Chit Chat Stocks - Dream Finders Homes (Ticker: DFH) Not So Deep Dive

Episode Date: October 18, 2022

DFH is a fast-growing home builder in the United States. The company designs, constructs, and sells single-family houses for for entry-level and move-up homes. At the end of the month, we will publish an Arch Capital episode (only available to CCM+ subscribers) that will cover the company: Consorcio ARA. Listen closely as Brad, Brett, and Ryan go through the history, financials, and future prospects of DFH. Enjoy the show! Is this episode locked? Access our “Not So Deep Dive” episodes by signing up for CCM+. Sign-up directly through Spotify or Apple Podcasts. If you listen on another podcast player, use this link and create a private RSS feed: https://anchor.fm/chitchatmoney/subscribe Need more information? Check-out our launch newsletter: https://chitchatmoney.substack.com/p/welcome-to-chit-chat-money-plus  Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (1:31) Industry | (10:22) Management & Ownership | (12:23) Earnings | (17:29) Balance Sheet | (21:07) Valuation | (26:50) Our Analysis | (27:41) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not So Deep Dive episode on Chit Chat Money. This show is only available to CCM Plus subscribers. So if you're listening to this, thank you for subscribing as

we continue our housing theme. And we're talking DFH, which is DreamFinders Homes. We're going to be i guess shortening that to dfh throughout the episode because the name is a bit strange but they're a small cap home builder really aggressive strategy and have grown phenomenally over the years uh but i'll let ryan introduce that but first just a quick side note if you are listening to this and you're not receiving our emails uh with the show notes and the charts that go along with each episode email us at chitchatmoneypodcast at gmail.com i know we got a few and if for some reason we didn't respond or you're still not getting them, just double email us, triple email us, and we will sign you up. So chitchatmoneypodcast.gmail.com. The spelling is in the

show notes. All right, Ryan, introduce DFH. Yeah. DFH employs basically a similar model to NVR. So if you are a new listener or you haven't listened to that NVR episode, I recommend that as well. We kind of go through the model, but basically when I say they employ a similar model, it's just that capital light financing strategy. And I'll talk a little bit about what that is, but basically DFH is just a really fast growing home builder that operates in six markets currently. So it's Jacksonville, Orlando, DC, Colorado, Texas, and the Carolinas. So a bit of more diverse markets as opposed to NVR. NVR was pretty much located primarily on the East Coast. This kind of spans different areas of the US. But that asset light land financing strategy

is basically, for those that haven't listened to it, haven't listened to the NVR episode, instead of buying the land outright and holding it on their balance sheet while they develop it and then sell it to prospective buyers. DFH enters into finished lot option contracts or land bank option contracts where they put down up to 10% or 15% of the estimated value upfront, but they can cancel the purchase at the end if needed

and they'll forfeit that deposit. So they're not buying it outright. They're buying the option to buy it later and they're paying 10 to 15% of the estimated value as a deposit on that. But anyway, during the time that the land is being developed, DFH is marketing and selling the prospective homes, typically to either entry-level or first-time move-up buyers.

Those are sort of the target customers for them. Their average selling price was, I believe, $463,000 this quarter. So slightly more expensive homes than when we looked at NVR, but still it's sort of that entry-level homes. And then they allow each buyer to kind of add some customization to their home, which they then pass along to their construction design team to initiate the building process. So once that lot is finished, the construction design team will kind of go in, start to, I guess, they're not the ones breaking ground, but they're giving the plans to subcontractors to go out and do the building. And so that part is similar to NVR where they don't have all the equipment on their balance sheet. They don't have all the bulldozers or all the materials it requires to build a home.

Well, they do have land. They talk about the asset light. They brag about that. There's some charts that will show, and maybe this is just a one-time thing, but the asset light has been a bit asset, maybe medium, or I don't know. I look at their inventory. It seems fairly large to me, but I bet it's better if they were doing the land purchase strategy outright.

