NVR's Land-Light Model Is Here to Stay

We met with CEO Paul Saville, CFO Daniel Malzahn, and VP of Business Planning and Investor Relations Curt McKay in late August at  NVR's (NVR) Reston, Va., headquarters get a better idea of the company's commitment to its land-light model and gauge the supply/demand environment for finished homesites for NVR to option.

We came away with increased conviction that the homebuilder will continue to use capital-efficient options on finished lots with developers for the vast majority of land needs, and that more capital-intensive land acquisitions and joint venture agreements that have entered the balance sheet over the past three years will be implemented only sparingly going forward. Management acknowledged that the competition for finished lots is intense, as is currently the case for all desirable land at various stages of development, but mentioned  PulteGroup (PHM) as the lone homebuilder remaining that has a stated desire to pursue a more land-light model.

We continue to believe that NVR will be able to generate strong economic profits from its uniquely exclusive, best-in-class land-light model, and that investors will be rewarded with accretive stock repurchases.

Investors don't need to worry about NVR's commitment to its land-light business model. When we presented the company as a Best Idea in our July 2013 Industrials Observer, we said that investors in NVR need to believe that (1) the company will stay true to its land-light model, (2) the availability of finished homesites will cyclically recover along with developers' financial health, and (3) competition for finished homesites will not intensify to the point where it impairs the economics. After our Aug. 22 meeting with management, we hold increased conviction in these three central tenets.

The company began acquiring land through alternative means in 2010, namely through acquiring raw land and forming joint ventures with land developers. As of June 30, 2013, NVR directly owns four raw parcels of land with a carrying value of $88 million that it intends to develop into 950 finished lots (less than 2% of the company's total controlled lots). The company also has three joint venture agreements with developers in which it infuses cash into an entity for the right to receive finished lots.

Joint ventures are typically structured such that NVR is a noncontrolling member and is at risk only for the amount it has invested, in addition to any deposits placed under fixed-price purchase agreements with the JV. As of June 30, 2013, NVR has an aggregate JV investment totaling $91 million that is expected to produce 7,500 finished lots (13% of total controlled lots). Although NVR leaves the land development to other parties under raw land ownership and JVs, both structures tie up more cash than when the company acquires finished lots through its usual method—fixed-price purchase option agreements that require cash deposits of up to 10% of the agreed-upon purchase price.

Much of NVR's inventory of raw land came about through a transaction management detailed in our meeting. The homebuilder had a strong working relationship with a developer in which together they had been building up a community for four to five years. In 2010 the developer notified NVR that it was going to bring to market land adjacent to land NVR was building on because the developer was experiencing liquidity issues, just as many developers were experiencing at the time. This parcel was important to NVR since it represented 15% of the lots that were expected to be built on over the next five years in Montgomery County, Md., ground zero for NVR's core Washington, D.C., metro area (about one third of total revenue, 20% local market share). Instead of letting the desirable land go to another developer or homebuilder, NVR wrote a check for $48 million and contracted the developer to do the development work.

We believe this particular land acquisition was a prudent move, especially considering the level of land price appreciation since then. In other cases NVR has entered into joint ventures with land developers that needed cash infusions amid then-challenging operating conditions and insufficient available financing.

We do not expect NVR to enter into any significant additional arrangements with land developers. Land developers' financial health is on the mend with frothy land prices (NVR management confirmed), which necessitates NVR's infusing cash into land to a much lesser degree. Further, management stressed that it does not want to be a land developer, as it believes this is a distinct business that requires a separate expertise and capital structure. The company believes that raw land will represent no more than 2%–3% of total controlled lots going forward, a positive affirmation in our view.

Virtues of NVR's Land-Light Model
NVR produces returns on invested capital that embarrass its homebuilding peers. From 2002 to 2012, NVR produced annual adjusted ROICs of 54%, well above the 10%–12% that its largest competitors have been able to achieve. We anticipate economic returns to continue accruing through the next five years; we project the housing recovery to lift ROICs to 29% in our assumed midcycle year, 2017, from 22% in 2012. Despite NVR's impressive ROICs, we do not believe it has earned an economic moat, as its superior land-light business model could be replicated by others and its industry is characterized by high fragmentation, low barriers to entry, and extreme cyclicality.

NVR is unique in that it relies nearly entirely on options to secure its land (representing 86% of controlled lots). NVR enters into option contracts with land developers that give it the right, but not the obligation, to take down finished lots at a predetermined price and pace. NVR attempts to structure its purchase agreements so that it takes ownership of the lots on a just-in-time basis, immediately before building a sold home. The only recourse to NVR is a nonrefundable cash deposit up to 10% of the full purchase price. This model has performed excellently throughout the cycle, as invested capital is consistently low, and the firm is able to walk away from or negotiate option contracts when land values plummet or the firm thinks it won't be able to profitably build on such land.

All companies use this option model to some extent, usually for 10%–30% of land needs, and not much prevents utilization to a greater extent. We believe other companies haven't used the land-light model to a greater degree for two primary reasons. First, there is only so much finished land available to option. In some markets such as in California, land developers develop few, if any, lots to a finished state. If the large, more national builders were to abruptly move all-in to a land-light model, they would not be able to secure enough inventory to keep up with recent sales trends, and revenue and earnings would suffer a meaningful one-time hit. Second, the culture among most homebuilders is land developer first, homebuilder second. Most homebuilders believe they are experts in both land investment and land development. It takes a lot for executives to swallow their pride, admit that land ownership and development is a very difficult, capital-intensive business, and pursue a homebuilding-only business model.

