Lennar Corp

Lennar posted mixed fiscal third-quarter results, as volume and pricing declined over 3% year over year but remained flattish sequentially. Earnings per share came in at $1.23 after excluding losses on investments and other one-time items.

Why it matters: Mortgage rates rose over the quarter as the war in Iran stoked inflation risk, which weighed on housing demand. The 30-year fixed mortgage rate is now approaching 7% and is a major headwind for the housing market. Lennar's stock has fallen around 25% year to date on investor concerns about its worst-in-class margins. Weak housing demand resulted in homebuilding gross margin declining 170 basis points from the prior-year quarter, although it did improve sequentially. Lennar's focus on even-flow production results in margins being a shock absorber during periods of weak housing demand. In our opinion, the margin profile of the company could improve more than its peers as Lennar rolls over unfavorably priced land contracts and the housing market improves.

The bottom line: We are maintaining our $120 fair value estimate. We plan on slightly tempering our near-term home delivery projections and changing the timeline for recovery, but our longer-term outlook is unchanged, and we see the shares as undervalued on a risk-adjusted basis. Earlier in the year, we expected mortgage rates to moderate through 2026, but given recent developments, we now expect mortgage rates to remain elevated and housing demand to remain soft through 2026 and into 2027. We expect gross margins to hold at current levels through 2026, consistent with management's guidance of 15.5%-16.0%. A core driver of our valuation is that we see homebuilding gross margins recovering to roughly 19%-20% on a midcycle basis.

Between the lines: Lennar is showing signs of improvement on the efficiency front as construction costs declined 6% year over year, with cycle time reaching a record low of 116 days, down from 126 days a year ago.

During the earnings call, management gave more color on margin underperformance and fully attributed it to higher land prices. Management said that higher option management fees for the land it controls reflect options that were "underwritten and committed to in very different market conditions." To us, this sounds like implicit acknowledgment of unfavorable land option deals signed in previous years. This is perhaps the clearest indication we have received from management with regard to its underperformance and further validates our core thesis on the company. While these unfavorable land contracts are binding and renegotiations are generally limited, our core argument is that over time, the firm will roll over the impact of these unfavorable deals. The land option contracts that are signed in the future will be on better terms, and corresponding homebuilding margins will also be higher when that land is eventually used.

Management further explained its rationale for prioritizing volume over margins in the context of unfavorable land contracts that were signed earlier. Management indicated that prioritizing volume and accepting low margins currently results in converting "expensive land into cash while we still produce positive margins" and "every quarter we move through that [expensive] land at a lower margin is a quarter closer to normalized land basis." These comments are in line with what we had suspected, and we agree with management's strategy. It is better to roll through unfavorable land option deals as early as possible rather than hiding the impact by waiting for a more conducive external market environment. The core question to us is about the timeline of recovery and not about whether the margins will eventually recover and be more in line with peers. It is difficult to predict the precise timeline for recovery, given limited disclosures around land deals. We estimate that in a worst-case scenario, the company can continue to underperform its peers for as long as the next four years. We believe a more likely outcome is a faster recovery.

Lennar remains our preferred idea in the homebuilding sector, due to its attractive valuation for long-term-oriented investors. We think that the market is worried about the lack of transparency and the possibility of negative surprises related to an aggressive shift toward a land-light strategy. The market is treating Lennar's business as permanently inferior to its peers, while we believe that the recent margin underperformance is mostly a medium-term concern. Current market prices imply that homebuilding margins will not improve materially from current levels (about 16%), which we think is excessively pessimistic. Our thesis on improvement in margins for the firm is based on both external factors (housing market recovery) and fixing Lennar-specific issues related to execution on the land-light front. We do not disregard the possibility of more negative surprises on the land deals that the firm had signed previously and the implications for the margin profile. But even if the shift to a land-light strategy proves to be disruptive for a while, we are confident of management's ability to fix issues over time as existing option contracts roll over.

We are slightly decreasing our fair value estimate for Lennar to $120 per share from $124 per share after updating near-term margin assumptions. Our fair value estimate equates to about 17 times our adjusted EPS estimate for 2027 and 1.6 times our tangible book value per share estimate for 2027. Our weighted average cost of capital for the firm is 10.0% based on a cost of equity of 10.3%, a 24.0% long-term tax rate, and a 95% equity weighting.

