Potential Upside In D.R. Horton

| About: D. R. (DHI)

D.R. Horton, Inc. (NYSE:DHI) is one of the leading homebuilders in the United States. Like many residential construction stocks it was hammered during the financial crisis as its revenue plummeted over several years. However, DHI was in decline even before Wall Street banks were going bust. Today, with much of the dust starting to settle, residential construction stocks, including DHI, may offer potential returns. While, as I noted in an earlier article, they may not provide enormous returns that some investors capture by buying during the panic, there is still potential for good returns if the housing market rebounds.

Current price more reflective of 2006 than 2009

DHI most recently closed at $20.72, up 409% from its $4.07 dividend adjusted low in November of 2008. However, in spring of 2009 when SPY dipped to new lows, DHI never traded below $5.90. In contrast, DHI traded above $40 per share for many parts of 2005 requiring another 100% increase from today's price. This most recent closing price of $20.72 is similar to the price in the late and early part of 2007. From a historical perspective, housing stocks were in decline long before mortgage securities were devastating Wall Street. The following graph shows the historical (monthly) price of DHI and SPY normalized to January 1, 2001.

Source: Yahoo!Finance for monthly prices, author calculations

This graph clearly shows that DHI achieved its peak from 2004 to 2005 on both a price and dividend adjusted basis. SPY, showing much smaller fluctuations, peaked in 2007. On the dividend adjusted basis, DHI was a much better investment over this time period. This second graph shows the last 5 years of data from October 2007 when SPY peaked.

Source: Yahoo!Finance for monthly prices, author calculations. Prices are not adjusted for dividends.

This second graph clearly shows that DHI has accelerated ahead of SPY over the last 15 months, despite aligning during the fall 2008 downturn and again in fall of 2011.

DHI Revenue is Still Recovering

While DHI stock has bounced back in the past 15 months, its revenue, like the housing market has been relatively stagnant for the past four years. The good news is that margins are adjusting back to more normal levels.

Source: SEC Filings, Author Calculations. Year is fiscal year for DHI which ends in September.

This table clearly shows the spike in revenue in FY 2006. One can also see both gross margins for homebuilding and the overall net margin steadily rising until 2005 and then a short decline followed by a precipitous drop in 2008. DHI's most recent net margin is reflective of a tax benefit. The gross margin is slowly becoming approaching the figures from 1996 to 2003. It should also be noted that DHI made a substantial number of acquisitions to help drive growth and enter new markets from the late 1990s onwards. These income statement figures suggest that there is still some upside on margins. Analysts forecast substantially higher revenues for FY 2013 and FY 2014 of $5.5 billion and $6.8 billion, respectively. Achieving these figures will likely require a further rebound in the housing market. As noted in my other article, housing starts continue to be mired at well below the long run average, despite a decent bounce off the bottom.

DHI continues to hold market share

Perhaps the best news for DHI is that they held and improved their market share during the past several years. This should position them to benefit as the housing market continues to improve. The following table shows the comparison of the number of houses closed by DHI each fiscal year in comparison to the total number houses completed in the U.S.

Market Share
Fiscal Year Thousands of DHI Homes Thousands of Completed Houses DHI Share
2012 18.9 619 3.0%
2011 16.7 582 2.9%
2010 20.9 706 3.0%
2009 16.7 865 1.9%
2008 26.4 1,208 2.2%
2007 41.4 1,644 2.5%
2006 53.1 1,993 2.7%
2005 51.2 1,905 2.7%
2004 43.6 1,813 2.4%
2003 35.9 1,662 2.2%
2002 29.8 1,638 1.8%
2001 21.4 1,544 1.4%
2000 19.1 1,598 1.2%
1999 18.4 1,574 1.2%

Source: U.S. Department of Commerce, SEC filings, author calculations. Housing completions data has been aligned DHI fiscal years which end in September.

One can see that DHI has a track record of growing market share, reaching 2.7% during the peak of the housing boom. However, that share stumbled in 2009 only to return to its highest level yet of 3.0% for 2012.

Discounted Cash Flow Model Suggests some Additional Upside

Applying a discounted cash model to DHI suggests some upside, especially given strong expected revenue growth over the next two years. The discount rate (weighted average cost of capital) was calculated as follows:

Discount Rate
WACC Component Value
Risk Free Rate 1.9%
Beta 1.54
Equity Risk Premium 5.0%
Required Equity Return 9.6%
Cost of Debt 4.0%
Tax Rate 35.0%
Debt Weighting 27%
Equity Weighting 73%
WACC 7.7%

Source: Yahoo!Finance, Author calculations

Key top line assumptions were estimated based on analyst projections and author estimates. This is probably one of the most critical parts of discounted cash flow since it requires the most assumptions and thus the most sensitivities. Many analysts are projecting relatively robust top line growth for housing companies. The 2013 and 2014 revenue estimates were used to back into the other variables (e.g., total housing units completed, new home sales prices, etc..).

