By William Trent, CFA of Stock Market Beat’
NVR, Inc. is a member of our Small Cap Watch List, Mid Cap Watch List and Large Cap Watch List. We reviewed its recently issued 10K and have outlined our observations in this article.
Summary: One of the largest homebuilders in the country, NVR operates primarily in the mid-Atlantic region and surrounding states. While earnings are depressed and could get worse, the company generates sufficient cash flow to meet near-term obligations and the enterprise value to free cash flow multiple is just 6-7x (free cash flow yield of approximately 15%), which apparently provides significant cushion for near-term earnings and cash flow declines before the current enterprise value could be considered expensive. However, the reported enterprise value does not take into account the considerable value of unexercised stock options. The intrinsic (minimum) value of these options at December 31, 2006 was nearly $1 billion. Treating these options as a liability would result in a much more normal (i.e. less cheap-looking) enterprise value to free cash flow multiple.
Sales growth
Unit vs. dollar – Homebuilding revenues for 2006 increased 17% from 2005, primarily as a result of a 10% increase in the number of homes settled and a 6% increase in the average settlement price. The number of new orders for 2006 decreased 10% from 2005, and the value of new orders for 2006 decreased 16% to $4,988,137 from $5,928,815 in 2005.
<!–[if !supportLists]–>· <!–[endif]–>Revenue recognition – In accordance with SFAS No. 66, “Accounting for Sales of Real Estate”, revenues are recognized at the time the unit is settled and title passes to the customer, adequate cash payment has been received and there is no continued involvement. In situations where the buyer’s financing is originated by NVRM and the buyer has not made an adequate initial or continuing investment as prescribed by SFAS No. 66, the profit on such settlement is deferred until the sale of the related loan to a third-party investor has been completed.
<!–[if !supportLists]–>· <!–[endif]–>Customer financing – NVR operates a mortgage banking subsidiary, which provides financing for approximately 85% of the homes sold by the company. It then enters into optional or mandatory delivery forward sale contracts to sell whole loans and mortgage-backed securities to broker/dealers. The forward sale contracts lock in an interest rate and price for the sale of loans similar to the specific rate lock commitments classified as derivatives. Both the rate lock commitments to borrowers and the forward sale contracts to broker/dealers are undesignated derivatives, and, accordingly, are marked to market through earnings. At December 31, 2006, there were contractual commitments to extend credit to borrowers aggregating approximately $175,000, and open forward delivery sale contracts aggregating approximately $338,000.
Earnings quality
<!–[if !supportLists]–>· <!–[endif]–>Capitalization of expenses
<!–[if !supportLists]–>· <!–[endif]–>Operating margins – Homebuilding gross profit margins have been negatively impacted roughly equally by lower selling prices and contract land deposit impairment charges in 2006, reducing gross profit margins to 22.1% in 2006 from 27.8% in 2005. Company expects the reduction in selling prices in 2006 and continuing uncertainty in many markets may further negatively impact gross profit margins in future periods. SG&A expense increased $86,794, or 25%, year over year and as a percentage of revenue increased to 7.2% in 2006 from 6.7% in 2005. $53,000 of the increase was attributable to newly-recognized stock option compensation under SFAS 123R.
<!–[if !supportLists]–>· <!–[endif]–>Stock options – reduced operating profit by 53,000 in 2006 compared to not being reported in 2005.
Balance sheet analysis
Debt load and maturity schedule – $388 million of debt, nearly half of which is due within one year. Company has sufficient cash on hand to meet these obligations.
Value of unexercised options – $925 million at December 31, 2006.
Accruals
<!–[if !supportLists]–>· <!–[endif]–>Warranty – The provision for warranty reserves declined relative to 2005 but the total reserve increased in line with sales. Had the provision for new reserves remained constant with the percentage of sales used in 2005, net income would have been approximately 1.5% lower.
