Chit Chat Stocks - 2 Stocks I Bought Last Month: Homebuilder Sector Analysis (DFH, NVR, DHI)

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Starting point is 00:00:42 public investing. You must activate your options account by March 31st for revenue share. Options are not suitable for all investors and carry significant risk. Full disclosures are in the podcast description, U.S. members only. Welcome to Chit Chat Stocks. On this show, hosts Ryan Henderson and Brett Schaefer analyze businesses and riff on the world of investing. As a quick reminder, Chit Chat Stocks is a CCM Media Group podcast. Anything discussed on Chit Chat Stocks by Ryan, Brett, or any other podcast guest is not formal advice or recommendation. Now, please enjoy this episode. All right. Welcome in, everyone. This is another edition of Chit Chat Stocks. My name is Brett

Starting point is 00:01:33 Schaefer. And as always, I'm here with Ryan Henderson. And surprise, surprise, we are talking different stocks today, some new ones that have been on our radar. And if you look at the title today. These are two stocks that Ryan has been buying. Actually, they're in his portfolio. And before you turn things off, it is in the home building sector. And I know that's not as sexy as maybe Supermicrocomputer, NVIDIA, or stuff like that. So Ryan, maybe as a tease for the listeners, why should investors be excited to invest in a stodgy old, boring, commoditized industry like home building? Yeah. Well, after you give it that great sales pitch, it has had exceptional returns. And some companies in this space in particular have been,

Starting point is 00:02:29 well, I know for sure one has been a hundred bagger. And there are characteristics here that if you are looking for durable multi-baggers that you don't sell for a long time, I think home building right now in particular is a good place to be fishing both because of the multiples across the board, but also because the industry has changed a lot. So I'm going to talk a lot about that. And I've got three businesses in particular that I'm going to profile and give explainers around the business, my thoughts, why I chose to buy two in particular, and full disclosure, not buying right now. We have some rules we like to follow.

Starting point is 00:03:15 So this is what I think the last time I bought was about a month ago. So not buying currently for that reason, not as if I'd be moving the stock anyways, but just to be cautious in case this show got really popular for some weird reason. So I'll leave it there. Home building, sexier than you might think. Exactly. So we talked recently about a professional investor that has done well over the long term. And one of the things he bought was a home builder. So we looked at this sector back in 2022. To be honest, it was probably a better time to buy because some of the stocks were really cheap, but we were a little sour on it for various reasons. But what got you more

Starting point is 00:04:01 interested now? I see some of your answers here, but was it the fact that they were more resilient to the mortgage rate hikes or maybe where do you want to start? Or we might go to some other directions later. Well, yeah, a couple of things happened. So I think everyone knows what happened with interest rates. Mortgage rates jumped pretty quick in short order, which made me a little cautious around homebuilders. And I think probably made everyone cautious. And that's why the multiples really compressed last year and probably rightfully so. But as we came out of it, a lot of the homebuilders came out last year and basically said demand wasn't as rough as everyone expected. They said we're still seeing really good demand, especially for entry-level

Starting point is 00:04:53 homes. And there's a couple of reasons for that that I think we can get into, but it sort of passed that test of rates jumping from 3% to 8%. And that was one of the things that got me interested. The other part is you mentioned that we talked about an investor, Norbert Liu. I think that the episode that we did on him is titled The Best Investor You've Never Heard Of. he had sort of this famous write-up now on value investors club about nvr and really he made a huge bet on nvr i think it was north of 30 of his portfolio when he first bought in the 1990s and he held it for almost 20 years and anyone who doesn't know nvr just look up nvr stock and then hit max on Google or go to FinChat. And you're going to see that thing is a hundred bagger and

Starting point is 00:05:47 the performance has been ridiculous. And just reading that write-up, even though it's 20 years old, makes you realize that home builders do have some qualitative factors or some qualitative characteristics that make them pretty attractive, especially the bigger ones. There's some competitive advantages. If they do things properly, they can generate good returns on the capital that they deploy. They've got plenty of room to invest capital because it's homes. There's plenty of land in America. And they're not really at the risk of being disrupted by new technology. There's no risk of cheap labor from – or there's no China risk like a lot of the other businesses we've been looking at lately and evaluations can get pretty

Starting point is 00:06:40 cheap. So because people are kind of afraid of them, these end up being pretty attractive. And so I kind of just started digging through researching a whole bunch of home builders and I found three that were very attractive. A couple of others that had some hair on them, but also pretty interesting. So the three that I'm talking about today are NVR, DR Horton, and dream finders homes and i'll go through all three of those but really i would say that's the big thing that attracted me is they passed a test in that i think everyone's kind of heard that there's a home shortage in the united states that that we aren't building enough and i was kind of hearing that going into 2020 i'm like yeah well you know rates are three percent let's see what

Starting point is 00:07:23 happens when rates jump and demand isn't so high if there's still that same home shortage and it seems like so far they have weathered that storm pretty well, the home builders have. So the home shortage feels legit. And I'd say that's probably what's got me digging in here. It feels like we're buying after a time when potentially the economy has shown that it can be immune to difficult economic conditions. Yep. And the ones that you are talking about today, we have again, And NVR, DR Horton, and DreamFinders Homes, just want to reiterate that for any listeners that, because I know a lot of the times when you listen to a stock analysis podcast, you want to look up the stuff that we're talking about.

