NVR, Inc. NVR W
June 20, 2001 by charlie479
2001 2002
Price: 143.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 1,415 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

NVR is a homebuilder.  Their operating model, which is unique (and which is
described later), allows them to assume the least risk in the industry and
produce returns that are the largest.  

Homebuilders are generally dismissed because they're cyclical and
interest-rate sensitive (really, though, which industry isn't?) and
downturns inevitably leave homebuilders holding large inventories of unsold
properties -- the unlevered builders then suffer large inventory writedowns
while the levered builders go into bankruptcy.  However, NVR's model will
prevent it from suffering the same fate and, indeed, NVR will prosper in a
downturn at the expense of the weaker builders.

Two of the most important facets to its operating model are:

(1) NVR acquires control of land inventory through options contracts.  These contracts give NVR the right to buy finished lots from developers.  NVR secures a supply of land for its homebuilding operations through the use of these options whereas other homebuilders purchase land outright and engage in land development.  By avoiding that speculative practice of land
purchase/development, and instead using options, NVR is able to control
large blocks of land (years' worth) in its markets while employing less
capital to do so.  The lower capital requirements of this method translate
into lower inventory risk and greater returns on capital.

(2) NVR pre-sells nearly all of its homes.  Other homebuilders typically
participate in some speculative construction.  NVR does not.  Before NVR
begins construction, an order must be placed and a deposit made.  This
practice reduces risk and working capital requirements, which further
enhance returns on capital.

In addition to NVR's superior model, consider the following:

-- Low valuation:  NVR trades at a P/E of 8.6x trailing (7.1x 2001E EPS) and a TEV / EBITDA of 4.7x (trailing).  TEV / (EBITDA - Capex) is 4.8x
(trailing).  TEV / FCF is 7.8x (trailing).  I am defining FCF as Net income plus D&A minus Capex.

-- Backlog:  NVR has a backlog of 5,765 ordered homes.  These homes
represent $1.49 billion of revenue.  To put this into perspective, this is
nearly three fiscal quarters of revenue.  In addition, the homes in backlog
carry higher gross margins than the ones in the historical results.  All of
this should translate into higher EPS.  (Management says 2001 EPS should be
just under $20 per share.  In the short history that the company has
provided guidance (previously they refused to) they have consistently been
ridiculously conservative.  Their 1Q results and the backlog indicate to me
that the $20 EPS estimate continues to be the case).

-- High ROIC:  The low capex nature of its business ($301 mil LTM
homebuilding EBITDA versus consolidated LTM Capex of $5 mil) and the low
working capital requirements of its model allow NVR to produce superior
returns on invested capital:  45.3% in 2000, and 5-year average ROIC of 25%. Bonus fact:  In 2000, NVR sold $325 mil more homes than it did in 1999, yet inventory (the bulk of a homebuilder's working capital requirement) increased only $11 million.

-- Intelligent allocation of excess capital:  High returns on capital and
excess cash flows are only useful if you have a management that is smart
about deploying it.  In NVR's case, management has chosen thus far to deploy that capital to buy back its own stock.  Between 12/31/93 and 12/31/00 the company reacquired 13.5 mil shares.  In the first quarter of 2001, NVR purchased another 0.85 mil shares For perspective, there are only 8.1 mil primary shares out today (I'm using primary shares to illustrate this but I use diluted shares for enterprise value calculations).  

-- Homes a basic necessity:  People will always need homes to live in.  The
process of building a home has not changed materially in decades.  Neither
of these statements is likely to change in the next year, the next 5 years,
or even the next 20 years.  There is minimal technological or obsolescence
risk.

-- Dominant in its markets:  NVR competes in 18 geographic markets.  It is
the #1 player in 10 of them.  As for the remaining 8, it is usually #2 or #3 (always at least in the top 5).  The rest are markets that NVR has just
recently entered and will dominate with time.  

-- Tax factors:  The industry has indirectly enjoyed the benefits of a
government subsidy in the form of tax deductible mortgage interest.
Additionally, in the last few years, homebuyers no longer have to pay tax on the first $500k of capital gains on a home.  This lowers the effective
purchase price of a home for a consumer, increases the relative
attractiveness of a home as an investment, and adds a little boost to demand for NVR's product.

NVR's profits and market dominance are all the more amazing when you
remember that the results have been achieved without land development.  NVR
has margins better than its competitors despite the fact that other
homebuilders benefit from the gross margin boost of speculative development
in an inflationary environment.

Catalyst

The small number of shares outstanding occasionally creates large downward
gaps.  NVR's recent 25% drop is one such opportunity.

Also, share repurchases will continue to drive the stock.  It's hard to
overemphasize the magnitude of the repurchases or the wonderful track record
of buybacks:

12/31/95:  15.21 (millions of shares outstanding)
12/31/96:  13.57
12/31/97:  11.09
12/31/98:  10.39
12/31/99:  9.17
12/31/00:  8.86
04/18/01:  8.14

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    Description

    NVR is a homebuilder.  Their operating model, which is unique (and which is
    described later), allows them to assume the least risk in the industry and
    produce returns that are the largest.  

    Homebuilders are generally dismissed because they're cyclical and
    interest-rate sensitive (really, though, which industry isn't?) and
    downturns inevitably leave homebuilders holding large inventories of unsold
    properties -- the unlevered builders then suffer large inventory writedowns
    while the levered builders go into bankruptcy.  However, NVR's model will
    prevent it from suffering the same fate and, indeed, NVR will prosper in a
    downturn at the expense of the weaker builders.

    Two of the most important facets to its operating model are:

    (1) NVR acquires control of land inventory through options contracts.  These contracts give NVR the right to buy finished lots from developers.  NVR secures a supply of land for its homebuilding operations through the use of these options whereas other homebuilders purchase land outright and engage in land development.  By avoiding that speculative practice of land
    purchase/development, and instead using options, NVR is able to control
    large blocks of land (years' worth) in its markets while employing less
    capital to do so.  The lower capital requirements of this method translate
    into lower inventory risk and greater returns on capital.

    (2) NVR pre-sells nearly all of its homes.  Other homebuilders typically
    participate in some speculative construction.  NVR does not.  Before NVR
    begins construction, an order must be placed and a deposit made.  This
    practice reduces risk and working capital requirements, which further
    enhance returns on capital.

