By The Valuentum Team
The underproduction of homes since 2008 has created pent-up demand, providing a material tailwind for homebuilders as of late. According to estimates from Toll Brothers (NYSE:TOL), the total estimated shortfall of housing starts from the period 2008-2014 was 5.7 million. That equates to an annual shortfall in production of ~818,000 new homes, providing significant opportunities for the homebuilding group as a whole moving forward.
Pent-up housing demand has been accruing for years, and stronger general economic conditions, including lower unemployment, modest wage growth, and general consumer confidence continue to drive demand. While pent-up demand and strong general economic conditions drive demand higher, land and labor shortages and the mortgage market constraining potential home buyers' access to mortgages will continue to pressure supply.
Recent performance at many of the major homebuilders also provides support for the dynamics outlined above, and backlog trends across the industry are pointing to continued growth for the group. D.R. Horton (NYSE:DHI) reported homes in backlog growth of 12% in the second quarter of fiscal 2016, ended March 31, on a year-over-year basis, and value of net homes in backlog growing slightly faster at 14%.
However, multiple factors keep us from truly considering a position in D.R. Horton. We like the company's focus on cash flow and reducing debt, but the latter will have an impact on the growth potential of its dividend, as it is a competing use of cash. Shares of D.R. Horton appear to be fairly valued on a discounted cash flow basis. The firm currently registers a 6 on the Valuentum Buying Index. This isn't the worst rating but it isn't the best either. Investors in homebuilders are playing the cycle -- some can do it better than others.
D. R. Horton's Investment Considerations
• D.R. Horton is one of the largest homebuilding companies in the US. Its homes generally range in size from 1,000 to 4,000 square feet and in price from $100,000 to $600,000. The firm also provides mortgage financing services through DHI Mortgage. It was founded in 1978 and is headquartered in Fort Worth, Texas.
• After a half-decade of uneven price retreats, declining interest rates, and a whole lot of litigation, the US housing market appears to finally be on solid footing. Consolidation may be heating up in the industry as well.
• Pent up housing demand has been accruing for years, and new home inventory is limited, which makes for an environment conducive to driving housing price improvements (as a result of simple supply/demand dynamics). Though we acknowledge the concept of "shadow inventory" -- sellers currently without a 'for sale' sign in their front yard -- overall inventory trends continue to move in the right direction.
• The last industry downturn has brought about change at D.R. Horton. The firm has been focusing on cash flow and reducing debt, and it has implemented restrictive land and lot inventory investment guidelines. Its home sales gross margin has expanded considerably since 2011, and its sales backlog stands at ~$4.1 billion.
• Things are on the up and up at D.R. Horton. In its fiscal second quarter of 2016, for example, net sales orders in homes increased 10%, while net income advanced 32%. Solid performance in its three core brands is enabling the firm to expand its industry leading market share.
• In fiscal 2016, D.R. Horton is expecting consolidated revenue to be between $12 and $12.5 billion, based on the closing of 39,500-41,500 homes. The firm is anticipating expanding margins and is projecting cash flow from operations to be in a range of $300-$500 million.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. D. R. Horton's 3-year historical return on invested capital (without goodwill) is 8.5%, which is below the estimate of its cost of capital of 9.1%. As such, we assign the firm a ValueCreation™ rating of POOR.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. D.R. Horton's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is -10.1 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. D. R. Horton's free cash flow margin has averaged about -12.6% during the past 3 years. As such, we think the firm's cash flow
generation is relatively WEAK.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At D. R. Horton, cash flow from operations decreased about 122% from levels registered two years ago, while capital expenditures expanded about 198% over the same time period.
In fiscal 2015, D.R. Horton reported cash from operations of $700 million and free cash flow of $56 million, resulting in free cash flow generation of ~$644 million. This represents a significant improvement over negative free cash flow generation of $762 million in the previous fiscal year.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think D. R. Horton is worth $26 per share with a fair value range of $20-$32. Shares are currently trading at ~$29, in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at the moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Looking ahead to the next few years, we are expecting double-digit top-line growth on the back of the strong backlog growth and favorable supply and demand dynamics currently in place in the housing market. We're projecting bottom-line growth to slightly outpace revenue growth as the firm continues to make margins a priority. We're expecting cash flows from operations and capital expenditures to normalize in the coming years as well, though our estimates are slightly below that of management's due to the firm's historical volatility in cash flow generation.
Our model reflects a compound annual revenue growth rate of 16% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 30.2%. Our model reflects a 5-year projected average operating margin of 11.3%, which is above D.R. Horton's trailing 3-year average.
For D. R. Horton, we use a 9.1% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $26 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for D. R. Horton. We think the firm is attractive below $20 per share (the green line), but quite expensive above $32 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate D.R. Horton's fair value at this point in time to be about $26 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of D.R. Horton's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $34 per share in Year 3 represents our existing fair value per share of $26 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.