Starting point is 00:08:10 I'll hopefully use our research, hopefully we give some nice insights here, but you're going to look up yourself. So NVR, DR Horton, and DreamFinders Homes. I will say there are some characteristics that you're going to talk about here that has helped these type of companies weather economic storms better than others in the past and hopefully will in the future but that's getting a little bit ahead of ourselves let's talk about what home builders do because i think people imagine and those these people exist the single person building a home like it was back in the day but right now you know in modern times

Starting point is 00:08:47 It's become much more, I would say, scaled, industrialized a little bit, like commoditized from a point of you're not just coming from scratch, building an individual home. You know, there's a commercialized, I guess, commercialized is probably a good way to put it as well. So what do home builders do? What are the value they are providing to all their different stakeholders? Yeah, I think like most people, when I hear the term home builder, I picture a group of people in construction uniforms doing the work themselves, drafting up the plans, the blueprints for building a home, going to Home Depot or wherever to acquire the materials, maybe getting a subcontractor here or there to help with wiring or plumbing or whatever, and then building the homes from scratch. That's not really what's going on. So I'm going to steal this quote from our friend Drew from Speedwell Research because he describes home builders really well. He says, referring to home builders as home builders can be a bit of a misnomer because they don't actually build homes.

Starting point is 00:09:50 Instead, they outsource to a network of subcontractors who are responsible for building the homes. Thinking of home builders as home coordinators would perhaps be more apt as the role is to vet subcontractors, order home designs, locate desirable land, procure materials, oversee the building, provide capital, and then find buyers. Now, I think that's a really great way of describing it, right? Because a lot of these businesses, it's not a construction company. They are, like he says, a coordinator and a facilitator, and they're creating these relationships with all these subcontractors, and they are sales organizations to some degree, right? They've got model homes.

Starting point is 00:10:30 They're getting people in the door. They're marketing these new developments, and they're saying, this is what it's going to look like to all these potential homebuyers, and they're hopefully selling as many homes as they can. Now, certain homebuilders, NVR is the one that comes to mind here, and typically some of the other larger ones as well, will do some of the manufacturing themselves. NVR, for example, has some manufacturing facilities that prefabricate walls, build trusses, and do millwork. I had to look. I'm going to be honest.

Starting point is 00:11:00 I looked some of that stuff up. Didn't know what all it was. I'm not the biggest handyman here. That's all right. But for the most part, home building, it appears, is a relationship to business. Do you have good partners and subcontractors that you can rely on in your area? Have you cultivated those relationships over time if you're the home builder? That's what really differentiates a lot of the best home builders and the most profitable

Starting point is 00:11:25 home builders from the smaller private ones that aren't really able to scale as well. So that's kind of the business. Moral of the story here is not a construction business. These are sales organizations. And we're going to talk about some of the differentiators here in terms of why it's not quite as cyclical anymore. But it's really a less cyclical sales organization that's built on your partnerships that you have in your local areas. Okay. Okay. And one of the things, and it comes back to what we talked about last week with Terry Smith,

Starting point is 00:12:06 one thing that people worry about with a business that has to invest into a lot of inventory is there's, you know, it's capital intensive. You might have to take on debt to buy up a bunch of this stuff, buy up all the, I don't know, do all the financing because you're building a lot of physical spaces. And one of the things that Terry Smith and a lot of other investors say is that good cashflow conversion, converting your earnings into cashflow, cash that you can have, cash that gives you, as some might call it, optionality or the ability to just be flexible and perhaps more aggressive with growth without having to take on a lot of debt. So what are the home builders that you've looked at that people have profiled before as well? Some

Starting point is 00:12:50 listeners, if you follow the industry closely, may have heard of this before with the land option versus the raw land strategy maybe try to explain it in detail but also give some layman terms for anyone that's you know hopefully doesn't get confused as a listener yeah so i mean when i think of a home builder a lot i had a lot of these kind of uh pre-existing ideas when i hear the term home builder and it was you buy up this huge chunk of land you go out you develop it you build homes on it and you're doing all that yourself but this land option model has really been popularized over the years. And I think that's probably because of the success that NVR has had with it. Plus there's just some other advantages as well.

Starting point is 00:13:34 But what this means is that instead of going the traditional route of acquiring large plots of land and holding that land on your balance sheet while you develop homes on it, you would instead purchase an option on the land. This typically means you pay five to 7% of the land value up front. I think it's increased a little bit. That was from Norbert Lue's write-up originally with NBR. So it might be more like 10% of the land value now. And then you can exercise the right to pay the remainder once the lot was finished and you found a buyer. This model is considered asset light because it keeps the inventory off your balance sheet, which helps during market downturns. And it keeps, in another way, inventory turnover higher. I know I was reading

Starting point is 00:14:21 DreamFinders homes, investor presentations. That's something they harp on a lot where they're basically want to accelerate or not accelerate, prioritize getting the, if we're going to have to put money in, we're going to get it back out as quickly as possible. Yeah, exactly. And there is some caveats. So as the home builder, if you're the home builder, you have to have a partner that's willing to hold the land. And as far as I know, this part was kind of muddled. It wasn't very clear to me. Not all home builders have access to that. So you've got, I think there's land banks that are willing to do this and you pay them certain interest. But if you don't have a great strategy for getting the homes turned over

Starting point is 00:15:08 quickly, you're not going to be able, you're going to be paying so much interest on that. It's not worth the money. It's not worth the interest that you're going to pay to the to the land bank or whatever. So that's one part of it. The other part is I believe in some agreements, I already mentioned this, but you're paying interest. So you have to, it really has to be worthwhile. You have to be able to turn that home over quick enough that it's still the cheaper option. The real big advantage here is that it's not on your balance sheet. And so why is it bad to have land on the balance sheet well land at best really probably appreciates like three to four percent a year in value you could call it on a normal year there's a lot of there's a lot

Starting point is 00:15:51 of variables that go into that like who knows what the migration patterns are going to flip you know right in a certain area or something or the governments can kind of control that a little bit yeah it's not earning anything just sitting there so you know there isn't that much upside to just holding land on your balance sheet. The downside though, is steeper than you would think. Like when I think of, you know, if you just picture a plot of land in your head, you don't really think of that as a volatile asset, but it can really swing depending on the overall housing market or like Brett said, the migration trends in that area. So I'll use the- Or local, yeah. And local businesses could start up. I know we use Seattle as a reference just

