“A talent for following yesterday’s ways is not enough to improve today’s world.”
A company creates value when it increases its revenue and earns a return above the cost of capital. NVRs (NYSE: NVR) is one of the great American companies. Society is the clever beneficiary of deep secular supply-side trends that are pushing house prices to high base levels. NVR has increased its market share, while increasing shareholder value. Its business model de-risks the company in the event of falling demand and market weakness, and its executive compensation policy aligns the interests of management with those of shareholders. It is a company that excels in creating shareholder value.
Recent financial results
According to the company’s 2020 annual report, NVR increased its revenue from $7.2 billion to $7.3 billion. NVR’s 3Q21 report showed a 21% increase in residential construction revenue year-over-year, from $1.9 billion to $2.3 billion. Mortgage bank charges decreased from $69 million to $59 million. Revenue increased 29% year-over-year after the first nine months of the year ended September 30, 2021.
Growth has been accompanied by greater profitability. In 2020, NVR achieved net operating income after tax (NOPAT) of $935 million, compared to $888 million the previous year. Between 2016 and 2020, NVR worsened NOPAT at more than 16% per year. In the current/last twelve month period (TTM), NVR has revenue of over $9 billion and NOPAT nearly $1.3 billion.
The company’s improved profitability is reflected in its NOPAT margin. In 2020, this stood at 12.4% and is currently 14.2%. NVR has improved its NOPAT margin every year since 2016, when it had a 7.5% NOPAT margin. The company’s capital turnovers increased from 2.7 in 2016 to 2.8 in 2020, and stand at more than 3.3 in the current period/TTM.
Consequently, the return on invested capital (ROIC) of NVR has increased from 20.4% in 2016 to 34.9% in 2020. The ROIC is 47.3% for the current period/TTM. NVR’s asset-light model allows it to generate an impressive return on investment and have a highly efficient balance sheet, which in the housing industry is particularly important given the dynamics we’ll discuss below.
The real estate boom rests on solid foundations
Any discussion of the housing market inevitably leads to the housing bubble that led to the Great Recession. Yet there are good reasons to believe that the current housing boom is based on solid fundamentals. Since their trough in 2012, house price indices have rebounded, rising at a faster pace than per capita income and inflation. The S&P Case-Shiller National Home Price Index is up nearly 95% from its 2012 levels, and the FHFA All Transactions Price Index is up nearly 74%. This represents a compound annual growth rate (CAGR) of 6.9% for Case-Shiller and 5.7% for the FHFA index. During this period, per capita income grew by about 40%, compounding at 3.4% per year, while consumer prices rose by 22%, or about 2% per year.
House price inflation predates the pandemic, which has only amplified a centuries-old trend. Anyone who claims “this time is different” almost always sounds like an idiot, but…this time is different. As The Wall Street Journal pointed out, mortgage lending standards are much higher than they were in the mid-2000s, when “borrowers with bad credit histories” could “buy homes at beyond their means, sometimes with mortgages that required low payments in the first years of the loan. Too much new construction has led to an oversupply of homes.
Today, the real problem is not the flexibility of mortgage standards, but the barriers to entry. Economists have called this a “debt-free housing boom,” due to the decline in home mortgage lending in the post-Great Recession era. Mortgage debt service payments have fallen from 6.3% of personal disposable income to 3.8% over the past decade. Therefore, it is difficult to say that the owners are hoarding the mortgage debt.
It is true that the pandemic has spilled fuel on the housing boom, as workers have realized that remote work gives them the freedom to move to larger homes outside of traditional metropolises. The pandemic has compounded affordability issues and deepened inequality, even at a time when mortgage rates were at rock bottom.
Construction costs (including the cost of land and improvements) are the main drivers of new home price inflation and played a significant role even in the housing bubble that preceded the Great Recession. This is especially true when local markets are competitive. According to the Federal Reserve, there is a strong relationship between sales of new single-family homes of comparable quality and the cost of residential construction, as shown in the graph below, increasing by 0.98% and 0.91% respectively. per year.
