Description

D.R. Horton

            In today’s market, it seems that companies with above-average growth, high-ROEs, and good balance sheets come with the expected burden of very rich-P/Es. One industry presents the combination of 20-30% ROEs, net-cash balance sheets, double-digit EPS growth, little threat from technological disruption (or aggressive Chinese competition). And, the said industry is trading at 10x earnings. This memo will focus on the largest, by units, homebuilder, D. R. Horton — which is a completely changed company in a completely changed industry, and one that now deserves to sell at a high PE ratio.

In the past, Horton and the other large builders were asset heavy real estate companies. Recently, the industry has completely changed. Now, the large builders are asset light, efficient manufacturing companies. As an asset light company, DHI is earning a high ROE and is generating large amounts of free cash flow. And, as a result of its large free cash flows, the balance sheet has become pristine. On September 30, the company’s homebuilding operations had more cash than debt…

And, in many ways Horton is a “growth” company. It is gaining market share at the expense of cost-disadvantaged small private builders. Between FY 2018 and FY 2023, Horton’s deliveries of homes increased at a 9.8% CAGR from 51,857 to 82,917 (its market share of single-family new homes sales increased from 8.2% to 12.6%), revenues grew at a 17.1% CAGR, profits at a 25.4% CAGR, and EPS at a 29.8% CAGR (from share repurchases). In FY 2023 (which ended on September 30), Horton earned $13.82 per share in spite of high interest rates that made the purchase of new houses less affordable and thus dampened demand.

Horton has said that it should grow its volumes at a ~10% CAGR.[1] Thus, one can guess that revenues grow at an 8-11% rate, profits slightly higher (homebuilding sports major efficiencies of scale), and, after repurchases, EPS should grow at least 11%. For comparison, the sell-side is predicting that, over the next four years, AAPL’s EPS will compound at a 9% rate and MSFT at 15% — and their shares are trading at 30x and 38x FY2023 earnings, respectively, in large part due to expected above-average growth. Horton is trading at 10.6x its 2023 EPS — and it doesn’t have to worry about selling iPhones in China.

As a quality company that has been growing at a high rate, I believe that Horton is worth 16-20 X earnings. Therefore, I conclude that, if Horton earns $19 in 2026 (an 11% EPS CAGR from 2023), the shares will be worth roughly $300 – 380.

Logic on why the large homebuilders deserve to sell at more than 16 X earnings

During the past 60+ years, the S&P 500 Index has sold at an average of just over 16 X earnings. I believe that the large builders are above average businesses in terms of their overall quality and growth—and therefore are worth more than 16 X earnings. In addition to faster revenue growth, D.R. Horton also enjoys a stronger balance sheet and higher returns than the average S&P 500 company (i.e. 16X P/E). 

My analysis of the quality and growth of the homebuilding industry is as follows... 

Not long ago, the large homebuilders were more real estate companies than manufacturing companies because they tended to own large quantities of land. Real estate companies normally deserve to sell at relatively low PE ratios because they own assets that can become impaired in value and because they tend to be at least moderately leveraged with debt, which increases the risks of financial stress. Furthermore, the values of the land owned by the homebuilders tended to increase at only a 3-4% annual rate over time—and thus a substantial portion of the homebuilders’ capital was invested in a slow growing asset. Also, because the homebuilders tended to invest a large fraction of their operating cash flows in the acquisition of land, their free cash flows available to their shareholders was diminished.

One homebuilder, NVR, famously operates a land-light strategy in which the company options and develops land lots via third parties, JVs, and land bankers. NVR’s strategy allowed them to generate strong cash flows, high ROEs, and with little risk of impairment or leverage. The NVR cat is well out of the bag and, between 2018 – 2023, the market rewarded owners with an average P/E of 17.3x. I importantly note that this is in spite of NVR’s below average growth (in fact, the sell-side is predicting that NVR will not grow at all over the next three years).

Importantly, in recent years, other large homebuilders have substantially and successfully reduced the amount of land they own to a very low level — thus, conceptually, they have transformed themselves from being real estate companies into being a manufacturing company like NVR (they are in a different business today). This transformation is a major development that, in my opinion, changes homebuilding from being a historically fair business to being a very good business.

