Description

From time to time we have an opportunity to purchase shares in an industry that is in the process of being transformed from a not-so-good business into a good business. Such was the case with the railroads during the period 2005-2008. And, such appears to be the case today with the homebuilders.

Until a few years ago, most homebuilders reinvested the bulk of their operating cash flows in land and land development. They desired to own large and increasing amounts of land so that they could grow rapidly. Their prime objective was growth. As a result of this growth strategy and the large sums invested in land, the homebuilders earned relatively low returns on invested capital – and were at considerable risk during periods of declining demand for new homes. Because of these unattractive attributes, the shares of the homebuilders deserved to sell at relatively low PE ratios – and they did.

One homebuilder, NVR, has been an exception to the rule. NVR purchases a majority of its developed lots just before the company starts to build on the lots. Whereas most homebuilders historically have been asset heavy, NVR has been asset light – and NVR has enjoyed relatively high returns on its invested capital, has generated large quantities of free cash flow, has aggressively repurchased its shares, and has been awarded a relatively high PE ratio by investors.

It is evident that most of NVR’s larger competitors have observed NVR’s successes and recently have altered their corporate strategies in the direction of becoming materially asset lighter. For example:

On Lennar’s Q4 2016 earnings call, Stuart Miller (CEO) stated that the company’s number one strategy is to “soft pivot on land”. Previously, Lennar inventoried a land supply that would be ample for more than five years of future building. Now, according to management, “we are targeting high-quality land acquisitions with a shorter two to three-year average life”. Stuart Miller added that a key goal of the restrained land holdings is to increase the company’s free cash flow.

On a call to announce its intention to acquire control of Forestar Group, D.R. Horton’s CEO said that his company “has been focused on limiting the number and duration of lots that we own. This has improved our returns, but it has also created tremendous appetite for optioned lots and lots developed by others”. He later added the “proposal (to acquire control of Forestar) is consistent with our stated long-term strategy of developing strong relationships for land developers across the country and growing the optioned portion of our land and lot positions to enhance both operational efficiency and returns”.

On its Q4 2016 earnings call, Pulte’s management said: “based on our trailing 12-month closing volumes, we have lowered our owned lots supply to less than five years. Our goal is to continue to shorten the duration of our land pipeline”.

The new asset lighter strategies already are beginning to change the fundamentals and economics of the homebuilding business. Whereas the demand for new homes has been growing at a rate in excess of 10%, the number of lots controlled (owned and optioned) by the 17 public homebuilders increased at only a 1.1% CAGR during the past two years (2015 and 2016) and the number of selling communities increased at only a 5.8% CAGR. These trends appear to be accelerating this year, leading to a tightness of the housing market in some regions of the country.

Looking ahead, we predict that there will be an increasing shortage of new homes in most geographic areas due to an inadequate supply of developed lots – and, as a result, homebuilders will gain pricing power that will lead to materially higher margins, earnings, and free cash flows. On Lennar’s first quarter 2017 earnings call, Stuart Miller (CEO) reported that “limited supply and production deficits are now intersecting with land and labor shortages, and this suggests, though not yet seen, that pricing power is on the horizon as we move through the year”.

Furthermore, since the asset lighter strategy of the homebuilders appears to be secular rather than cyclical, the homebuilders continually should enjoy materially improved ROEs and free cash flows – and, therefore, the shares of the homebuilders deserve to sell at higher PE ratios than in the past.

Given this outlook, the shares of the homebuilders appear to be particularly attractive. I will use D.R. Horton as an example of the attractiveness. Horton, the largest of the builders, specializes in the construction of lower priced homes sold to first time buyers. The company is well managed and enjoys an excellent reputation. It adopted an asset light strategy a few years ago and, as a result, has been generating substantial free cash flows ($618 million last year), which it has used to reduce its debt to abnormally low levels for a homebuilder. Very recently, the company announced a share repurchase program and announced an agreement to acquire a controlling interest in Forestar, a real estate company that will be used by Horton to purchase and develop land off of the parent company’s balance sheet.

Horton expects to deliver 44,500-46,000 homes in its current FY 2017 (ends on September 30), up 10-14% from the 40,309 delivered last year. We believe there is a high probability that, over the next several years, the demand for new single-family homes will continue to recover from current depressed levels. This recovery will be driven by the number of family formations and by a deferred demand for housing units. Horton has projected that its revenues should continue to grow at double-digit rates over the next several years.

We project the following: (1) Horton’s deliveries will increase at a 10% CAGR, (2) the company’s unit costs, which somewhat will benefit from positive leverage over fixed costs, will increase at a 3% CAGR, and (3) prices will increase by more than costs as the company enjoys pricing power. Our specific assumption is that Horton’s prices will increase at a 4% CAGR in 2018 and 2019. Based on these projections and assumptions, Horton’s homebuilding revenues would increase at a 14% CAGR from an estimated $13.5 billion this year to $20.0 billion in FY 2020, its homebuilding margins would increase from an estimated 11% this year to 13% in FY 2020, and, after including small profits from the origination of mortgages and from the sale of land, the company’s EPS would increase from a projected $2.70 this year to about $4.75 per share in FY 2020. The $4.75 assumes that the company’s effective tax rate remains at 35.5%.

During the three-year period 2014-2016, Horton’s shares sold at an average PE ratio of 13.1 X while NVR’s shares sold an average PE ratio of 16.7 X. With Horton becoming more NVR-like, I would estimate that its shares will be worth at least 15 X earnings. Therefore, I believe that, about three years from now, Horton’s shares will be worth at least $70 vs. their current price of about $34.

Catalyst

recovery of housing market and transformation in direction of becoming materially asset lighter.