Source: SEC Filings, U.S. Department of Commerce for historical data, Author estimates for projections based on trend and literature review

The biggest assumption in the revenue projections is that we are at the inflection point when growth will trend back to the long run mean of about 1.5 million housing units per year. My estimate targets 1.3 million by 2017 and rising to 1.5 million by 2020. This provides a very long time to return to the long run average. So unless, there is a paradigm shift, this is probably a conservative assumption. It also assumes the new home prices will continue to grow somewhat above inflation and that DHI will sustain its market share. Note that if DHI can continue to grow its market share, the other variables could slip a little. This revenue projection in combination with margin assumptions and other financial data is then used to compute the unlevered free cash flow.

Unlevered Free Cash Flow ($ Millions)
Year Status Net Income Depreciation Change in Working Capital Capital Expenditures Unlevered Free Cash Flow
FY 2010 Historical 322 49 (55) (19) 375
FY 2011 Historical 148 57 (193) (16) 25
FY 2012 Historical 1,042 59 (274) (34) (386)
FY 2013 Projected 282 53 (654) (34) (304)
FY 2014 Projected 432 42 (193) (34) 296
FY 2015 Projected 409 37 259 (34) 703
FY 2016 Projected 493 36 (821) (35) (295)
FY 2017 Projected 583 35 (874) (35) (258)
FY 2018 Projected 636 35 (522) (35) 147

Source: Yahoo!Finance, Author calculations

Combining the DCF with a long term growth rate of 4% suggests that DHI trades at slight discount to its intrinsic value. However, even a slight decline in margins would suggest fair value or even a possible slight overvaluation.

Equity Value
Valuation Component Value ($ millions)
Enterprise Value $ 9,048
Debt and Liabilities $ 2,496
Cash $ 1,097
Potential Equity Value $ 7,650
Current Equity Value $ 6,650
Potential Appreciation 15%

Source: Author Calculations. Cash excludes about $300 million of marketable securities, suggesting some upside.

The critical sensitivities beyond the top line revenue assumptions would be margin. A 1% drop in gross margin would decrease the equity value by almost $2 billion from $7.7 billion to $5.7 billion. A 1% increase in long term growth from 4% to 5% would add $2.3 billion in value.

DHI has typical valuation multiples relative to its competitors

Despite being an industry leader, DHI has just a tiny 3% market share. This demonstrates a high level of market fragmentation which at least provides the potential for numerous competitors for comparisons.

Residential Construction Stocks
Ticker Name 1/4/2013 Closing Price Market Capitalization ($B) Enterprise Value ($B)
LEN Lennar Corporation 40.23 7.7 11.5
PHM PulteGroup, Inc. 19.06 7.4 9.0
DHI D.R. Horton, Inc. 20.72 6.7 7.8
TOL Toll Brothers Inc. 33.66 5.7 6.7
NVR NVR, Inc. 954.49 4.7 4.2
MDC M.D.C. Holdings, Inc. 38.57 1.9 1.9
RYL Ryland Group, Inc. 37.73 1.7 2.2
SPF Standard Pacific Lp 7.66 1.6 2.8
MTH Meritage Corporation 38.78 1.4 1.8
KBH KB Home 16.22 1.3 2.5

Source: Yahoo!Finance

This set of homebuilders shows that most companies have managed to stay relatively unleveraged, with the exceptions of LEN, KBH, and SPF.

Valuation Multiples
Ticker 1/4/2013 Price Forward EPS Forward P/E TTM EBITDA ($ Millions) EV/ EBITDA
PHM 19.06 1.14 16.7 215 41.7
RYL 37.73 2.02 18.7 61 35.5
MTH 38.78 2.06 18.8 39 46.2
NVR 954.49 48.46 19.7 250 16.8
Average 23.4 42.8
DHI 20.72 0.88 23.5 279 28.0
MDC 38.57 1.52 25.4 18 106.0
LEN 40.23 1.57 25.6 345 33.5
SPF 7.66 0.29 26.4 67 41.8
TOL 33.66 0.94 35.8 188 35.8
KBH 16.22 0.1 162.2 -8 na

Source: Yahoo!Finance, Author calculations. Note that companies have different fiscal year ends. Target year was calendar 2013. Data is ranked from lowest forward P/E ratio.

DHI shows an average forward P/E despite a low EV/EBITDA multiple. However, larger and smaller competitors have better P/Es. It is also worth noting that forward P/E and EV/EBITDA have little correlation.

DHI shows potential upside

DHI shows some potential upside given its ability to grow market share and hence revenue despite overall market trends. Its relatively low leverage and good scale provides flexibility against its other large competitors. DHI also offers a slight dividend - about 0.7% yield - that is better than most of its competitors. While there appears to be some upside, there are also significant risks related to the timing of the overall market turnaround as well as on margins. The other key consideration is that this article only reviews DHI with an analytical approach. Additional research should be completed on the quality of management, growth and acquisition strategy, and market approach. Furthermore, a more detailed review of each of the other homebuilders might reveal more compelling opportunities.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.