Our revenue growth projections are based on our US housing demand forecast, along with Lennar’s market share and average selling price assumptions. We forecast Lennar to increase consolidated revenue at about a 3.4% compound annual growth rate through 2035. We expect single-family housing starts to rebound to over 1.1 million units by 2029 as the housing market recovers and starts to remain above 1.05 million units on a mid-cycle basis. We expect Lennar to continue gaining market share and project its share of home sales to reach around 14% by 2035 from 12% in 2025. This results in a 2.5% CAGR for homes closed over the next decade. We assume roughly 0.9% ASP growth through 2035 (compared with 2025) due to a continued mix-shift to lower-priced homes and moderating new home prices in 2025-2026.

Lennar and other homebuilders enjoyed robust pricing power between 2020 and the first half of 2022, which resulted in elevated homebuilding gross profit margins. Indeed, Lennar’s home sales gross margin reached nearly 28% in 2022 compared with 21.5%, on average, between 2016 and 2020. More recently, Lennar has focused on affordability and margins have been pressured due to increased use of sales incentives, aggressive volume share gains, and a mix-shift toward entry-level homes. Lennar’s gross margin moderated to 23.5% in 2023, 22.3% in 2024, and slipped to 17.5% in 2025. Additionally, Lennar will be paying Millrose and other land banks, monthly land option premiums after the recent transactions, and we believe that these expenses, which are currently being capitalized on Lennar’s balance sheet, would weigh on the firm’s gross margins when these option contracts are exercised. As such, we expect further pressure on gross margins in fiscal 2026 and 2027, but we think the firm’s gross margins will rebound above 18% when mortgage rates normalize and economic conditions improve. Over the longer term, we expect Lennar's gross margin to migrate closer to 20% on a midcycle basis, which is a little lower than Lennar’s historical average. Our mid-cycle assumptions for the firm account for the shift toward a land light model, which leads to higher ROICs and cash generation but lower margins.

We expect muted growth prospects in fiscal 2026 to result in less operating expense leverage, and increased investments in technology will add to selling, general, and administrative expenses. We forecast SG&A expenses as a percentage of home sales to be in the 8%-9% range in fiscal 2026-27. However, over the longer term, we expect stronger revenue growth, more efficient homebuilding operations, and SG&A cost-saving initiatives to unlock operating leverage, reducing SG&A expense as a percentage of home sales revenue. We model Lennar's SG&A ratio moderating to 7.8% on a midcycle basis.

Homebuilder valuations based on a DCF model are sensitive to inventory assumptions. Our assumptions reflect our belief that Lennar will continue to operate a land-light strategy. We model inventory as a percentage of home sales to average roughly 56%-57% over the next decade. We think Lennar's land-light strategy will translate into a consistently higher operating cash flow conversion ratio. We model operating cash flow as a percentage of net income to average around 80%-90% by the end of the decade.

We use a three-stage DCF model for valuation, with the first stage being explicit forecast years. The second- and third-stage assumptions in our DCF model imply a terminal EV/EBITDA multiple of 7.7 times.

We assign a no-moat rating to Lennar as we believe the firm has limited benefits from its scale and has no significant cost advantages. US homebuilders operate in a highly cyclical, competitive, and capital-intensive industry that makes it challenging to earn consistent economic profits over the business cycle. The market has been consolidating but remains highly fragmented and intensely competitive. Homebuyers looking for new homes in a specific market have many options, and pricing is often the primary lever in their decisions. The industry is characterized by a lack of sustained product differentiation, which translates into minimal pricing power for homebuilders. Due to this dynamic, brand loyalty among homebuyers is virtually nonexistent, making homebuying decisions highly price sensitive. Scale-based cost advantage is the most relevant moat source in the homebuilding industry. Large homebuilders have an advantage over small-scale (local mom-and-pop) builders in their ability to acquire regional builders and capture market share quickly. However, we believe the market, especially in densely populated metropolitan areas, is largely saturated, which will make it harder for builders to grow their market share as quickly in the future.

