NVR, Inc. (NVRs) builds and sells real estate. These are single-family detached houses, townhouses and condominiums. It operates in two segments: residential construction and mortgage banking.

The Residential Construction segment sells and builds homes under the trade names Ryan Homes, NVHomes, Fox Ridge Homes and Heartland Homes. The Mortgage Banking segment issues mortgages primarily for its own home buyers, although this segment is much smaller.

We are bullish on the stock due to its excellent track record and relatively low valuation.

NVR: an excellent track record

NVR stock has performed very well in the past and has outperformed the SPDR S&P Homebuilders ETF (XHB) by a wide margin over the past five and ten years due to its strong fundamentals and growth. Its five-year returns (including dividends) are 113%, compared to 75% for the Homebuilders ETF. Its 10-year returns are more impressive, reaching over 460% versus 211% for the ETF.

This excellent performance can be attributed to a few factors: steady growth in revenues, earnings and free cash flow, as well as high return on capital, growing profit margins and a strong balance sheet. Let’s discuss these factors below.

Steady growth in revenue, earnings and free cash flow

Starting with revenue, it has steadily increased every year for at least the past 10 years. In 2012, the revenue was $3.19 billion, and in the last 12 months, it had a revenue of $9.3 billion. That’s pretty impressive growth for a relatively boring company. When looking at diluted earnings per share, this figure has increased at a CAGR of 25.3% over the past five years.

Similarly, from December 31, 2012 to December 31, 2021, free cash flow decreased from $252 million to approximately $1.23 billion. Another thing that separates NVR from its peers is that its free cash flow has been positive in each of the last 10 years.

Many of its peers have volatile cash flow, which makes the company much harder to predict. This is likely due to the company not actually developing land, in general.

Instead, NVR primarily acquires finished building land from other developers in the form of fixed-price lot purchase agreements, known as LPAs. The company usually pays a deposit of up to 10% of the purchase price of these LPAs. It seems like a more stable business model when it comes to cash flow.

High return on capital

When it comes to NVR’s cash return on invested capital (CROIC), which is measured as free cash flow divided by invested capital, its five-year average is 27.7%. It has consistently been above 20% for the past five years.

Since its return on invested capital is higher than its weighted average cost of capital (cost of doing business) of 7.5%, it is considered a value creator. This is called the economic gap, and it is calculated as ROIC minus WACC.

Growth in profit margins

The other things investors like to see are growing or stable profit margins. NVR’s gross profit margin has been relatively stable from 2017 to 2020, hovering around 20%. However, over the past 12 months, that figure has increased to 25.6%, and the last quarter saw a gross margin of 28.5%.

Here’s what the company’s latest earnings report, released earlier this week, said about its gross profit margin: “Gross profit margins were favorably impacted by the aforementioned increase in average settlement price in first quarter of 2022, associated with lower lumber prices quarter on quarter.

It will be interesting to see if he can maintain those margins, as house prices could fall due to rising interest rates and lumber prices are volatile. However, lumber prices have been relatively stable since the start of the second quarter.

Nonetheless, its profit margins, including net income and FCF margins, have followed multi-year upward trends. For example, NVR’s net profit margin has grown from 5.7% in 2012 to over 15% for the last 12 months.

Solid balance sheet

NVR has a strong track record, especially for a homebuilder stock. This is likely due to the fact that, as mentioned above, the company generally does not develop any land. Because of this, it requires less capital to operate than other businesses (which also explains the high returns on capital).

NVR has cash and cash equivalents of $2.14 billion and debt of $1.52 billion. Therefore, it has a net cash position of approximately $620 million. The company can use its cash and free cash flow to repurchase shares, which it has done. Its TTM redemption yield is 9.4%.

Additionally, over the past 12 months, its earnings before interest and tax (EBIT) were approximately 37 times greater than its interest payments. Overall, the company is financially sound.

Risks: rising interest rates, slowdown in real estate

The most obvious risks for a residential construction company like NVR are rising interest rates and a possible recession on the horizon. Rising interest rates dry up demand for housing because they increase the cost of borrowing.

Redfin Real Estate Company (RDFN) has already seen signs of a slowdown in the housing market. Redfin Chief Economist Daryl Fairweather said: “Most homebuyers are still facing bidding wars, but competition is starting to die down as soaring mortgage rates and house prices prompt some Americans to back off or suspend purchase plans.”

He continued: “We expect the bidding wars to ease further in the coming months as rising mortgage rates rob more buyers from the market.” Some people may still be scarred by the Great Recession of 2007 to 2009 – when real estate prices fell. Although prices may fall, we are unlikely to see a Great Recession-style housing market decline, because back then banks were lending money much more recklessly.

Additionally, according to TipRanks’ risk analysis tool, NVR disclosed 21 risks in its latest filings. Most risks come from the Production category.

Regardless, we believe the company’s risks have been priced in to some degree, as NVR stock is around 25% off its highs and trading at a relatively cheap valuation; we discuss it below. Additionally, due to its strong balance sheet mentioned above, NVR should be able to easily weather a real estate downturn, as it has in the past.

Evaluation

On a forward price/earnings basis, NVR is trading at a much cheaper valuation than it has over the past five years. Its forward P/E ratio is 8.8x compared to its five-year average forward P/E ratio of 15.7x. Using the same metric, it is even below its March 2020 low of 9.6x.

It is most likely trading at a discount due to the rising interest rates discussed above. However, we think this discount is a bit too high, and analysts seem to agree as well.

The Taking of Wall Street

As far as Wall Street is concerned, NVR shares are in moderate buy form based on two buy and three hold ratings given over the past three months. The average NVR price target of $5,800 implies an upside potential of 29.1%.

Conclusion

We don’t generally invest in home builders as they often have volatile cash flow. However, NVR has been an outlier in this sense. It also has a strong balance sheet and high returns on capital. Due to his strength, he was a long-term outperformer in his industry.

At its current valuation, we are bullish on the long-term stock despite potential headwinds.

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