Starting point is 00:16:30 because we're from there. It depends, you know, if Amazon wasn't started there, what would land values be like there, right? There's going to be some variables outside of your control. Exactly. I'll use the founding story of DreamFinders Homes here as an example. So Patrick Zalupsky, he's the founder of DreamFinders Homes. He started the company in 2008, right in the heart of the housing crisis. So he took out a $200,000 loan from the Clay County Housing Finance Authority to help build affordable homes. With the loan, Zalupsky bought three home sites in Jackson, basically the, I think it's the greater Jacksonville area for $25,000, I believe a piece. Pre-GFC, that land was going for $80,000 a plot. So it's a 70, he was buying it at a 70%

Starting point is 00:17:16 discount. Now think if you're holding that land on your balance sheet and it's being appraised at 80 grand per plot, and then it's being appraised two years later at 25 grand a plot, you're going to have to write down the inventory value, which it's really going to hurt your gap earnings and obviously probably worth less than what you paid for, I'm guessing. So yeah, it can be very difficult to have that land on the balance sheet, which that's why that land option model can be really attractive is if worst case scenario, something like that happens, you forfeit the deposit, but you don't end up holding the rest of the land on the balance sheet. Now that's kind of worst case scenario, GFC, I would say. But there can be, like Brett said, micro instances of this

Starting point is 00:18:04 where maybe something really bad happens in the area or so there's something, some bad development that happens really close to it that really marks down the land value. So there are instances like that. Yeah. And if you have a balance sheet like that, that's e-liquid and you're trying to finance yourself with debt right like if you get run into trouble your cash flow stuff is could be a concern as we'll talk about with dream finders homes they did finance a lot of their growth through debt and it would be i would say much more risky if they weren't doing this option strategy because it gives them much more much cash excuse me much more predictive cash flow of course they're going to get hurt if the housing market turns you know into a big down cycle but there'll be a little

Starting point is 00:18:58 weather that hopefully given this model much better than everyone else anything else on land options yeah that you want to hit on yeah one more thing so my first thought here was okay this seems like a superior strategy why doesn't the whole industry just do this And so I think I've kind of got that question answered, but I'm not, this might not be 100% accurate. If you're in the industry, please feel free to reach out and let me know if I'm getting anything wrong here. But for one, you have to have a partner that's willing to hold the land. And I don't know if that's really that easy to find. So that's a big one. But then the other one here that I've heard people talk about is that some management teams just prefer to buy

Starting point is 00:19:44 the land outright. Maybe they think they can identify better land plots, better than competitors. Maybe they think they have a strategy that they can develop the land itself, the raw land, say there's trees on it, whatever. They can get it ready to put houses on it at a better cost than other people. So sometimes it can be cheaper to buy the land outright as opposed to the option model. So not everyone does it. And I think management teams know that there's some risk there, but some management teams are just willing to take the risk. So you really have to look at, if you're looking at a home builder, they'll say it in the 10K, most of them, whether they buy the land outright or they use a land option model, it's important to pay attention to that figure.

Starting point is 00:20:35 Okay. Now let's move on to competitive positioning. This is an important one for us. It's an important one for a lot of investors. And I think when first looking at home builders, a lot of people, myself included, would say, you just look at two housing developments and you go, this looks the exact same. Why can't anyone do this? A lot of people actually can do it where there's a lot of small players out there still since it's such a large industry. But you look at some of the stock returns, I see NBR as the classic example, Hunter Beggar over about 25 years, maybe a little longer. But generally that timeframe, really strong performer. And if it was truly commoditized, I would think that the returns

Starting point is 00:21:21 would be more like what an energy mining, whatever, really, really tough. It'd be hyper competitive, terrible margins, really low returns on invested capital and return on equity, which is Probably, you know, fairly important for this industry, although I'd say that can be some companies like DFH or DreamFinders Homes brag about that. And I kind of go, I don't know if, you know, you can manipulate return on equity, but that's a conversation for another day. To get back to the companies, why are some of these companies, do they have competitive advantages? Why are the bigger ones more attractive in your opinion? Yeah. Like you said, you see two similar developments. You think, how could there really be that much competitive advantages? How could there be this huge discrepancy in cost? But this really is an underappreciated aspect of the home building industry, and it's one that I couldn't appreciate for a long time. But when you are one of the largest players, and for reference, the largest home builders in the United States are D.R. Horton, Lenar, NVR, Pulte Group, and I think Toll Brothers is up there as well.

Starting point is 00:22:32 You have a real advantage in your costs versus the little guys. So I'll go through a couple. Number one, you can buy land cheaper and better. And it kind of sounds funny, but you can buy bigger plots. So you're probably getting, if you're taking a huge chunk of land off of whoever the owner is, you're probably going to get a per plot value that's cheaper than taking just one of the plots or whatever. So you're getting cheaper plots than other people because you can afford that. But you're also more likely to have the land bank partners that are willing to option you the land.

