Chit Chat Stocks - NVR (NVR) | Not So Deep Dive

Episode Date: October 4, 2022

NVR is a homebuilder in the United States. The company has two segments: Homebuilding and Mortgage Banking. The company has a unique strategy in its homebuilding process that your hosts cover in the first portion of this episode. 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 Brett and Ryan go through the history, financials, and future prospects of NVR. 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 | (2:10) Industry | (12:30) Management & Ownership | (15:27) Earnings | (20:03) Balance Sheet | (23:41) Valuation | (26:17) Our Analysis | (29:17) 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 is the episode that is only available to CCM Plus subscribers. So if you're listening, thank you for being a

paying subscriber. We really appreciate it as we start out this premium side of the podcast. And this week, we're transitioning outside of our gaming theme and into our new theme for October, which is housing. We're kicking it off with one of the best run and best returning home building stocks of all time. And that is NVR. And let me tease the rest of the schedule for the month. Next week after this, we will be doing Zillow and that'll be with Brad Freeman, stock market nerd. After that, we'll be doing DreamFinder Homes. After that, oh gosh, LGI Homes. And then after that, to conclude things, Consorcio Ara, which is a Mexican home builder um and if one note here if you are on apple podcast i know you are someone is listening

on apple podcast that is not giving us our email because i know the subscribers are slightly higher than the emails that have been given to us and if you don't care that's fine but email us at chitchatmoneypodcast at gmail.com the emails and the show notes and we will get you on the ccm plus subscriber list and get all the emails sent to your inbox which will be referencing the charts and notes we put out for that on every episode. So if you want help with that, it's a great part of the service here. And we think it's well worth it.

All right, let's get right to it. No advertisements today because it's the premium episode. Ryan, discuss what NVR is and the history of the business. NVR is one of the largest home builders in the United States on a revenue basis and probably on a unit sold basis as well.

But the stat I saw was by revenue. But the focus for them is primarily building single-family homes, townhomes, and condos on the East Coast. And they segment it into four markets. So there's the Mid-Atlantic, the Northeast, the Mideast, and the Southeast. I think it's 15 states altogether, if you include D.C. as a state, although it is not. But they do this under three different brand names. So there's Ryan Homes, Envy Homes, and Heartland Homes. and the bulk of these homes are marketed and sold to first-time buyers or first-time move-up buyers

and they're generally on the more affordable side at least that's how I would characterize it I think they would as well so the average price of NVR's new orders in 2021 was $436,000 so we're in the middle of the pack it's not like the uh which we're going to do one that's I think lga homes the the the detached homes it's not something like that they're like more you know they're nicer homes but they're not in wealthier wealthier neighborhoods yeah typically yeah i guess depends that some of theirs are some of their prices go as low as 200 000 and then uh some of them are as high as two million dollars but on average it's generally that 300 to 500 000 range and it's gone up over the last year but historically it's kind of in the high 300

thousands. But the interesting part about NVR's business model is that it doesn't operate like a typical home builder. And if you've heard of NVR before, you may know this, but I think it's a very important characteristic with the business because it's what has really driven outsized returns relative to their peers. So instead of the traditional home builder will buy a giant plot of undeveloped land. Which costs a lot of money. Costs a lot of money. They'll develop it into buildable lots. So developed lots that they can then build the homes on and they'll sell it along that process. But in that time, they're going to have all that land as inventory on their balance sheet. NPR doesn't actually engage in the land

development process at all. So the way it works for them is they enter into what are called lot purchase agreements with third-party land developers to acquire it once it's finished. and they put a deposit down. So they're basically buying the option to buy the land after. And so the deposit can be up to around 10% of what they estimate the final purchase price to be. So they're taking the 10% risk, but typically it's better for the cashflow perspective. And once they have these finished lots done, which basically means you have the roads going there. And I think the electricity maybe in kind of the pipes going into the lot and everything's ready for the home to be built, you can get a quicker process from the capital you need to invest

or not even the capital because whatever, whatever you define it, all the expenses to building the home, it can be a quicker turnaround from that investment with this land, whatever the land option strategy, I think is how it's defined, but there's a lot of different ways you can call it. Yeah. And so the way, so once they've entered into these LPAs or the purchase agreements and put down the 10% deposit of whatever that plot is going to be worth, they're going to start marketing and selling these homes. So basically as homes under construction, they sell

these typically by turning the garage of one of their own furnished and finished homes. So they take one of their homes, it's furnished, it's finished. They take the garage, turn it into a bit of a sales center. They say, here's what the home's going to look like. They have a little blueprint out for it. And then they sell it in that process. Once that home is sold, MVR then says, okay, I have no problem buying the actual lot, but if they can't sell the home, they don't have to buy that lot. The most they'll have to do is forfeit the 10% deposit. Obviously they don't want to have to forfeit that, but it's much less risk than having all of the land owned and not being able to sell it. So that's one of the advantages. The other part is once the purchaser

agrees to buy the home, NVR can then, when it comes to the actual construction process, they don't do any of that so they are hiring subcontractors to do that um the agreements are kind of uh i'm not sure what what exactly the agreements are like but basically you're getting a fixed price uh they say here's how much they're going to build it for that kind of thing they go through they do quality checks um but they are not building or constructing it themselves it's strange how they have gotten to this position where they're doing as minimal as possible and kind of earning just this spread, I guess, on, on what, on their car. I mean, the spread is probably when I work, but yeah, they're not doing business.

