Long NVR @ $2,800 –
- NVR’s unique capital light business model allows them to deliver superior returns whilst assuming the least amount of risk in the industry
- The firm has effectively taken market share from competitors while improving its profitability – growing EPS at 26% p.a. since 1994
- Management is focused on the long term and is firmly aligned with shareholders
- Cyclical tailwinds over the next 4-5 years provide the perfect environment for NVR to outperform
NVR is the 5th largest homebuilder in the United States, concentrating on a 15-state region from Pennsylvania to the north and Florida to the south. Its primary brand is Ryan Homes, and across its brands it focuses on affordability and first-time homebuyers. NVR also has a mortgage banking and title services company which principally services its homebuilding operation.
Homebuilders are typically overlooked due to the capital-intensive nature of their business and the cyclicality inherent in the industry. In downturns, homebuilders are inevitably left with large inventories of unsold land/properties – the unlevered builders then suffer large inventory write-downs while the levered builders go into bankruptcy. However, NVR’s highly efficient process around land acquisition separates them from other builders. In 2009 the three largest US homebuilders (Pulte, D.R. Horton and Lennar) reported a combined $3bn in losses, whilst NVR made a quarter billion in profit.
NVR’s unique business model is predicated on two main features:
- NVR acquires control of land inventory through option contracts that give them the right to buy finished lots from developers. The cost being between 3-10% of the aggregate purchase price. NVR also pre-sells nearly all of its homes.
- NVR is geographically dense and highly focused on obtaining and maintaining a leading market position in each market they serve.
Feature #1 enables NVR to avoid the speculative practice of land purchase/development. The firm is able to control large blocks of land (~5 years’ worth) whilst employing less capital to do so. As a result, NVR has much lower capital requirements, less inventory risk and is able to generate far superior returns on invested capital. Feature #2 effectively leads to local economies of scales, as NVR develops greater leverage with local developers and is able to be more efficient and low cost in the markets in which it operates. For instance, NVR can usually deliver a home in <90 days, often 60-70 days (compared to ~100-120+ industry average).
NVRs unique capital light business model and operational efficiency have produced exceptional results
- Growing revenues, earnings and OCF at 15%, 24% and 17% p.a. respectively over the last 5 years
- EPS has grown at 26% p.a. since 1994 (helped by steady, sizeable share repurchases)
- Industry leading ROIC – 27% in 2017, averaged 19% over the last 5 years
- Superior margins – GPM 21%, EBITM 14%, NOPATM 9%
- Growing market share – since 2005 NVR has doubled its market share to 5%
- Pristine balance sheet – company currently has a net cash position
As exceptional as NVR is, it remains valued at just 16x forward earnings – an attractive price when considering the quality and track record of the company.
THE OUTLOOK FOR US HOUSING IS POSITIVE
As with any cyclical business, the current dynamics at play in the industry are paramount. When looking at the data I believe there is no question that US housing is likely to be one of the strongest sectors over the next 4-5 years.
- Single-Family Housing Starts remain depressed relative to historical cycle precedents. At current levels, the supply of new homes is dramatically below household formations and Single-Family Housing Starts are still 63% below the average peak levels (Ref. Chart 1 below).
- Current Existing Home Inventory data is sitting at an all-time low. Existing Home inventory is significantly below the 6-months of inventory level that’s generally considered a “balanced market” (Ref. Chart 2 below). This dynamic is being driven by a combination of (continued) strong demand and an accelerating decline in unit inventory growth. Historically, when inventory levels fall in the bottom decile of the historical range, as they are now, home prices have tended to rise at double digit rates (i.e. roughly double the current 6%).
- Demographics suggest that a significant increase in demand is coming from the millennial generation. In the US, the average age at which an individual will rent their first home is 26/27 years old and the average age at which individual will buy their first home is 32/33 years old. Knowing this fact and looking at the current population distribution in Chart 3, one can anticipate that there is the potential for a massive influx of would be first-time homebuyers over the next 4-5 years.
- Intelligent allocation of excess capital: cash is primarily used to buy back stock. NVR has reduced its share count by 30% over the last 5 years, compared to a 10% increase for the average builder.
- Executive compensation plan: in addition to NVRs CEO and Chairperson having sizeable holdings in the company, their bonus payments are based on return on capital and vest over a 4-year period. A much more favourable structure than peers, many of whom have a primary focus on maximising profits over the NTMs.
- US tax reforms: one important change starting in 2018 is that homeowners can only deduct interest on mortgages up to US$750,000, down from a previous cap of $1,000,000. This will have very little impact on NVR given that they focus on the starter home market with an average sales price of just US$382,000.
THE BOTTOM LINE
NVR Is a high quality, best-in-class homebuilder with a superior business model that was resilient to the worst residential real estate market in the last 80 years (profitable every quarter but one). The firm has exceptional management and cyclical tailwinds should provide a favourable operating environment over the medium term.
If we assume a somewhat conservative scenario where (1) settlements growth moderates from the current 11% p.a.to circa 8% p.a. over the next few years, and; (2) ASPs are flat for 2018 and then grow at the rate on inflation (~2.5%) thereafter, and; (3) no improvements in gross or operating margins going forward, and; (4) prudent capital allocationI as NVRs history would suggest, I estimate that an investment at current levels should generate an IRR of ~20%.