Starting point is 00:23:09 So it's a little bit less risky. Like I said, you're getting better, cheaper land. That's one competitive advantage. Second one, you get better rates from subcontractors. So this is one that I didn't appreciate either. If you think about it from the subcontractor's point of view, when you have a company like a D.R. Horton where they bought up these – or let's say they optioned this land and it's being owned by some land bank and it's got 40 houses in this development and a lot of them are the same sort of blueprint. You can go in from house to house to house with little to no downtime, especially if you're like a specialized subcontractor. You just have to do one thing on the house, whatever. You can go in little to no downtime. Same with your workers. You're not wasting a whole bunch of time. You take all your materials to the same place. You're not going from built, like driving from place to place and wasting all this time. So it's way more efficient for the subcontractors. You're probably

Starting point is 00:24:11 going to get a better rate from them. Third one here, your materials are cheaper per unit. So Ed Wachenheim, he did this interview recently on DR Horton and used this example. He said, Horton buys its appliances from Whirlpool. They are now buying 90,000 dishwashers a year. They used to buy 30 or 40,000. They are getting a better price. Chances are, if you're Whirlpool and you're getting 40, 90,000 dishwashers order, you're probably going to give a better rate on those dishwashers than on a per dishwasher basis than whatever the smaller mom and pop player that's trying to build a house themselves. So there's those structural cost advantages and those, you can see them in the gross margins. DR Horton, Lenar, these guys have higher gross margins than

Starting point is 00:24:59 the smaller private companies. Then there's also the generic scale advantages. So think about anytime a company gets larger, if you've ever been a part of a company that grows, you can spend more on marketing. You have cheaper access to capital probably as a public company. You have just more resources, more employees to cover more ground. There are some inherent scale advantages. Before we move on, we want to talk about our friends at FinChat.io. FinChat.io is the complete stock research platform for fundamental investors. Beyond having all the standard financial data for companies around the globe, they also have company-specific segments and KPIs on over 1500 stocks. So if you want to see Amazon's AWS revenue over the last 10 years,

Starting point is 00:25:44 or you want to track match groups paying users, maybe you're curious how many stores Sprouts Farmer's Market added last quarter. FinChat tracks all those KPIs and literally half a million more. We know that if you're a fundamental investor, you probably track this stuff yourself, but this saves so much time and it has all the data you already need. If you aren't sure where to go. You can also simply ask FinChat. That is their conversational AI powered by FinChat's proprietary data. So that'll save you tons and tons of time researching. They've got stock screening tool. They've got fundamental charting that is best in class in terms of design. I use FinChat every day. I absolutely love the platform. Brett does as well. We both use it as our primary

Starting point is 00:26:29 dashboard and the place where we do all our research. So if you want to get 25% off any paid plan, use our link finchat.io slash chitchat. That is finchat.io slash chitchat. The link will also be in our show notes. Now, one thing people bring up is the local scale advantages. So how important do you think it is when analyzing one of these home builders to look at not just how big they are nationally or even if they're in international markets i'm not sure if any of them are um or versus looking at say how big they are in minnesota yeah the concentration is important so what like it's not to say you don't want to be in a lot of markets but the markets that you are in, you don't want – it's much better to have one development with 10 homes than 10 developments

Starting point is 00:27:30 with one home. You know what I mean? Because you're going to get much better rates from all the subcontractors. So there's some important – it is important to have concentration in certain markets. Now, you look at a company like D.R. Horton, they have 118 markets in 33 states. but the volume more so comes from specific markets so they still have those scale advantages but they just have them in a number of different markets as well same with the dream finders homes this is actually kind of an area where they're lacking a bit is they've tried to expand into new markets those new markets aren't going to be nearly as profitable as jacksonville is for dream finders so you know they launched into denver denver's not operating at the same profitability or same

Starting point is 00:28:17 margin as Jacksonville. So, yeah, concentration is a big thing. Establishing relationships and building rapport with subcontractors and material providers in the area is also a big aspect as well. Okay. And

Starting point is 00:28:33 maybe I'll say follow-ups and devil's advocates and push back until the end. Let's actually go through the businesses first. First one, yeah, Okay. Well, I guess you can say what ones you own, but NVR is the first one on your list here.

Starting point is 00:28:55 Thoughts on them? What are some interesting things you've noticed when researching them? I don't own NVR. This is the one I don't own. We're going to talk about the other two here in a second, but I might at some point, who knows? This is the best run home builder over the last three decades, I'd argue. Maybe some people would argue, some others as well, but they have just been the top. It seems like they are the home builder that every other home builder is chasing. They really pioneered, from what I can tell, the land option model. They are a home builder really in the DC metro area and they have pretty big concentration there. They've got other markets as well, but the DC Metro is where they have the most home closings. And to give some

Starting point is 00:29:44 context or a little bit of background here, they actually went bankrupt in 1993. And the CEO at the time, it must've been quite the eye-opening event for him because he came out of this and said, I'm doing the land option model. I'm not keeping any debt, or I'm going to try to get my debt down as quickly as I can and try to be as asset light as possible. And that's really what they did and it worked out really well for them. Keep in mind, it wasn't like this was some tiny home builder. They were already one of the biggest, if not the biggest home builder in the DC metro area. So they did have those local economies of scale. And they're a good example of how concentration in that individual market can really help. I talked a little bit about it,

Starting point is 00:30:28 how they have those manufacturing advantages. They build the trusses themselves. They do some the millwork, the prefabricated walls, stuff like that. So they have the highest inventory turns as well in the industry. And it's not particularly close there. I think they're at like three and a half times, three times. And the next closest that I saw was DFH, who also runs a pure asset light model. But DR Horton, we'll talk about them in a little bit. They do a mix of kind of asset light, raw land purchases, NVR, pure asset light.