Now, as asset light manufacturers, the large homebuilders earn relatively high returns on their invested capital and generate large quantities of free cash flow. They have been using their sizable free cash flows to reduce their net debt to very low levels (they now have fortress balance sheets) and to repurchase shares—all attributes of a very good business.

Another transition has been occurring in the homebuilding industry. It has been consolidating as many small builders shrink or entirely close their businesses as a result of  the difficulties and costs of obtaining financing, land, labor, materials, or regulatory permits. As a result of the consolidation, the largest builders are able to grow materially faster than the industry as they gain share.  And, the industry itself should grow at a good rate over at least the several years because the underbuilding in the United States over the past sixteen years has created a shortage of housing units (the shortage is commonly estimated at 3,000,000-5,000,000 units). All-in-all, although the growth can vary from year to year depending on the economy and interest rates, Horton should be able to grow its unit sales at high single-digit rates. Quality companies that grow unit sales at 7-9% per year deserve to sell at high PE ratios—and they usually do.

When thanking about relative valuations, I note that many U.S. companies face serious long-term problems, such as competition from low cost countries (particularly China), severe price competition for their products or services,  increased competition from Amazon or other e-commerce platforms, or threats of technological obsolescence. While all companies and industries have some problems, the homebuilding industry is relatively free from serious problems. It does not face competition from China or Amazon. It is not in danger of being threatened by a new technology. Furthermore, price competition between homebuilders tends to be less severe than for many other manufacturers because no two new homes are exactly the same (if nothing else, no two homes can be at exactly the same location)—and therefore it is relatively difficult for homebuyers to compare the value of one house to another.

            Will the investing public recognize that the large homebuilders have become strong, well-positioned, and higher growth companies that deserve to sell at a materially higher PE ratio than in the past? I note that NVR, which historically has been asset light, often has sold at more than 16 X earnings. NVR’s average PE ratio during the 5-year period 2015-2019 (a relatively normal period) was 16.3 X—and NVR currently is selling at about 16.5 X commonly projected 2024 EPS. While NVR is an excellent company, it lacks Horton’s and Lennar’s scale and geographical reach—and its growth rate materially has lagged Horton’s. In my opinion, if NVR has been selling at more  than 16 X earnings, there is no reason why Horton cannot—and it certainly deserves to.

Note on the future demand for new homes

            As mentioned above, underbuilding during the past sixteen years has created a shortage of housing units in the US. While the demand for new homes can vary some from year to year, the number of families in the United States grows by about 1,100,000 per year—and these families need to live somewhere—so there is a built-in need for new housing. In addition to the net need of about 1,100,000 new housing units per year, roughly 400,000 housing units per year are demolished due to age, damage, location, design, etc. Thus, there is a total need for about 1,500,000 new housing units per year in the United States. When the existing shortage is added to the 1,500,000 annual need, the demand for new homes should exceed the capacity to build new homes, thus creating a tight and  growing market for foreseeable future (although, of course, there could be temporary disruptions). The following chart from a Sherwin Williams presentation concludes that “it would take almost of decade of 2,000,000 annual housing starts to make up the (housing) deficit”—and I believe that the industry lacks the capacity to build 2,000,000 new units  per year. 

Important Disclaimers

The author of this report and his employer own shares of D.R. Horton and other homebuilders—and thus have a vested interest in the prices of their shares.

This report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of D.R. Horton or the other homebuilders. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information and the author’s estimates. And, past performance is no guarantee, nor is it indicative, of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on D.R. Horton or the other homebuilders may change  at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herein.

No investment decisions should be  based in any manner on the information and opinions set forth n this report. Readers should verify all claims and data.

In investment in D.R. Horton or in another homebuilder does not guarantee positive results, as an equity investment is subject to market, economic, and other risks that may result in a loss of principal. Thus the author and his employer disclaims any liability for investment losses that you may incur under any circumstances.

Catalyst

A fully changed and improved business model which should lead to a rerating.

An underbuilt stock which may take 10-20 years of above-normal production by the industry to satisfy. 

Within the industry, a seriously consolidating landscape with the largest player enjoying key economies of scale.