    In addition to NVR's superior model, consider the following:

    -- Low valuation:  NVR trades at a P/E of 8.6x trailing (7.1x 2001E EPS) and a TEV / EBITDA of 4.7x (trailing).  TEV / (EBITDA - Capex) is 4.8x
    (trailing).  TEV / FCF is 7.8x (trailing).  I am defining FCF as Net income plus D&A minus Capex.

    -- Backlog:  NVR has a backlog of 5,765 ordered homes.  These homes
    represent $1.49 billion of revenue.  To put this into perspective, this is
    nearly three fiscal quarters of revenue.  In addition, the homes in backlog
    carry higher gross margins than the ones in the historical results.  All of
    this should translate into higher EPS.  (Management says 2001 EPS should be
    just under $20 per share.  In the short history that the company has
    provided guidance (previously they refused to) they have consistently been
    ridiculously conservative.  Their 1Q results and the backlog indicate to me
    that the $20 EPS estimate continues to be the case).

    -- High ROIC:  The low capex nature of its business ($301 mil LTM
    homebuilding EBITDA versus consolidated LTM Capex of $5 mil) and the low
    working capital requirements of its model allow NVR to produce superior
    returns on invested capital:  45.3% in 2000, and 5-year average ROIC of 25%. Bonus fact:  In 2000, NVR sold $325 mil more homes than it did in 1999, yet inventory (the bulk of a homebuilder's working capital requirement) increased only $11 million.

    -- Intelligent allocation of excess capital:  High returns on capital and
    excess cash flows are only useful if you have a management that is smart
    about deploying it.  In NVR's case, management has chosen thus far to deploy that capital to buy back its own stock.  Between 12/31/93 and 12/31/00 the company reacquired 13.5 mil shares.  In the first quarter of 2001, NVR purchased another 0.85 mil shares For perspective, there are only 8.1 mil primary shares out today (I'm using primary shares to illustrate this but I use diluted shares for enterprise value calculations).  

    -- Homes a basic necessity:  People will always need homes to live in.  The
    process of building a home has not changed materially in decades.  Neither
    of these statements is likely to change in the next year, the next 5 years,
    or even the next 20 years.  There is minimal technological or obsolescence
    risk.

    -- Dominant in its markets:  NVR competes in 18 geographic markets.  It is
    the #1 player in 10 of them.  As for the remaining 8, it is usually #2 or #3 (always at least in the top 5).  The rest are markets that NVR has just
    recently entered and will dominate with time.  

    -- Tax factors:  The industry has indirectly enjoyed the benefits of a
    government subsidy in the form of tax deductible mortgage interest.
    Additionally, in the last few years, homebuyers no longer have to pay tax on the first $500k of capital gains on a home.  This lowers the effective
    purchase price of a home for a consumer, increases the relative
    attractiveness of a home as an investment, and adds a little boost to demand for NVR's product.

    NVR's profits and market dominance are all the more amazing when you
    remember that the results have been achieved without land development.  NVR
    has margins better than its competitors despite the fact that other
    homebuilders benefit from the gross margin boost of speculative development
    in an inflationary environment.

    Catalyst

    The small number of shares outstanding occasionally creates large downward
    gaps.  NVR's recent 25% drop is one such opportunity.

    Also, share repurchases will continue to drive the stock.  It's hard to
    overemphasize the magnitude of the repurchases or the wonderful track record
    of buybacks:

    12/31/95:  15.21 (millions of shares outstanding)
    12/31/96:  13.57
    12/31/97:  11.09
    12/31/98:  10.39
    12/31/99:  9.17
    12/31/00:  8.86
    04/18/01:  8.14

    Messages


    SubjectGreat company
    Entry06/20/2001 01:41 PM
    Membercherb405
    NVR is a great company.

    SubjectDitto
    Entry06/20/2001 02:25 PM
    Membertim321
    Charlie - Was just about to post on these guys. A few notes to add.

    Besides an ROIC of 40+, NVR has shown a five year EPS growth rate of 70%. The company gets little attention from Wall Street (UBS Warburg is the only company that follows them) because management doesn't care much about street opinion (talked to other homebuilding analysts who once covered the stock) or I-banking business. Any conservative DCF model will get show NVR's intrisic value at least in the 300 dollar range. As Charlie stated, the company has bought back 40% of the float since 95 and has outperformed all of its peers in almost every relevant category (I attribute this to what I believe is its competitive advantage - the risk here is that its CA isn't replicable in the other markets it enters). NVR was recently in the 200 dollar range but fell after some significant insider sales.
    Run any kind of shareholder return on NVR (5 year, 3 year, etc.) and NVR is always at least 2x its next closest competitor. There is a fundemental reason for this.

    SubjectI forgot to add
    Entry06/20/2001 03:31 PM
    Membercharlie479
    NVR has a little mortgage banking business that I did not include in the valuation. I have excluded its contribution to EBITDA in my calculations (but I did not make any corresponding beneficial adjustment to enterprise value) for the sake of conservatism and also to illustrate what great cash flow the homebuilding operation produces just by itself.

    If you liquidated the mortgage banking business and gave no credit to the ongoing stream of income that it produces, you would get approximately $3 per share.

    There is no risky subprime lending going on in this division. It is strictly Fannie Mae type stuff that NVR immediately resells. And NVR no longer writes loans for any other builders.

    Subjecttim and cherb
    Entry06/20/2001 03:41 PM
    Membercharlie479
    Thanks for the feedback.

    Tim, I agree that NVR gets little attention from Wall Street. I have owned this stock for 4 years and during that time, they have not held any earnings calls or even hired a public relations firm. Only a few months ago did they give their first ever public presentation to investors. A couple of other firms have picked up coverage recently in addition to UBS. CSFB and Legg Mason both do fine jobs. They have grown to become such a large and dominant homebuilder that the equity analysts can no longer ignore it, even though NVR will not generate any investment banking business for them.

    I agree that any reasonable DCF produces a value north of $300. That is still only still only 15x P/E by the way, for a company with high ROICs and its 2001 EPS in contractual backlog.

