Description

NVR Inc (NVR) $5846.52

Summary

NVR Inc (NVR) stands alone among the homebuilders due to its capital efficient operating model and exceptionally strong capital allocation by management. NVR was the only public homebuilder to remain profitable throughout the 2006 – 2011 housing downturn. While NVR has performed exceptionally well over the last cycle, I believe that its structural advantages remain underappreciated in part due to non-economic factors including limited analyst coverage, the lack of earnings calls and shareholder engagement, and a price-to-book ratio that is much higher than its peers (4.9x vs 1.7x). NVR’s price-to-book ratio is a bit distorted by massive share repurchases that have reduced shares outstanding by -42% from 2005 – 2022.

Background

Historically, homebuilders were essentially land developers, driven by misaligned incentives that ignored the cost of capital. This led to a predictable boom-and-bust cycle. NVR went through bankruptcy reorganization in 1993 and radically changed their approach to the business in the years that followed.

NVR’s strategy centers around a few key differentiators:

• NVR uses a land-light model. They only acquire developed lots through option agreements with premiums roughly 10% of the lot cost. This is not only more capital efficient than owning land outright, but it removes a lot of operating and financial risk associated with carrying land.
• NVR is an efficient operator. They focus on gaining leading market share in the markets that they choose to operate in, and they generally select second and third tier markets where competition is weaker. They operate factories near their markets to pre-fabricate components, lowering costs. Their SG&A expenses routinely run several percentage points below their competitors.
• NVR’s management has proven to be very effective capital allocators. Instead of chasing growth at any cost, they have prudently directed the majority of their income over long periods of time to repurchasing stock, boosting per-share earnings. This is supported by incentives including moderate cash compensation, performance compensation tied to performance, and periodic stock option grants. Their culture is uniquely shareholder aligned with the CEO not on the Board of Directors and executives must hold 4x – 8x their salary in NVR stock.

Following the great recession, most of the remaining public homebuilders shifted towards an NVR operating model, specifically lowering the amount of owned land, and increasing the use of land options. Many have seen their returns on equity improve significantly, and the industry is far healthier today than it was 15 years ago. However, most of the other homebuilders can be considered NVR-lite at best. Lennar has increased its share count 80% since 2005 and D.R. Horton has increased its share count 10% since 2005, while NVR has reduced their share count by -42%. 

The Opportunity

Homebuilder stocks fell sharply in 2022 in response to rising interest rates before rebounding in the fourth quarter and rising into the second quarter of 2023. Investors likely recognize that the homebuilders do not have the financial risks that they had in 2006 and that any recession is likely to be mild unless unemployment spikes. And the stocks had become statistically inexpensive with many of the homebuilders trading below 1x book value in late 2022.

I believe investors generally undervalue greatness. The long-term capital compounding ability of certain businesses and managements is often discounted greatly. NVR is an excellent example of this. NVR is a compounder not because it operates in a great industry, but rather because it is managed by exceptional capital allocators. Berkshire Hathaway under Buffett and Teledyne under Singleton are analogues.

NVR’s structural advantages are deeply embedded in their culture as evidenced by differentiated market selection, operating efficiency, management incentives, and capital allocation. This is further evidenced by the long tenure of its workforce.

In addition, NVR is easily overlooked by most investors. Management is not promotional. They do not hold earnings calls or present at banking conferences. In an industry where a rule-of-thumb is that you buy below 1x book value and sell for 1.5x book value, NVR is an anomaly. The stock has routinely traded at a healthy premium to book value given the distortion resulting from their substantial share repurchases. Finally, I think even professional investors sometimes get disoriented by high share prices, resulting in irrational behavior.

This Time It Might Be (A Little) Different

Homebuilding is a cyclical business tied to macroeconomic factors including interest rates, household formation, and employment rate.  This has been well illustrated over the last few years. Interest rates were lowered sharply at the onset of the COVID pandemic in 2020 which ultimately led to increased homebuilding activity as multi-generational low mortgage rates incented demand. Conversely, as the fed funds rate rose from 0.25% in March 2022 to 5.25% as of May 2023 – the most rapid increase in history – mortgage demand fell and homebuilding declined sharply.

