We are recommending a short sale of NVR.  NVR is regional homebuilder levered to the D.C metropolitan area, with 40% of its production in this region.  The company trades at 3.8x book value and 11x 2007E earnings.  Charlie479 penned a prescient writeup of NVR in 2001.  We suggest you read it as it includes some useful background information.  We believe that Charlie479 was right because NVR’s business model is similar to a call option on the DC housing market, designed to generate excess performance in the up years.  However, there is similar leverage to the downside.  Despite this leveraged business model, the stock is only down 16%, year to date, in line with its peers.  We believe the stock is worth half of where it is currently trading.  Potential catalysts in the near term: additional write-downs, lower than expected 2007 earnings, and increased cancellations.

 

NVR is the eighth largest public homebuilder in the U.S by revenue.  There are four different trade names under which NVR builds homes: Ryan Homes, NVHomes, Fox Ridge Homes and Rymarc homes.  Ryan Homes, Fox Ridge Homes and Rymarc homes are moderately priced and marketed to first time homeowners and first-time move-up buyers.  NVHomes is marketed primarily to move-up and upscale buyers.  The company operates in 11 states, and 20 metropolitan areas.  Its mix is as follows: 30% First-time buyer, 31% second time buyer, and 39% active adult/age restricted/second home.

 

The company segments its results into four regions: Washington, Baltimore, North and South.  North is Delaware, Kentucky, Maryland Eastern Shore, Michigan, NJ, NY, Ohio and Pennsylvania.  South is North Carolina, Tennessee and Richmond, VA.  The company delivered about 15,000 homes in the last twelve months and had homebuilding revenues of approximately $6 bn.

 

In unit terms, 38% of their deliveries, and 42% of their backlog is in the DC/Baltimore region. Because of higher average prices, DC/Baltimore represented over 50% of total revenues in 2005.  The break down of deliveries in each area is as follows:

 

 

While we could go into some detail with regards to industry specifics, we have no desire to waste everyone’s time given the bounty of better analysis with regards to whether the homebuilding industry is at a bottom, a top, or somewhere in the middle.  For the purpose of this trade, the only thing that is important is that we do not return to a bull market next year, which even the most optimistic of homebuilder investors do not claim.  In terms of real estate, the Washington DC metropolitan area has had extraordinary performance in the last five years.  Average home price appreciation is 2.5x that the national average since 2001.  As with any hot real estate area, speculators’ participation in the frenzy contributed to over-building on the part of homebuilders.  Current inventory levels are over twice what they were last year, and are at the highest levels since 1998.  As demand has stabilized, the only way for this inventory to decline is either for 1) prices to drop or 2) significant cuts in production.   Both are currently being seen in the market and either scenario negatively impacts NVR’s 2007 earnings power.  Some data points on the DC/Baltimore region: 

 

When we first looked at NVR’s numbers in the second quarter of 2006, we were puzzled by a couple of discrepancies: 1) cancellations were not as high as we would have expected, 2) revenues are not off as much as their peers, and 3) gross margins were relatively high.  All of these would speak to a better run company than average (and thus destroy our short thesis).  We will take you through why each of these figures is in fact disguising a business that is currently falling off a cliff.   First, cancellations have already started to rise vs. the second quarter.  In Q3, NVR saw cancellations of 27% vs. 13% in Q2, giving credence to anecdotal comments that NVR had been aggressively discounting at close to prevent cancellations.  Presumably, cancellations at NVR will show incremental declines going forwards, bringing them in line with industry performance; either that or gross margins will decrease significantly.  Second, revenue growth and settlement (aka closing) growth has exceeded their peers due to a large increase in the number of communities open.  In the third quarter, NVR had 609 communities open vs. 518 communities in the prior year, an increase of 18% yoy.  An active increase in community count into a slowing market is risky.  While it temporarily props up results, it also may make it more difficult for NVR to cut expenses as orders continue to slow.  Third, gross margins are relatively high largely due to NVR’s mix – gross margins in the DC area average above 30%, well above that of the average homebuilder.  We have been told that NVR is simply a better operator than its peers, but this is simply not true.  Given Stanley Martin (a DC only builder) had gross margins of 30% in 2005 vs. 27% for NVR, one might argue that NVR’s margins should be even higher were it a better operator.

 

 

NVR’s recent results show a disturbing trend.  In addition to poorer margin performance and increasing write-downs over the past couple of quarters, the company’s new orders have fallen dramatically.  Currently, they are receiving 0.6 orders for every house they close, despite the increase in community counts yoy.   New Order trends continue to weaken despite lower average prices.  NVR commented in the last quarter that Washington DC prices were down 25% yoy while showing New Orders declines of 18% yoy.  The company is clearly unable to replace their backlog.  If current trends continue, next year production could fall down 10K homes, well below street expectations of approximately 12K homes delivered.

