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Jan 16, 2015

Homebuilders: Disappointment Presents Opportunity

Samantha McLemore

Stop, take a breath. Now another. Do you feel better? I say this to my three-year-old daughter quite frequently when her emotions get the best of her. But I feel this advice is just as relevant for some of the recent market reactions we are seeing. And in total honesty, I’ve been taking a few deep breaths myself.

Let’s recap. The builders ran up late last year on the expectation (or hope) of a strong selling season. Then we started off the year with some solid gains on the back of government comments about easing credit conditions for housing. We were optimistic that this year would prove out our bullishness on housing (actually, we still are).

When KB Homes (KBH) reported disastrous fourth quarter results (not an understatement as that was one of the worst quarters in memory), gains quickly turned to losses. It announced a terrible quarter with weaker gross margins than expected. They also revealed that they would fall short of their 20% gross margin goal for the entire year and things would get worse before they got better. KB discussed pressure on sales in some locations and increasing costs as justification. After investing aggressively in land last year, KB discussed the potential for further land impairments. The market rightly flipped out as weakness in housing would obviously hurt homebuilders, but it would have broader implications for a slowly healing economy as well. KB’s 16% drop on the day ranks as the second worst single day since 1986, inclusive of the entire financial crisis.

Many wondered whether this weakness was confined to a poor operator or a broader phenomenon? People looked to Lennar (LEN), widely considered one of the best if not the best operator, for the answer. When it reported a couple days later, it beat earnings and guidance looked ok. Initial gains turned to further sizable losses as the company guided for year over year declines in gross margins and sounded cautious on the environment.

We asked ourselves whether our view on the group was wrong. Could we be seeing weakness despite the notable improvements in employment and confidence, and the marginal improvement in credit availability? We are comfortable that the answer is no.

We like Lennar management for their abilities, insight and transparency. Stuart Miller, CEO of Lennar, still voiced optimism about the outlook on the quarterly call. He said, “We continue to believe that we are still in the early stages of a protracted, slow growth housing recovery. The recovery continues to be driven forward by increased pent-up demand derived from a now multi-year production deficit and the increasingly high monthly cost of rentals. At the same time, volume growth has been constrained by overly conservative lending standards, a regulatory environment that discourages mortgage lending by banks and a negative bias overhang against homeownership. Complicating matters, the housing recovery has been somewhat erratic as macroeconomic factors have continued to both positively and negatively affect that recovery…. Simply put, we believed and continue to believe that the downside in the housing market is very limited and the upside is very significantAny pull back in housing volume would be short lived as there is a need for shelter in the country and there is very little inventory with almost no likelihood of mortgage foreclosures, given the stringent underwriting standards of the past years.” (Emphasis mine.) It’s a long quote, but it clearly demonstrates optimism that we still have ample room for growth.

Miller also mentions the possibility of a pullback, which is more caution than we’ve heard previously. When we spoke with Stuart, we asked what had changed since we last saw him in Sept 2014 to lead to this change in tone. He replied that the drop in oil and the move in the dollar increased uncertainty. However, they weren’t yet seeing any negative impact in the business. We concluded we always like prudent caution from a quality management team.

Lennar currently trades at 13x fiscal 2015 consensus earnings, which have fallen a modest 2% over the past 4 weeks. At this level, the company would still grow earnings 13% year over year as volume growth offsets gross margin pressure. We actually think consensus is too low so it’s even cheaper with better growth. The S&P 500 trades at 16.4x 2015 estimated earnings, which is 8% year over year growth. Housing volumes remain depressed and we are early in the recovery, while the market includes areas clearly under fundamental pressure like energy.

Lennar seems like a great bargain, especially since you get a management team who has demonstrated continued excellence. It bought land early in the recovery generating great returns, started Rialto to benefit from housing improvement through asset purchases and entered the multifamily business, which is working out better than expected. It will continue to look for new ways to improve shareholder value. Since Miller took over Lennar in early 1997, the stock has returned over 15.1% annually to investors, almost doubling the S&P 500’s 7.8% annual return, even including the housing crisis.

While this demonstrates the upside we see in Lennar, the case remains for the broad group, which actually trade at deeper discounts to the market. KB has issues but it currently trades at 0.7x book value, a depressed level for a profitable company that should be able to grow earnings over the next few years.

Employment gains have accelerated, especially among the younger cohort entering prime marriage and child-rearing years that are crucial to our demographic case for housing. Confidence improvements help the psychology of home buying. Lennar has concerns about oil’s drop, which is legitimate especially in areas like Houston where energy represents a significant part of the economy. Broadly though, we remain convinced that the drop in oil prices is a net positive to consumers. Both Jamie Dimon, CEO of JP Morgan and Brian Moynihan, CEO of Bank of America commented on the net benefit they were seeing from the drop. (As a side note, banks dropped after earnings as well. We thought earnings were ok, but falling rates will pressure those businesses).

We still believe there is a reasonable probability spring selling season, which doesn’t start until after the Super Bowl, is much stronger than anyone currently expects. Broad traffic numbers continue to show surprising strength and year over year growth. Employment, confidence and traffic are leading indicators for housing. While credit remains constrained, it is easing on the margin. The market doesn’t seem to be pricing this potential outcome in at all.

In late 2011, homebuilder stocks traded down to half their financial crisis lows while the builders noted improvements in traffic and confidence for the first time since the crisis. It was a stark divergence, and a great buying opportunity. While managements noted the improvement then, they still cautioned about significant uncertainties. Though not as extreme, the situation today reminds me of then. Uncertainties weigh on the stocks, which have traded off significantly while fundamentals have held in. Even if we don’t see acceleration, the stocks are bargains currently versus the market. You get a free option on any upside.

The views expressed in this commentary reflect those of LMM LLC (LMM) portfolio manager(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading on behalf of any portfolio. Any data cited is from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. References to particular securities are intended only to explain the rationale for the portfolio manager's action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

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