    SubjectOption model
    Entry06/20/2001 04:07 PM
    Memberlil305
    I have been watching NVR as well- their RoC jumps out of most return on investment screens. In order to make an apples to apples comparison (since so many of these companies have a large amount of debt), I recently did an analysis of adjusted earnings (NIAT+ interest, tax adjusted) to EV for the 7 largest home builders (CTX, DHI, KBH, LEN, NVR, PHM, TOL). NVR is the cheapest stock by that measure among the group.

    I confess that I don’t fully understand why NVR’s stock price trails the group – the lack of Wall St attention is too pat. I think that the market may be questioning their model, specifically, their lack of land inventory. The market may think that they will have trouble finding adequate building plots in the future at competitive prices or that in a downturn, the cost of the options on unused land will be substantial (a situation not faced for many years). I’d love to be educated more on this issue (I doubt that there is any problem applying their option model to new markets as suggested by tim321).

    All of these stocks are cheap by normal measures - their operating margins and profits have gone up incredibly for the last 10 years – and the cycle shows no sign of turning given the lower interest rates. Today’s Lennar results have propelled the entire group so your recommendation looks timely. But, the relative P/E ratio of these companies has historically been around 60% of the market P/E. Notwithstanding the superior cash flow and share repurchase policy, I view NVR as a trading opportunity to be sold on any run ups – the market just won’t apply a decent multiple. The market schizophrenia about the industry should result in continued volatility (buying and selling opportunities). All of that leads me to think that I can wait for the price to come down to 125 before jumping in.

    SubjectOption Model
    Entry06/20/2001 05:21 PM
    Membertim321
    NVR's option model relies heavily on the relationships that have been developed over the years with local developers in the markets it operates in. It is NOT a foregone conclusion that similar deals can be struck in the new markets that NVR chooses to enter (remember, they still derive a majority of their revenue from the D.C./Maryland area). This strategy may restrict growth to markets where such a strategy is viable (note however that they have entered 6 new markets over the past five years).
    NVR management recently showed a slide that detailed how through an investment of 96mm, they controlled 36,600 lots and produced $9.4 billion in revenue. While other homebuilders show negative operating cash flow during economic expansions (due to significant land reinvestment) NVR generates significant operating cash flow. As Charlie stated, even with softening, NVR’s write-downs would primarily be limited to forfeiture of option deposits (they would also try to be renegotiated to reflect prevailing economic conditions).

    Subjectlil
    Entry06/20/2001 05:31 PM
    Membercharlie479
    I am always on the lookout for reasons that NVR might deserve it's low multiple. You have an interesting theory about the Street questioning their no-land model but I am not certain it's right.

    NVR has options to buy enough land for 2 to 3 years' worth of sales so there is little danger that they will run out of plots. If you look at the "Contract land deposits" item on the balance sheet and make some estimates knowing that these options are roughly 5% of lot value, you can see that their effective land inventory is in line with management's statements about having 2 to 3 years of land.

    As for your suggestion that the cost of options will be substantial in a downturn, I think the opposite will be true. In a deflationary environment, land developers will be more than happy to sell options cheaply -- they won't be worried about foregoing rising land prices. Just think about equity options: in a bull market, the call option prices on the S&P index tend to become more expensive than they are in a bear market.

    Also, in a downturn, NVR will be able to walk away from its options while the other builders will suffer larger losses because they own the land outright.

    Yes, all of these homebuilders are cheap on a P/E basis. Some of them deserve low P/Es -- many have leveraged themselves in order to buy land and speculate on development, and none of them (other than NVR) produce attractive returns on capital because of their operating model. So perhaps a sub 10 P/E is appropriate for the leveraged companies in the industry with 10% returns on equity.

    However, NVR does not have these same drawbacks. It's leverage and ROEs are magnificent. Maintenance capex is almost zero. I am mystified that any company with these characteristics trades for less than a market multiple. I suspect that it is because 90% of all investors have (like you) said to themselves "oh, all of the stocks in this industry trade for a low multiple, it's not really that undervalued after all" without really thinking whether the financial characteristics of this specific company warrant a low multiple.

    More broadly, I do not think it's relevant to look at industry multiples in evaluating a stock. I know that this is not what Investment Banking analyst programs having been teaching for years ("always look at the comps") but Buffet would retort: What Mr. Market is willing to pay for your business today has no impact on your business's intrinsic value. So why should Mr. Market's offer for your neighbor's business have any more impact on the intrinsic value of your company? Surely if Mr. Market started quoting Pepsi at 50% of its current value, you don't think it would alter the intrinsic value of Coca-Cola, do you?

    SubjectExtension of the model to othe
    Entry06/20/2001 06:54 PM
    Membercharlie479
    Tim, I think it will not be a piece of cake to apply NVR's operating model to new markets. For this reason, I doubt that NVR will ever be a nationwide builder. In some markets (California for example) there are too many eager, speculative builders who are willing to bear the risk of owning land. No land developer would sell an option on their land when they can just sell it outright to an eager-beaver builder who wants to speculate.

    NVR does not need to expand into new markets in order for the stock to go up. In fact, I prefer that NVR stick to its markets where it can use the option model and reinvest the excess cash flow into stock buybacks rather than into operational expansion into new markets. So far, management has been very prudent about only expanding into markets where it can apply its model. It has not been tempted to use its massive cash flow to expand into areas where the economics are not as attractive.

    Still, NVR will be able to find markets here and there to expand into:

    One reason that NVR has been able to employ the options model is that it has long-standing relationships with developers who are willing to sell NVR options (these relationships represent another moat around its business, but that is a topic for another post). NVR has been able to leverage those relationships and extend into adjoining markets. Generally, these developers are in the same markets and will work with NVR under the same model in the new market.

    The other reason that they have been able to use the options model is that they are usually the largest builder in the markets they are in. If you are a tiny local developer and NVR comes in and offers to buy options on your entire inventory, and is willing to begin a working relationship with you to potentially buy your future inventory, you'd consider going to the options model. It sure beats selling one property here and there to Joe's Homebuilding Shop or Bob's Homes R Us. As long as there are markets served primarily by small, private builders, NVR will be able to find new markets where it can apply its operating model. I remember reading a statistic that less than 20% of all homes built in the US are built by the publicly-traded builders. If this is true, there are still markets that NVR can enter and be the big bully.

