NVR, Inc.: Risk-Reward Finely Balanced
Summary
- I like NVR’s flexible acquisition lot strategy which mitigates land development risk.
- The mortgage division which accounts for c.10% of total group income may have to contend with a spike in credit default risk.
- Housing-related data has been largely encouraging over the last month or so.
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Without stable shelter, everything else falls apart. - Matthew Desmond
If you follow me on Twitter, you’ll know that I’ve always kept a keen eye on the goings-on in the housing sector. I don’t want to make grand pronouncements suggesting that we’ve effectively moved away from the worst, but some of the housing data that has come out in the recent past has been rather promising (which I will highlight later), pushing me to explore some stock opportunities in this space.
NVR, Inc. (NYSE:NVR) is one of the homebuilders I’ve got on my watchlist but the recent run-up in the price makes me wary (up 70% from March lows). The company operates under two complementary business units- Homebuilding and Mortgage banking. Under homebuilding, which is their primary business, they construct and sell single-family detached homes, town homes, and condominium buildings, which are all primarily constructed on a pre-sold basis. These are sold under three brand names - Ryan Homes (for first-time and first-time move-up buyers), NV Homes (for buyers with more discretionary architectural taste), and Heartland Homes (for buyers interested in luxury homes). To supplement their activities in the primary business, they also run a mortgage banking service called NVR Mortgage (NVRM) where they earn revenue from mortgage origination fees, gains on sales of loans in the secondary market, and title fees.
Before I proceed with some of the key talking points of NVR, let me take a moment to highlight some of the interesting housing data that has caught my attention. I often find that investors, when gauging housing-related stocks, tend to be less considerate to the specific story of a company and tend to react to the broad housing-related macro data. I am not looking to debate the rights and wrongs of this basket-case approach but I can’t disregard it and thought it would be pertinent to highlight what’s happening here before proceeding to company-specific issues.
Housing industry data
Whilst a few of the key homebuilding metrics still continue to be subdued, there is also ample evidence of a pickup. Let me first start with the weak data. Housing starts of 891,000 in April were pretty dire, down 30% m-o-m, the lowest percentage decline ever. Home Building permits too for April were weak, down 20.8% at 1.074 million units. While this may come across as a case of slim pickings, I am somewhat encouraged by the fact that permits fell at a slower pace than starts. On account of the lockdown, it is understandable that excavation and foundation work related to housing starts would have stalled, but I’ve often found that permits (authorization to start work) are a better metric of providing some texture into what the months ahead could look alike. This is also validated by the rebound in the NAHB/Wells Fargo Housing Market Index (measuring builder confidence in the single-family housing market) from 30 in April to 37 in May.
Housing inventory in April fell by 20% YoY and 1.35% M-o-M to reach 1.47m units. Do note that housing inventory has been trending lower for many years and we entered the coronavirus crisis in something of an underbuilt state. This situation could likely correct going forward, which bodes well for homebuilding.
Source: Ycharts
Subscribers of the Lead-Lag report will note that Lumber/Gold relationship has always been something I’ve closely followed to gauge risk-on risk-off conditions in the market. (In fact, if you’re interested, here’s a whitepaper I wrote, explaining this dynamic in more detail.) Lumber’s relative performance to Gold over the past month has been quite encouraging, suggesting that housing momentum is gaining pace. Fundamentally, this makes sense as the average home is made up of around 14,000 feet of lumber.
Source: Yahoo Finance
The big positive surprise in housing-related data was new home sales growth, which rose 1% m-o-m in April, beating expectations of a c.22% decline. More recently, according to the MBA, purchase applications continue to trend upwards, week on week (on a seasonally adjusted basis), and are up by c.50% since early April; for the week ending May 29th, the seasonally adjusted purchase index was up 5% from last week.
Besides, with the 30-year rate at record lows, conditions for financing a mortgage are at extremely sweet levels.
We also have a rather elevated savings rate, incidentally at the highest level ever, and whilst this might suggest general trepidation amongst the populace, I also don’t believe this is sustainable. We could see some mean reversion here with the excess savings being diverted into avenues such as housing, equities, commodities, etc.