 

In addition, NVR’s unique business model leads to several questions.  For those less familiar with the company, NVR exited bankruptcy in the early nineties.  The management team switched NVR from the typical developer/builder model to a pure builder business model.  Therefore, rather than take any land development risk, NVR does not take land onto the balance sheet until it has 1) a contract to sell the home and 2) the land is fully developed and ready to build.  NVR is the only large homebuilder whose land strategy is 100% options-based. This model has led to greater asset turns, greater free cash flow generation, and greater returns on equity during the bull times.  However, there are several disadvantages to this model as well, arguably the reason why the other homebuilders have chosen not to copy NVR.  1) The need to transfer development risk to a partner results in higher average prices paid/lot as well as higher option deposits at risk.  Therefore, barring large land or land development price increases, NVR should produce sub-par margins in comparison to their peers.  2) This is a difficult model to grow as it depends on the availability of partners.  In some markets, there simply may not be developers willing to enter into these contracts.  3) As the number of builders in each market grows, it becomes more difficult for NVR to retain its market leading position, given these supply constraints, without signing irrational agreements.  Given the rapid increase in option contracts signed in 2004 and 2005, it seems NVR started signing bad deals in an attempt to maintain share in its markets.

 

As we mentioned in our summary, we liken NVR’s business model to a call option on the metro DC/Baltimore housing markets.  As you can see below, the correlation between gross margin increase and home price appreciation has been significant, with margins growing from 13% in 1994 to 28% in 2005.  In comparison, Toll’s gross margins increased from 24% in 1994 to 32% in 2005.  We believe the reason for this dramatic increase is NVR’s strategy of signing option contracts for finished lots.  Option contracts are in essence a call option, with the strike price being the price/lot and the expiration date, being equivalent to the date the lots are purchased.  The agreed price/lot is determined when the contract is signed, and a deposit is given to the land owners (aka, the price of purchasing a call option).  The deposit is forfeit iin the event the land is not purchased.  Some price appreciation is built into the forward price/lot, generally in line with historical average land price growth of 5-10% per year, as well s some inflationary cost of 2-5% for development.  The time frame for these options is dictated by the parties involved, but is generally around 3-5 years. 

 

As a result, we believe NVR’s price per lot was dramatically below the market for two reasons: 1) Land prices increased on average 20% per year for the past five years and 2)  Land development costs showed double digit growth for the past five years.  We believe the second reason to be why NVR’s gross margin performance has exceeded their peers.  As opposed to absorbing the increasing land developments costs, we believe the brunt of the unexpected cost was borne by their partners, who ended up selling finished lots to NVR at below market prices.  Given land development can be up to 50% of the cost of a lot, this gave NVR a substantial cost benefit in comparison to peers – hence the relatively large increase in margins.  NVR has controlled an average 6 years of supply since 2003.  So it is possible that until recently, they were selling houses with finished lot prices set in the late nineties.  However, like all FIFO inventory accounting systems, eventually inflation does start affecting a company’s margins.  It’s just more delayed in the homebuilding sector than most industries.

 

 

With pricing declines and high inventory levels in much of the US, homebuilders are walking away from deals signed with bull market expectations.  Those who were more aggressive in 2005 are facing larger write downs than those who were more conservative.  NVR appears to be in the former category.  From 2003 to 2005, lots controlled increased from 70,000 to 105,000 lots – an increase of 50% vs. an increase in closings of 14%. 

 

The company has $437.5 mm of option deposits on its balance sheet as of Q3 ’06, 19.4% of assets, and 40.4% of shareholder’s equity.  Including deposits held by consolidated joint ventures and letters of credit outstanding of $17 mm, the total is $500.5 mm.  (NVR is required to consolidate joint ventures where they are deemed to be the main beneficiary under FIN 46.  Hence the cash they have on deposit is greater than the amount on their balance sheet.)  In addition, in the 10-K, there is the following disclosure on page 63: “At December 31, 2005, assuming that contractual development milestones are met, NVR is committed to placing additional forfeitable deposits with land developers under existing lot option contracts of approximately $214 [mm]”.  This number is not updated quarterly, so the current amount is unclear.  If you include the $214 mm of additional deposits, there is a total of $714.5 mm in cash deposits at risk, over 70% of shareholder’s equity.