Yeah, exactly. It's, it's, it's, it's asset light for sure. Yeah. And then they also provide mortgage financing for their buyers. And once again, it's almost like not really earning a spread, but I think you're earning a fee here, but they, so if NVR has marketed sold the home to someone, they go in, they also say, would you like, you know, help financing this with a mortgage? they'll originate the loan, but then they'll actually sell the loan itself into the secondary mortgage market. So they're not really taking the financial risk. The Fed is. The Fed can buy that.

Yeah, I guess if the Fed has bought mortgages in the past. So they are really just, they're a sales business, essentially. They really aren't involved in the building process. They like, it seems that- I mean, they have the designs for the house. Yeah, they do a lot of different things, but it seems like one of their core philosophies is whatever assets we have, we want to turn them over as quickly as possible. Right. And then I'll try to talk about the history, but there is not a whole lot of company history available. In fact, they are generally quite quiet, no conference calls or anything like that. And no annual letters. I mean, I don't think I've ever seen that combination.

Usually there's either, if there's no conference calls, people, they give out written commentary. They're neither. They just shoot out that press release and say, that's all you got. And they have one of the shortest 10Ks I've read, which is- That's a positive. Yeah, that's kind of nice to see. So, NVR was first founded in 1980 as Envy Homes by Dwight Schar. I believe I'm saying it right.

It's either Schar or Schar. But six years after its founding, NVR was basically taken on debt to try to finance this purchase of Ryan Homes. So it had both bank credit lines and then it issued some high yield debt as well to try to acquire Ryan Homes. And they did. And Schar actually, prior to founding Envy Homes, worked at Ryan Homes. And he left Ryan Homes, started something called Envy Land, which I think was just land development. Then he started Envy Homes, acquired Ryan Homes. Keep in mind, it was it was financed by debt. And then as soon as the real estate market sort of tanked in the early 90s, so a couple, I guess, five years after the acquisition, NVR had a whole bunch of land on its balance sheet, a whole bunch of inventory, and the value of that declined pretty quickly. they hit a slump. They had to file for bankruptcy in 1992, but they reorganized,

emerged from bankruptcy, and had this essentially new structure where, or I think it inspired the new structure where NVR no longer was going to hold that inventory on the balance sheet. They moved to that option model and they actually went public in 1993. They continue to expand that option model into several new markets. But generally, the new market expansion hasn't been too crazy. They typically acquire, I guess they have three brands, so they've only acquired two, but those brands had their own markets as well. They say they'd rather, they say this in explicitly themselves, they'd rather gain market share within their existing markets to get more dense and more and better operating leverage than expand. Although in the past they have expanded,

And we'll probably talk about that later, whether we're coming up on a time where they're going to have to enter another market if they want to get bigger. And then, so the third acquisition was in 2012, uh, Portland homes, but just prior to that was obviously the financial crisis. NVR was, as far as I can tell, the one of, if not the only home builder that remained profitable every year throughout the financial crisis. And so, yeah, they got really close in one year, but they made it. It allowed them, I think this pretty much ended up inspiring the Heartland Homes acquisition where a lot of other home builders were in kind of a distressed period and they were able to take advantage of it and acquire another one in Heartland Homes at least four years after.

And then in 2019, they were added to the S&P 500. Just as a note, since listing in 1993, NVR stock is up 40,000%. So it is a 400 bagger. This has been the best returning home builder stock of all time, as far as I can tell. I think Lennar, since it's so old, might beat it out. But I mean, from that time period, I'd almost guarantee it. Annualized returns must be. Yeah, exactly.

So, yeah. So, I guess while we're kind of talking about the business and we're going to talk about the landscape here in a second, there hasn't been DreamFighter homes and maybe there's been some other upstarts that have replicated this model, but some of the bigger home builders have not converted to this model. It's still a lot of land purchasing and developing. It might be an innovator's dilemma. There might be, you have the existing, you know, thing in there, just the existing model of buying the land yourself. And also, I think from what I've read, just some commentary for some people, I think this was on a Valley Investors Club write-up, a lot of these builders or basically real estate people love speculating on the land, which is risky, but it's just more exciting because it's kind of gambling on what a market could end up being worth. NBR is a lot more disciplined.

