Analysts were very pessimistic about 2023, discussing the probability of a recession and high unemployment as the Fed continues to increase rates. The stock market and the economy surely outperformed expectations.
I published a “Buy” article in August 2023 on one of the largest homebuilders: NVR (NYSE:NVR). Although valuations had already risen this year, I believed that it had the potential to achieve even higher gains, driven by ongoing trends such as the housing shortage and the reluctance of homeowners to sell in the face of high mortgage rates.
The stock has outperformed the market so far, but I still believe it should be priced higher. The U.S. economy remains strong, and while the recent market optimism around interest rate cuts might make this trade risky, I reiterate my “Buy” rating for NVR due to the strong long-term and short-term trends explained in this article.
I published two articles on homebuilders, one on NVR and the other on Cavco Industries (CVCO). If you have read these articles, you’re aware of my bullish stance on the industry, particularly regarding those two companies. This article is going to focus on NVR and revisit my initial thesis in August 2023.
While these companies benefit from similar trends we were experiencing, I had slightly different motivations for the two. The housing inventory in the U.S. was not enough and high mortgage rates disincentivized homeowners from selling as they had locked in lower rates in 2020 and 2021. Consequently, I expected the demand for new homes to increase not only in the long term but also in the short term as buyers had limited options.
This has indeed happened. We’ll get into the details later, but new home sales skyrocketed while existing home sales collapsed. There have been a lot of developments since I published those articles. Fed pivoted (as many say), the economy outperformed expectations in 2023, and inflation and mortgage rates started to decline.
Given these developments, I believe a review is needed.
NVR constructs single-family homes, townhomes, and condominium buildings. It is one of the largest in the U.S. The company also has a mortgage banking arm to support customers buying homes.
One big differentiator for NVR is the fact that it doesn’t own any land. The company focuses solely on building. It acquires a finished building lot, pre-sells the project, and then builds. But this is not the biggest factor making NVR an interesting company. It is promising largely due to the fact that it is huge in an industry where size matters.
By gross revenue, NVR was the fourth largest homebuilder in the U.S. in 2022. Its established position in 15 states and 35 metropolitan areas allows it to spot big opportunities faster than its competitors and close deals on favorable terms. The huge amount of cash it sits on is only beneficial. As I’ll mention later, this cash amount keeps getting bigger.
It has five operating segments, four being geographical and the other one being Mortgage Banking. Its biggest footprint is in the Mid-Atlantic, although it has been growing rapidly in the South-East with a CAGR of 23% since 2012. While the Mid-Atlantic revenue declined in LTM Q3 2023, the South-East continued to grow.
Performance Since Publication
I published the NVR article on Aug. 31, 2023. Initially, homebuilders’ stocks declined due to concerns about a potential recession and high mortgage rates, but they reacted positively to market developments in the past three months.
Since the recommendation, NVR is up 10.5% at the time of this article’s writing, while the S&P 500 is up 5.3%.
Have a look at it below.
A lot has happened since last summer that requires a deep dive into the economic realities.
The U.S. Economy And The Housing Market
Let’s tackle this step by step.
First of all, the U.S. economy survived 2023 better than most people expected. GDP growth, which turned negative at the beginning of 2022 and was slightly above 2% at the beginning of 2023, jumped to 4.9% in Q3 2023. Excluding the volatile years of 2020 and 2021, this quarter’s growth was the fourth fastest in the last two decades.
While it is true that the Federal Reserve pushed interest rates higher aggressively in the last two years, it has not led the economy into a recession as initially expected. In fact, inflation has been on a downward trend since June 2022, while unemployment remains lower than 4%.
Some may define a recession as having back-to-back negative GDP growth. However, as long as the labor market is strong and unemployment is low, people will have money to spend, stimulating the economy.
You can see how inflation and the unemployment rate changed below.
While the economy remains better than expected, the market has mixed opinions about the housing market.
Mortgage rates are of course impacted by the Fed funds rate. We have seen it fall to below 3.5% after the pandemic and people took that chance to either refinance or buy new homes, effectively locking in exceptionally low rates.