 

As mentioned earlier, we believe that most of these option contracts assume some average increase in land prices to determine the final purchase price/lot.  Given the recent performance of 20% growth per year, it is likely that developers that signed contracts in 2004 and 2005 required more aggressive land price appreciation assumptions.  Given current expectations are for land prices to decline, or to rise in the low single digits, many of these contracts have agreed purchase prices/lot well above market.  And similar to any call option that is significantly out of the money, the current value is likely close to zero.  Therefore, if NVR is unable to negotiate the purchase price down, all these contracts could be worthless.  Assuming that all options struck since 2003 are worthless, there will be another $150 mm of write-downs expected.  If you assume that at least 50% of the additional $214 mm of deposits that due is associated with worthless contracts, that increases our expected writedowns to $257 mm. Given NVR trades at 3.8x book, an asset writedown of $257 mm could reduce the equity value by about $140/share, assuming that you keep the same egregious multiple of book.

 

Looking at potential asset writedowns in another manner, according to NVR’s 10-K, “The Company generally seeks to maintain control over a supply of lots believed to be suitable to meet its sales objectives for the next 24 to 36 months”.   Given the current run rate of deliveries, NVR should have about 30,000 to 45,000 lots under control.  As options are not without carry costs, it makes little sense to keep up a large supply of land that will not be used.  Potentially, we could see NVR write off an additional 40,000 lots in the upcoming quarters, eliminating an additional $200 mm of book value.  Given NVR trades at 3.8x book, an asset writedown of $200 mm could reduce the equity value by about $100/share, assuming that you keep the same egregious multiple of book.

 

 

Note: we believe that the $ deposits in cash and the controlled lots in the text of the SEC filings does not reflect the recent impairments of $106 mm ytd (hence the drastic increase in the difference between the balance sheet and $ deposits in cash found in the notes). 

 

The company’s management team, while claiming to act in the shareholders best interests through extensive share buybacks, has been taking home an extremely generous compensation packages, self-dealing, and actively selling shares.  The extensive share buybacks, in essence, resulted in the management taking control of the company without paying a premium.  The company is controlled by the management team through their option holdings.  There are 5.754 mm basic shares outstanding, and 2.796 mm options outstanding (strike at $293).  How many management teams do you know own 33% of the company strictly through free options?  In fact, if you could name one, we would love to know.

 

In terms of self dealing, the following is found in the proxy.  While the numbers were small, aren’t shareholders already paying this team enough money?  After all, shareholders gave the management the keys to the kingdom in exchange for a couple of share buybacks.

 

“During the year ended December 31, 2005, NVR entered into forward lot purchase agreements to purchase finished building lots for a total purchase price of approximately $41,000,000 with Elm Street Development, Inc., which is controlled by Mr. Moran. These transactions were approved by a majority of the independent members of the Board of Directors, and the finished lots under these transactions are expected to be purchased over the next three years at market prices. During 2005, NVR purchased 182 developed lots at market prices from Elm Street for approximately $29,000,000.

 

NVR periodically leases, at market rates, an airplane owned by Mr. Schar for business-related company travel when the use of the airplane lends itself to business travel efficiencies. NVR’s independent directors annually review these expenditures. During 2005, NVR paid approximately $323,000 for business-related use of the airplane.

 

 

While NVR may seem reasonably valued on earnings and EBITDA, we believe it is difficult to value homebuilders on this basis given their earnings represent a match between current housing prices with land prices from up to 5 or 10 years ago.  In the DC area, land values represent at least 30% of the cost of the home, if not more in certain areas.  As mentioned earlier, we believe that contracts signed up to six years ago are responsibly for much of NVR’s gross margin increase.  However, without visibility on current contracted lot prices, one cannot extrapolate past earnings performance as a meaningful indicator of future earnings power.  Therefore, valuing a homebuilder on earnings or EBITDA is flawed.  To us, homebuilders are more like portfolio managers, and should be valued on their ability to manage their capital.  As most banks and asset managers do not trade for more than 2x book, we believe this would be a fair place for NVR to trade.  Given the $225 mm in asset writedown we expect, which would lower book value per share to $123, and a 2x multiple on that, our target for NVR is approximately $250/share.

 

In response to the cheap P/E and earnings power of the business, we believe that if you adjust NVR’s results for performance more in line with the industry, and for gross margins more in line with a non-bull market level, then you should have on-going normalized earnings at around $30/share.  The current street expectations for 2007 do not reflect the recent order trends at NVR, and therefore expect a closing rate close to 20% above what their current order rate implies.  At $250/share, you would trade at around 8x earnings, in line with overall homebuilding multiples.

 

Catalysts

1)       Additional asset writedown in the next couple of quarters.

2)       Poor 2007 earnings performance

 

Risks

1)       Share buyback propping up the stock

2)       Substantial short interest

3)       Quick turn in the housing market in the next year, especially in the Washington DC area.

4)       Technically there is some takeout risk in the homebuilding market, but most of the homebuilders that are mentioned as potentially acquirers are focused on purchasing assets below book value – in essence buying a builder for its land bank.  Given NVR’s multiple and strategy, it seems an unlikely target.