    Subjectinsider selling
    Entry06/21/2001 09:27 AM
    Membermichael99
    It's really a neat company - it comes up on screens regularly, and the financial press has interviewed analysts now and then that point to NVR's model The buybacks have been nothing short of amazing. And it could have been bouhgt for 5 bucks back in 1994. The same model was in evidence back then! Now it's up 30X since then, 3X since 2000 started. Just the sheer amount of the run-up - could that be the reason insiders are selling and have never bought back a share as far as I can tell? This company just tricks one of my hot points: significant insider selling into a large buyback.

    No doubt, NVH along with CMH are to me the two best companies in the homebuilding industry. But the market has in the past neglected these stocks during rougher times for the industry (even just 18 months ago, when NVH was at 43). Now, 9 years into a real estate boom with many analysts and Wall Street talking heads saying that real estate cyclicality has been repealed, it seems that we've had an overreaction. I'm not knocking NVH as a business.

    This is a good healthy baby that is bound to be thrown out with the bathwater sometime. Right now, everyone's standing around, gawking and talking up the baby's prospects while the parents are sneaking out the back door.

    Mike

    SubjectHomebuilders
    Entry06/21/2001 10:57 AM
    Memberandrew109
    Good Report. Hopefully my insights are useful...

    1. Actually, most large homebuilders don't build on "spec" any more (other than a model home in each development).

    2. Additionally, other large homebuilders frequently use land purchase options.

    3. Large homebuilders are quickly gaining market share because bank financing has dried up for land purchases (large homebuilders have access to capital markets).

    4. Large homebuilders are increasing margins by leveraging their size (placing orders for 20,000 dishwashers, etc.), using the internet to their advantage (marketing, scheduling, mortgage applications, bypassing real estate broker commisions, rtc.). These are huge opportunities.

    5. Housing starts might not be that much above normal, and new housing should be in short supply over the next few years.

    6. I think Centex is very attractive here. Excellent mangagement, very conservative accounting, good land position, and some other businesses with lots of potential (lawn care, pest control, wiring services, etc.).

    7. Please see my recommendation on Ryder (R).

    Subjectmichael99
    Entry06/21/2001 06:49 PM
    Membercharlie479
    Yes, there has been some insider selling recently (well-timed ones at that. I noticed most were at or near the $200 high).

    I am not terribly alarmed. These are the same folks that did a little selling at $20 and $40 and $100, etc. I suspect that these guys are not wealthy outside of their NVR holdings and it is simply a little cashing in rather than a vote about the prospects of the company. Management still has a meaningful stake (especially meaningful to them).

    One last note about insider selling:

    Some of Berkshire Hathaway's best purchases have been acquisitions of entire businesses for cash. In several of those cases, there was the ultimate form of insider selling -- they sold their entire stake in the business! Despite this, Buffett still knew those companies were fundamentally great companies because he knows sellers are motivated by a whole slew of non-business related reasons.

    Subjectandrew
    Entry06/21/2001 07:08 PM
    Membercharlie479
    Thank you for your post. You are obviously familiar with the industry.

    #1 and #2 is true. Many other builders use options and they do try to keep speculative development low. However, all of the other builders at least dabble in land purchases and speculative development from time to time. Ultimately, this creates unnecessary risk and ties up valuable capital. I am still amazed that the other companies lack the discipline to apply the NVR model exclusively. Perhaps it is because most managements are focused on absolute dollar profits instead of returns on capital. Do you have any insights into why folks like CTX still employ operating models that tie up large amounts of capital in inventory?

    #3 to #5 are all true and are all potential benefits to NVR that I did not mention. I hate saying this because it is so overused by Wall Street, but the industry is truly fragmented. All of the public builders account for a fraction of the total homes built in the U.S. (does somebody know this statistic I am referring to? I would hate to be quoting it incorrectly here). The small private builders lack the advantages that the larger builders have - access to lots, capital, economies of scale in purchasing, etc. And I believe there is room to create a large, recognized brand in this industry. For many customers, it is the single largest purchasing decision of their life when they buy a home. Customers are likely to feel safer making that purchase from a brand they recognize and trust.

    Subjectfalling house prices
    Entry06/21/2001 07:53 PM
    Memberelan19
    I think this is a great idea and great writeup. One question I have is what whould happen if house prices fell over a several year period in many or all of NVR's markets? Options would expire over and over and over, racking up large expenses, possibly causing sales to fall more rapidly (and losses to mount more quickly) than a traditional home builder. NVR must have fixed expenses (paid staff, machines, etc.) that would rise as a percentage of dropping sales.

    Unlike many home builders, NVR's model has not yet been tested during a sustained recession, so perhaps its low multiple reflects that uncertainty.

    But clearly, relative to technology growth companies, this company deserves a higher multiple - just the threat of recession sends tech company sales and earnings down, whereas it would take at least a pretty severe and protracted recession (producing falling land prices and house prices for several years in a row) to hurt NVR. It's mysterious to me that many tech companies which are demonstrating high susceptibility to even the slightest economic slowdown are still trading at much higher multiples than NVR, despite most of them having inferior business models even in good times.

    SubjectOptions, developers, etc.
    Entry06/22/2001 10:58 PM
    Membermike61
    Great write-up and great discussion.
    Options are used in CA, but not the dominant land transfer initiator (usually a sale w/a long due diligence period unless its for ready-to-build lots which can trade readily). I think this is a case where NVR has the better mouse trap and we'll see Centex, Pulte, etc. using more options in the next three to four years. Clearly better mgmt of capital. As builders continue consolidation they will have more leverage against developers, and probably supply developer liquidity thru options @ early development stages (similar to miners and farmers selling their crops forward), and get better deals thru options.
    Developing lots is a highly politicized process, and incurably local in nature; the players will, IMO, never consolidate due to necessity of political connections to get local approvals. Builders are great consolidation candidates, as described in previous posts, and to take advantage of NVR's model.
    In my experience, development takes place as much to assuage egos of developers as for profit, which is why so many of them go upside down in bad times (and even a few in good). This is clearly an inappropriate activity for large builders; its a very different business. I expect publicly traded builders to do less development over time, again gravitating existing players more toward NVR's model.
    Assuming these observations are correct, Centex & others will get better @ managing capital and laying off land risk on local players, making the whole group a better set of businesses (much as FRE & FNM became better businesses as they learned to lay interest rate risk off on the markets).
    That leaves the perennially low multiple and recession as the main risk issues (assuming insider selling is considered elsewhere; nothing to add on that).
    The low multiple, I think, will slooowwwly improve as the sector business model improves & gets recognized. I think this is an area where the generals (the Street) are fighting the last war, and haven't figured out the structural shift in building as an industry. However, the street's mentality on Q'ly profit hasn't changed much in half a century, so the cyclicality (building can flat die due to buyer mentality from layoffs or high interest rates) will always keep a lid on multiples. 12x is probably the best PE we'll ever see, for the best company in the sector during a great year.
    Looks like a great company.