Yeah. And I'll talk about that when we get to the balance sheet. The construction in process is recorded on there as inventory, which has been growing and it's a sizable amount of their assets in total. So they do claim pretty asset-light, but there are some areas where they do hold assets on their balance sheet in the form of equipment and homes. But once the lot is finished and the customer has put the deposit down, they've got the mortgage approval, and they start to break ground, apparently DFH says that the typical construction lasts or takes 75 to 150 days. And that was for basically, I think it was like their four bedroom units, which is sort of that average size for them. Although it kind of depends if it's a luxury home or if it's a bigger home and there's a bunch of customization, sometimes it'll take longer. And I imagine that during some of the supply constraints, when they were struggling to procure a lot of the materials, that construction process took a little longer as well. The reason I say the duration of the construction is because that construction in process, like I said, is inventory on the balance sheet. So they're holding that on the balance sheet.

And the longer that it is, the longer they have to hold that. And then in addition to their core home building operations, DFH offers some ancillary products like mortgages and title insurance. So they offer mortgages through their jet home loans. It's not a subsidiary, but it's a mortgage banking joint venture. So they own 49.9% of it. i believe that allows them to keep it off yeah they love it they love the complication stuff it was like the opposite of nvr nvr was the simplest uh 10k whatever balance sheet all that stuff and dfh um they gave us a little bit of homework yeah and so they do not own the majority

of that mortgage i'm not going to call it a subsidiary but partner um however they offer mortgages on behalf of DFH. And then they also have the title insurance. That's a wholly owned subsidiary called DF Title. Basically, the goal of these services, they're small relative to the overall home building operation, but the goal is to kind of hold the hands of the buyers and make that closing process as simple as possible so that it encourages more people to buy through DFH. As for the history, kind of a fascinating story, actually. So Patrick Zalupsky, he's been around the homes business for a long time. His mother was a realtor in Jacksonville and her husband, I wasn't sure if that was his dad or not, was basically a home flipper, I guess, that he would

buy foreclosed homes and rehab them. And then so in 2005, Patrick kind of wanted to get into that business himself. So he bought his own foreclosure and began rehabbing it into what was going to be a nine unit condo, but he kind of learned to, in building that condo, he learned he does not want to be a part of, or he doesn't want to be in the condo market. He said they are the first, it was the first to go and the last to come back in sort of a recession. And he wasn't fond of that. And so he quickly realized he wanted to do single family detached homes and he was trying to get into it, but he said in the lead up to the recession, it was impossible to get any available land because the big home builders would come in

and just buy 500 lots in one gulp and basically speculate on it and then build it in the meantime because it was so easy for them to sell to those homes given some of the misleading mortgages that were offered at the time. But once the great financial crisis hit, Patrick saw a lot more opportunities.

He said there were a couple lots that were being offered for 80,000 the year before that were then being quoted to him for $20,000. So he saw the opportunity, took out a $200,000 loan from the Clay County Housing Finance Authority in 2008. And he was able to build three homes with that $200,000 loan. At the time, he was able to convince the developer to let them pay for the land after they'd sold the homes. I don't know if this was common practice at the time or maybe the land developers just didn't have a whole lot of options or a whole lot of buyers given the market environment at the time.

So either way, he was able to basically start what would eventually become his now today option model where he didn't have to pay for it until he actually sold the home. These homes in particular were low-income homes. So they had to find the right buyers, which was a little difficult, but they basically just replicated this process

a couple of times. He'd take out these loans from the Clay County Housing Authority until they became big enough in 2011 to get a real bank facility. So I think they'd sold like 27 homes doing it this way. And then they became a real company 2011, got a bank facility, were able to expand the operation. And then over the last 10 years, they basically just grown like a weed. So they've grown into new markets, both organically and through acquisitions. We'll talk about that in a little bit. Their largest acquisition was $471 million purchase of MHI.

Huge, almost a merger. Yeah, which operates in Texas. So that's kind of been the strategy. And then they went public in 2021. And part of going public, part of one of the benefits of going public was that they had a whole bunch of different revolving credit facilities under like 30 different, I guess you would call them, DFH subsidiaries. So they were able to consolidate all of that into one single unsecured credit facility. They love the credit facility.

They do. They love it. We'll get to the balance sheet later, but. It's been basically their growth strategy since the beginning, it looks like. And so they were able to make it much more seamless by going public and they've raised a lot of capital in the last year or so.

