Build Your Portfolio With NVR
Summary
- NVR has earned shareholders an 87% total shareholder return over the last five years, against 46% for the S&P 500.
- Management is rewarded for allocating capital in ways that benefit shareholders.
- The business model is asset-light, robust and very profitable.
- NVR is the best capital allocator in the industry and investors should bet on it to once again become a market beater.
Pgiam/iStock via Getty Images
NVR, Inc. (NYSE:NVR) has been an elite performer, delivering exceptional returns to its shareholders. While the company’s total returns to shareholders have declined in recent times, this ignores how well the company has allocated capital, largely thanks to an executive compensation policy that links shareholder interests with those of management. As the best capital allocator in the business, NVR will return to its spot as a market beater.
A Historically Elite TSR Performer
In the last five years, NVR has earned a total shareholder return (TSR) of over 87%, compared to 78% for the U.S. Select Home Construction Index (DJSHMB), and nearly 46% for the S&P 500.
Source: Morningstar
The results reflect the success, not just of NVR as a company, but of the home construction industry as a whole. Whereas it is typical to see businesses as stand-alone entities, the reality is that a business' returns on invested capital (ROIC) are largely a product of the industry it is in, and revisions in ROIC, which drive changes in corporate value, are often driven by industry-level changes that individual businesses respond to.
NVR, as we have seen, is however, more than just the beneficiary of industry tailwinds. Judged against its peer group of D.R. Horton (DHI), Meritage Homes Corp. (MTH), M.D.C. Holdings (MDC), Lennar Corp. (LEN), PulteGroup Inc. (PHM), Toll Brothers, Inc. (TOL), KB Home (KBH), Taylor Morrison Home Corp. (TMHC) and others, NVR shines. Over a 20-year period, NVR generated a TSR of 3,201%, which was nearly thrice the TSR of the next highest among its peer group, DR Horton, and nearly eight times the 409% TSR of the Dow Jones US Homebuilder Index (DJUSHB).
Source: NVR, Inc. 2022 Proxy Statement
Over the last decade, NVR has fallen to third on the list, but is still a strong performer, with a TSR of 490% compared to 370% for the Dow Jones US Homebuilder Index.
Source: NVR, Inc. 2022 Proxy Statement
In the last five years, NVR has dropped to fourth, with a TSR of 148% compared to 106% for the Dow Jones US Homebuilder Index. Finally, in the last year, NVR had a TSR of 7%, placing it eighth among its peer group. Across this article, I will argue that NVR is due to outperform its peers and the market.
Incentives Align Shareholder Interests With Those of Management
Incentives are the hidden forces that shape behavior. When we discussed the asset growth effect, we said that part of the reason that managers feel compelled to expand assets are emotional, or behavioral. In “The Psychology of Human Misjudgment”, Charlie Munger, vice chairman of Berkshire Hathaway (BRK.A) (BRK.B) says that “Never, ever, think about something else when you should be thinking about the power of incentives.” Incentives are incredibly powerful in shaping behavior. Everyone knows this, but businesses are seldom designed to promote good behavior. NVR, however, is one of those rare companies that has made explicit attempts at easing the agent-principal problem that often leads to conflicts between shareholders and managers. NVR does this by linking long-term compensation with return on capital. This is important because, since John Burr Williams wrote The Theory of Investment Value in 1938, we have known that the value of a firm is the present value of its future cash flows. A business that can increase the value of those cash flows will, therefore, by definition, increase the value of the business. By rewarding managers for improving returns on capital, NVR is, therefore, saying, “Increase the present value of future cash flows”. This “forces”, if you like, managers to think like owners and perform the actions that shareholders would like managers to take.
According to NVR’s 2022 Proxy Statement, performance-based stock options awarded in 2020 are 50% of executive’s long-term incentive awards and are based on average return on capital performance against its 12 homebuilding peers. In the 2018 to 2020 period, NVR’s return on capital was the highest in the group, which led to a vesting of long-term equity awards at target. In that 2018-2020 period, NVR earned an average return on capital of 26.5%.
Source: NVR, Inc. 2022 Annual Report
In the long-run, returns drive corporate valuation, and as the market catches up to NVR’s superior capital allocation, its TSR will improve and the company will beat its peers in terms of TSR, having already proved it is a better company in terms of capital allocation.
Strong Financial Performance
Between 2018 and 2022, consolidated revenue grew from $7.16 billion to $10.53 billion, at a 5-year revenue compound annual growth rate (CAGR) of 8.02%. In the 1950-2015 period, 24.2% of businesses enjoyed a 5-year revenue CAGR of between 5% and 10%, according to Credit Suisse’s “The Base Rate Book”. The mean 5-year revenue CAGR for the period was 6.9% and the median 5-year revenue CAGR was 5.2%.
