The Market Undervalues NVR Inc.’s Cash Flows

Cyclical tailwinds provide the perfect opportunity for industry leaders to shine. This firm has effectively taken market share from competition while improving its profitability. Add a shareholder-friendly executive compensation plan, and we believe the firm will continue to outperform. NVR Inc. (NVR: $2,112/share) is this week’s Long Idea.

NVR’s Strong Profit Growth

Since 2011, NVR has grown after-tax profit (NOPAT) by 26% compounded annually to $440 million in 2016. Per Figure 1, the company’s NOPAT margin has improved from 5% to 8% over the same time. Longer-term, NVR has grown NOPAT by 10% compounded annually since 1998, the earliest year in our model.

Figure 1: NVR’s Profit Growth Since 2011


Sources: New Constructs, LLC and company filings

In addition to NOPAT growth, NVR has generated a cumulative $821 million (10% of market cap) in free cash flow (FCF) over the past five years. Throughout the company’s history, including the 2008 economic recession and its fallout, NVR has earned a double-digit return on invested capital (ROIC). NVR currently earns a top-quintile 21% ROIC.

Executive Compensation Plan Is Aligned With Improving ROIC

NVR’s executive compensation plan includes base salary, annual bonuses, and long-term stock-based compensation. 50% of long-term stock options are tied to the firm’s return on capital performance. Additionally, for performance-based options, vesting is subject to NVR’s return on capital relative to its peer group. Return on capital has been part of NVR’s executive compensation plan since 2014 and is one of the reasons the stock is on April’s Exec Comp Aligned With ROIC Model Portfolio.

The focus on return on capital helps ensure executives continue to be good stewards of capital. Per Figure 2, NVR’s ROIC has improved from 12% in 2011 to its current 21%. More importantly, NVR has grown economic earnings from $88 million in 2011 to $352 million in 2016, or 32% compounded annually.

Figure 2: Executives Are Focused on the Right Metric

Sources: New Constructs, LLC and company filings

We know from Figure 3 below, and numerous case studies, that ROIC is directly correlated to changes in shareholder value. NVR’s use of return on capital to measure performance ensures executives’ interests are aligned with shareholders’ interests.

Improving ROIC Correlated With Creating Shareholder Value

Per Figure 3, ROIC explains 75% of the changes in valuation for the 16 homebuilders we cover. Despite NVR’s 21% ROIC, well above the 7% average of the peer group, the firm’s stock trades at a slight discount to peers as shown by its position below the trend line in Figure 3. If the stock were to trade at parity with its peers, it would be at $2,178/share – 3% above the current stock price. Given the firm’s consistent and much higher ROIC, improving profitability, and shareholder-friendly executive compensation plan, one would think the stock would do better than just trade at parity and would garner a premium valuation.

Figure 3: ROIC Explains 75% Of Valuation for Homebuilding Firms

Sources: New Constructs, LLC and company filings

High Profitability Gives NVR A Competitive Advantage

In the homebuilding market, builders have numerous tools to entice buyers, such as price breaks, upgrade packages, and even financing deals for using a preferred vendor. These incentives can destroy margins if overused. Per Figure 4, NVR has the top ROIC and one of the highest NOPAT margins versus peers, which include Lennar Corporation (LEN), PulteGroup (PHM), Toll Brothers (TOL), D.R. Horton (DHI), and Meritage Homes (MTH).

High margins allowed NVR to remain profitable after the housing bubble burst and grow profits as the market improved. Additionally, NVR’s profitability gives it greater ability to pressure competitors and offer more value (through lower prices or more features) while remaining profitable. Lower margin competitors must choose between giving up the business, matching NVR and taking a lower margin, or offering a lower quality product to maintain margins.

Figure 4: NVR’s Profitability Ranks Among the Best

Sources: New Constructs, LLC and company filings.

Bear Concerns Assume Housing Market Has Peaked

Since the housing collapse in 2006-2008, the housing market has seen growth in both new home and existing home sales. Bears will argue that the market is once again peaking and cannot support greater sales growth. We wrongly argued in 2015 that the housing market might have reached a top in terms of prices and sales. In fact, current trends, including new home sales and inventory of available homes, are creating tailwinds for NVR that should not be overlooked. Any bear case against NVR ignores these tailwinds, and NVR’s ability to effectively capitalize on the housing rebound.

Figure 5 shows that annual new home sales remain well below the average of any 10-year period since the 1960’s. Even 2016 sales of 559 thousand remain 20% below the 30-year average. While the housing market has posted impressive growth since the bubble burst, it has yet to reach even pre-bubble levels.

Figure 5: Average New Homes Sales by Decade

Sources: New Constructs, LLC and U.S. Census Data

While new home sales remain below average, the existing supply of homes is falling as well. Since 2011, existing inventory of homes for sale has fallen from nearly 3 million to below 1.7 million in December 2016, the lowest supply level since 1999. Low inventory of existing homes provides an opportunity for homebuilders to attract customers. Per Figure 6, new home sales as a percentage of home sales has grown from 6% in 2010, to 11% in 2017. However, the percentage of new homes sales remains well below the pre-recession average of 24%.

Figure 6: New Homes Sales as a Percent of Home Sales

Sources: New Constructs, LLC, National Association of Realtors, and U.S. Census Data

NVR has leveraged these trends, along with five consecutive years of rising average sales prices to grow its market share. In 2006, NVR held a 3% market share, based on total closings. NVR doubled its market share, to 6% in 2016, at the expense of competitors such as PulteGroup, KB Home, and Beazer Homes, all of which lost market share over the same time.

Bears will also argue that rising interest rates will have a negative impact on the industry as rising mortgage rates make homes less affordable. Preliminary sales data shows otherwise. The average 30-year fixed rate mortgage, as of April 12, was 4.2%, up from the 3.65% average in 2016. Nevertheless, new home sales in 2017 rose 6% and 13% year-over-year (YoY) in January and February respectively. Also in February, applications to build rose to the strongest level since September of 2007. In March, mortgage applications for new homes rose nearly 7% YoY to the highest level since the Mortgage Bankers