Yeah. All right. I'll hit industry and competition, very simple. So I'll keep this part short because I think the management and ownership is a lot more interesting for DFH. So they operate in the home building industry. If you listen to the NBR show,

it's the exact same market opportunity as NBR. I'll give the same fact here. iBizWorld estimates the home building industry in the United States to be $129 billion in 2022. So with about $2.67 billion in trailing 12-month sales, DFH has approximately 2% market share based on those numbers. I think that makes sense.

If you look at the largest home builders, they're about 25% market share. And you have NVR, I think was what? It's like 7% to 10%. I can't remember exactly. So DVH is smaller, but still, as they've grown really, really quickly, they are not that small anymore. Now, a couple other notes here. As we mentioned before, the industry is affected by many macroeconomic factors, including the

big three, which would be interest rates that affect mortgage rates, current supply of homes, and demographics. So how many people are looking to buy homes? Now, lastly, I'll just list off some competitors, although it's not, since at its heart, it's really a commodity industry and it's kind of, you know, what markets are you in and what landlots do you have and all that good stuff. And once you have the lot, you're going to build on it. No one can just compete for you on that.

So it's not too relevant here, but the other competitors, you know, include NBR, who has the same sort of strategy that DFH has learned a lot from. And then there is Lenar Group, DR Horton. I think those are the big three. mean there's a ton out there there's also a ton of small business uh home builders and all that good stuff and they really model themselves after nbr they talk about nvr in their shareholder letters which some people might find a little weird but um so far it's it's been yeah i would argue and maybe at the end we'll discuss whether they're actually the same as nvr um or whether

they want to be yeah or i guess this the the business model may be the same but the culture seems a little bit different and that kind of leads into the management ownership section here's some facts i think that were important so dfh was founded still run by patrick zalewski that ryan mentioned he is currently 41 years of age so quite young but still not you know a kind of tech founder young um and he has the majority ownership and voting rights of the company so he can basically run this as a dictatorship if he wants to if we look at the table i won't read off the whole table, but he has 65.5% ownership that grows to 84.7% voting power because of his class B stock. Now, other important board members that I thought were relevant include William Walton III,

which is a funny name, I thought, very East Coast. And then Radford Lovett, both of them have really, they're kind of lots of experience in the real estate industry. I think Lovett is in the tower industry, but still kind of real estate. And then they also own a sizable chunk of stock. So if you look at the board members, Lovett owns about 5.5% of the company and William Walton owns 2.7%. I thought that was nice. If we look at total board of director compensation was below $101 million in 2021 at about $734,000. So it's an immaterial part of gross profit. However, both Lovett and Walton are on the board and they are uber rich. It was a little bit disappointing not to see them waive their salaries, but it's fine. Not a big deal. Now, if we look at total

executive compensation in 2021, it was $21 million or approximately 6.7% of gross profit, kind of something to keep an eye on as that it's a sizable portion of gross profit. And if they keep up this executive comp, that's going to hurt their operating margins down the line. Now, the big thing I found when looking at the proxy statement were a few red flags. So first, and maybe we'll discuss how red these red flags are. First one are that executive bonuses are based on adjusted pre-tax income. Here's the quote.

When determining actual adjusted pre-tax income, the committee, which is the compensation committee, may decide to exclude one-time items, including merger slash acquisition costs, litigation expense, restructuring costs, and changes in accounting. This one opens it up to me to them, basically being able to always give themselves the bonuses

whenever they want to, and it incentivizes them to go after acquisitions, which may or may not be a good thing. Yeah, exactly. And then write off those expenses. Take the pre-tax income. Yeah, exactly. All right.