It does not do that, which has served them well. All that industry and competition, they're pretty simple, although the market is kind of complicated because all the variables, but the revenue isn't that complicated. So the market size of U.S. homebuilders is estimated to be about $129.3 billion a year. So that means $129.3 billion spent in revenue for across these companies every year. And when we get to the revenue, that'll make MVR approximately 7.66% of the market. So they're one of the largest, but if we look at their competitors, the two largest are going to be DR Horton, which has about 25% market share. And then Lenar with 24% market share. Those are the two giants that are bigger

than NVR, but there's no other companies that are, there might be one slightly bigger, but there's not many that are any significantly different. And then besides that, there are tons of other competitors. I mean, you can get a list. I'll actually have a link here in the show notes that'll be sent out that you can check out all the market share from all these companies. Now, iBizWorld, which again, it's just a place that's doing estimates. They expect the industry to decline by about 4.6% in 2022, given where interest rates are and given where housing prices are going. The home building industry has grown by about 4.4% a year since 2017. Now, since there are a ton of macroeconomic factors that affect the home building market,

you have interest rates, demographics, current housing supply, that makes it a cyclical industry that frankly, is really, really difficult to forecast. We see a lot of people have made predictions or write-ups or whatever, where the housing market is going. And a lot of the times they're wrong because there's so many variables, it's really hard to tell. And when you're getting into the different areas, like what area is actually going to benefit, you know, are NBR's areas going to be, you know, safer from any sort of housing bust compared to the West Coast? Who knows? Now, the one thing we do know now is that rising interest rates have affected mortgage rates and therefore affordability. There's a good update from Redfin that was

posted recently and has a chart here that home buyer mortgage payments are up 50% year over year in 2022. And that is mainly because of the increase in mortgage rates. But on the flip side, there's also a housing shortage in the US right now. I did a little bit of research, not just found some stuff. It's impossible to know what the actual shortage is. Yeah, that's true. And it's a bit dynamic. So it's tough. Some people try to make estimates. And from what I found, unfortunately, the areas with The highest shortages are now where MVR operates, except for outside the Washington, D.C. area. So are they going to benefit from the housing shortage? Probably, but it maybe isn't as acute as on the West Coast.

And I think that's it for the industry. Simple, but cyclical. And also, like, it's simple to understand, but complicated, I think, to try to figure out where demand is going to be. And I'll go through some of the information around the industry as a whole and the anecdotal evidence. just kind of little things that I pulled from different people's writing. Yep. Well, that'll be good. We'll get to that later. If we go to management and ownership, they have a long running management team. CEO is Paul Saville, who has been at the helm since 2005. And he is a lifer at the company has been there since 1981, according to the company. So basically at the start, he is 66 years old. So looking at his age versus, you know, when he

started at the company, he has basically worked there his entire working life. I think that is great to see. A good chunk of the management team has been there for a long time. The CFO has been there since 1994. They brought in some new executives recently, and that's where the stock comp has been increased because they gave them a lot of stock. But they explicitly talk about NVRs, and this is in the prerogative statement, unique compensation structure and how it is, quote, a competitive advantage. However, when I looked at this, it's not like they had bad compensation tactics, but it didn't look any... It's compensation. It didn't actually looks special to me. Maybe some of the other home builders have egregious compensation and I think

the incentives they have here are good, but I wouldn't define it as an advantage. What is it? Return on capital? So we look at their annual incentive bonuses. They are based on pre-tax profits and net new order hurdles. Both seem like good metrics to me. Those are great. You have your margin and then you also have the number of homes that you're shipping. Now their performance-based stock options are giving out based on return on capital, which is probably a good number for this business versus other home building peers. Now, I would maybe like to be, I think that's good. I think it's fine. It's fine. After all the shitty proxies we've seen. Well, here's the only, the only grab I might have is that comparing to the home builders

might be a little bit disingenuous if they don't have the land light model. So it might be almost too easy for them to beat them on return on capital, if you get what I mean. and if we look at that SBC has been a major headway they easily clear the return on capital each year for the last 10 years versus the home building peers I would maybe want them to have

well I mean look at share count I mean the share count over the last five years hasn't declined even though they've had aggressive buybacks hasn't declined meaningfully like it has the first two decades as a public company now if we're I mean it's still good it's still I

think it's still good compensation strategy That's just the only slight gripe I have is they might be a little bit cheating themselves by not giving them a nominal return on capital to go after. Now, executives are also required, and I thought this was a positive, a healthy chunk of stock as a percentage of base salary. It kind of ranged for different executives, but I think it was like 10 times their base salary for the CEO. And as you can see from the chart below, which you can't see if you're listening, but if

you're looking at the newsletter, there's a lot of insider ownership. So if we look at all directors and executive officers, they own 10.6% of this company. On the positive side, that's great. From the flip side, it's because they're heavy SBC, heavy stock-based compensation. Now, if we look at the two largest shareholders, they're Vanguard and BlackRock, pretty standard. The main thing I think I wanted to point out there is that NVR has been a heavy share repurchaser. I think shares outstanding are down over 80% since their IPO. and when you're a heavy share repurchaser,

you kind of want that stock liquidity to make it a lot easier. I wanted to look at the 10-day volume that NVR trades at because I kind of get worried when it's a company like this, you know, you have, I mean, secretive, high share price,

you know, I was worried that there wouldn't be that volume for the repurchase is kind of a Berkshire Hathaway A shares problem. Okay, yeah. But I looked at the volume, it was fine. is the average daily volume is $77 billion. So compared to the market cap, not going to be a big issue.