Source: Credit Suisse
Revenue derives from NVR’s two operating segments: homebuilding and mortgage banking. The homebuilding segment generates the bulk of revenues. In 2022, the homebuilding segment was responsible for 98% of revenues. Homebuilding revenues rose from $7 billion in 2018 to $10.33 billion in 2022, at a 5-year CAGR of 8.03%. Mortgage banking fees from $157.3 million in 2018 to $199.66 million in 2022, at a 5-year CAGR of 4.88%.
Source: NVR, Inc. 2022 Annual Report
The homebuilding segment offers single-family detached homes, townhouses, and condominiums, of different designs, elevations and other options. In 2022, NVR settled homes at an average price of $434,500, up from $403,900 in 2021, and a price range of $160,000 and $2.6 million. The homebuilding segment has four segments, which operate in the Mid Atlantic, North East, Mid East and South East. The Mid Atlantic is the biggest geographical segment, which, in 2022, was responsible for 46% of homebuilding revenues.
Source: NVR, Inc. 2022 Annual Report
The homebuilding segment operates under three brands: Ryan Homes, which targets first-time and first-time move-up buyers; and NVHomes and Heartland Homes, which targets move-up and luxury buyers.
NVR constructs homes using independent sub-contractors, none of whom are so important that a failure on their part would threaten the existence or financial strength of the business. Using independent sub-contractors also contributes toward creating an asset light model. As an example of this, the firm’s annual revenues are far in excess of its total assets, which in 2022, were worth $5.66 billion, compared to consolidated revenues of $10.56 billion. This will become clearer, and its significance more obvious, as we go on. The homebuilding segment also has a backlog of homes that it has sold but not settled.
Regarding the mortgage banking segment, it provides mortgage-related services in each of NVR’s homebuilding markets, through NVR Mortgage Finance, Inc. NVR Mortgage Finance, Inc. originates mortgage loans for the company’s homebuilders, and earns fees from originations, gains on sales of loans, and title fees. Nearly all closed mortgage loans are sold on secondary markets.
Gross profit for the homebuilding segment rose from $1.3 billion in 2018 to $2.66 billion in 2022, at a 5-year gross profit CAGR of 15.4%. Again, the Mid Atlantic is the most important geographical segment, earning 48% of gross profits in 2022.
Source: NVR, Inc. 2022 Annual Report
The homebuilding segment’s gross profit margin rose from 18.7% in 2018 to 25.8% in 2022. Gross profitability, which is gross profits scaled by total assets, rose from 0.41 in 2018 to 0.47 in 2022. Robert Novy-Marx’ research shows that gross profitability of 0.33 and above makes a stock attractive. It is a potent sign of a stock’s ability to earn profits. it is also a more powerful signal than the traditional price-earnings (P/E) multiple. An example of this is with Amazon (AMZN), who, at the end of 2015, had a trailing P/E multiple of around 540, and a gross profitability of 0.54. Listening to the P/E multiple would have led to investors missing a great investment opportunity.
The homebuilding segment’s cost of sales -which includes items such as impairment, such as the 4Q 2022 impairment NVR suffered as a result of a joint venture; and interest cost for land development of now-settled homes and respective lots - grew from $5.69 billion in 2018 to $7.66 billion in 2022, at a 5-year cost of sales CAGR of 6.12%. Selling, general and administrative (SG&A), includes items such as equity-based compensation, rose from $428.87 million in 2018 to $532.35 million in 2022, at a 5-year SG&A CAGR of 4.42%. In the mortgage banking segment, general and administrative, which includes items such as compensation costs, rose from $83.84 million in 2018 to $92.95 million in 2022, at a 5-year general and administrative CAGR of just 2.08%.
Operating income, meanwhile, rose from $895 million in 2018 to $2.17 billion in 2022, at a 5-year operating income CAGR of 19.37%. Operating margin also rose, from 12.5% in 2018 to 20.61%. In the 1950 to 2015 period, the mean operating margin in the industrials sector was 8.1%, while the median operating margin was 8.5%.
Source: Credit Suisse
NVR’s net income rose $797.2 million in 2018 to $1.73 billion in 2022, at a 5-year earnings CAGR of 16.7%. In the 1950 to 2015 reference period, 20.3% of firms enjoyed a 5-year earnings CAGR of between 10% and 20%. The mean 5-year earnings CAGR was 7.3%, while its median 5-year earnings CAGR was 5.9%.
Source: Credit Suisse
Net income rose as a function of the rise in the profit margin, which went from 11.38% in 2018 to 16.71% in 2022.
NVR’s free cash flow (FCF) rose from $704.72 million in 2018 to $1.85 billion in 2022, at a 5-year FCF CAGR of 21.32%. In that 5-year period, NVR generated more than 31% of its market capitalization in FCF. That is an enormous amount and shows just what a FCF machine NVR is.