Second one, red flag I saw, also tied to compensation, Zalepsy essentially gifted himself, as he controls his company, $10.6 million in stock awards last year, even though he already owns over half the company. I put a question here, why does he have to be so greedy? I, when this happens, it really concerns me when someone already has kind of a founder stake in a business and is still trying to pay themselves a really, really large portion

of, of the, of say the gross profit. It's offsetting deletion just for him. Yeah. I don't mind if they are deciding to pay the other executives handsomely, but that don't have maybe ownership in the business. But for someone who already owns over 50% of this thing, it just doesn't make sense to me. it rubbed me the wrong way. And then lastly, there is DF Capital. So here's the quote,

and it's confusing. And if you're really interested in this business, I would look at it because the related party stuff here kind of threw me in a pretzel because there's a lot of ways you have to connect it. But here's the quote from the proxy. The company has a 49.9% ownership interest in DF Capital, an investment manager focused on investments in land banks and land development joint ventures to deliver finished lots to the company and other home builders for the construction of new homes. So this DF Capital is the one that is finding the land lots for DFH, and I guess among other companies.

So this wouldn't be that big of a deal, but the fund has investments from both Celebski, the COO, CFO, and board members, which feels to me a little bit, I know it's not that bad, it feels a little bit like self-dealing to me, so they can earn extra returns on lots of DFH buys from the fund. I wonder why this can't all be consolidated under DFH. If I was going to be an investor in this company, I would want to ask the management team why it has to be this way,

because it seems like it's another way, and maybe I'm reading it wrong, to enrich the board and executives. I agree. It's just a question I would have. I always get a little hesitant whenever there's a limited partnership associated with a business where- And the executives are on it. Executives are a part of it.

And I think that's probably due to Enron, but, and maybe there's situations, and maybe it helps in these situations because you can raise capital from- Exactly. They raised from the, yeah, I think, I forget what are the board members. Walton, I think owns Rockpoint,

which is a, actually, whatever. There's something that Rockpoint is a real estate investment company and they gave DF Capital $100 million. And maybe that's very helpful for the expansion strategy. I just, I would just be concerned. I have questions.

I would ask, I'd be asking management that. All right, let's move to earnings, Ryan. Yeah, so I'll talk 2021. And then basically the same way we did for NVR, I want to talk about the most recent quarter because the quarter over quarter numbers matter a lot given how much rents have changed. Yeah, mortgage, I saw a good chart,

mortgage rate velocity, the move up in rates is at the highest in history. So just the change in the market is just really rapid right now. So 2021, they had just under 5,000 unit closings. That was up 55% year over year. That generated $1.9 billion in revenue and $149 million in pre-tax income. However, most recent quarter, and a lot of these numbers are going to look great, but there's some more recent data that you want to pay attention to as well. Yeah. And then some of this is inorganic because of the MHI acquisition.

Which was a little frustrating because they didn't break out how much and they didn't state it. Yeah. Some math in the SEC filings. So revenues were $791 million for the most recent quarter. That was up 118% year over year. Gross margin, this one I think is a real figure. It's hard to like go around this, but 19.7% gross margin. that's up pretty significantly from last year. It seems like a lot of the supply chain crunches are starting to abate a little bit where I think the materials costs last year were starting to hurt them. So gross margin might've been slightly down, but just in general, 20% gross margin for a home builder, pretty solid. They had 1,649 home closings. That was up 66% year over year.

So, so growing on a year over year basis, once again, and the average sales price was $463,000. That was up 30% from last year. Now I want to go to the quarter over quarter numbers, because this gives you a better, I think it encapsulates maybe what's going on a little, a little more closely. So sales price from the first quarter to the second quarter declined 1.4%, not too bad, especially given how much rates rose during that time. Backlog of sold homes declined 3% during that time. And then net new orders from the first quarter to the second quarter declined by 41%. Now, there might be some cyclicality within the new orders. I know they talked about some seasonality in the business, but even on a year over year basis, the net new orders were down 6%. So they're clearly seeing a bit of a demand fall off. The other part that's really important, cancellation rate has jumped from 14.4% to 21%.