As the Fed increased the rates, mortgage rates also trended higher, with the 30-year fixed rate mortgage average reaching nearly 8%. Recently, the average dipped below 7%, amidst expectations of rate cuts in 2024.
High mortgage rates affect distinct parts of the housing market differently. It disincentivizes homeowners who locked in low interest rates from selling, as they would face much higher mortgage rates on a new home purchase. That is why existing home sales were down 15% year over year in October 2023.
In the meantime, buyers who cannot find any existing homes turn to new homes. Despite the high mortgage rates, new home sales surged 18% year over year in October 2023.
With inflation falling faster than expected, the market thinks the Fed is going to pause or start to cut rates in 2024. If in the meantime the labor market remains strong, there is a chance we will see a soft landing.
These developments would lead to lower but still high mortgage rates. As long as rates are reasonably above 3.5% or rates seen in 2020 and 2021, homeowners will be reluctant to sell. Each drop in rates will benefit homebuilders, as buyers gain easier access to financing.
Additionally, there is another strong trend that affects demand for NVR.
The U.S. needs more homes. Housing inventory continues to be low, making it difficult for people to find homes to purchase. In fact, a comparison of the U.S. population and the number of single-family units constructed monthly shows the problem clearly. The population keeps increasing every year, while the housing market is cyclical and has never really recovered from the Great Recession.
This is and is likely to remain a long-term issue, leading to constant demand for homebuilders like NVR.
The Company Continues To Thrive In This Economy
While economic data reveals a favorable environment for NVR, the company-specific developments since August show that NVR is positioned well to thrive.
The third quarter results show that while the company’s revenue decreased 7% year-over-year, its net income increased 5%. More importantly, new orders increased by 7% compared to the third quarter of 2022. Thanks to high interest rates, mortgage banking income more than doubled from $17.6 million to $38.5 million.
As of September 30, 2023, NVR had $2.8 billion in cash, which is even higher than the $2.5 billion it had at the beginning of the year. This is extremely important for NVR to be able to act upon spotting opportunities in the markets it is present.
Thanks to this strong cash position, NVR was able to approve a buyback of up to $750 million of its outstanding common stock, as the company announced on November 9.
This valuation follows the model I built for NVR for my initial coverage.
I use a very conservative terminal growth rate of 2%, in line with long-term inflation targets. The cost of equity is calculated using a long-term risk-free rate of 2%, a market risk premium of 5.7%, and the stock’s 5-year equity beta. I use 5.14% for the cost of debt, which is the current yield to worst of its 2030 bonds.
I separate cash and short-term investments into operating and excess in my calculations. There are many ways of calculating operating cash, but I use a certain percentage of revenue, typically between 5% and 10%. This is going to be spent on the day-to-day operations of the company for a year. Any remaining cash is considered excess. In my opinion, shareholders have a claim on the excess cash, but not the operating one, because the business needs it.
Using these calculations, we find an equity value of $29.25 billion for NVR, which means a target share price of $8,458. This is a 20% upside at the time of this article’s writing.
This thesis is not without risks.
The market seems to be convinced that there are going to be several rate cuts in 2024. The market recently surged higher due to this widespread belief. If this expectation does not come true, and the Fed continues to pause or even increase rates, we might experience a downturn in valuations.
While I believe that higher rates would discourage homeowners from selling, thereby sustaining demand for homebuilders, a negatively impacted labor market and a potential recession could reduce this demand.
Unemployment is an important metric to track to understand the purchasing power people have. High unemployment, in turn, may significantly affect the housing market and the broader economy.
NVR is one of the largest homebuilders in the U.S. that specializes in traditional single-family homes and townhomes.
With its scale and unique position, the company has benefited and is likely to continue benefiting from trends such as the housing shortage and high mortgage rates that disincentivize homeowners from selling.
The stock has surged recently, buoyed by expectations of rate cuts in 2024. Should these expectations not materialize, and mortgage rates remain high, the stock may initially struggle. However, with long-term trends driving demand, I think NVR should trade higher.