An Asset-Light Model
An often overlooked aspect of a business is its asset growth. Research shows that there is an inverse relationship between asset growth and future returns. In other words, low asset growth stocks tend to outperform high asset growth stocks. This phenomenon is called the “asset growth effect”. The reasons for the asset growth effect are contested, but, a large part of this can be ascribed to the difficulties of forecasting future demand, and the emotional reactions to booms and busts. During a boom, managers tend to overestimate future demand, raise too much capital, and invest too aggressively in expanding output. Although demand in the short-term is fairly easy to forecast, the longer the forecasting period, the greater the error. For businesses such as NVR where “production” of the “good” takes time, it is easy to end up with too much inventory once a boom busts. Not only do firms end up with too much inventory when a boom busts, capital exits and the business is forced to work on repairing its balance sheet. Capital only begins to return when profitability is restored to the industry or business. So, although in the near-term, it makes sense to expand assets aggressively, in the long run, it is often a huge mistake.
What makes NVR’s business model special is because NVD does not undertake land development. Rather, what NVR does is buy finished building lots from third-party land developers according to fixed price finished lot purchase agreements (LPAs), under which NVR pays a deposit that may be forfeited if it fails to perform under the LPA. The deposits that the LPA requires are in the form of cash or letters or credit and are worth as much as 10% of the total purchase price of a finished lot. This ensures that NVR’s business model is not as capital hungry and risky as it would be if they owned land directly and engaged in land development. Given that NVR can decide not to perform under an LPA, it is not locked into a long-term asset growth strategy and, can simply walk away if conditions are no longer favourable. All NVR loses from this is the deposit which is, at most, 10% of the value of a finished lot. When NVR attains control of raw ground, it decides whether it should sell the raw parcel to a developer and enter into an LPA with a developer to purchase finished lots, or hire one to develop it on NVR’s behalf. There are occasions in which NVR enters into joint venture agreements and direct land development to acquire finished building lots, but this is not something NVR does often.
If you look at the company’s assets, they are, as we highlighted earlier, very small in comparison with the firm’s revenues.
Source: NVR, Inc. 2022 Annual Report
Furthermore, this has the obvious impact of elevating returns on invested capital: a conservative lot acquisition strategy means that the invested capital needed to generate profits is very low. So, while assets grew from $3.17 billion in 2018 to $5.25 billion in 2022, at a 5-year asset CAGR of 10.62%, profits are so large in comparison to assets, and profits have grown so much faster, that the effect has been to raise returns. Indeed, ROIC rose from 32.7% in 2018 to 50.1% in 2022.
Source: NVR, Inc. Filings and Author Calculations
With greater profitability than its peers, NVR can develop its competitive advantages at a higher rate than its peers to protect itself during a bust, and to take advantage of booms. In an era of uncertainty, inflation and rising interest rates, businesses like NVR are even more valuable.
Valuation
NVR has a P/E multiple of 11.18, compared to an average, equal-weighted P/E multiple of 4.95 for its peer group. NVR also has an inferior FCF yield to that of its peers, at 10.34% compared to the 13.49% of its peers. However, it enjoys a greater gross profitability and ROIC than that of its peers, and its superior shareholder yield of 9.07% gives investors a greater margin of safety than the 7.35% shareholder yield of its peer group.
P/E | FCF Yield | Gross Profitability | ROIC | Shareholder Yield | |
NVR, Inc. | 11.18 | 10.34% | 0.47 | 50.10% | 9.07% |
D.R. Horton | 6.07 | 4.16% | 0.35 | 22.60% | 4.64% |
Meritage Homes Corp. | 4.1 | 9.45% | 0.31 | 21.10% | 3.21% |
M.D.C. Holdings | 4.81 | 32.52% | 0.26 | 12% | 5.30% |
Lennar Corp. | 6.63 | 10.99% | 0.0053 | 17.70% | 7.36% |
PulteGroup Inc. | 5.02 | 4.46% | 0.33 | 22.10% | 10.26% |
Toll Brothers | 5.1 | 13.53% | 0.2 | 12.20% | 9.94% |
KB Home | 3.91 | 4.73% | 0.25 | 13% | 6.22% |
Taylor Morrison Home Corp. | 3.93 | 28.07% | 0.24 | 13.70% | 11.84% |
Peer Group Average | 4.94625 | 13.49% | 0.2431625 | 16.80% | 7.35% |
Source: Company Filings and Author Calculations
On balance, NVR appears to be a superior business with a greater likelihood of increasing its corporate value.
Conclusion
NVR is a business that, over its lifespan has delivered exceptional TSR for its shareholders. In recent years, it has not performed as well as it should have, despite strong financial performance. However, the firm’s incentive policy has made it a leader in ROIC, a metric that is closely linked to future corporate value. Given the strong underlying performance of the business, and how it has performed against its peers, it is likely to once again become a leader in TSR. Investors should consider it to build a portfolio for an uncertain era.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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