But yeah, it's important when, if buybacks are going to be a big strategy for NBR and they have been over the last three decades, I think it's important to look at the ownership structure or not structure, just who owns what, whether there's going to be liquidity for buybacks, all that good stuff. All right, Ryan, do you want to hit earnings?

Yeah, this is kind of an interesting point to raise because if people aren't selling, I would think that it would keep sort of a buoy on the valuation, but that hasn't seemed to be the case. The other thing there was, it seems pretty liquid. Yeah. There was a quote. I can't, I might botch it, but I heard a quote from the CEO at one point where they, someone asked him about continuing the repurchase program. He said,

if you hold onto your shares, maybe at some point in the future, you'll own one share and we'll own one share and that'll be it. So. They love, they love share buybacks. That is correct. We love that too. All right. Well, let me talk about earnings. So there's, I typically try to segment it into the last full year and then the most recent.

Sometimes there's not really much of a difference, but in this case, there's a pretty substantial difference. So it's important to look at. So last full year, they had $8.7 billion in revenue. That was up 19% and their gross margins were about 22%. That was slightly elevated relative to the years prior, but not crazy. So typically gross margins from what I've seen are really high teens, 19%, maybe 20% roughly. And then they had 21.5 thousand home settlements in 2021.

So that was up 9%. And then they had 12.7 thousand home orders in the backlog, which was also up 10%. So good growth on both those there. Operating cash flow was $1.2 billion. dollars. That was up 34 percent. They have little to no CapEx. So free cash flow is about the same. Really, if you're looking at this business, this was probably the best. This was the best year they've ever had. It was really good across the board. And that was in the face of a lot of supply constraints as well. But the most recent quarter, if you go to their Q2 report, new orders decreased

by 16 percent. New order cancellation rate, which is included, that's included in the new orders. but the cancellation- It's a good number to look at, yeah. Jumped from 8.3% to 14.3%, which is a huge jump. And obviously that kind of goes in sync with the rise in mortgage rates. And then the average new order price actually increased 7% year over year, which surprised me.

So in the face of new orders going down 16% in volume, prices went up 7%. And so there's kind of, that is the huge question is, or a lot of people think there's, is that going to reverse and hurt them? Yeah. Okay. And during the first six months of the year, they did generate $450 million in free cashflow. So another healthy first half of the year,

but cashflow is correlated to settlements. And inventory buildup. So right. Sort of in, you know, like, there can be a bit of a lagging effect. Basically you want to pay attention to the backlog and the new orders. If we look, there was a fascinating chart. I, well, Well, if you don't have access to YCharts, you may not have it. But if you do, I think I shared this one online. They basically, their free cash flow, it's weird how it slowly trails as they're growing,

slowly trails their operating income as a conversion. And that's because as they're growing, they're getting maybe more inventory, the working capital is getting bigger. So they don't have, the conversion to cash flow is just going to be slightly lower. However, the only time free cash flow is higher than operating income was through the financial crisis when I believe the business likely slowed down quite a bit. Yeah. That pretty much covers the earnings. I can't think, I think those are really the important metrics you want to pay attention to are cancellation rate, because if you're paying

a 10% deposit and your cancellation rate starts to hit 20, 25%, you start to have a problem. Yeah. I would say even sustained above 15%, you kind of have a problem. It's not as bad as probably some of the other home builders, but it's an issue. And then new order volume. And then obviously average price. And margin. Yes. And historically, they've done a really good job lowering their sales general and administrative expenses per settlement. I believe it's tracked, it's declined about 5% a year annually over the last decade. I think I remember that from a Value Investors Club write-up. So they've done a really good job managing expenses. As for the balance sheet, they have a billion and a half of cash and cash equivalents. So 1.5

billion. And they generated, as I said, $450 million in free cashflow the first six months, as long as prices don't decrease rapidly, I see them generating positive cashflow for this year. I think pretty much every year since they reorganized, they've been cashflow positive. So yeah, good thing about the real estate market is if there's going to be declines, it's going to be slow moving. It's not slow moving, meaning multiple, you know, possibly multiple years. So it's not like they won't be able to, yeah, it's not like they won't be able to adapt. Right. And then as far as liabilities go, they have $916 million in senior notes. I believe all of those, maybe a little bit, 900 million of it is due in 2030 with a 3%

interest rate. So really cheap debt there. And then they also have a $300 million available revolving credit agreement that they haven't used. And then NVR, the mortgage subsidiary has a $150 million revolving mortgage repurchase agreement. The way I understand this is it allows the NVR mortgage subsidiary basically to finance their own loans if needed. So both of those have gone on tap. No one's haven't used them. I'm glad the mortgage part is a small part of this business because I would be a bit concerned about if interest rates rise rapidly while they take on interest in, or sorry, take, you know, sell a mortgage and then they have it sitting on their balance sheet for however many days and then sell it back to the market, like how much money they

could possibly lose there. But it's about 10% of the business. So I really inconsequential unless they were, I don't know what they would be doing. I mean, all of it's fixed rates. So I don't think there's going to be any issues there. However, you know, any, any sort of financial thing, there's always the risk. And just overall, in terms of balance sheet, they tend to run with some net cash. So like I said, a billion and a half in cash equivalents and $900 million in true senior notes. So some net cash there kind of allows them to be flexible. Sometimes that'll get a little more elevated. They really kind of depends on their valuation and how much they're repurchasing is that that's going to determine what their net cash position seems to be.