Starting point is 00:31:03 And because of that, because of the high inventory turns and the land option model, they generate significantly higher returns on equity compared to their peers. So if you just do a comp and you look at, I use FinChat for this, and you can just look up home builders and you can pick each one. You can say return on equity and you can see what it's like over the last 10 years. NVR is significantly higher pretty much every year for the last, what is that, since 2009. So coming out of the GFC, and they were the only public home builder that remained profitable throughout the entire great financial crisis. So they really have done an exceptional job. Their 10-year earnings per share CAGR is 25%, but they have a slightly more premium valuation relative to some of the other home builders, I believe the EV to EBIT or the enterprise value

Starting point is 00:31:59 to earnings before interest and taxes is 12 times. So that is, we're going to talk about it here in a second, slightly higher than some of the other home builders. They've earned the premium. And frankly, if they can continue to grow earnings per share at 25%, that's going to be a hell of an investment. It's going to work out great, I would imagine. But yeah, they've done a tremendous job, the only thing here and the only reason I don't own it is the cat's out of the bag. I mean, everyone knows this is a business that generates high returns on equity and it's very resilient. It's survived the GFC and generated profits all the way through it.

Starting point is 00:32:37 So investors have rightfully rewarded them with a premium multiple. Okay. So yeah, it's more of you think they're efficiently priced. Maybe. compared to 15 20 years ago yeah i guess we look at the rest of these and kind of compare them but i think there would be a lot of pushback of saying at least from investors hey this one's been a hundred bagger it's trading at a reasonable valuation some people get into trouble going after the second best maybe player and not going for the winning you know the winning the company that's

Starting point is 00:33:19 you know, considered the number one in the industry and has been for two decades. Yeah, I mean, it's true. They will probably still continue to do well. I've just, of the home builders I'm looking at, I mean, D.R. Horton is not necessarily, over the last decade, D.R. Horton might be the better business. It's grown its earnings per share at a quicker rate. And part of the thing here is that, you know, buybacks come into the equation. NVR, when it's trading at a steeper multiple, it just can't reduce share count. Even though it wants to, it just can't reduce share count quite as quickly. So no fault of their own. And maybe they can, and EBITDA EBITDA 12 times, but investors have rewarded them, rightfully so, a better multiple.

Starting point is 00:34:03 The other thing is I don't love the DC metro area in terms of... I mean, I guess I haven't looked at that closely. And to make some prediction on what population trends are going to look like is probably the wrong thing to do. But some of the markets that DreamFinders Homes is in have better net positive migration trends. So more people are flooding to those cities than the DC metro area. So that's the only thing that's kind of keeping me. Sunbelt, Texas, Florida, Colorado. But there can be some misleading things where like, okay, if DC metro area grows 1%, that could be a lot more home sales than if Jacksonville grows 3% or whatever,

Starting point is 00:34:44 because nominal matters a lot more than the percentages. Okay. Let's move on to the second one. D.R. Horton. What interests you about this one? A lot. So I really like this one. This is one that I own, full disclosure. They are the largest home builder in the US by volume. Last year, they closed 85,000 homes and they sell primarily entry-level homes. So 70% of their homes are below $400,000. I mentioned it earlier, they sell in 33 different states, but 50% of their volume comes from the South Central and Southeastern markets. So basically anywhere from Texas to Florida. But make no mistake, this is a national home builder. So anything that affects really the nation at large will

Starting point is 00:35:36 probably affect DR Horton. This is one of the businesses in the industry that seems to have undergone the most change over the last decade. So I'm sharing this chart in our document. And if you want to see that, we post them to Substack and you can feel free to look at that afterward, but it's a lots option versus lots owned chart. And Brett, maybe I can find a way to pull that up and share my screen here. I can do that. Okay. It's on FinChat. And I really, actually, I just basically asked the data team to put this in so that I could put this chart on our file here. But really, they have moved from a predominantly land heavy model to this newer asset light model and also really optimize their inventory turns in the meantime as well. So Brett's sharing

Starting point is 00:36:30 the chart now. You can see in September of 2012, lots owned was, it looks like two-thirds of the total lots controlled versus one-third for lot options. Today, it's more than 75% of the lots that they control are lots option versus lots owned. So they've made this entire shift to the asset light model. And there's always going to be probably some level that they choose to own instead of option because maybe the situation calls for it. For example, I know they buy, they'll sometimes buy up smaller home builders just because they can get the land at a discount that way. So they'll do that. But it's really helped them improve their, between the inventory, higher inventory turns and the asset light model, they've really improved their returns on equity

Starting point is 00:37:20 over the last decade. So over the last five years, DR Horton has averaged a 27% return on equity. That's starting to close the gap there with NVR. And Brett mentioned this, some companies can certainly massage or find ways to juice that return on equity at the risk of other elements of their business. Because basically you can take on more debt and you can juice the returns on equity. That's not what's happening here. The net debt to EBITDA for BR Horton has declined from 3.3 times in 2014 to 0.4 times. So to kind of summarize here, business model shift has made them more asset light. They have those competitive advantages that I talked about earlier where they get better rates. They have significantly higher margins than the smaller players because

Starting point is 00:38:11 they have inherent cost advantages. They are turning a lot of that income into true cash flow and they've de-levered in the process. So lots to like and the cash flow they can plow into buybacks, which is what they've been doing. So over the last couple of years, they've accelerated the buyback program a bit, reducing share count by about 3% a year. And for them, it's a choice, Do you want to put that money into new land options or would you rather buy back shares? Now, the management team here has decided that they're going to err on the side of caution and continue to put money into the new land options and also deleverage. But Ed Wachenheim, who I think is on the board of D.R. Horton, said he's been imploring – I could be wrong by that, so don't quote me on that – he's been imploring the management team to start buying back more shares. So maybe him being vocal about it will help them start to juice that buyback program.

Starting point is 00:39:10 But the point is, there's room for them to buy back a lot of stock now that the cash flow is legit. If we look at the last 10 years, their earnings per share has grown at 27% annually. That's slightly higher than NVR's. And their EV to EBIT is nine times. And they don't have, they're not really that levered. So EBIT's not the worst proxy in the world for cash flow. I think there's just a lot to like here. It's durable, very little innovation risk, and the business model is very different than it was during the GFC. So I think if we had a downturn, it's a business that would still be profitable. Going on vacation? We're here for it. With kids who turn the backseat into a courtroom drama over whose tablet is louder,

Starting point is 00:39:57 whose charger is faster and why watching the same cartoon for the hundredth time is a human right? Yep, we totally have vehicles to handle that because whether it's a road trip or a business trip where your flight's delayed, your phone's at 2% and your dinner is whatever is open, yep, here for that too. Enterprise, we're here for it.