Inventory trends (DOH) – Inventory levels declined during the year (in part due to writeoffs) and ended the year at 57 days supply, down from 77 at year-end 2005.
Receivables trends (DSO) – receivables are down sharply and account for less than one day’s sales at December 31, 2006.
SPEs and other off-balance sheet items –
<!–[if !supportLists]–>· <!–[endif]–>SFAS 157 will become effective for the fiscal year beginning January 1, 2008 and provides guidance for using fair value to measure assets and liabilities and expands disclosures about fair value measurements. Its potential impact is being reviewed by the company.
<!–[if !supportLists]–>· <!–[endif]–>At December 31, 2006, the company controlled approximately 88,500 lots with an aggregate purchase price of approximately $9,000,000, by making or committing to make deposits of approximately $632,000 in the form of cash and letters of credit. The entire risk of loss pertaining to the aggregate $9,000,000 contractual commitment is limited to the deposit amounts.
<!–[if !supportLists]–>· <!–[endif]–>$114 million in future operating lease payments and $134 million in purchase commitments are carried off-balance sheet.
Cash flow analysis
Operating cash flow and net income trends – cash flow from operations grew in 2006 despite a decline in net income, primarily due reduced investments in new land and inventories and to the reduction in net income attributable to forfeited deposits. The cash flows for these deposits occurred in earlier years.
Free cash flow and net income trends – free cash flow rose from approximately $510 million in 2005 to approximately $660 million in 2006.
Footnotes
Legal issues – Company does not believe it is involved in any legal proceedings that are likely to have a material adverse effect on its financial condition or results of operations.
Social concerns – The EPA has sought information regarding the company’s storm water management discharge practices in North Carolina, Pennsylvania, Maryland and Virginia during the homebuilding construction process. Additionally, in 2005, the EPA notified it of alleged storm water management violations under the Act at a homebuilding site in Pennsylvania, and that it may be subject to administrative fines. Deferred revenue
Growth indicators
Backlogs – 6,388 units and approximately $2.6 billion at December 31, 2006 compared to 8,310 units and approximately $3.7 billion at December 31, 2005. Cancellation rate was approximately 19% during 2006. During 2005 and 2004, cancellation rates were approximately 12% and 11%, respectively.
Macro-economic factors – prevailing market conditions exerted downward pressure on selling prices, and in response, the company increased incentives to homebuyers and reduced prices in many markets. These pricing pressures led to a 7% decrease in the average selling price for new orders in 2006 as compared to 2005. Average selling prices for the six-month period ended December 31, 2006 were down 10% from the same period in 2005. The company is seeking concessions from its developers to reduce lot purchase prices to current market values and/or to defer scheduled lot purchases. If it cannot negotiate concessions, it may exit the community and forfeit its deposit.
The proxy statement and other issues
Related party transactions – During 2006, 2005, and 2004, NVR purchased, at market prices, developed lots from Elm Street Development, a company that is controlled by a member of the NVR Board of Directors (the “Board”). These transactions were approved by a majority of the independent members of the Board. Purchases from Elm Street Development totaled approximately $50,000, $29,000, and $8,200 during 2006, 2005 and 2004, respectively. NVR expects to purchase the majority of the remaining lots under contract at December 31, 2006 over the next three years for an aggregate purchase price of approximately $85,000.
The author may hold a position in the securities discussed. The author’s current holdings are as follows: Long: Union Pacific (UNP) put options; Air Products (APD) put options; Bookham (BKHM; Ballard Power (BLDP); Syntax Brillian (BRLC); CMGI (CMGI); Genentech (DNA); Ion Media Networks (ION); Three Five Systems (TFS); IShares Japan (EWJ); StreetTracks Gold (GLD); Starbucks (SBUX); U.S. Oil Fund (USO); Plantronics (PLT) call options; Short: Ceradyne (CRDN) put options; Tempur-Pedix (TPX) put options; Landstar (LSTR) put options; Plantronics (PLT) put options
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