Yeah, but I had a good chart. I made sure to chart that going back to 2018, 2019, it was slightly above 15%. So this is even above pre-COVID. And so hopefully that gives a better picture. a good sort of sense of like what the financials look like for the business right now, they can generate, I think on a good year, I would say they're generating 10% operating margins, slightly lower. And on the last full year that looked like a good one,

they did about $2 billion. Well, here's an interesting on the operating margin. So from 2018 to 2021 operating margin went from say 4.7% to 5.9% to 7.1% to 8.3%. So I think they're getting, and we sell with NVR, it was closer to 12% or higher. So I think they're getting that economies of scale. So as they grow, hopefully there should be operating leverage here. All right. Balance sheet. This was a bit of a tough task, but I'm going to start with the liabilities. Pretty much the only and the biggest liability was DFH's revolving credit facility. So it's a pretty, I tried digging in on the 10 K and it's a little bit of a complicated

agreement. There are a bunch of different covenants and contingencies that would allow the banks to pull funding if they violate certain of the covenants and the actual rate changes frequently. It changes, changes each year, but what they base the interest rate on change can change as well yeah so it's based on libor which we don't need to get what libor is but that's kind of the rate that banks are giving out um well i don't and that's not always not i know it's well say for this say scenario it could be based on libor but it might be based on something else uh but just for reference uh the one month libor is now 3.4 percent and i think it was libor plus one percent right for them so if you kind of take that that can be a good measure

as say because you can track libel in real time so if you wanted to calculate what their interest payments might be on that construction credit facility um this could be a good estimate although it might change just because of all the complicated things that ryan was mentioning there's also yeah is i think libor plus one is what they went with but then there's also like you they could choose the lesser of the rates of a bunch of different yeah sofr plus two kind of thing and they've got a whole bunch that they could choose from effectively the interest rate As of the latest 10Q, their interest rate was 4.1%. I would expect that to jump.

As Fed, I think even simplifying it is probably as simple as you want to get it. As Fed funds rate rises, their interest rate will rise. I guess, yeah. The most important thing to understand is that this is a variable rate debt structure, and it's debt that has continued to grow. So in the last quarter, they had $875 million drawn from their revolving credit facility. The credit facility itself has commitments of up to $1.1 billion. So they can draw more from that credit facility if they'd like. And then there's something called an accordion feature, which I imagine means they have to

hit certain hurls that could expand the borrowing base up to $1.6 billion. And so I think basically it's just saying like, you know, if they get to certain, I'm assuming it's pre-tax income hurdles, you can expand the borrowing base. Yeah, the important thing to understand here is that the interest rate is going to rise on this and they use this constantly as a growth tool for themselves. And it's one that continues to grow. They've amended it once since coming public already. I wouldn't be surprised to see them maybe add another amendment to it if they, in a couple of years. So something to keep an eye on. And then the assets slash sort of, I guess, cashflow, you could say here, they only have $84 million in straight cash and cash equivalents, but they have $288 million in lot deposits, which as we know, can be called back if needed, minus you'd have to forfeit your deposit. But, or sorry, no, I thought about that wrong. Yeah, that is better.

But the inventory is what they can- It could go into essentially inventory. Yeah, yeah. So it's actually, that's probably not, I mean, but still look, the inventory stuff has been ballooning and maybe the cashflow has been hurt by that. So maybe they're about to get a ton of cashflow right now.

Yeah, management on the last quarter said that they see it as $334 million in available liquidity. They didn't exactly state how they get to that number. How expensive is that liquidity? Yeah. But just know, I guess they're borrowing pretty much all of it. And so on that last 10Q, they had $1.4 billion in inventories on the balance sheet. I believe 80% of it roughly was construction in process.

So if the business is growing, which it has been quite quickly, and I think shareholders there are expecting it to continue to do so, the construction in process, unless the construction times shrink dramatically, the construction in process is going to grow constantly. So inventories are going to look larger each year. Yeah. And there might be some, it might be inflated right now and there could be a benefit as it flows through. The supply chain stuff seems to be normalizing the United States. So we'll see if that helps it. But either way, since they're a home builder, that cashflow, even though they're in that asset light model, it's still just a downside of the business. Yeah, I guess the way I'm thinking about it is that if your construction and process is sort of the biggest asset on your balance sheet and you're growing, it's going to continue to balloon. If you stopped growing the homes that you're building, you'd kind of have this windfall of cash. Yeah, but that's not realistic. That means you're going out of business. Yeah, and then if anyone, for reference on the Substack newsletter or Drive, I'll have a chart of inventory plus lot deposits over the years.