Starting point is 00:40:18 Right, that is interesting to see that the balance sheet's much more cleaner and they're getting that cash flow conversion. So, you know, the various scenarios that we could go through, one, if we go through a tough downturn in the housing market, they should be more resilient, as you just mentioned. But second, if things keep going as we are, they can start reducing share count or pay out a dividend or whatever the combination is at a higher rate per year instead of 3%, maybe bump it up to 6%, 7%. And that could really help with returns going forward. okay last one this is a smaller one just went public two years ago i believe or maybe it's three now and it's called dream finders homes uh ticker is dfh i know nvr's ticker is nvr dr horton i believe is drh but let me confirm that dhi for anyone that wants to look these up but yeah dream finders home uh as you already said is one of the ones you do own and why is that Yeah, to put some context behind its size, this is 7,000 home closings, a little over 7,000 home closings last year versus D.R. Horton, which delivered almost 90,000 last year.

Starting point is 00:41:35 So it is much smaller. They've got about a $4.5 billion enterprise value. And I think it's the smallest one I've looked at in the home building space so far. And like DR Horton, they sell primarily entry-level homes. So, well, entry-level and first-time move up. So the average selling prices are a little lower and they operate in the Southeast and the East. And I've got a map here, kind of a heat map in terms of where their markets are, but it's really kind of throughout the Carolinas, Florida, and then they have a market in Denver and they've moved to Texas as well. So they're a little more spread out than a company like NVR, which has these huge scale advantages because of their concentration. So DreamFinders Homes does not generate the same sort of operating margins that DR Horton and NVR does. However, Brett's sharing a chart here. They have grown at a breakneck pace. So in 2008, I mentioned that Patrick Celebski bought three plots of land last year. So 15 years later, they're doing 7,000 home closings a year, a little over. So they've actually grown home closings at more than a 60% CAGR over the last, what is it, 15 years. So really, really,

Starting point is 00:42:55 accelerated the growth, especially in their Jacksonville market, but they've expanded into other markets as well. And they actually are one of the few I've noticed that make big acquisitions. And the reason for that, I think, is I think, and Patrick Celepki has been fairly straightforward about this. It's hard to move into a new market organically. Like if you move to Denver and you're just dream finders homes, but you're moving to Denver. No one's heard of your name. You have to find those relationships. You have to find the partners. It's not easy to do. Whereas if you buy a home builder in that space, you help them shift to an asset light model, or maybe they're already employing the asset light model and you have cheaper access to capital. You can kind of

Starting point is 00:43:43 buy those existing relationships, buy the land that they might already have and kind of super charged to growth that way. So that's been a little bit of the model for them. And I mentioned that Patrick Zalepsky has got kind of that unique founding story. And I told you how he bought the land at 70% discount to what it was trading for pre-GFC. But there's this interesting tidbit, which is that Zalepsky literally did not have enough money to buy the land outright and just develop the homes and then try to sell it. So he had to basically create this agreement with the landowner at the time that said, I'll give you some of the money now, but I'll buy the rest of it once I've actually sold the home. And that was the beginning of the asset light model.

Starting point is 00:44:31 Since that time, there's actually kind of this unique story where it's him. It was him and a partner and he really loved the model. It was working really well. And there was like this program in Jacksonville for the affordable housing that was a place where they could deploy a lot of capital. But the co-founder was starting to get a little wary about how fast they were growing. So he, I believe, sold the stake to Zalewski. Zalewski now owns 65% of the shares outstanding. But the question I guess to ask here is how has DreamFinders Homes grown so quickly? And part of that is buying those other home builders, which I talked about. But the other part is that they've chosen to. It is a bit of a choice, right? So

Starting point is 00:45:14 they are willing to invest most of their cash flow into new land options instead of buying back shares or doing whatever with it. And taking on debt. And taking on debt to do so as well. So they've been a little riskier in their growth strategy, and they've moved into less established markets like what they're doing with Denver. So So they still generate pretty strong returns on equity, north of 30%. But like Brett just mentioned, they've taken on some debt to do it. They currently have net debt to EBITDA ratio of a little under one times. So it's higher than DR Horton, but it's still not bad.

Starting point is 00:45:55 It's manageable. The only thing I'm worried about is I think it might be through a revolving agreement, which means it could be variable rate, which don't love that. But if things work out, if they believe, or if I'm right, that they can consistently generate good returns on capital that they put into new land options and new homes, it's going to pay off big time because they trade at an EV to EBIT of 10 times. And it's a much smaller business today. and they are growing their home closings at double digit percentage each year. It's been 60% over the last 15, but that's not going to continue. Obviously, it's going to slow down.

