Description

Will the equity of Dream Finders Homes (DFH) be the next NVR, Inc (NVR)? I believe it may be. Not only is NVR the best performing homebuilding stock, but it is among the best performing stocks period over multi-decade stretches. This is a link to an outdated list, but it provides an idea: https://stocksoftresearch.com/best-performing-stocks-20-years/. NVR went public in 1986 at around $180 and today trades at roughly $7500. Below is NVR stock chart:

NVR, Inc. Long Term Stock Chart

NVR, and our subject of discussion today, Dream Finders, are homebuilders, but with an asset-light business model relative to their more traditional peers. This asset-light strategy has been key to NVR’s long-term success and should also serve as a similar tailwind for DFH.

NVR is considered asset-light because, while most homebuilders invest in lots and even raw land, NVR only buys ready-to-build lots and options on lots in order to meet short-term needs. First and foremost, this strategy limits the amount of capital tied up in land and limits the need for additional spending to upgrade and hold the land until the point of vertically building on the property.

Second, the strategy of purchasing lots just in time means that the cost of the lots generally reflects the going price of lots at the point construction begins. This latter point, I infer, enabled NVR to maintain a positive homebuilding margin even at the worst of the GFC and housing bust. In a collapse in land prices, such as the GFC, they were not burdened with a large inventory of legacy lots priced well above the market. With this in mind, NVR does occasionally walk away from and write off options in return for not having to burden the balance sheet with significant borrowings or to be stuck with a large inventory of overpriced lots.

I highlight these points about NVR’s strategy as Dream Finders’s management is intentionally modeling its business strategy on theirs, though with a couple differences. Like NVR, DFH purchases lots last minute and/or controls them via options, but DFH also has exposure to a related-party landbank which may contribute 10% or less to the lots required.

These below slides from the DFH Nov 2023 presentation detail DFH’s two-tiered land-light strategy. (Full slide deck here: https://investors.dreamfindershomes.com/news-events/presentations)

Lots obtained via landbank option contracts (per the above slide, right side) are initiated through DF Capital Management. DF Capital Management is 49% owned by DFH, the public company. DFH, the public company, invests de minimis sums in the partnerships that invest in the land. However, of the limited partner money that is invested in the partnership, material sums do come from related parties of DFH, including the company founder and CEO, Patrick Zalupski. While the landback invests the capital to purchase the land, DFH does pay the carry costs for the partnerships to own, control and upgrade the land. Through its 49% ownership in the general partner, DFH earns a share of any profits in the LPs.

As of 2022 9%+ of the company’s controlled lots came primarily from a $322m “Fund II” launched in 2021. (An earlier “Fund I” of $36.7m is winding down.)

No related party transactions at all would be best. DFH argues the strategy increases the company’s flexibility and speed to market. It probably does, but NVR manages to survive without it. That’s the negative. The positive is it allows them to more precisely select some community locations without incurring the largest cost of doing so; namely, the purchase of the land. I’ve decided I am comfortable with the strategy and believe management’s true pay day comes from a much higher DFH stock price.

About Dream Finders:

Dream Finders is a Jacksonville, Florida based homebuilder with a market cap of ~3.35 billion. It trades at a 12 p/e, 10x ev/ebitda, and roughly 4.2x tangible book value per share. The notion of a homebuilder trading at over 4x tangible book per share might, understandably, strike one as a stretch. However, I don’t think the yardstick applies here. (NVR is currently 5.5x book, slightly higher on tangible book.)

The reason to assign a valuation to a homebuilder that rarely strays too far from tangible book value is because the value of the business in a distressed situation is the value of the assets – land and lots – on its balance sheet. Clearly, no one is buying DFH and NVR for those “assets” because they do not exist other than what is required for near-term sales.

Book value for a company focused on minimizing tangible assets is of limited meaning. In fact, I believe DFH and NVR are simply not traded on their book values at all. P/E is probably a better metric. NVR consistently trades around 15x p/e and is currently trading at that level now. DFH trades at a 12x p/e and I suspect it will achieve that 15 multiple over time as they reach a full geographical footprint.

On ev/ebitda they both trade around 10x to 11x. Relative to the size of its business, DFH has more debt which it has taken on to acquire businesses in new locations in order to increase its exposure to new markets.

DFH debt peaked around $1.1b soon after IPO when they purchased Houston, Texas-based McGuyer Homebuilders (MHI) for $442m. Exiting 2023, debt remains at that level. MHI brought DFH greatly increased operations into high growth Texas via locations in Houston, Dallas, Austin, and San Antonio. In years immediately prior to the 2021 IPO, additional smaller purchases were made that brought exposure to the Carolinas.

In any case, in 2021, the year of that last acquisition, home closings, ebitda, and free cash flow prior to expenditures on homebuilding inventory where 4874 closings, $174 in ebitda and $130m in fcf prior to inventory purchases. For full year 2023e (Q4 not reported) I have them on track for ~6750 closings (per management guidance), ~$400 in ebitda and ~$290 in fcf before inventory costs.

