I have been working in the construction industry and my dad is a home builder back in India. I was never enthusiastic about home builders as I know this is a very fragmented industry with low margins and high working capital requirements. However, the company we are going to discuss today is above average business in my opinion that sparked my interest.
The housing market is linked to the overall economy of the country. The industry is cyclical and its important to know where we are in the cycle. Home builders in the U.S have experienced good recovery since last 10 years after 2008 recession. The home ownership is around 65% which has been an average over a 40 year period. 38% of the population is between 26 to 54 which shows that there are enough home buyers in the market (Source)
The NAHB index is around 62 which indicates good housing market. The 30 year mortgage rate is at 4.4% which is below 30 year average of 6.46%. It indicates availability of finance at moderate rates if not cheap. The housing starts are at rate of 1.1-1.2 million which is still below the average rate of 1.5 million over 30 year period.
The industry is quite fragmented. For instance, top 10 home-builders make only 32% of the market share. The biggest challenge has been affordability and it can be seen through recent drop in the affordability index. The interest rates, although at moderate levels are rising and they are likely to rise moving forward. In my opinion, there are no alarming signs that we might be in the peak of the cycle but, we are definitely not at the bottom of it. There’s a room for market to grow at steady rate unless economic downturn is underway.
Residential construction has low barriers to entry and is very competitive. There’s hardly any pricing premium that builders can benefit from unless they are in the niche market. There’s shortage of labor and materials nationally which causes downward pressure on margins.
The industry is consolidating due to acquisitions and attrition of smaller, less efficient and financially weak builders that leave the business. Large home builders have been growing through acquisitions to expand their market share. Because of their size, they enjoy important efficiencies of scale and better supply of labor and material. They can also avail finance at better rate than their local competitors. Ideally this should help improve the margins. However, in my opinion, this has actually proven counter-intuitive as most of the acquisitions are funded by dilution of shareholders equity or debt. Companies end up with financial liability in uncertain and susceptible business environment. Thus, reducing shareholders returns and returns on invested capital.
Traditionally, home builders have been investing their free cash flows into buying land in order to support their growth. Recently enough, home builders have started understanding the efficient use of capital and are moving to asset light model. The asset light strategy allows, reduced debt burden, higher ROE, and free cash flow generation which can be returned to shareholders.
Overall, profitability is a function of cost efficiencies, demand-supply and affordability. A disciplined approach of being an efficient, lowest cost operator helps home builders sustain their moderate growth and profitability.
NVR is the 4th largest home builder in the country and also has mortgage banking business. They mostly operate in niche and mature markets of 32 metropolitan areas in fourteen states including Maryland, New York, North Carolina, Virginia, Ohio, Indiana, Illinois, South Carolina, Pennsylvania, Tennessee, Florida, Delaware, West Virginia and New Jersey, as well as Washington, D.C.
NVR has been benefited by their long term strategy of working in mature, niche market and expanding by leveraging their employees, management talent, business relationship and local market knowledge rather than expanding into new markets . They are able to lower their costs and increase their efficiency by expanding within existing markets
Their biggest differentiator is the asset light model. NVR is not involved in land development business. Instead, they acquire finished plots from local developers through option contracts. In Simple terms, they put maximum of 10% price of developed plots minimizing their exposure in case the demand for housing stagnate. They purchase the finished lots on a just in time basis, after they have sold homes on these lots. They don’t build speculatively which reduces the risk of excessive inventory. The liquidity generated by this approach provides NVR better financial flexibility to take advantage of whatever opportunities that may arise.
NVR’s mortgage banking business supports their core as affordability is the biggest factor for buyer to purchase the house. Company has been really good at selling these mortgages in the market in less than 30 days to reduce their risk and exposure.
The management has been very disciplined in execution of their long term strategy. The asset light model has generated strong free cash flows and management has been prudent in keeping the costs consistent if not lower. The executive compensation is directly tied by 50% to performance of ‘return on invested capital’. Although the revenue’s have grown barely at 10-12% annually, shareholders have been rewarded 6 fold in last decade. There have been no irrational acquisitions or dilutions of shares. Rather, strong and consistent stock buyback program (Buyback yield 5%) has created enormous shareholder value. I am quite impressed by how management has made this from not so attractive to an attractive and above average business.
NVR has an above average business economics compared to the industry. This can be evidently seen through their financials. NVR has low financial liability, higher returns on invested capital and strong free cash flows. Given the cyclicality of housing market, NVR is in better position than its competitors for upcoming downturn if at all. NVR has lowest debt to equity ratio of 0.33 and interest coverage ratio of 45.
NVR has above average returns on equity and highest inventory turnover in the industry which is one of the reasons Mr.market has rewarded the company with higher multiple of earnings with respect to the industry.
Being a cyclical company, NVR has still been a positive free cash flow company in comparison with its competitors. NVR has earned around $2.8 billion of free cash flows from $250 million to $700 million in last 10 years. The FCF on average was around 250 million up until 2015 after which it spiked up to $700 million because of strong recovery in the housing market and NVR’s disciplined approach towards growth.
I believe it will be harder for NVR to achieve the same growth rate moving forward. I am assuming normalized FCF of $300 million growing at 9% to give myself enough margin of safety. Thus in my opinion, an intrinsic value might be somewhere between $1,500 to $2,000 a share.
Stress Test: If there is a recession and NVR’s revenue drop by 25% from current levels of $7 billion to $5 billion for next two years. Assuming their gross profit margins reduce to 13% from average levels of 18%. They will still be able to generate operating income worth of $630 million where as their average operating expenses for last 3 years have been around $500 million after servicing debt. Thus, they will still be profitable.
I really like NVR and its management. Their prudent strategy of being asset light, disciplined execution has rewarded its shareholders. But, did I mention moat? Not really. NVR belongs to cyclical industry where their competitive advantages if any, are prudent management and niche market opportunities. If there happens to be an economic downturn, there would be a lot better opportunities out there. A silver lining could be irrational movement in housing market that could bring stock to attractive levels.