NVR's unique commitment to a superior land-light model is a major factor for our awarding it the only Exemplary stewardship rating in the homebuilding industry. Its commitment to using a just-in-time land acquisition approach has never strayed, save for limited raw land purchases and joint venture investments over the past few years in response to a shortage of finished lots from developers.

NVR Operates Superior Land-Light Model

source: Morningstar Analysts

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NVR's land-light model has led to healthy and relatively consistent profitability and free cash flows. NVR has managed to produce GAAP profitability through the downturn at a time when all its competitors were hit with large inventory impairments that brought huge losses. NVR's earnings quality is also quite high, with relatively few inventory impairments to prop up adjusted earnings and a high FCF conversion and FCF yield. One additional reason for the attractive cash flow is that NVR's actual cash tax payments are well below statutory rates thanks to the extra tax deduction allowed for exercises on deep in-the-money stock options, so as long as the stock is rising, cash taxes will be lower than what's implied by the effective tax rate. Indeed, NVR's cash tax rate has averaged 23.7% from 2002 to 2012, below its usual 39% effective tax rate.

Unlike many of its peers that are strategically positioned in some of the faster-growing population areas such as Texas, Colorado, and the West Coast, NVR has stayed true to its mid-Atlantic roots. We believe NVR has thus far not ventured west of the Mississippi since it likes to achieve local scale in each of its markets and is not interested in a hasty nationwide rollout. Indeed, NVR holds a number-one market share position in most of its markets and holds more commanding market share positions in Baltimore (about 30%) and Washington, D.C. (about 20%), metro areas. Management noted that it would rather invest an incremental dollar in its current markets than open up shop in Texas or California, where it lacks local expertise or cannot achieve local scale quickly.

Although NVR has less-robust near-term volume growth prospects than its peers since it's not as exposed to the faster-growing Sun Belt states, the firm's core D.C. market seems to be holding up well despite the recent sequestration. In fact, in the mid-Atlantic segment, where NVR houses its metro D.C. operations, second-quarter order units were up 27%, slightly above the 26% corporate average. Management expressed that the D.C. market's resilience is due to a general numbing to budget-cut talks that seem to constantly dominate the headlines. Other markets that exhibit attractive growth characteristics include Florida (recent expansion into Tampa) and Charlotte (executives see this geography similar to D.C. 10–20 years ago; NVR holds an 8% market share).

Big Share Repurchases Continue
NVR has rewarded shareholders handsomely with net share repurchases composing 89% of free cash flows since 2002. Since 1999, diluted share count has fallen a cumulative 58%, or over 6% annually, an impressive feat given the company's liberal use of equity option grants over the years. In fact, since 1999, NVR has issued 7.1 million shares through stock option exercises and equity grants (higher stock pay offset by lower salaries and cash bonuses than peers). To put this in perspective, NVR's share count in 1999 stood at 12.1 million. The fact that it can shrink its share count by so much and at the same time give inordinate amounts of shares away through option grants testifies to the cash-flow-generating power of NVR's business. Further, shares were purchased at attractive valuations for the most part, largely below prices implied by discounting our $1,150 per share fair value estimate by the company's 10% cost of equity. In contrast, the other public builders employ few to no share buybacks or dividends, and many issued a substantial amount of shares in recent years, severely diluting existing shareholders.

Recent actions signal that the company's commitment to share repurchases has not waned. NVR attempts to be opportunistic in regard to where it purchases its share, and can go through a months-long share repurchase drought when it believes its shares are not trading at an adequate discount to estimated intrinsic value. For example, following share repurchases in July, August, September, and November 2012, the company did not resume share repurchases until April 2013. But when it does buy back stock, it usually does so in big chunks; during the second quarter, NVR repurchased 300,100 shares for $295 million, immediately reducing its diluted share count by a sizable 5.9%. We expect further share repurchases over the quarters ahead; on July 30 the board authorized the repurchase of an additional $300 million of stock.

NVR to Continue Share Repurchases

source: Morningstar Analysts

Company Background
NVR operates in 27 metropolitan areas in 15 states across the mid-Atlantic, Northeast, Midwest, and Florida. NVR holds a leading market share in most of its markets and controls a more sizable 30% market share in Baltimore and 20% in Washington, D.C. In addition to the Ryan Homes and NVHomes brands, it owns the Fox Ridge Homes and Heartland Homes brands, primarily targeting the move-up and upscale buyer with a $317,000 average price point in 2012, slightly above the $292,000 average new-home price in the U.S. The company constructs and sells single-family detached homes (historically 70% of units), townhomes (25%), and condos (5%), primarily on a pre-sold basis, and uses independent subcontractors under fixed-price contracts to perform construction work. Like most other homebuilders, it also operates a mortgage banking unit that originates loans for its homebuilders and then sells all mortgages loans into the secondary market usually within 30 days of closing.