It has grown quite quickly. I'll move to valuation. Let me just- Or you have one more thing. $256 million in operating income over the last 12 months. That's a pretty solid number. It's going to be enough to service the credit facility that they have if that is steady, if not growing. Yeah, if it ever becomes an issue.

All right. Valuation. market cap, $983 million enterprise value because of that debt is higher at $1.78 billion. So we're going to use enterprise value to gross profit, enterprise value to operating income and enterprise value to free cashflow. Although free cashflow is not helpful right now because it's negative. But if we look at enterprise value divided by gross profit, it's 3.7. And then enterprise value divided by operating income, it is 6.9. So an operating income basis is pretty cheap, but I think the market is telling you that they don't believe that that operating income is

sustainable over the next couple of years and that 2021 was inflated and then also home builders get a discount because the cash flow stuff so evita free cash flow is negative 26 and that's because the inventory right now they're actually um and we'll talk about maybe how they're trying to hide free cash flow uh expense or sorry their their cash flow statement may not i don't know you gotta look at that a little bit more closely but let's move to anecdotal evidence uh ryan what do yet well nothing with the homes but i thought it's a pretty good shareholder letter they also have the partnership with dream fiber homes thing with boston omaha which could be nice for attracting people you know you have that i mean it's just a nice little add-on that they partner

with them for yeah it was i guess it's nice to the boston omaha meeting they talked a little bit about dfh um mainly the the fiber partnership but yeah yeah on a large no i guess we should mention that Boston, Omaha owns a large chunk of it. If that matters to you, um, they had high praise for, uh, Patrick Zalupski as well. Yeah. Well, he made, he made them a lot of money. Yeah. What about anything? Uh, I mean, reading the shareholder lever. Yeah. I mean, it's clear that management has a great track record of growth. I mean, what would they say? 40% growth, something like that. I think, uh, lot growth or whatever metric they were using for the top line. However, I get a small, bad feeling in my stomach when I look at how fast they are moving and then

some of the compensation stuff. I think one word to describe my feeling on this business is aggressive. That's just the one word here. I'd say the biggest discrepancy between them and NVR is NVR's patience. The cultures could not be different, even though the business model seems

very similar. Future growth opportunities though, Ryan. Okay, so there isn't a lot talked about on this, but I went with build for rent. I mean, really the growth avenue here is that they build more homes, which is kind of too obvious. So I'm going to not use that.

These business models are so simple. Yeah. Yeah. So build for rent homes are basically the same homes DFH would be building, but designed for long-term rentals. I think there's a quote from, I believe it was the second quarter release. They said in quotes, our build for rent platform provides a consistent home deliveries pipeline, which is less susceptible to temporary changes in demand from individual home buyers. Apparently built for rent homes comprised roughly a quarter of the homes in DFH's backlog

last quarter. So I think this just gives them a little bit of optionality in case home buyer demand drops off a cliff. And they can sell to institutional buyers, maybe bigger companies that are trying to maybe own a bunch of whatever and start a community. The thing that concerns me about this is rentals are a different business. like it requires different i think systems in place like it's i don't think the transition's that easy and it seems like they're trying to do this because they're feeling demand falling off from the home buying that they need to give these buyers maybe an option before they can get financing to rent for a couple of years maybe it's easier than it sounds but i would think that

there's a whole different business that's required to manage that bill for rent platform yeah yeah exactly like we don't we have no we both have no experience with that but there is uncertainty like there's just some unknowns there all right mine is acquisitions i mean they explicitly stated this in the annual letter acquisition is going to be a part of the strategy mhi uh as ryan mentioned was 471 million dollars and that is before the contingent considerations which is the long-term paths they get on earnings and make sure to look at those on the cash flow statement because they're not they're included on the cash flow part so they can uh just they're not including the free cash flow. So whatever. But if they want to move quicker, they can find a new home builder in

a new market, maybe a smaller one. They can accelerate volume growth of say, where they wanted to enter, I don't know, Nashville. They can enter there, Nashville and the suburban areas over there. However, the only downside here is it's likely going to be fueled by debt, raising preferred stock, which we didn't even mention. We probably, if you're really interested in the company, check out that preferred stock deal, but it's not a huge part of the balance sheet, or equity raises due to how little cash they have on the balance sheet for funding these acquisitions. So they said they're going to acquire companies. And given their liquidity position, it seems like it's going to have to be done with more debt. So again, balance sheet,