    Subjectelan
    Entry06/23/2001 05:09 PM
    Membercharlie479
    >Options would expire over and over and over, racking up large expenses, possibly causing sales to fall more rapidly (and losses to mount more quickly) than a traditional home builder.

    If there was a steady bear market in land prices, I agree that many options would go unexercised. However, I am not sure I agree with your characterization of these as "large expenses". For one, these losses should be less than the losses if they had purchased the land (I'm talking about absolute dollar losses, not percentage of original value). Secondly, the value invested i these options is not exceeding large relative to annual cash flow. Contract land deposits were approximately $111 mil at 3/31. If it takes 3 years for all of these to expire worthless, the company will have produced nearly $900 mil in EBITDA minus capex during that period. This is far from ruinous and likely to be much better than the performance of other operators in such an environement.

    I'm not sure I'm clear on the point you are making in the second half of your sentence. Does the expiration of options have any impact on sales? Sales is a function of consumer demand.

    FYI. NVR uses contractors for much of the actual homebuilding. And there is very little fixed PP&E involved -- a few model homes is all that is necessary. The only portion that I consider truly fixed is the SG&A, which is approximately 6% (and declining).


    Subjectmike
    Entry06/23/2001 05:15 PM
    Membercharlie479
    You make good observations.

    >Developing lots is a highly politicized process, and incurably local in nature; the players will, IMO, never consolidate due to necessity of political connections to get local approvals.

    I agree. The developers that supply the homebuilders are doomed to remain small and fragmented. Homebuilders, as they grow larger, will only gain leverage over them as the industry develops.

    >In my experience, development takes place as much to assuage egos of developers as for profit, which is why so many of them go upside down in bad times (and even a few in good).

    Yes. I think many of the public builders have not (and may never) be able to stick to the "options-only" model. It is too tempting for builders to purchase land and develop, especially in boom times. Management sees "can't lose" development opportunities and gradually succumbs. Note that inventories of these builders have swelled steadily as the boom 80s and 90s have continued.

    Subjectfalling real estate prices fol
    Entry06/23/2001 11:48 PM
    Memberelan19
    Thanks for the response. To clarify my concern about declining sales in a protracted bear market for real estate with a specific example:

    Let's say NVR pays $10,000 for an option to purchase a property for $100,000, which expires 2 years after the date the option contract is written. Assume this property is worth $95,0000 at the time the contract is written. Furthermore, assume that a bear market begins three months later, causing the underlying land value to decrease to $93000 at the end of year 1, and $90,000 at the end of year two.

    NVR would have 2 choices:

    1) NVR could let the option expire worthless, in which case they do not buy the land, they do not build a house on it, and they do not sell a house on this land. But they did incur an options expense, and there is no sale of a house on this land to offset the option expense.

    2) NVR could exercise the option, buy the land, build the house, and sell it, at a price the market would bear. If this was done at the end of year two, they could profitably sell a house if they bought the land for $90,000 (+ the $10,000 option they already paid for) but if bought for $100,000, as required by the option contract, they would be incurring an additional $10,000 expense due to overpaying for the land. Other builders would be paying $90,000 for similar parcels and pricing their homes accordingly.

    In case 1, there is no sale to offset the option expense. In case 2, the sale is far less profitable, and possibly a loss if the option strike price is too far above the market value of the land.

    And all the while, they are still incurring 6% SG&A (The fact that most work is contracted out is very helpful as they at least will not have idle machinery). Obviously, they have a large portfolio of options with different expiration dates and terms. But assuming many of them expire worthless as in case 1, and there are no sales to offset the expense of the options, and the SG&A continues at the same levels, then I don't think it will be very good for NVR, to say the least.

    A conventional homebuilder, on the other hand, does not have the problem of a huge portfolio of options expiring worthless. They can drastically slow down land purchases and continue to develop on existing properties at a slower pace.

    I don't know how the numbers would work out for conventional landholding homebuilders vs. the NVR option model in this worst case scenario of declining real estate prices over a several year period. If real estate prices fall over a several year period, we know this hurts conventional home builders. Would this hurt NVR more or less than a conventional home builder? While I am convinced that NVR's model is superior in good times, mediocre times, and slighty bad times, I am not yet convinced that NVR's model would be superior during terrible times. Their model has yet to be tested in terrible times. Comments?

    Subjectelan
    Entry06/24/2001 10:39 AM
    Membercharlie479
    I understand your example but I think your conclusion is incorrect. I'll show that NVR's model actually produces *inferior* absolute profits versus the competition in a stable or inflationary environment (as a tradeoff for better returns on capital) but produces superior absolute profits versus other builders in a deflationary environment. Given that we have been in an inflationary environment for the last 7 years or so, it is all the more amazing that NVR has been able to produce profits consistent with operators which are using a riskier (but, in an inflationary environment, inherently more profitable) model.

    Let me use an example with slightly different numbers than you did:

    1. NVR buys a two year option on a piece of land with a current market value of $100k. The option costs $5k and entitles them to buy the land for $100k. (I believe these figures are closer to reality - it costs about 5% of land value for an at-the-money land option).

    2. Homebuilder "RVN" buys the same piece of land for $100k.

    Let's consider 3 scenarios: an environment of rising prices, stable prices and falling prices.

    Rising prices. In one year, if the land price rises to $110k and NVR and RVN build a house on the land and sell it, RVN will have an embedded profit of $10k on the land whereas NVR will have an embedded profit of $5k. RVN and NVR will sell the house to the consumer at the same price, but RVN will realize a higher profit.

    Stable prices. If the land price stays at $100k, the result is similar. RVN has no embedded profit, while NVR has an embedded loss of $5k. Again, RVN will realize a profit that is $5k higher than NVR's.