Yes, I can appreciate that things are still fragile on account of the crippling unemployment situation in the country, and it will take a while for widespread spending to return, but there are green shoots popping up every now and then, as we’ve most recently seen with the auto numbers, that have been trending upwards on a weekly basis. We may see similar momentum come back into housing over the next few months.
NVR’s home building division is less exposed to land development risk
One of the reasons I like NVR’s business model is because they are largely insulated from land development complications. There are a lot of complex hard and soft costs and regulatory encumbrances related to land acquisition, construction, labor, site preparation, and substructure work that make the land development aspect of homebuilding rather challenging. Besides in a downturn, if land prices potentially tumble, they don’t have to worry about a decline in carrying costs.
NVR can mitigate this land development risk, as it typically acquires ‘finished building lots’ at market prices from various third-party land developers. They pay an initial deposit of c.10% of the aggregate purchase price to book these lots, and always have the option of not acquiring the finished lots under contract, as long as they provide prior notice. On account of this flexible lot acquisition strategy, they can gauge market sentiment, and not get weighed down by burdensome financial commitments.
Mortgage division might have to contend with default-related issues
NVR’s mortgage division (which accounts for c.10% of total group income) sells all the loans that it originates in the secondary mortgage market. On account of the dire employment situation in the country, this division might likely have to contend with a spike in default rates. Due to this, they might also have to repurchase the loans from the investor or indemnify the losses. There have been a lot of reports over the past few weeks on how banks have begun tightening mortgage lending standards and NVR will likely have to follow suit (thereby reducing loan origination prospects) or risk getting involved with sub-standard credit profiles which could later harm their business. All in all, business here in the near term could look a bit dicey. Worth noting that, loan productions in Q1-20 fell by 1% YoY and PBT fell by 62% YoY on account of a reduction in fair value of mortgage servicing rights and disruptions on account of the COVID-19 pandemic.
Technical Analysis
Over the last 5 years, NVR has been a great source of alpha generation for investors, beating the two biggest benchmark homebuilders’ ETFs - the iShares U.S. Home Construction ETF (ITB) and the SPDR S&P Homebuilders ETF (XHB), handsomely.
Source: Yahoo Finance
If you look at the longer-term monthly chart, you can see that it has been in the midst of a long-term ascending broadening wedge pattern, with some violent moves being seen once it broke past the crucial psychological level of $2000. What’s been quite heartening to see is that levels close to $2000 have served as really strong support barriers; once in 2018, and more recently in March-2020. To be more specific, it has formed a double bottom at the $2040-2043 levels and bounced strongly from there, up by almost 70% since! It has also managed to respect the lower boundary of the wedge for over 6 years now, never closing below that.
Source: Trading View
Source: Trading View
While the price action towards the downside has been quite reassuring, that doesn’t necessarily mean that one is only likely to see a one-way continuation of the upswing. Rather I think some caution is warranted at these levels as the $4000 price point looks like a very decisive barrier, and even before you get there, you can spot a lot of long wicks on the candles, indicating increased supply of stock at those levels. Another hindrance worth mentioning is that on the daily chart, the stock has just hit the 200DMA, close to the psychological $3500 levels; this may act as a stumbling block in the near term.
Conclusion
I’ve been encouraged by the green shoots seen in the housing market of late and this will likely buttress sentiment for homebuilding plays such as NVR. NVR’s reduced exposure to land ownership risk is something to behold but its mortgage division - which is admittedly a smaller part of the large pie - might have to contend with some business origination and default headwinds in the coming quarters. On the charts, I’ve been quite impressed by the fire-fighting qualities of the stock at lower levels, but entering at this juncture could be rather risky, given the challenges the stock will have to face at around the $3500-$4000 levels. I would rather wait for a pullback before considering a position. Broadly, all things considered, the risk-reward looks fairly even and I am neutral for now.
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Comments (5)
On the origination and sells almost all of the loans immediately to a mortgage servicer. They don’t carry the loans on their books.