very, very important here. All right, highlights and lowlights, Ryan. Highlights, I like the flexibility of the land option strategy in tough times, kind of allows them to pull back and mediate spend better than the typical home buyer. Also, I keep thinking like, how's this different than NVR? I think this strategy generally is better than most of their competition. Yeah, and the thing is that it allows them to be more aggressive,

which could be a good thing or a bad thing because it's allowed them to get more aggressive on like future lots and homes under construction and stuff like that. However, if you're too aggressive, you might be in the same position relative to your balance sheet as the traditional home builders.

Yeah, I agree. That's one of my lowlights. But other highlights, Zalopsky's basically been employing this build on leverage model since 2008. And so I think he has a good sense of how to manage it and hopefully not get ahead of himself. And then the last one is that they've just, I would think that it's really hard to grow fast in the home building business. Yeah, it's a commodity at its heart. And they've done it. Yeah.

And yes, it seems like they've taken on a little more risk to do it, but you can't really argue with the growth. Low lights, the big jump in cancellation rates is pretty concerning. They may have to forfeit a lot of those deposits if that's the case. The second one, there's a part of me that feels like Zalupsky tries to time the market. So there's this quote from, and this might not be timing as much as like just coincidence but there was a quote from the second quarter earnings release he said during the first month of the quarter the company delayed the sale of homes until later stages of the construction

cycle later in june demand tightened in response to the rapid rise in mortgage rates coupled with continued home price appreciation i'm trying to think if maybe they were like why would you delay the sales process right like hoping that rates decline yeah yeah that's yeah i agree which i guess leads to my maybe one of my other points is the land option strategy gives you flexibility to pull back in tough times unless you're levered like like crazy because then you've got to pay back your lenders and you don't have as much, you're not as inclined to exercise the right to like defer. You're not going to say, oh, don't worry. I'll wait because I don't need it right now. You're going to buy it because you have to service that debt. So you're just, you're taking

out part of the benefits of this strategy is that you basically functionally get a longer time horizon than the traditional home builders. And you're taking that away, I think by putting a whole bunch of short-term debt on you yeah it seems like the low light here is that they're kind of like saying they have this advantage like nvr but the decisions they're making might be shooting themselves in the foot and not giving them that flexibility um last one uh i just get a weird feeling when you establish a limited partnership under your umbrella it feels like i'm like a lot of it feels like money might be flowing through to executives that isn't deserved Yeah. Look, we can't go over this in the audio format. There's a ton of... Just look at the

cashflow statement and investigate that. And if it's super complicated, that's their fault. They should make it really simple. I mean, if you're establishing a limited partnership, I think you have an obligation to shareholders to explain why you're doing that in a very concise and simple to understand manner. And it has grown to a bigger size. All right. My highlights, let's see anything else that you didn't have i mean i have the moving into texas i think it was a big positive through that mhi acquisitions i mean they're in all four of the big markets there in that state and all you know the state is growing quickly um it seems to be set to have a ton of homes built over the next day i think that mhi acquisition can really be great for

unit volumes uh low lights uh we talked about management integrity already and a little bit bit risk there. We talked about using adjusted income as the incentive measure. The third one is, you know, it's just what creates true shareholder value is, you know, free cash flow available to shareholders. I think we all know that if you're listening. DFH has struggled to generate cash recently and, you know, they have some expenses hidden in the cash flow statement that might make the quote free cash flow number look high when in reality it's not available to We return to shareholders that are paying back maybe the preferred stock stuff. The contingent considerations, I'm forgetting exactly, but just there's a lot of stuff that

might be sketchy there. And lastly is the macro, or not lastly, I guess you already talked about interest rates. So maybe the last one for me, macroeconomic uncertainty. How far will housing prices drop? What will materials costs look like? We don't know how bad it will get, or even if it's going to get bad over the next few quarters. Maybe as we're recording this right now, mortgage rates are at 7%.