Last year, they generated, I think it was 1.2 billion in operating cash flow and their cash and cash equivalents actually decreased. So they spent nearly all of it on buybacks. Yeah. 1.54 billion on buybacks, dollar amount. All right. Let's get the valuation. Pretty simple here. The stock price of $4,020. They don't do stocks, so it's apparently that's another reason why I was worried about the liquidity, but again, seems fine. Market cap is approximately $13.2 billion. Enterprise value is $12.6 million, so slightly less. And the two metrics I like to look at here would be enterprise value to operating income and enterprise value to free cash flow, which is just enterprise value divided by both metrics. So if we look at trailing 12-month

enterprise value to operating free cash, or excuse me, operating income, I may have said some of those wrong, it is 6.2. So it's really, really cheap. However, because the cash conversion hasn't been that great lately it's been slight i mean he's usually been solid but it's been slightly worse lately um trailing 12 month ev to free cash flow is 11 so still fairly cheap trailing basis and we'll maybe talk about whether ford could look better or worse um but ev to operating income looks cheap either free cash flow looks you know fair pretty cheap um and then if we look at shares outstanding like we talked about no real big concern there they do have heavy stock-based compensation programs or they historically have. However, share count has

gone down consistently over the years. And yeah, the SBC has been a bit of a headwind for returning capital to shareholders. But if you look at that share count, I don't think anyone can complain. SBC has been what? 100 to 200 million a year, roughly? I didn't calculate. I didn't do that out. But I mean, it's fairly high for the size of their business. It's not crazy high, but again, over the last five years, let me give you some notes here for the listeners. If we look at the dollar amounts they have spent on buybacks, so in 2017 to 2021, they spent $400 million, $850 million, $700 million, $371 million, and then $1.5 billion on share buybacks. However, shares outstanding really only started going down in 2021. So a lot

of that for 2017 to 2020 was just offsetting dilution. So yeah, it's, you know, you got to have, they're going to buy back a ton of stock, but a lot of that, you kind of got to look at it on a net basis. Just like where shares outstanding are going to go. I'm looking at their 2021 right now. Equity-based compensation was, nope, that's not it. All right. Well, hopefully we'll find it so we can actually i mean give it give it yeah but those are all estimates so i kind of just like to look at you know they can change because it's based on black skulls so i just kind of go where share count is going honestly with a share price down recently um that could be a benefit they've been because a lot of that too uh yeah i mean the especially because they do stock options

only, their share, like their SBC could be really, really overstated. Yeah. Because if the stock price goes down, those won't convert. All right. Do you want to do anecdotal evidence? What do you got for us? Yeah. So I haven't bought a home. I think it'd be tough to buy a home right now for myself. We are. Yeah. We were both in our 20s. So we kind of are in a, maybe, you know, at least we're not 30. Maybe if we were living in the 1940s. Yeah. Well, we just got back from World War II. Yeah. You know, they give us that nice GI Bill or whatever. But let me just lay out some information around the real estate market as a whole today. And a lot of this is from other people's work. So I've linked to it in the relevant sources. So I recommend going and reading

that. And I don't have this part down, but I remember it. Colin Roche wrote that since 2019, median income has rose by about 15% in the United States. House prices since that time have rose 50%. That's not even affordability. That's just the nominal housing price. Right. And then mortgage rates have gone up from 2.75% to 7% in that same time. So today, the median income earner in the US would have to spend roughly 50% of their income on mortgage payments to buy an average priced home. That's the least affordable, maybe of all time. In the U.S. at least. Yeah. You'd probably say that for certainty. Yeah. And then also not all these are bad things. So today, American homeowners have an all time

record of home equity. So ownership of their houses across all of the U.S. is at an all time high also unlike 2008 the vast majority of u.s household debt today is fixed rate not variable and so uh the reason i say that is when you combine all-time high home equity with fixed rate debt not variable debt if rates rise the likelihood of yeah catastrophic defaults It's much lower than 2006. However, on the flip side, when you're looking at a stock like NVR, we're not buying what earnings were in 2015, we're buying what future earnings are. And future earnings don't come from existing home builders, or excuse me, homeowners, they come from new home buyers. So I think the most important number there is that first 20

reference. Yeah. And then also, I don't think I put this one in here, but the number, so So people are, on average, living in their homes for longer now, too. So people aren't moving to retirement communities as young of an age. So that's keeping people in their homes, which is kind of driving down less transactions that are needed. And supply. So maybe that could help with the supply shortage thesis. Yeah. And then today, the number of homes listed for sale is also near a record low.

