NVR: A Great Company, But Don’t Ignore the Stock Comp
NVR is a high quality company that investors really like.
Unlike most homebuilders, the company has no net debt. And despite being a homebuilder, the company has tremendous returns on capital due to its well known capital-light land option strategy and because mgmt runs a tight ship.
Pre-Tax Return on Assets:
NVR 30%
DR Horton 19%
Pulte 12.5%
Lennar 8%
NVR has also managed to grow revenues nicely across the cycle by slowly expanding into new geographies and taking share by chasing density in the geographies in which it already operates.
The proof is in the pudding:
NVR Stock Returns
3 Years 13% CAGR
5 Years 18.5% CAGR
10 Years 18.2% CAGR
The 2018 Proxy also contained this tidbit: TSR of 15,938% over the 20 years ended December 31, 2017 was 7th highest among Fortune 500 companies
However, the options issuance and resultant shareholder dilution has been something to behold.
Over the 5 years 2014-2018, NVR issued ~1M options to management (net of forfeitures). This is a company that had 4.5M shares outstanding in the beginning of 2014 and has 3.7M outstanding today.
So, management retained ~20% of the upside (1 / 4.5) of the overall enterprise while common stockholders retained 80%.
I think that’s the right way to think about this company.
Work out in your analysis how well you think NVR is going to do over the next 5 years, and then give yourself 80% of the upside, while assuming 20% will be retained by management through your dilution.
So for example, I think NVR can grow cash flows at 5%-6% CAGR over the next 5 years and buyback around 7%-8% of diluted shares outstanding per year. Let’s call that a 13% return.
Over 5 years, that accumulates to 85% upside (1.13^5 - 1). If I keep 80% of that 85% upside, my return will come to something around 10%-11% per annum.
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All this is not to say that I think the management are pirates. There truly are few “moats” or structural advantages at a homebuilder apart from the employees and management.
And NVR’s management team is truly exceptional.
They’re also pretty aggressive about clawing back options when targets are unmet. The company cancelled ~500K options in 2008 when the firm failed to meet targets.
During 2005, the Company’s shareholders approved the Board of Directors’ adoption of the 2005 Stock Option Plan (the “2005 Plan”). There are 500,000 Options authorized under the 2005 Plan. All Options under the Plan were granted at the fair market value underlying the Shares at the date of grant and were subject to two vesting conditions. The first vesting condition required that the Company satisfy a performance target based on growth in earnings per share (“EPS Target”) as of December 31, 2008. The EPS Target was set at a level that reflected a growth rate in diluted earnings per share of ten percent per year for four years, based on NVR’s 2004 diluted earnings per share of $66.42. The aggregate EPS Target was $339.00 per share, the measurement of which was based on the sum of the actual diluted earnings per share results for the four annual periods ending December 31, 2005 through 2008. As of December 31, 2008 the EPS Target was not met and all Options in this plan expired unexercisable. As a result of failing to meet the EPS Target, the plan was terminated effective December 31, 2008 and no future Options can be issued from this plan.
The 2018 Equity Incentive Plan also had 50% of options grants that were performance based.
However, it’s one thing to take 20% upside when the intrinsic value of the company was growing at 20%-25% per annum over the last 1-2 decades.
That’s not realistic anymore. I think a more realistic growth rate is 12%-14%. At this rate of growth, giving 20% upside to management starts to hurt.
It’s possible that future equity incentive plans at NVR will not be as dilutive. The 2018 Incentive Plan only authorized the issuance of 275K new options, or about 7%-8% of shares outstanding, in contrast to about 17%-18% of shares outstanding under the 2014 Plan.
But that remains to be seen. For now, I assume a 80%/20% split of upside, similar to a hedge fund of sorts.