Maybe that's the peak. who knows, but they could go higher. It's uncertain. And it kind of shows that they're in a tough industry when the macro stuff can affect them combined with a tough, it's a tough ability to generate consistent cashflow because of the inventory. All right. Bold case for you, Ryan. Yeah. I think the bold case is pretty simple. I'm just going to kind of put some numbers on the next few years. So let's say the average selling price annually over the next three years is flat with where it's at today, $460,000. Home closings increased by 10% a year. That would be a little under 10,000 homes closed on by 2025,

so 9,300 roughly. And then operating margins remain somewhere between 9% to 10%. You've got About $430 million in operating income by 2025. I don't think you have to jump through a whole lot of hoops and hurdles to get to a pretty good return there, if that's the case. $430 million in operating income. Today's enterprise value is $1.8 billion. I think you're going to generate good returns, assuming any sort of reasonable multiple. Yeah. And if anything drops there, they could grow quicker just because historically they've grown their home closings at a faster rate.

Now, I mean, mine is just the aggressive growth strategy works wonders. you know you hit economies of scale you get 10 operating margins uh as we mentioned before that they've been growing as they've you know trying to get that operating leverage and it leads to consistent cash flow generation because of the asset light model and even though cash flow is a little bit inconsistent it's been it it's it's able to stay positive giving them that flexibility i mean at the current ev below 1.8 billion dollars and with 255 million dollars in trailing operating income if they continue to grow at a rapid rate it's it would be extreme i mean almost impossible to lose money here if they continue to grow while being profitable now let's move to bear case

ryan i mean it's pretty easy here well with with the amended credit agreement it feels like they're getting really aggressive heading right into a potential downturn yes that happens cancellations will jump if cancellations jump to say like 25 i think the math starts to break here they're gonna have to forfeit deposits margins will contract surfacing that debt's gonna get much tougher it basically becomes this total momentum reversal in the business yeah and i don't think they've really protected themselves for the downside if that's the case like that starts to happen i mean momentum we don't need a science lesson here but momentum is mass times velocity So, the difference between them and NBR is NBR's velocity is pretty slow for a reason, because they want to be cautious because they know the industry.

When you have a growing amount of mass inventory and you're moving fast, you multiply those together, it just creates a lot of risk. Let's see, anything else from my head is similar. I mean, we get margin pressure due to home price drops, I think. The strange expenses that keep showing up could be hurtful for shareholders. I don't think that's a business quality risk. It's more of a shareholder risk in relationship to executives. And I do think executives could be running this business for themselves and standing together for themselves and minority shareholders.

I think that's a fair case as well over the long term, even if the business quality stays intact. Now, again, the aggressiveness just, it worries me. I mean, here's the question I'd ask. What happens if this immature home builder with tons of debt on its balance sheet is making some sort of mistake as we head into a brutal housing downturn? You know, what if mortgage rates stay at 7% or higher for three years? We don't know.

That is a plausible scenario. I don't know what mistakes they could be making, but it scares me, especially because they started at the end of the GFC, have never faced a real housing downturn. Right. Especially not one where they have a whole bunch of leverage. Yeah. All right. More or less interested.

I think people, if you're listening, you might know the answer. I know the answer to both of us here, but Ryan. more or less i'm i'm less interested um it just feels like they're potentially ruining a good thing it's so risky if it works it's going to be great for shareholders would not be surprised this is a 10 beggar but like i would just rather have nvr yeah what's the risk reward like i think the downside here is high and i'm in the same exact boat less interested just because of that i mean could this have a 10 billion dollar market cap in five years i think i would not be i would i'd be shocked if that happened no but they got to take a lot there they have to

feels yeah it's just risk there's a lot of risk i think yeah i agree um all right that's gonna do it for this episode thank you all for listening remember we are not financial advisors anything we say on the show is not formal advice or recommendation we are general partners at arch capital and clients may hold securities discussed in this podcast we're closing up on the housing theme uh so next week we'll be doing lgi homes i believe they are a home builder let me pull up the definition traditional traditional they're traditional we're doing one that's non-traditional later but uh we'll figure it out as we go we take this week to week but we have the schedule out there if anyone's interested. All right, that's going to do it. We'll see you

guys next time.