    Falling prices. If the land price falls to $90k, RVN will have an embedded loss of $10k but NVR's loss will be limited to the $5k value of the option. NVR will simply not exercise its option and instead purchase the land at the current market price of $90k. (NOTE: I think you incorrectly imply in your example that RVN is no worse off than NVR in this case because it can also purchase the land at the current market price of $90k and incur no loss. This is not correct. RVN has already purchased the land - it cannot purchase it twice. Even if RVN finds an identical property that it can buy for $90k, it does not eliminate the fact that it has an embedded loss of $10k on the first property).

    There are two additional observations that can be drawn:

    1. In a deflationary environment, buyers may not at all be interested in the specific property that NVR and RVN bought! Buyers may instead want a property in the next town, or something near the highway, or something in blue. NVR will be able to respond by walking away from their option on the property and then buying the lot in the next town near the highway with the color blue. RVN will be stuck. It will have to wait for a buyer to show up for its property, risking further price decreases in the meantime.

    2. Theoretically, RVN could also try to buy the blue property in the next town to satisfy the buyer. However, RVN will likely face capital constraints when it looks in its piggy bank for funds to buy the second property. Remember, RVN has already incurred $100k of debt to buy the first piece of land that it holds in inventory. It's unlikely they'll be able to borrow another $90k. (RVN may have enough cash to do this the first dozen times, but multiply these figures by the thousands of lots that builders have in inventory to see why the debt amounts would be too large. Note that most builders currently have significant debt. NVR has almost zero net debt). NVR, meanwhile, has only incurred $5k of debt, so it has the financial flexibility to purchase the land.

    SubjectMore comments
    Entry06/24/2001 11:15 AM
    Memberelan19
    Thanks for your detailed reply. A large cost you left out of your analysis is the cost of capital - assuming all land and options are acquired with borrowed money, RVN has to pay interest for the money borrowed to acquire the land. Using 8% simple interest for 2 years on the $95,000 difference between acquiring land out right for $100,000 at the beginning of the 2 years versus buying an option for $5000 at then exercising at the end of the 2 years, this results in extra interest costs for RVN of $15,200. So NVR comes out better in a scenario of rising land prices as well.

    Using the example numbers you gave, I can't argue with your conclusion. Do landowners truly sell options for such foolishly cheap prices? If so, they are earning a negative return on their real estate investment when the interest costs to the landowner are factored in. This raises further questions for me:

    Why are the options so cheap?

    With such cheap options, why isn't there bidding from other large home builders? Acquiring an option at a higher price than you gave in your example is still a phenomenal deal for the homebuilder.

    If the options are truly so inexpensive, then NVR is benefitting from a severe market inefficiency which I would imagine must in the long run become more efficient due to competition. If it takes 10 or 15 years for other homebuidlers to catch on and start bidding against NVR, then that is 10 or 15 years NVR will continue to have such phenomenal performance.

    Perhaps that is why NVR maintains such a low profile with investors - perhaps they are afraid that publicizing their success would attract other homebuilders to move into their markets using the same model. This would cause multiple bidders for land purchase options, causing them to become more rationally priced, and causing NVR's advantage versus other homebuilders to eventually disappear.

    Subjectelan
    Entry06/24/2001 06:34 PM
    Membercharlie479
    Management has said that options are typically 6% to 7% of land value. This is not quite as cheap as the 5% I used in my example, but I agree with you that it's still fairly cheap. I will try to confirm these prices again.

    You raise a good follow-up question: if the options are so reasonably priced, why don't the other builders go in and bid on them? I have two theories on this: (1) The other builders still prefer outright land purchases instead of options because of the greater profit potential in an inflationary or rising environment. Therefore, competition for land is always intense, but not necessarily for options. (2) There are local oligopolies in the homebuilding industry. Builders need a certain threshhold level of construction and sales activity in an area to reach economies of scale for purchasing materials, showcasing model homes, having sales agents, etc. If there is a builder that already controls most of the land in a locality (years' worth, even), it is difficult for another builder to get enough inventory to support a critical level of sales. Therefore, even if there are a options here and there to acquire at cheap/reasonable prices, competition for them is limited to existing builders in the area with enough scale. Note that NVR is the largest builder in over half its markets, and is number 2 or 3 in almost all the rest.

    Your question deserves a more thorough answer, so I will attempt to get management's opinion about why other builders don't compete vigorously for these options, and what motivates developers to sell options at such prices.

    I agree that this could be one reason management does not like to communicate with the street. The other rumored reason is that NVR has been an eager acquirer of its stock and management is interested in increasing its stake relative to the public float at the cheapest price possible. I've never quite believed this (sounds too much like a conspiracy theory). I think the most likely answer is they just don't like the Street and prefer to focus on the operating the business than promoting the stock.

    SubjectRumors of demise exaggerated
    Entry06/25/2001 01:16 PM
    Membercharlie479
    FYI. These are existing home sales but they are generally highly correlated with new home sales.


    Existing-Home Sales Rise Unexpectedly
    As Housing Sector Remains Strong
    A WALL STREET JOURNAL ONLINE News Roundup


    Sales of existing single-family homes rose in May as the housing sector continued to show resilience to the sluggish economy.

    See the report from the National Association of Realtors on existing-home sales in May.

    Read analysis from Briefing.com on the home-sales report.

    Existing-home sales rose 2.9% to a seasonally adjusted annual rate of 5.37 million in May from an upwardly revised pace of 5.22 million in April, the National Association of Realtors said Monday.

    Economists surveyed by Thomson Global Markets had expected sales to be flat.

    "With slightly higher mortgage interest rates in a slowing economy, some forecasters have been expecting a sales slowdown," said David Lereah, the association's chief economist. "However, demand is still very high, interest rates remain close to historic lows and many people are confident about their own economic future."

    The national average rate for a 30-year, conventional fixed-rate mortgage was 7.34% in May, according to HSH Associates, a Butler, N.J., research firm.

    The median price for an existing home was $145,500 in May, up 5.7% from May 2000 when the median price was $137,600.

    Housing inventory levels at the end of May dropped 6.1% from April to a total of 1.53 million existing homes available for sale. However, the May inventory level is 2.7% higher than May 2000, when 1.49 million homes were on the market.