And depending on the source you use, there seems to be a significant shortage of just overall housing supply relative to demand. Yeah, that's one of those numbers you can't pin down exactly, but I think you can generally say there's a shortage. So that's why we say it's kind of tough to determine whether or not – when I hear that affordability is the worst it's ever been, I think, all right, well, housing prices are going to have to come down. But when I also see that prices are going up for NVR while new orders are going down 16%, it seems like there's just such an undersupply that prices could potentially stay the same. Yeah. And it's tough because the most dangerous time to buy cyclical stock is when the numbers look good and we could be at almost the peak and maybe the market is kind of pricing it with the stock going down so much this year. Yeah, there's so many things that could go on. I mean, we'll talk about it maybe later in kind of the Bull Bear case or while we're more or less interested, but we don't need to go on forever. I mean, my anecdotal, yeah, we already talked about the real estate market. I'll say for MBR specifically, though, I mean, in this market, it is positive that they mostly

do build-to-own and the land options because it should help them from becoming potential bag holders, for lack of a better term, on inventory that would need to be written down. Still, though, even with those two advantages, build-to-own and land options, there's uncertain times for this company right now and not surprised people are pessimistic on the stock given where mortgage rates have gone kind of thrown a potential like we don't know what's going to happen but there's a potential wrench getting thrown into the next year that the outcome is uncertain all right future growth opportunities i guess we're probably it's it's tough there's not much i mean what do you got i think they might do some ancillary stuff beyond mortgages too so

there's might be like title or stuff like that, but I'm not going to do any of that. Basically the blueprint for growth is pretty simple, which is to build more homes. But I want to try to maybe put a creative spin on this. If we're right and prices decline, home prices, that's home prices that is. So home prices decrease and trend, basically the way I see it, either new orders and volume is going to decrease substantially or prices have to decrease or some sort of combination of both. Yeah, probably big. Well, I think it's like almost a mix because there's given how bad affordability is

at current prices. If prices stay the same, you, we've seen the numbers of mortgage applications falling off a cliff. Like I just think it right. You know what I mean? And both are not good for NDR. Okay. Yes, but they're worse for other home builders. Sure. Better and maybe, yes. Which makes me think that given the net cash position they have and the ability that they've had to, and I think they can sustain this even if volumes come down a little bit,

the capacity to keep generating cash, they can be acquisitive and expand quicker in down markets, which sucks during those years, but I think they end up better because of it. I think the Heartland Homes has probably proven to be a pretty good acquisition now. Yeah, I agree with that totally. And to go on that, again, the future growth opportunities for a home builder,

it's going to be tough, but I mean, the main one is build more houses and then sell them. But, and another thing I would say to caveat my future growth opportunities, they state that you do not like to expand into different markets, which would be, like Ryan mentioned,

the south florida east coast eastern midwest or which they call the middle east but to perhaps confusion they're not building homes in saudi arabia it's the eastern part of the middle west you know region east i know yeah i mean yes that is a nice little anchorman joke but the i think all over the long term they're going to need to if they're going to grow the business they're going to need to get unit volumes higher i think they're going to need to be a geographic expansion you Maybe they make another acquisition in a place like the Rockies. Who knows what area it would actually be. But if they're going to get market share within the home building market, they're going to have to expand.

And yeah, if the stock's cheap enough, it'll be fine if they don't. But I kind of think that needs to happen. We don't know when because they don't give much management commentary. But it would be nice to see if I was an investor in this company. I think it would be really nice to see them talk about expansion or an acquisition. and maybe they will if the housing market goes into a downturn over the next couple of years. All right. Highlights, lowlights, Ryan, what do you like and dislike? I like, I think this kind of goes without saying, but I like the capital light model. And I,

I think it's validating that other home builders, other established home builders haven't switched. I think that validates sort of the innovators dilemma here that it's not as easy to just replicate it. It's been years too. Yeah. I think that, yeah, it's been two decades. So, So I really like that they've proven success with it. And it seems like it should be able to be replicated pretty much anywhere. I can't see why it wouldn't. And they've been gradual with their expansion. So it's not like this.

I feel like typically when we look at a company that's had 40,000% return since inception, it's almost a case study. This feels like there's still plenty of market for them to go after. Yeah, they're only, what would I say, 7.66% of the market. And we've seen in Lenar and D.R. Horner, 25% each. So there's room. I mean, this is an industry that consolidates for sure. The other part I like, over the last roughly 27 years,

NBR has reduced their share count by 82%. And they're accelerating that buyback pace right now. They bought more than a billion in the first half of the year, a billion dollars worth. Keep in mind this enterprise value, I think of like 12.5 billion. um so really we're kind of ramping up the pace that's that's yeah it's been a percent of the current market cap that's not including stock-based compensation but that's yeah it was weak the last the years before that and yeah some of that could have been you know covid but yeah 2021 was solid

though that's what yeah i'm saying yeah exactly the years before that yeah 2020 to 2015 now if we look at share count decline over the last 10 years 32.6 percent and a lot of that came out of the GFC when their stock was much cheaper. It tamed off in the years of the late years of this bull market. And now they're accelerating again. I mean, that's even better because they're actually timing these quite well. And maybe if their stock goes down, that's actually like a double positive on their valuation because you know, they're going to be smart about what they do with their cash. Yeah. Along those lines, insiders have also been buying lately, which gives me just a little bit of sense that maybe they are seeing better results than what the industry-wide metrics are showing