Industry Dynamics: America's homebuilding industry remains highly fragmented despite considerable consolidation in the past four decades. This fragmentation is driven by the highly local nature of residential construction, where homebuilders must respond to local demand and supply while also navigating complex zoning ordinances, land-use regulations, and building codes. The industry’s low barriers to entry allow thousands of small homebuilders to compete in the US.

Lack of Pricing Power: Due to the highly competitive environment, we believe homebuilders lack significant pricing power. By comparing the average sale price of new homes nationally with homes sold by Lennar, we see that large homebuilders adjust their prices in line with the market. Moreover, we believe affordability is a key driver of home prices, as seen in the decrease in Lennar’s average selling price during periods of high mortgage rates. In addition to simple price cuts, homebuilders often turn to incentives (like lower mortgage rates) to maintain a consistent volume, which compresses margins even further during downcycles. We believe Lennar’s lack of pricing power stems from its largely undifferentiated product. We see location, quality, and pricing as critical drivers for consumers. Competitors can also enter new markets and replicate successful product and land acquisition strategies with relative ease, potentially diminishing returns for incumbents. We see few barriers preventing builders from replicating successful product and land acquisition strategies, especially for public companies with the scale, experience, and capital availability to do so.

Cyclicality: The homebuilding industry is highly cyclical, with economic downturns driving significant slowdowns in housing starts. During downturns, smaller homebuilders that do not have strong relationships with banks can feel significant pressure when demand for housing decreases. In response, many of these small firms may trigger price wars to drive up volume, despite suffering poorer margins. Due to the lack of pricing power across the industry, these price wars can exacerbate downcycles even for the largest of homebuilders. On the other hand, during good times, low barriers to entry can fuel the inflow of new entrants when returns are high, thereby lowering returns across the industry.

Land-Light Strategy: Lennar has shifted toward controlling land through options contracts that grant it the right, but generally not the obligation, to purchase land at a future date. While these contracts boost ROICs, the option contracts charge a premium over the underlying asset, and therefore, the cost of acquisition, on average, is expected to be higher than buying raw land itself. Land optioning reduces outsized cyclical downside risks, provides better capital efficiency, and improves free cash flow conversion, but this strategy can result in margin compression, assuming everything else is equal.

Scale: We believe that the decentralized structure of the industry, across both small and large firms, makes it challenging to gain any cost advantage. Lennar, despite its national scale, hires subcontractors to manage local building operations. The market for subcontractors is highly competitive due to low barriers to entry and subcontractors are often selected by homebuilders through a bidding process. Additionally, scale does not have a material influence on the cost of land acquired by homebuilders. We believe larger homebuilders do gain from volume discounts on materials such as timber, concrete, and home appliances, but we also think that most publicly listed builders benefit from similar discounts, preventing large players such as Lennar from gaining any advantage. Overall, these arguments, regarding both labor and material costs, explain why size shows little correlation with margins within the homebuilding industry.

We do not have confidence in the firm's ability to generate excess returns over the next 10 years, given the current industry dynamics. The industry has consolidated significantly over the past few decades, and the competitive positioning of the largest players has improved relative to peers, but the core characteristics of the industry remain unconducive to moats. Lennar’s scale will benefit the company over the next decade, and we expect the firm to continue gaining market share, but we would like to see significantly more consolidation and stronger evidence of volume-based scale advantages before we reconsider our moat rating.

The US housing market is undersupplied. This supply/demand imbalance will take years to address and should support ongoing pricing power for homebuilders.

Demand for entry-level housing should increase as more members of the large millennial generation form households. Lennar is well positioned to capitalize on this growing market.

Lennar's shift to a more capital-efficient business model could drive valuation multiple expansion. Land-light homebuilder NVR enjoys a premium valuation because of its industry-leading ROIC.

Higher-for-longer interest rates, lofty home prices, and economic uncertainty could stifle demand. Muted demand, along with elevated new homes inventory, can pressure margins.

Land banks charge a recurring monthly option fee from Lennar. Lennar’s land strategy can weigh on cash flows during a downturn and erode its margins compared with competitors in the event of an elongated downcycle.

Constrained land supply and elevated labor and material costs, especially if restrictive immigration policies are enacted, could limit Lennar's production and/or profitability on delivered homes.