    SubjectKBH
    Entry06/26/2001 12:21 PM
    Memberelan19
    From today's 6/26/01 conference call for homebuilder KB Home (which focuses on low end single family homes in the Western half of U.S.), I thought readers of this board would be interested in the following:

    Out of KBH's current 73,000 lot positions, 26,000 are optioned, and management indicated (in response to a question on whether working capital requirements could be reduced) they hope to increase the percentage of optioned lots, in markets where that can be done.

    Anyone know if this is a goal of most of the traditional home builders?

    SubjectCongrats
    Entry06/29/2001 01:00 PM
    Memberstat820
    Well deserved winner of the week.

    Subjectfollow up for elan
    Entry07/10/2001 06:02 PM
    Membercharlie479
    The example we were using was a little too simplified and ignored cost of capital. Therefore, the example produced a result that showed the developer was not being compensated for his cost of capital (or his development efforts) if he went down NVR's option path.

    In reality, the developer would be compensated for cost of capital and their development efforts. For example, for a a lot worth $100k in 2 years that NVR would pay a $5k deposit for today, a developer might be able to sell that same land now but they wouldn't get $100k for it. The sale price would be something lower -- with the difference being the profit that the developer gets in return for holding and developing the property over that time period.

    This does not alter the conclusions of our previous example. Other builders will enjoy higher embedded gross profits per unit than NVR in a stable to rising environment but they will tie up more capital (and produce lower returns) to do so. Obviously, the other builders assume more risk and it shows up in the falling price environment. NVR will not have large amounts of capital tied up in a recession and its losses on inventory will be lower than the other builders. The other builders will likely be left with large amounts of debt while they try to liquidate excess land.

    Despite this inherent gross profit disadvantage in the recent inflationary environment, NVR has in recent years been able to generate gross margins that compare favorably to other builders. I am repeating what I've already said in previous posts but I believe this is a result of their operational efficiency and dominant position in its markets.



    SubjectNVR, Inc. Announces a 60% Incr
    Entry07/20/2001 10:46 AM
    Membercharlie479
    NVR announced 2Q results today. Orders and backlog were up. Free cash flow improved and the company repurchased another 300k shares in the quarter.

    Management now estimates EPS around $22.85 for 2001, which looks easily achievable given the average selling prices of the homes in backog.

    SubjectGreat company in a bad industr
    Entry09/10/2001 12:08 AM
    Membergophar571
    Great Idea. I really like this company. Unfortunately, I am extremely bearish on real estate right now and can't get comfortable going naked long a homebuilder. Which companies in the space do you feel our most overvalued? - is there a paired trade opportunity that makes sense?

    thanks.

    Subjectgophar
    Entry09/19/2001 11:37 AM
    Membercharlie479
    >>Which companies in the space do you feel our most overvalued? - is there a paired trade opportunity that makes sense?

    I generally discourage a paired trade in this industry. This is not because I disagree with your assessment that most of the companies in the sector are bad businesses, but because many of these companies already trade for extremely low P/Es. The potential downside of shorting something with a low P/E (even in a paired trade) can be massive.

    That said, if you insist on shorting something as part of a pair, I'd do a simple screen and pick out the most leveraged lenders. These are the ones run by aggressive management who have been unable to resist accumulating inventory. Centex pops up at the top my screen.

    Subjectcharlie
    Entry09/27/2001 02:10 PM
    Memberandrew109
    Charlie -- I agree with you that homebuilding is not a "bad business" (as gopher suggested). However, I don't understand your reasoning for suggesting that CTX would be the homebuilder that you would short (assuming you were forced to choose one to short).

    Subjectandrew109
    Entry10/03/2001 11:30 PM
    Membercharlie479
    To be clear, I would not short any of the homebuilders. CTX benefits from the same advantages over the private builders that NVR does. And, it's hard to make a lot of money by shorting stocks with single digit P/Es.

    If I would have to pick a few builders to short, though, CTX would be on my short list. The company has shown the behaviors that have gotten homebuilders into trouble. Centex has decided to get into the real estate development business. They've got such developments in their huge inventory balance and they even have a few real estate joint ventures. Additionally, they are increasing their financing operations.

    I view both the financing business and the development business as capital intensive low-return businesses. In a serious down-turn, they will be stuck with unsaleable developments and loans that could potentially deteriorate.

    Look at CTX's returns on invested capital over the last 10 years. Also, note the increase in leverage. Sure signs of of a mediocre business.

    Subjectcharlie
    Entry10/04/2001 12:06 PM
    Memberandrew109
    Thanks for your response on Centex. I agree that none of the homebuilders should be shorted. I disagree, however, that CTX is the most expensive homebuilder.

    With respect to the real estate development business, you should know that the real estate was acquired through bankruptcy (Vista) and that there is no tax basis on the land. Management is extremely smart (which would be another reason not to short CTX)and had other reasons (taxes, etc.)for this acquistion.

    With respect to the financing business, the company in two years should earn $150MM-$165MM pre-tax on $300MM of capital.

    Again, management is extremely smart and accounting is very conservative.

    SubjectAnother share repurchase
    Entry01/14/2002 01:34 PM
    Membercharlie479
    NVR authorized another share buyback last week. This one is for $300 mil, which is quite significant relative to the market capitalization.

    SubjectCurrent Price
    Entry02/01/2002 05:25 PM
    Membertim321
    Charlie - What is your exit price on this? While the the price is closing in on my target price (high 200's) I really like the intangibles here (management, b-model etc) that are hard to quantify. What is your take?

    Subjecttim321
    Entry02/03/2002 06:41 PM
    Membercharlie479
    I don't really have a target price. With $30 per share of earnings likely this year and high returns on capital that will continue because of its better operating model, I would not sell under $300. But this does not mean I would sell over $300 -- this is a company to own for a long time.

    SubjectOption grant
    Entry04/11/2002 02:43 PM
    Membermark227
    This has been a great pick and a great stock. However, according to the annual, 1.9 million options were granted last year, which seems a tad much given the company has only 7.5 million shares outstanding? Doesn't an option grant of this size (Black Scholes value $200 million) have to be figured into the value equation?