or predicting. So it kind of gives me a little bit of sense of confidence. I know that can- Yeah, they know better about the housing market than us. Given how good they've been at buying back their own stock, it gives me a little sense of confidence. The last one, last highlight I'll put here, if market conditions really deteriorated, they are well insulated because they're able to avoid losing money on developments at less of a rate than other developers. So their competitive advantages really show up when things get bad. Yeah. All right. You have one low light. What is it? uh the decrease in new orders i think i already kind of said this but either prices come down new orders come down or a mix of both

either way i don't see cash flow growing over the next couple years um which just makes it the the face value multiple a little misleading yeah all right my highlights i mean the track record of steady volume growth over the years combined with the steady repurchase is fantastic. I mean, you know, we have the headwind from the stock waste compensation that we talked about, but clearly management understands how to treat shareholders the right way to drive long-term returns. Second, reading what information we have in the business, I get the feeling that they are both frugal and disciplined in a good way, and they don't mind being out of the limelight. This is the recipe, I think, over, it's not going

to be, you know, a hundred bagger over, you know, one decade. It's not going to be that miracle stock that people find and it's talked about in the media all the time but this type of strategy good you know good business strategy combined with out of the limelight so you're not pumping in your stock and stuff like that and the repurchases is where hunter beggars are built over a multi-decade period which has happened with mbr third is the asset life strategy we talked about that clearly winning clearly makes sense um and it clearly is better versus the other home builders from a financial perspective it's why mbr puts up those cash flow numbers they do Low light though, I have one low light, which is built deposit. I think we only have one low

light. It's simply the macroeconomic stuff outside of management control. I mean, no matter how well you run MBR, it's still a home builder. That's at the mercy of the Fed. It struggles to convert earnings into cash and it's at the whims of housing prices and central banks. I mean, that's just tough it it's not um what's a perfect business it's not visa what yeah so i mean macro condition seems to be our low light what if you had to put a low light on the actual business itself is there anything you didn't oh just the fact that they talk about the spc like it's some sort of magical thing i think they're trying to maybe mask the fact that they really really give they're really aggressive on giving out SBC and they talk about like this, oh, how much money

we're spending on repurchases, whatever. I guess they don't talk about it, but they do press releases. I think that's just a little bit of, it's just been a headwind, especially if the stock is more expensive than it has been historically. It's just more of a headwind now versus where it was. And that's probably why share count was so, hasn't been coming down as much, even though they're spending on buybacks. I think you might be able to fool yourself as an investor into thinking that they're returning more capital to shareholders than they actually are. All right. Bold case, I'll go first. I'm just going to paint like a bold case scenario. So let's say five years from now, NVR sells 25,000 homes at an average price of

$400,000. That's a little bit lower than their average price currently. They'd be generating $10 billion in revenue. That's up slightly from 2021. Assuming that their SG&A expenses per settlement decline at all, or just continue to decline at the rate they have. And gross margin goes back to about 20%. So a little lower than they had. I'm going to put some round numbers on here. That would mean they're probably earning about $1.5 billion a year. That is in cashflow. So before you include stock-based compensation, let's also add, let's also say that they return or they repurchase $2 billion cumulatively. Yeah, net.

That would be net too. Yeah, net. Which seems very realistic. That's realistic, yeah. I think it's more realistic than some of your other numbers here, but yeah. What about these don't seem realistic? The gross margin, I would be a bit nervous on

if we look at their home builder gross margin, or excuse me, home builder- It was 22% last year. Yeah, I'm looking at home builder operating. Okay, look at, I didn't do home builder gross margin, But if you look at home builder operating margin, let me see if you can figure out what's the anomaly, listeners. 2017, 12.6%. 2018, 12.4%.

2019, 12.8%. 2020, 12.8%. 2021, 16.3%. I would guess we're going back closer to 12%. So, yeah, I think that number might. And a lot of that's due to gross margin. Maybe the SG&A can be so good that they can get that operating margin higher. But I just think that gross margin might be a bit aggressive.

Okay. All right. You could say more homes sold or a slightly higher price. I mean, five years from now, I'm just trying to put round numbers on it. Well, this is the bull case. If they earn a billion and a half, they earned $1.2 billion in free cash flow last year. If five years from now, they earn $1.5 billion in free cash flow, which is about a 20% increase, probably annualized, like 5% to 6% growth. I don't think that growth will come this year or next year, but annualized it could over the next five. And they returned $2 billion to shareholders at the current stock price, because it's going to be unpredictable.

They'd be sitting at about an $11 billion market cap. If you put a low teens multiple on this business, which is generally where it's traded historically, you're getting good, potentially maybe a double return on your shares. Yeah. Yeah. I guess we'll get to the bear case where maybe some of those numbers might be worse than we think. I mean, my book is simple. Like at current share price, I think you just need to hope that the housing market doesn't take a steep tumble, which, you know, I think NBR is fine.