This relationship is strong not only in the long term, but in the short term, suggesting that the floor for house prices has risen and should remain high.
Risks to growth and profitability
According to Clever Real Estate, in 2021 Americans needed an income of $144,192 to afford a home, well above the median household income of $69,178.
As a general rule, buyers are advised not to spend more than 30% of their gross monthly income on housing. Some experts advise setting a limit of 2.5 times the annual salary. The dramatic rise in house prices has made this increasingly difficult to do. Clever Real Estate estimates that house prices are now 5.4 times higher than the typical buyer’s gross income. This means that only six US cities have a healthy price-to-income ratio of 2.6 and below: Alabama, Birmingham, Cincinnati, Cleveland, Oklahoma City, Pittsburgh and St. Louis. Cities like Los Angeles, New York, San Diego, San Francisco, and San Jose have price-to-income ratios above 9.8.
Demand constraints started showing up in the data. According to the National Association of Realtors, pending home sales for November 2021 were down 2.2% month over month. Pending home sales are a leading indicator of existing home sales, ahead by a month or two. Existing home sales in November rose 1.9%.
The Census Bureau estimates that sales of newly built single-family homes fell 14% in November from a year ago. October sales figures were revised to their lowest point since the start of the pandemic.
Regardless, the median price of new homes sold in November was up 19% from a year earlier.
While house price inflation is expected to moderate somewhat, the base level will remain given rising construction costs. Nobel Prize-winning economist Robert Shiller pointed out that it is rare for house prices to rise with stocks and bonds. He thinks changes on the supply and demand side will help stabilize prices over the next two years, but he said it was far too early to discuss a price crash. High house prices have real reasons on the supply side.
These risks seem outweighed by the reasons why demand will also remain high. Regardless of the Federal Reserve’s intention to raise interest rates, interest rates will remain at historically low levels. Second, remote work allows millennials and other buyers to buy homes outside of traditional metropolises where the price/income ratio is unfavorable.
We are living in an eight-century, supra-secular trend of falling real interest rates, and so in the long term, rates are likely to stay low. Data from Freddie Mac shows that 30-year mortgage rates remain at historically low levels, even taking recent increases into account.
The interests of management are aligned with those of shareholders
NVR’s executive compensation plan links 50% of long-term stock options to NVR’s return on capital. Performance-based options vest based on the performance of NVR’s return on capital relative to its peers.
Research has shown that return on capital is a key factor in the long-term valuation of companies. For the shareholders, having a management which, since 2014, has a remuneration policy linked to the remuneration of the capital, means that the management is focused on the same thing as the shareholders: the creation of value. Not only has NVR increased ROI from 20.4% in 2016 to 47.3% in the current period/TTM, but the company has increased economic profits from over $313 million to $1.14 billion. dollars during this period, or 24% compounded annually.
The NVR has an attractive price
With a stock price of just over $5,700 and an economic book value per share of just over $6,400, NVR has a price-to-economic book value (EPBV) ratio of 0.89. This implies that the company’s zero growth value is greater than the stock price. The market expects NVR’s earnings to decline by 11%, a finding which, given the company’s track record of profitability and secular trends that fuel house price inflation and housing demand nine, seems incredibly pessimistic.
According to New Constructs, consensus estimates call for the company’s earnings per share to grow 43% year-on-year in 2021, and 21% year-on-year in 2022. NVR market pricing means the market has pulled back the risk of the decision and presented investors with a lossless decision. If the NVR exceeds market expectations, there is a benefit. The greater the disconnect, the greater the potential benefit. A profitable business whose profitability improves but is priced based on declining profits is a freeroll decision.
Investors should buy companies with growing free cash flow available at attractive prices. NVR’s free cash flow (FCF) grew from $332 million in 2016 to $859 million in 2020, growing 20.9% annually over that period. The company has over $1.2 billion in current period FCF/TTM or 5.8% of its market capitalization. With a current enterprise value/TTM of over $20.86 billion, NVR has an FCF return of 6%. Not only is the company’s FCF growing, but it’s available at an attractive price.