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Summary

  • NVR's use of land purchase agreements helps it not tie up capital in land and reduces risk if land use is delayed.
  • A growing new home market, shown by an 18.6% increase in sales in May, will generate more business for NVR.
  • NVR has had a return on invested capital of over 50% for the last 10 years despite the subprime mortgage crisis.
  • Low debt and $900 million of share repurchases in the last two years combined with a forward P/E of 14.5 suggest NVR is undervalued.

The price of NVR Inc. (NYSE:NVR) stock rose 11% since the beginning of 2014 despite reporting first quarter earnings 50% below analysts' predictions and slightly below its first quarter earnings last year. Despite a decrease in first quarter earnings and an increase in price, NVR still is an appealing buy.

NVR is the parent company of Ryan Homes, NVhomes, Fox Ridge Homes and Heartland Homes, which all build and sell residential properties. NVR announced it had acquired Heartland Homes in early 2013 giving it a majority share of the Pittsburgh housing market. These companies build homes in 14 eastern US states and Washington D.C. Ryan Homes' and Fox Ridge Homes' target market is first-time homebuyers and first-time move-up buyers while NVhomes and Heartland Homes focus more on move-up and discretionary buyers. In addition to single-family homes, NVR's subsidiaries also build townhouses, garden condominiums and villa-style homes. The average home price among the four companies was around $350,000 in 2013 up 12% from 2012. NVR also has a mortgage banking sector which consists of NVR Mortgage and NVR Settlement Services both of which are headquartered in Reston, Virginia and designed to provide services to customers of NVR's homebuilding segment.

Unlike its competitors, NVR avoids buying speculative land in favor of land purchase agreements. These land purchase agreements are options bought by NVR that can be exercised to purchase land. By using these contracts, NVR can buy land close to the time when it will be used. This model has helped NVR achieve a return on invested capital of 51% in the last 10 years compared to its peers, most of which only achieve returns on invested capital between 5% and 15%. NVR's limited land ownership also helped it reduce losses during the prior housing market crash and will continue to be beneficial if the housing market recovers more slowly than expected.

In May 2014, new home sales increased 18.6%, suggesting a seasonally-adjusted annual rate of 504,000 home sales. This growth counteracted a slow start in new home sales this year and pushed seasonally adjusted annualized new home sales to a six year high. Although this jump is likely somewhat overstated and not indicative of the long-term growth rate, it still suggests the housing market is continuing to recover. While there is some concern of another housing bubble, home prices have increased less than 2% this year, which hardly suggest another housing bubble. New home sales will also likely receive a boost in the coming years as millennials, who have had to delay home purchases due to a weak job market, are finally able to buy their first homes.

Competitive Advantage

The US homebuilding market is made up of hundreds of small companies with no clear market leaders. Last year, the five largest homebuilders accounted for under 20% of the total market. However, NVR has been able to achieve a high market share in several eastern cities. In Pittsburgh, PA, NVR has a 60% market share of the new home market, in Baltimore, MD, 30%, and in Washington D.C., 20%, as of 2013. NVR's scale and established relationships help it maintain a steady stream of land and labor in these areas. Sales and administration of the company's four subsidiaries are integrated and managed by NVR which helps keep these costs low and gives them a marked edge over smaller local competitors. These factors, combined with NVR's use of land purchase agreements, have led to average operating margins of 9.7% over the last five years and operating margins of 10.4% in 2013. Comparatively, NVR's three largest competitors, Lennar Corp (NYSE:LEN), D.R. Horton Inc (NYSE:DHI), and PulteGroup Inc (NYSE:PHM), had operating margins of 4%, 2.3%, and -0.6%, respectively.

Financials

NVR seems to have recovered well since the housing market collapsed in 2008. Its revenue has increased 58% in the last two years to $4.22 billion in 2013 although it is still significantly below the $5-6 billion year revenue achieved before the recession that began in 2008. NVR also has a very strong balance sheet with $1 billion in cash, cash equivalents, and short-term investments and only $600 million in long-term debt and almost no short-term debt.

NVR's strong financial footing gives it the opportunity to make more acquisitions similar to its purchase of Heartland Homes or expand its market. The south and southwest US are projected to have the fastest housing growth which would make this a good time for NVR to try to expand into these markets. NVR may also choose to repurchase more of its shares. NVR has already spent $300 million every six months on share repurchases in the last 18 months.

In 2013, NVR's backlog reached $1.8 billion, up 6% from the year before. NVR also has purchase agreements for 51,800 lots which it plans to use for future building projects.

Although NVR's year-over-year earnings decreased in the first quarter, its free cash flow increased from -$82 million in the first quarter of 2013 to -$21 in the first quarter of 2014. This quarter also saw a small jump in operating margins and revenue. Abnormally high general, selling, and administrative expenses and a raised tax rate were the main factors that contributed to this decrease in earnings.

Valuation

Despite weak earnings last quarter and an over 25% appreciation in its stock price in the last year, NVR is still trading at a reasonable price. Its current P/E ratio is 21.3, which is below NVR's 5-year P/E average of 23. Looking ahead, NVR's forward P/E based on projected earnings for the next year is 14.5, suggesting a significant upside for NVR if it at least meets earnings estimates. One commonly used metric for finding the value of homebuilding companies is the price-to-book ratio. Since many of NVR's competitors have price-to-book ratios between 1 and 1.5, NVR's price-to-book ratio of 3.8 seems at a glance to suggest that it is significantly overvalued. However, this figure is highly deceptive, as NVR's use of land purchase options keeps its inventory low. NVR's inventory is historically between $400 and $800 million and is at $739 million as of 2013 which is very small compared to D.R. Horton's inventory of $6.2 billion at the end of 2013 and PulteGroup's inventory of $4 billion at the same time. Although D.R. Horton and PulteGroup both have market capitalizations just under $8 billion, which is higher than NVR, this alone does not explain the difference in inventory values. D.R. Horton, PulteGroup, and most of NVR's other competitors make large speculative land purchases and hence have high inventories. Since NVR limits speculative land purchases, comparing its price-to-book ratio to that of its competitors provides little insight into its value and its high price-to-book ratio is a result of NVR's different business model.

Risks

Although the housing market is expected to continue its slow recovery, NVR is very dependent on the strength of single-family new home purchases which account for the majority of its revenue.

NVR is also dependent on a few markets for a large portion of its sales. Washington D.C. and Baltimore accounted for 31% and 15% of NVR's revenue respectively.

A decrease in finished lots for sale or an increase in NVR's competitors' use of land purchase agreements could make it more challenging for NVR to find reasonably priced land purchase agreements to maintain its land-light model and avoid speculative land purchases.

Conclusion

Strong results for May new home sales suggest that the US housing market is still recovering and many analysts predict it will continue steady growth over the next few years. NVR is well positioned to profit from the housing recovery. Its use of land purchasing contracts proved beneficial during the recession and is still profitable and low risk today. NVR's strong balance sheet and relative strength during the recession are also promising for its future success. $900 million in recent share repurchases combined with NVR's strong returns on invested capital and operating margins make it an appealing buy. Despite trading near its all-time high of $1220, NVR still appears undervalued with a forward P/E of 14.5 which is rather low for a stock which historically has a P/E above 20.

Source: NVR: Land-Light Business Model Will Continue To Provide Significant Upside