Sunday, 20 January 2013

The peculiar case of Lennar

Idea: Buy Len.B, Sell Len.A (Currently 23.5% profit potential)
Decision: No trade, monitor spread

Lennar Dual Class Common Shares
The information below will show that Lennar Class B shares have greater voting rights, tightly controlled issuance, and extreme alignment of interest with management; and therefore should trade at a premium to Class A shares. However Lennar Class B shares currently trade at a 24% discount to Class A! And during the financial crisis the spread was over 50%!! I am obviously extremely disappointed I did not discover this spread between the two classes at a more opportune time; however the trade is still worth examining with a 24% profit potential and limited downside. Really the only thing that would suggest that this spread would remain this high is the fact that it has done so for the last five years.

After much deliberation, I decided not to execute the trade and wait until the spread provides a 30-35% profit potential; at a 30% profit potential Class B is trading at 77% of Class A. Not quite the 70% NCAV Graham threshold, however this is a much less riskier trade than owning shares in a company.

Purpose of Dual Class:
In April 2003, Lennar Corporation adopted a dual share structure. The purpose is to maintain the managements control over corporation without compromising its ability to raise equity for acquisitions. The voting rights, share dividend policy, and the termination of Class B shares are all created in a manner to allow management to maintain control over the organization and avoid dilution. Both shares are traded publicly. Differences in the two classes are listed below:
Class A
Class B
·    1 vote per share
·         10 votes per share
·         Class B votes together 
·    When voting without regard to class, must be approved by majority of the Class A shareholders.
·         Equal cash dividend payout
·        Share dividend may be distributed in Class A shares as determined by the BOD.
·         Equal cash dividend payout
·         Share dividend may be distributed in Class B shares as determined by the BOD.
·         Class B shares will be converted into Class A if:
            I.        Number of Class B shares outstanding is less than 10% of all Class A shares.
            II.        Majority of Class B share holders vote to convert shares to Class A
·         Equal rights in event of a liquidation
·         Equal rights in event of a liquidation

Stuart Miller (CEO) Ownership:

# of Shares Held Miller
# of Shares Total
% of Class Held Miller
# of Votes Held Miller
% of Total Votes Miller
Market Value ($millions)



Rarely can you see this kind of alignment of interest with management in a possible trade. The 68% holding of total Class B shares by Miller represent 90% of his ownership in the company and likely his net worth. If the Len.B shares began to trade at parity with Len.A, Miller’s net worth would increase by $171 million. Likewise, if the remaining Len.B shares not owned by Miller were allowed to convert to Len.A, Miller’s voting power would increase to 58% of total votes.

There is really no scenario I can think of where in the long-run Miller would allow this spread to increase or even stay at its current level. Nor can I think of any fundamental reason why the spread between the two classes to be so large, and in favor of Class A shares; Class B shares have 10 to 1 voting rights and their issuance is tightly controlled.

Spread Analysis:

1) On an absolute $ basis, the spread is near its all time high. However on a % basis, the spread has come down from its recent highs of 32%.
2) The spread was much narrower until Lennar’s dividend deteriorated in 2008.

· The extremely low volume of Class B shares traded help explain

Potential Catalysts:
1.      A number of shareholders of Class B shares have put forward the proposal of allowing conversion to Class A shares; a one way conversion. Remember that Class B shares can be converted to Class A if majority of the Class B shareholders vote to do so; however, Miller controls the Class B vote with his 68% ownership of the class.

2.     Currently Lennar’s dividend yield is 0.4%; not providing a big income incentive in owning the shares. However if Lennar provided a 3.0% cash dividend yield, Class B shares would be yielding 3.7% due to their current price discount, providing a clear incentive in owning Class B shares (along with their higher voting rights).

On a side note, from looking at Lennar’s dividend history, I am once again in awe of the recent enthusiasm in housing stocks. Even during the remarkable housing bubble of the early 2000’s, which was fueled by overbuilding and over investment, Lennar’s dividend yield ranged from 1-3%. This was followed by a five year housing slump and hefty deterioration in shareholder value. Even after failing to receive any meaningful cash flows during the most exuberant housing bubble in U.S. history, investors are jumping back into the sector in hopes that a gradual recovery to the natural rate of demand will result in enormous profitability.

Housing is remains an extremely competitive business with gross margins near 20% and little value add from builders. Therefore, it will always be tough to generate meaningful profits from the business aside of periods of overbuilding and over-investment. However the future of housing does not affect this trade in any way!

Even with no fundamental reason for this spread to exist in favor of Class A shares, I am not entering the trade at this moment and will be monitoring the spread for a better entry point or any news on the proposal put forward by Class B shareholders.

Sadly the historical performance of this spread has deterred me from entering this trade and thus also provided the basic explanation for why it exists. The combined psychology of other traders monitoring this trade is likely similar and again shows that the market tend to be backward looking.