Even after inventory costs, DFH generally generates free cash flow even with its rapid growth (though they did not in 2022). I have them on track to generate, perhaps, $150m in cash flow for 2023. (I do not know Q4 inventory expenditures.)

A very recent, February 2024 acquisition, brings DFH additional exposure in the Carolinas and their first toe into Tennessee.  Perhaps the company will want additional exposure in Tennessee that will come via acquisition. They likely will need exposure in Arizona, and perhaps this will come via acquisition. I expect rolling out a complete footprint to be an ongoing effort and to be achieved via a mix of organic growth and acquisitions, see below:

As one can see from the slide above, fast growth in new markets comes initially with lower margins. Organic expansion, as detailed in that slide (see Denver and Orland on left side of the slide) started with minimally positive margins (and I suspect some startup locations begin with negative margins).

Acquired operations of smaller builders are likely to depress margins, too. These operations have less scale to begin with, need streamlining and integration, and are likely to be asset-heavy businesses which will need to be converted to the asset-light strategy as their existing inventory is sold off.

Below is a comparison of margins for DFH, NVR and all homebuilders, pulling 2022 data. NVR stands well above the averages in the first column, DFH is below even the averages for asset-heavy homebuilders. My belief is that over the course of a number of years, DFH should be able to increase margins to the average at a minimum. That would add about 300 bps to the bottom line. However, DFH’s mostly asset-light strategy (not quite as asset light as NVR, but close) should push margins above industry average and in the direction of NVR.

I don’t expect DFH to ever fully reach NVR’s margins for two reasons. First, NVR is spread narrowly on a geographic basis with operations only up and down the Eastern Seaboard. This tight footprint allows NVR to save cost by operating central workshops that build portions of the homes, such as roof trusses, which they can affordably ship throughout their smaller building footprint. This is not part of the DFH strategy now, nor do I expect it to be.

Also, NVR offers extremely standardized homes with essentially no options or upgrades from which to pick and choose. NVR buyers are offered a handful of models, they choose the one they want, and the process is done. DFH offer some level of customization, particularly on their higher priced homes.

With these additional limiting factors in mind, my working thesis is that DFH can, Step 1, bring margins up to peer averages and then, Step 2, hopefully bring margins somewhat up above those levels due to their asset light strategy, though never to NVR levels.

Another facet of the NVR business model: buy backs.

Buybacks have been an important part of the return profile for NVR. Over the past ~20 years, NVR’s share count has been reduced from 6.47m shares in 2004 to 3.44m shares in 2023, a reduction of 47%. As DFH reaches a footprint that mostly covers the high growth areas of the country, I expect new locations to be largely organic (not acquisition) as they fill in around existing operations. At that point, cash flow can be directed to pay down debt and ultimately be directed into buybacks.

Earnings & Valuation:

I estimate 2023 earnings to be approximately ~$2.68. At stable margins I expect earnings to increase 10% or more per year as they increase the number of communities from which they sell homes. At the stock's current 12 multilple that would yield a stock price rising about 10% per year.

However, community count has been rising well in excess of 10%, in part due to acquisitions. Annual community count growth at an average of 10%, or even slightly less, may be likely as the company matures, but 10% may be too low for the next few years. I prefer to be conservative, but I would not be surprised to see something a bit higher.

As far as margins go, I do not expect them to remain stable. I can’t predict precisely when, but I do expect margins to eventually rise toward industry averages, which will add 200 to 300 bps in margin improvement. Eventually, I suspect the asset-light strategy will push margins above industry averages. Though increasing margins could come in an unnaturally smooth and steady increase, I suspect that some improvements are likely to happen in jumps, such that I need to be in to be bought in to benefit from them when they happen.

Using my estimate of $2.68 for full year 2023 and adding 300 bps of improvement, an amount that would bring DFH margins in line with industry average, would yield earnings of $3.44 or 28% higher. Should margins go above industry average even 200 bps, yields earnings of $3.95, or 47% higher.

Eventually, buy backs should kick in, slowly reducing share count, which should become an annual factor adding some additional earnings growth.

Finally, should the company continue to execute on growth in closed homes, margins improve, and free cash flow be consistently converted to a predictable reduction in sharecount, I suspect the equity will be awarded a slightly higher p/e multiple. The p/e is currently at 12 and should trend toward 14 to 15, which will further increase the stock price.

I view DFH as a long term holding for a buy and hold investor.

Risks:

Homebuilding is a cyclical industry which will add volatility to the business and the equity during times of homebuilding downturns and recessions.

Related party involvement with the landbank does not seem to be a problem, but is not ideal.

Catalyst

Continued growth in community count, improving margins, hopefully buybacks, slightly higher multiple all contribute to return over time.