Starting point is 00:46:43 So basically, you've got an EV to EBIT of 10 times on a business that could grow considerably quicker than some of these more mature home builders. They're just taking on a little more risk to do so. And there are some red flags with the business, not huge red flags, but some that you don't find with the big home builders like dr horton and nvr what what are those well the leverage is one um like the revolving facility that's you don't really see that with dr horton you could get into trouble if they go through a real real rough patch yeah the other one is they there's been i i don't know how much to chalk this up to just like chat forums always being complainers or legitimate concerns but there's been some complaints about the quality

Starting point is 00:47:39 of the builds so people have said like you know you could look up like home builders bad houses or whatever on google and you'll probably find tons of complaints about people like never buy a home from dfh because they had some problem with the frame or whatever so them trying to grow at a breakneck pace and trying to turn inventory as quick as they can and generate those high roes if they compromise their brand in the process and i imagine if i'm buying a home it's not like you're not buying a candy bar right you're gonna look who's building your home Um, so you're going to probably take a good look and examine online, you know, what's a dream finder's home, like, you know, try to look up some reviews that could really

Starting point is 00:48:27 damage their brand in the long run. So that's a bit of a risk for me is basically, are they trying to cut corners? And then the other risk, and we can talk about this, is that yes, they survived and everyone survived. It seems like a three to 8% mortgage jump. However, when mortgages jumped from 3% to 8%, everyone that had a home wasn't looking to move. So existing home inventory shrank as well, right? All the demand that was left, most of it had to go to those new homes because no one was exiting their existing home.

Starting point is 00:49:03 So home builders were in a good position. If rates drop now, I wonder how much homes will come online and how much that will affect home builders. Right. And you see some of the repricing in the rental markets where it's gotten much more aggressive. Prices have come down a little bit in a lot of areas for monthly rentals, like an apartment building. And they're giving out tons of promotions, like one month, two month free. So I could totally see that as well being a risk. The thing is, and yeah, I guess to close on that the story probably isn't entirely over on whether you know how the mortgage rates going from three to six percent seven percent you know basically a double how that's going to affect

Starting point is 00:49:54 stuff over the long term over say you know it's been about a year or two um yeah maybe closer to two years now with rates rising this much um for a business cycle that's not that long and we could see some more impact over the next three to five years but as you mentioned i would i don't think with these three companies maybe with dream finders homes if they get into real trouble and they they seem to have much more execution risk because they're kind of being more aggressive with growth. So if they really screw things up and the market goes into a downturn, they could run into some issues, especially with that debt. But compared to these other home builders, it seems like if there's a downturn, yeah, some of these companies,

Starting point is 00:50:45 you know, MVR, DR Horton, and DFH are going to have earnings probably not grow for a little bit, but it's not like they have an existential risk, given that they can just slow down. They might be a little bit less profitable, but they can work through any downturn. And I think maybe the bigger question is the long-term demand for new homes. And I guess, how do you think about it all? Is that a big part of the thesis? Stuff like migration patterns within the U.S., immigration from outside of the U.S. into the United States, as we've seen. You know, it's probably the biggest political football of, you know, maybe not just football, but the biggest political issue at the moment, although it does kind of pop up every few years of, you know, a large number of people coming into the United States.

Starting point is 00:51:38 That's obviously going to help homebuilders over the long run, at least. And then also the demographic stuff. So I know I saw a good chart from DFH, and I'm sure you've seen that we're in peak millennial family formation, which means home formation. Do you see that as a potential or a little bit of a risk? Because I feel like when I look at that chart, you go, okay, well, in three to four years, there could be a little bit of a vacuum there. So I'm curious if that's a big part of the thesis here, or given that those are kind of on the edge, do you think these home builders will be fine? They don't have to grow to succeed? well they don't have to grow for this to be an okay investment like i mean nvr let me check on

Starting point is 00:52:25 finch out right now yeah the eps so the earnings per share estimates it's not expected to grow for the next three years on according to consensus estimates it's still going to be fine they can buy back plenty of stock if that's what they do. Same for the other guys as well. In fact, they could probably buy back more assuming that they continue to earn similar amounts of cash flow to the last couple of years. I don't really concern myself too much with the big overall migration trends. It seems like we're pretty underbuilt right now and that seems to have kind of shown itself over the last couple of years and still seeing strong demand despite the percentage of one's paycheck needed to go to a mortgage today is like 50% versus 25%

Starting point is 00:53:19 two years ago. And the fact that there's still that much demand for entry-level homes is pretty remarkable. I think that's a testament to both the local places that they're in, but also the fact that there isn't that many options and people constantly want to buy homes. And so unless the u.s's population fell off a cliff and the population of jacksonville and stuff like that fell off a cliff i think household formation is going to be probably pretty consistent i i wouldn't expect a huge change there and i don't really consider i don't think about it that much yeah it seems hard to predict because some of it's what kind of the government decides right some of it is just shifting it would be almost like reading the tea leaves to try to

Starting point is 00:54:05 predict whether people are going to move from you know in the last few years they moved from california to texas that's the big example just because those are two of the biggest states but from other areas as well like if someone has okay are going to people going to be moving more to california or texas in five or ten years i would have no clue because it kind of shifts randomly i guess a lot of the data is the biggest sales pitch right now but it might you know like what it's hard to repeat that i say like for some of these companies it's helpful for them right now if they're in these areas but betting on that being your whole thesis is probably at the edges and maybe smaller than people think i would guess most cities the big cities kind of continue to

Starting point is 00:54:50 grow especially the urban areas around it the and you think about like a market like california what's the best sales pitch for california oh people are leaving oh finally all right that's good it's like disneyland it's like the lines are shorter at disneyland oh okay time to go so it i don't know it i think people concern themselves too much with the population trends here i'm going to summarize it like this because i saw this was the opening line from a value investors club write up for dr horton so and i think it summarizes the entire opportunity pretty well it says in today's market it seems that companies with above average growth high returns on equity and good balance sheets come with expected the expected burden of very rich price

Starting point is 00:55:33 to earnings multiples one industry presents the combination of 20 to 30 returns on equity net cash balance sheets double digit earnings per share growth and little threat from technological disruption or aggressive chinese competition and that said industry is trading at 10 times earnings i think that's enough for me to be convinced honestly that companies like dr horton are going to be just fine probably nvr as well so i like um the only thing with dream finders homes is a little smaller for me just because there's a little more higher risk higher upside here because they've got some more debt on them than some of the other companies But like D.R. Horton, it's mostly asset light at this point. So even if the population trends or the demand trends turn down, it's not like this is becoming a zero. They're going to be just fine. And they've got cash to weather the storm.

