knowledge of, and experience related to real estate properties, loans and securities, including any lending and financing activities as well as other criteria.

Until 2006, the company had both a chairman of the board and a chief executive officer. When the then chairman of the board died in 2006, the company did not replace him. Instead, LEN has a lead director, who presides over board meetings and presides at all meetings of the independent directors. Non-employee directors are paid annual fees of $50,000 per year, payable on a quarterly basis, 50% in cash and 50% in shares of common stock. We view favorably that the shares are not transferable until three years after the last day of the quarter in which they are issued. INVESTMENT RISKS Risks to our recommendation and target price include the possibility of prolonged housing weakness that further impairs new home purchases; higher mortgages rates; and weaker-than-expected demand from first-time homebuyers after the federal tax credit expiration. Rialto Investments remains an investment risk with respect to market conditions and credit trends. In February 2010, LEN acquired indirectly a 40% managing member equity interest in two limited liability companies in partnership with the FDIC, for approximately $243 million. The transaction consisted of more than 5,500 distressed residential and commercial real estate loans with an initial fair value of $1.2 billion. CONCLUSION We view LEN as a compelling investment opportunity. We think the combination of a slow economic recovery, affordable housing prices, and increasing buyer confidence should lead to positive growth in new orders and homebuilding revenues for the company and support positive cash flow generation and profitability. Additionally, we believe that LEN will gain market share over its competitors. In our opinion, the company stands to benefit from a more favorable mix of communities targeted to the first-time homebuyer and first move-up home categories. We believe these product groups will grow faster than near-luxury and luxury homes through 2011.

While LEN was recently trading below its peers based on forward price to book analysis, we believe the shares should trade at a premium valuation given our view that the company has scale advantages over its peers, a diversified geographic presence, and $1.3 billion in cash to meet working capital needs and for potential real estate investments. Our recommendation is Strong Buy./Kenneth Leon, CPA

26-Jul-2010 10:00:20 (15682431)   Copyright 2009 The McGraw-Hill Companies, Inc, Standard & Poor's, a division of The McGraw-Hill Companies, Inc., and their affiliates (collectively, "S&P"). Reproduction of this content in any form is prohibited except with the prior written permission of S&P.