Morningstar - Fall 2019 - 67

Lallos: D.R. Horton DHI was one of your top picks
a couple of years ago because they were
meeting this need for entry-level homes, but it looks
like the valuation isn't as attractive today.

Bernard: Both Lennar and Toll Brothers started
out building them and selling them. But
both are now shifting toward operating them.
Toll Brothers has joint venture partners,
and Lennar has something akin to a private
equity fund that investors such as pensions are
investing in.

Bernard: Correct. But among our coverage,
we think they're going to be the fastest-growing
because they have a strong position in entrylevel homes. Another factor to consider is
D.R. Horton's willingness to build speculative
homes (that, is building homes without
having a signed sales contract). Now this can
be risky, and a lot of builders minimize spec
building. But it is attractive to entry-level buyers
to see a community that is already out
there, and that's another reason why D.R. Horton
is getting a lot of growth.

This is inherently riskier than building single-family
homes because you need to maintain
occupancy in these big structures, so both Toll
Brothers and Lennar are reducing their
exposure and risk. In the grand scheme of things,
this business is still pretty small for both of
them. But it is a hedge if we're wrong about the
trend in homeownership.

Lallos: Lennar LEN is highlighted in the report

Lallos: How has your growth forecast affected your

as a top pick right now, but they aren't building those
entry-level homes.

Bernard: Again, spec building risky: If the market
turns and you're stuck with these homes,
you're going to have to cut prices. Lennar is still
shying away from that kind of building out
in the exurbs. Instead, they are building higherdensity townhomes. Their price point is
still more attractive than some other builders out
there, so they will benefit from entry-level
buyers-versus Toll Brothers TOL, which is a luxury
builder. And even Toll Brothers is actually
creeping down in price point.

We cover five homebuilders, but I track all
of them. I can't think of one homebuilder that has
not in some way, shape, or form shifted
their strategy to go after a lower price point. That's
a big, big demand driver. And Lennar is well
positioned for that.
Lennar also has a multifamily business, as
does Toll Brothers. If you disagree with our view
of new construction, that's kind of a hedge.
I think for both Lennar and Toll Brothers, investors
don't quite understand the scale of what's being
built there. Multifamily is a pretty young
business for Lennar, but it could be basically like
having an apartment REIT within Lennar.
Lallos: So, they build these multifamily
units, and then continue to own them and rent
them out?

valuations of the homebuilders on your coverage list?

Although we have a slower growth forecast
now, we didn't change our valuations. That might
cause some investors to scratch their heads.
However, the unfavorable valuation impact from
our modestly lower growth expectations has been
offset by homebuilders moving to a more assetlight land strategy faster than we had expected;
this has been improving and should continue
to improve returns on invested capital, which along
with growth, is a key valuation driver.
Over the past several years, homebuilders have
been shifting away from owning land
outright, which is held on the balance sheet, in
favor of buying land on option from land developers,
so the developer is the one that holds it on
their balance sheet until the homebuilder
exercises the land option. Basically, it's just-in-time
for land; when the homebuilder needs to build,
they take it from the developer.
That pushes the risk off the homebuilder's balance
sheet. It really improves their returns. There
are pluses and minuses. It's more expensive and
you can't do it in all markets. But all the homebuilders I cover are shifting toward this asset-light
model. Again, when you figure that into
the equation, the slower growth is about offset
by what they're doing there.
Industry consolidation is a factor that could
support stronger growth for the largest

homebuilders. Over the past few years we've
seen consolidations both large and small.
The Lennar-CalAtlantic merger was a big deal that
allowed Lennar to pass D.R. Horton as the
largest homebuilder by sales (D.R. Horton is still
the largest by units).
However, public homebuilders-there are 18 of
them that have about 35% market share-
are also buying smaller builders. Smaller builders
struggle to do entry-level building, because
it has lower margins. When you have scale, you
can get past that. In fact, D.R. Horton's
margins have been fine even though they're
growing their entry-level business. So, a lot of the
smaller builders are selling to these big guys.
As the big guys are consolidating, they
are able to leverage their size. There are now
three big developers that are exclusively
working with Lennar. With that kind of relationship, they're able to push that option
strategy. D.R. Horton actually acquired majority
stake in a land developer (Forestar). You're
starting to see large homebuilders push back
on these developers and use their scale. Lennar's
percentage of owned land has been above
average for the industry, historically. Now that
percentage will shift to average, or maybe
even below average, within a couple of years.
Again, an asset-light strategy is good in
that it reduces a homebuilder's risk and improves
return on invested capital.
Lallos: How about building products? Their
fortunes are linked to housing, but also tariffs and
trade wars. Masco MAS has a narrow moat
and is a top pick right now, but how exposed is it to
that risk?

Bernard: Masco is a little bit more exposed
to that than Fortune Brands FBHS, its close peer.
Within their plumbing segment, they have
the midtier Delta but also the entry-level Peerless
brand, which is being sourced from China.
Whereas Fortune Brands is not sourcing as much
from China for that sort of thing. But both
of them do get some components for cabinets
and whatnot from China, so they're both exposed.
It does have the potential to have a negative
impact on margins, but in the grand scheme of
things, it's pretty small, in our view.

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Morningstar - Fall 2019

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