They'll be fine going through it. But I'm just talking about from an investor perspective at these prices, as long as the housing market doesn't collapse, I think it'll be fine. And given management's discipline, the healthy share repurchases, and the starting valuation, you'll probably be fine over 10 years as long as free cash flow generation is stable, like Brian mentioned. I think you probably need to grow a little bit, but not too much, as long as average selling prices don't collapse. Now, let's move to bear case. I think any listeners will be hearing that average selling price, and I think we're going to talk about that on the bear case here. So, Ryan, what do you have? uh well uh yeah just macro conditions worsen and whether or not it comes in the form of volume or

price decreases revenue declines um i think that would mean cash flow probably goes nowhere probably declines over the next couple years there's operating leverage some margins yeah i don't see a world i have a hard time seeing a world where they are selling if you take a 10-year perspective, they're selling less homes or prices are not close to where they are today. Yeah. And here's the thing though, on the, say $400,000 average selling price, which is right around where it is now, a little lower than where it is now, slightly higher than where it was in the 2017 to kind of 2020 period. I worry that if you're an investor, you're making an interest rate bet and that's just hard to do i think

past five years i don't think it's as much an interest rate bet at that point being better advantage depends how high how high interest rates go if interest rates go really high it everyone else gets hurt more yeah but eventually homes have to be built like There's no way that- I know, but can they, if say, and this would be a drastic scenario, it's not realistic. If housing prices go down by half, would they be able to make that up by doubling their volume? I just am concerned there. Coming out-

And the margins- How have they doubled their volume since 2008? On the 10-year succeeding period after 2008. That's a tough, that's a tough- It's exactly what you're painting. That's a tough scenario. Prices have, what happens? They benefit.

i think it'd be the exact same thing yeah i don't could they i just worry about whether they'd be able to double volumes because that's basically what they have to do to stay in place i mean let's see if they i think it would be if prices have over the next 10 year period well i mean yes they would not be able to double and their margin and that's just to stay in the same spot they are now and margins would a hundred percent be worse. Let's okay. I don't, I don't think so. So during that building, they're building double the supplies and the costs during the prices when during the period when prices have, yes. But I'm saying from that point, if you take five to 10 years from that point, they are much better off for it. Yeah, exactly. But that doesn't mean that

investors from these stock price today will do well. I mean, that's just my big concern. in that could be priced in maybe here's the thing you look at the trailing numbers the valuation looks good my bear case is just you have the combinations of margins reverting back which will make the numbers look worse uh which would be from the kind of the 16 margin back down to the 12 to 13 margin or lower depending on where commodities are and stuff like that i mean we're in a beautiful time for weather supplies in the last uh pre-covid and if housing prices go down And that combination is just really tough. I mean, it's the numbers.

I mean, it's just hard to make the numbers work for the earnings to grow. Now, do you need the earnings to grow for the stock to work? I don't know, but I don't. I think if margins both go down and housing prices go down, it's hard to see at these prices how they make money because the earnings multiple on a forward basis is higher than on a trailing basis. And you'd kind of be at a peak cyclical here. Yeah.

I mean, it would look more expensive. Yeah, the forward earnings are going to be less. I think you can already see that with the sixth month, the trailing sixth month cash flow and the new orders coming down. But I just can't see a world in which 10 years from now, they're not selling more homes. Maybe, maybe. Yeah, I mean, but how much more? At what price? At what margins?

I mean, this isn't semiconductors, so the supply chains aren't insane, but- What's that quote? I've seen the future and it looks a lot like the past. I think it's going to be just like the past. Maybe. S&A per settlement declines? Maybe. But they were in.

For 25 years. And for 25 years. That's not a cycle. We got to wrap up. but the commodities of prices and whatever, labor prices that go in for the subcontractors, it has been hugely advantageous for corporations that do this type of thing the last 25 years.

What if we hit, what if we had to change? They generate no cash? No, I mean, just the operating leverage is not destined to continue. Yeah, they have their best- I don't think it needs to. Look, I think there just is a risk of deleverage here. All right.

Well, let's wrap up. More or less interested, Ryan? More. More. All right. Why? I think it really kind of fits innovator's dilemma. And I think this is a business that does where its advantages shine coming out of bad times.

Yeah. And now that's why I'm more interested, but not at these prices because look, I'm not, I'm not, I'm not predicting a stock price, but if things get worse, the stock will go lower. And I would much, I would only want to own a business like this, a cyclical when the numbers, when, just when things look very, very pessimistic and the, I think they look pretty pessimistic right now. No, the trailing, no, I'm talking about the trailing earnings when it's just, I would hate to be, take the risk of this being the peak of the cycle of their earnings. And it just makes it tough. I want a big margin of safety on price when I'm buying a cyclical and I'm more interested in this business because they are definitely the best one run well run, at least at the

large home builders. But the price, I don't, I don't think the stock is that cheap to be frank. so i'm more interested but not not these prices all right stock for next week let's look at the schedule zillow zillow uh should be a fun one one of the only tech companies in the industry we're talking with brad freeman on that one should be a fun discussion uh they gave up on i buying which i guess we'll maybe talk about or not uh but that's gonna do it for this episode thank you all for listening remember we are not financial advisors anything we say on this show is not formal advice or recommendation. We are general partners at Arch Capital and

clients may hold securities discussed in this podcast. Thank you all for listening. We'll see you next time.