James Krapfel: Homebuilders are in a prime position to sell more homes because the large millennial generation is aging into their late 20s and 30s, which are the prime home-buying years. Further, homeownership rates across age groups should increase as a significant amount of pent-up demand releases alongside greater levels of employment, improving wage growth, and looser mortgage eligibility standards.
Indeed, recent data indicates that the housing recovery is back on track, following the material slowdown of last year. However, we expect homebuilder investors to be disappointed by a lack of operating leverage. Homebuilders' gross margins already improved to near or above prior peak levels in 2014 but began to descend late last year as rising land, labor, and material prices more than offset decelerating home-selling-price advances. We expect the trend of declining gross margins to continue over the next several years in this no-moat industry, especially because of rising land costs and the sales mix shift to lower-margin entry-level homes.
Still, there is one homebuilder that stands out from its peers. NVR (NVR) employs a unique land-light model that entails entering into options with land developers to acquire housing lots on a just-in-time basis. Although NVR sacrifices a bit on margins, the increased flexibility and lower capital requirements afforded by its strategy allow the company to (1) produce ROICs that embarrass its homebuilding peers, (2) generate significantly higher free cash flow as a percentage of sales than peers, and (3) repurchase a substantial amount of stock at shareholder-value-accretive prices.
NVR is not immune to the gross-margin headwinds, but we believe it is the homebuilder to own over a full housing cycle. The stock currently trades in 4-star territory relative to our $1,600 fair value estimate.