    Subjectthere were 344,000 issued, not
    Entry04/11/2002 04:06 PM
    Memberallen688
    I have a question though, what premium does this stock deserve to its peers? Its at about 45% on '02 and '03 earnings to CTX.

    SubjectOptions
    Entry04/11/2002 04:54 PM
    Membermark227
    I'm looking at page 42 in the annual report. I believe there were 1,823,100 options issued under the 2000 option plan and 106,000 issued under the 1996 plan in 2000. Where are you getting your numbers?

    Subjectoptions
    Entry04/12/2002 04:38 PM
    Memberallen688
    you have the 1.8 mil figure as options granted in '01, but that is how many were outstanding at 12/31/2001. they were issued over the past 9 years. and as far as recognizing them in their valuation, you indeed need to include them. the company reports 7,927,315 outstanding to calculate basic and 9,525,960 for diluted. the difference recognizes the options and forwards.

    Subjectoptions
    Entry04/12/2002 04:39 PM
    Memberallen688
    you have the 1.8 mil figure as options granted in '01, but that is how many were outstanding at 12/31/2001. they were issued over the past 9 years. and as far as recognizing them in their valuation, you indeed need to include them. the company reports 7,927,315 outstanding to calculate basic and 9,525,960 for diluted. the difference recognizes the options and forwards.

    SubjectPrice
    Entry04/13/2002 04:46 PM
    Membertim321
    Charlie - I haven't had a chance to update my model (back when the stock was trading at 140) that showed a very conservative value for NVR of at least 300 dollars a share. What are your risk/return thoughts now on NVR given the huger run up (this was the company I submitted for VIC membership). BTW - While it won't exhibit the same run-up as NVR, UST is another unique company that I believe will deliver investors a great return (see write-up). Thanks Tim

    SubjectOptions
    Entry04/14/2002 07:09 PM
    Membermark227
    I believe that your numbers are incorrect. As I previously said, if you look at page 42 in the annual report, you will see that last year 1,823,100 options were granted under the 2000 Option Plan and 106,000 were granted under the 1996 Option Plan. If you simply ADD UP all the options granted, exercisable and unexercisable of all the different plans as shown on the very next page, you will see that the number far exceeds the number that you mentioned. The number thatyou are referring to is the dilutive effect from exercisable options under the treasury stock method, which is calculated as the total number of exercisable options outstanding less the total

    SubjectOptions (continued)
    Entry04/14/2002 07:17 PM
    Membermark227
    exercise value of these options divided by the current stock price. If you still don't believe me, look at the proxy. You will see that Dwight Schar received 400,000 options, equal to 21.9% of the employee options issued in 2001. This implies employees received 1.826 MM options last year. Perhaps some of the other VIC members could help us resolve this issue and give their thoughts on the options grant.

    SubjectOptions
    Entry05/27/2002 07:30 PM
    Membercharlie479
    The options grants for this company are excessive and the board's allowance of it is repulsive. This is the main negative of this stock.

    The 10K has the correct issuance number in 2001. The exact number is not important. The bigger point to realize is that this company is reducing its stated earnings by a significant measure by issuing options every few years.

    There isn't a lot of reassuring things I can say about the options program. It's essentially one of the costs of owning this otherwise very sound operation. I have drafted a letter to the board but have not gotten around to sending it. Perhaps several letters from VIC members will get them to change their long-term compensation policy.

    SubjectI
    Entry05/28/2002 10:37 PM
    Membertim321
    talked with the CFO (Paul Saville) a while back and he did
    not seem like the kind of guy who would do this sort of thing. Very dissapointing. Any new stock ideas?

    P.S. - I have been researching Kookmin Bank, Regis, and Polaris. Some NVR like qualities here. Thanks Tim

    Subjectcfo
    Entry06/03/2002 10:47 PM
    Membercharlie479
    I have briefly met the cfo and ceo and I agree that they don't seem like the kind of guys who reward themselves with huge pay packages. They seem like down-to-earth straight-shooting. Nevertheless, there's no denying that they were party to these ridiculous stock option grants. So, whether they seem like it or not, they have a failure in corporate governance and executive compensation.

    Thanks for the stock candidates. I will look when I get a chance. I honestly have not any good ideas since my NVR post (except my WNMLA post, which I like but is a different breed). I average maybe one every year or so but this year seems to be relative short on obvious things.

    Subjectquestion
    Entry12/02/2002 08:59 PM
    Membertim321
    Charlie - can you email me at xxxxxx
    I have a quick question for you. Thanks Tim.

    Subject10-k
    Entry02/11/2003 11:03 AM
    Membertim321
    NVR's 10-K just released. One of the more amazing cash flow statements I have ever seen. Look at the amount of money going into share buybacks (362mm in 02 alone). One of the research analyst's told me a while back (kim from SSB) that the rumor on NVR was that they (management) were secretly trying to take the company private and that management paid no attention to Wall Street coverage.

    Subjecttim321
    Entry02/11/2003 03:38 PM
    Membercharlie479
    The cash flow statement is indeed pretty good. There is almost no capex so all of the operating cash flow is available for share repurchases, which they have been eagerly doing.

    Management indeed pays no attention to wall street coverage. It's a great thing.

    I noticed your previous msg. I would send you an email but the address seems to be deleted from the post. It's probably better to post the question on VIC anyway.

    SubjectNVR
    Entry07/28/2005 03:35 PM
    Membertim321
    Charlie -

    I hadn’t looked at NVR for a while (cognitive dissonance I think from selling in the low 400’s) and almost fell out of my chair today when I saw it was at 935. Looks like you are officially closing in on a 10 bagger. The amazing thing to me is that NVR is rarely mentioned when the housing stock group is brought up – despite its tremendous success and unique model. Ron Muhlenkamp was one of the few other managers who spotted it early. Maybe Schar really does deserve that mansion!

    Subjecttim321
    Entry07/28/2005 11:58 PM
    Membercharlie479
    Yes it's been a crazy ride. Schar's discipline in sticking to the land-light model and returning excess cash to shareholders deserves much of the credit for the company's success. But so does a lot of luck and some of these Option ARM thingamajiggies that folks in the other threads are talking about. Also, Schar's way too greedy to make it to my favorite CEOs list. His mansion was paid for with wheelbarrows of liberally-issued stock options. NVR would have been a truly fantastic one if they had just kept their stock option appetite in check.
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