However, there are several reasons why the outlook for homebuilding is more robust than the rapid increase in interest rates might suggest including:

• Unemployment remains low. Barring a sharp increase in unemployment that would lead to forced existing home sales and a fall in home prices, housing demand should remain strong, with affordability being the primary offset.
• Constrained supply of existing homes. Many existing homeowners are effectively locked into their houses because they purchased or refinanced in mid-2020 – early 2022 when mortgage rates were at generational lows. Unless they must sell due to a life event, it does not make economic sense to sell a house and forfeit a 2.5% mortgage to purchase an equivalent house at a 6.5% mortgage. While existing home selling inventory has risen since the low levels seen during the early stages of the COVID pandemic, it remains very tight in many markets. While home prices have softened from their pandemic highs, they remain well above pre-pandemic levels in most markets.
• Homebuilders are well positioned. With limited competition from existing home inventory and the ability to provide financing incentives such as mortgage rate buydowns, the homebuilders are taking a greater share of the home sales market. In addition, new homebuilders can shrink the square footage of new builds and reduce the standard finish levels to reach a price point that its buyers can afford. Finally, public homebuilders cater primarily to first-time buyers who are not encumbered by an existing low-rate mortgage.
• Millennials and Gen Z. The last wave of millennials and the first wave of Gen Z are entering the point in life where households are formed and homes are purchased, creating demand for housing that the public builders are well positioned to address. It is well understood that the country faces a shortage of housing supply due to underinvestment due to the housing downturn in 2006 – 2011 combined with increasing demand from a rising population of homebuyers.

The Data

NVR has routinely directed well over half their earnings towards share repurchases even while achieving attractive returns on the incremental retained earnings. NVR does not pay dividends.

From 2005 to 2022, NVR reinvested 37% of cumulative earnings at an estimated 30% return on incremental invested capital. Shares outstanding decreased by -43% over 17 years. Over this extended time period, the CAGR of the stock price of 11.7% largely tracked the intrinsic value compounding rate of 11.5% (37% * 30%). Net income grew at an annualized rate of only 5% given the deep housing recession from 2006-2011, which makes NVR’s capital allocation driven performance truly an exceptional outlier.

From 2017 to 2022, NVR reinvested 42% of cumulative earnings at an estimated 56% return on incremental invested capital. Shares outstanding decreased by -13% over 5 years. Over this period, the CAGR of the stock price of 5.6% significantly trailed the intrinsic value compounding rate of 23.5% (42% * 56%). This is in part explained by NVR trading at an elevated valuation in 2017 of 27x trailing P/E vs. 9x trailing P/E at the end of 2022. The valuation in 2022 was depressed by interest rate concerns. Net income grew at an annualized rate of 26%, boosted by the sharp rise in demand and resulting home prices during the Covid pandemic.

Going forward, consensus estimates are for net income to fall -24% from 2022 to 2025, a CAGR of -9%. I believe this is unduly pessimistic barring a deeper, unemployment-driven recession. I think over a five year time period, Assuming consensus 2023 net income of $1.4b as a starting point, NVR should be able to grow net income at a CAGR of 8% to 10% even with 2023 and 2024 results underperforming 2022 as conditions revert following the Covid boom, resulting in 2027 net income of $1.9b to $2.0b. Cumulative net income over the next five years could be $8.0b to $8.4b, and 60% of net income ($4.8b to $5.0b) is likely to be directed towards share repurchases, potentially reducing the share count. Assuming shares are repurchased at a conservative 25% greater than the current quote of $5846, shares would decline by -20% to -21% to 2.6mm in 2027.

Net income of $1.9b to $2.0b in 2027 would equate to EPS of $720 to $783. Assuming a conservative P/E multiple of 13x to 15x, implies a 2027 share price of $9360 to $11745, equating to a 5-year CAGR of 10% to 15%. I believe this is attractive given the conservative estimates used and NVR’s strong track record of value creation. Most notably, while I believe the stock is attractive at current prices to a long-term holder, if the share price were to recede on short-term concerns like a weakening economy, the stock should be considered increasingly attractive to the long-term holder.

Catalyst

continued exemplary capital allocation resulting in significant share repurchases