Starting point is 00:56:28 Okay, let's close things out. Final question. What are you looking for as reasons to sell? i am a never sell guy now i think is the camp i'm in the i make that like half jokingly if if i saw that you wouldn't buy any more what what would cause you to not buy any more obviously valuation could you know it could go up 4x but what will cause you to be okay i got it depends on which company yeah it depends on which company so for dfh i've noticed a couple of yellow flags just around like business practices and if i got started to get the sense that they were like scamming in any way like any any more yellow flags i think i'd put breaks on buying shares. The other part is if that interest expense starts to really creep up

Starting point is 00:57:32 as a percentage of their revenue, I would get concerned because that's always risky. The idea here is that these are asset-less levered companies, so hopefully they're not quite as at risk. For DR Horton, I don't really know what would scare me off. I mean, If I started to see a couple of years where EPS was just going nowhere, I guess it kind of depends with what the stock does, but I would maybe buy a little more as long as I think the business is still intact because I think long-term, they're all well-positioned. They have the competitive advantages. Like if housing – the one good thing about having a competitively advantaged business is that if the industry struggles, they are not hurt as much as the little guy and they'll probably still share. So in D.R. Horton's case, they would be in a much better position than a lot of their competitors and I imagine they would be able to build even more homes coming out of it. So I'm not exactly sure what would cause me to sell DR Horton yet.

Starting point is 00:58:40 If they really just didn't buy back any stock, I'd be kind of bummed. It would probably stop me from buying a whole lot more, but that doesn't seem to be the direction they're heading. All right. And big news. Ryan's officially a never sell guy. Is this, is this the kind of a pop everyone, right? No, I'm just kidding.

Starting point is 00:58:58 It could be. It could be for sure. I don't think the toppy never-sell people are buying boring old home builders. I think it's more – I just care a little less than when we're managing other people's money. I'm not looking at it on a daily basis. I'm not – And you have the cash flow coming in. Yeah.

Starting point is 00:59:22 To me, it just feels like the never-sell approach works better in that kind of scenario. Would you buy any of these? I think so. The one thing that keeps me... One thing I prioritize a lot is cash flow conversion and having really good working capital advantages. and even though comparatively dr horton dfh and vr have better cash flow conversion than their competitors it's not supreme in you know the general sense versus any other businesses so i kind of prioritize that and asset light you know like you mentioned they're more asset light but not too like in general they're not that s light so i think that keeps me out a bit but valuations are still reasonable yeah and dfh is not their cash flow conversions worse just

Starting point is 01:00:21 because of how much they're reinvesting into land options right right right if you believe that they're able to sell those homes the same way they have in the past it should be worth the money but yeah it's like yeah and we are i mean they have 100 free cash flow conversion so yeah so they're a little little software business wrapped as a home builder yeah that's what everyone says they always say this is like a software business but i think people i think software just isn't as good of a business as everyone thinks you know where they're like this is such a good business it's like a software business and i'll push back on that 10th time we said that and say

Starting point is 01:00:59 software businesses inherently are great but but some some other ones are good too they're poorly most of them are poorly run that's fair because I mean it's just yeah

Starting point is 01:01:15 as long as the product's good hey that's just pure mark like pure profit and they can have better they can have better than 100% cash flow conversion which is quite advantageous but i'd say in general i i could see myself owning these i like all three of these

Starting point is 01:01:36 but you just like buying the dip on things man no i yeah it's not down i try to i try to work through that that is something that yeah it's not a dating conglomerate so you can't buy it uh i mean there's i think they'll do fine over the long term i don't know it's you know you can't buy everything it's a little boring so i hope this show did not bore people so much that they wouldn't buy it or maybe you know what maybe that's better for me the yeah you don't want anyone to buy these i mean 27 earnings per share kegger over the last 10 years for dr horton

Starting point is 01:02:25 if that's boring yeah i'll take boring all day the comp the comp is decent versus i mean it's not exactly the low of the gfc but it's coming out of the great financial crisis so 2014 is not that bad yeah but uh yeah i mean they seem to be well run um yeah i wouldn't be surprised they outperform especially well i guess i always think in the lens of outperforming the market but in reality that's not what actually matters because you don't take home out performance but i i could see them doing very very solid absolute returns but given the market is trading at 28 times earnings um saying that as you know s&p i mean these seem very attractively priced compared to that wouldn't be stressed um yeah all right well i think that's all i got what's our what's

Starting point is 01:03:20 our next stock that we're going to be covering at um i guess on your radar yeah from us i have and people are going to be surprised because they probably heard this name but it's actually not their business model anymore it is gogo uh aviation which it's not entertainment yeah they used to own that uh but they don't anymore it's actually a much more interesting model and there's a big narrative out there that starlink is going to crush them along with the starlink adjacent companies but i've been doing some research i don't know if i've come to a conclusion yet on whether starlink is not going to crush them but there seems to be some misleading information and I think they might be trading at, you know, five, six, seven times earnings a few

Starting point is 01:04:05 years out. So a new Brett value pitch. All right. Yeah. Could be that. Could be that. Yeah. We'll have to find a good way to tease a niche internet play as the title. But let me hit the disclosure before we get out of here. We are not financial advisors. Anything we say on the show is not formal advice or recommendation. Ryan, I, or any podcast guests we have may hold securities discussed in this podcast. I may have held them in the past. I may buy, sell, or hold them in the future. Thank you everyone for listening, and we'll see you next time.

Chit Chat Stocks - 2 Stocks I Bought Last Month: Homebuilder Sector Analysis (DFH, NVR, DHI)

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