In depth analysis of DR Horton (from July 2010 Partner Letter)

1. DR HORTON – PARTNER LETTER EXCERPT
Jason C. Norbeck, CFA
Managing Partner
JCN Investments, LLC
JULY 2010 - DR HORTON is the most dominant homebuilder in the United States, the 700lb gorilla of the industry and the company’s 1st quarter
results highlight this fact. DR Horton’s 1st quarter results were materially better than that of its competitors and while DR Horton’s results have no
doubt been aided by increased demand related to the tax credit, this is a factor that favorably impacted the entire industry and cannot be used to explain
DR Horton’s strong relative performance. Sales orders (new contracts) increased by a staggering 56% (the second consecutive quarter that DR Horton
has achieved sales order growth greater than 50%) and DR Horton was one of only two public builders to report an increase in revenue (16% increase)
in the quarter. DR Horton was also one of only two public homebuilding companies to report a profit for the seasonally slow first quarter and the
company produced the highest level of sales per employee in its industry. It is becoming increasingly more apparent that DR Horton has been and will
be able to capitalize on the distressed conditions in its industry at a faster pace and to a greater extent than I had previously anticipated. This is in large
part due to the company’s unique business model. DR Horton’s results indicate that the company can grow regardless of the challenging conditions in
the housing market.
1Q 2010 Year over Year % Change 1Q 2010 Sales per Employee
Sales Revenue
DR Horton 56.0% 16.1% DR Horton $ 488,000
MDC Holdings 34.9% -16.4% Meritage $ 382,857
Lennar 20.1% -4.9% Ryland $ 270,854
Meritage 15.5% -13.0% KB Home $ 263,571
KB Home -4.4% -14.1% MDC Holdings $ 236,639
Pulte/Centex -12.2% -26.7% Hovnanian $ 211,429
Ryland -12.7% -5.7% Pulte/Centex $ 191,404
Hovnanian -19.6% -19.9% Lennar $ 163,755
Before I compare DR Horton’s operations to that of its public competitors, it is important to note that public homebuilders as a group are positioned to
benefit tremendously from the collapse of the housing market. During the boom, the majority of new homes in this country were built by small private
builders, mostly financed by loans (collateralized by land) from commercial banks. The collapse of the housing market has permanently altered the
landscape of residential construction finance in a way that greatly favors public builders. In order to appreciate the opportunity that lies ahead for the
large public homebuilding companies (who are not reliant upon collateralized loans from commercial banks) it helps to understand how commercial
banks operate and how they are regulated.
The banking industry operates like a herd of elephants, chasing loan categories as a group while at the same time never forgetting their past
transgressions (an elephant never forgets). Banking history is marked by severe disruptions or crises often highlighted by losses related to a single loan
category. For example, in the early to mid 80s banks became overexposed to “LDC” loans (Lesser Developed Countries) now known as Emerging
Market Debt. The US Treasury eventually guaranteed a significant amount of LDC loans (via Brady Bonds) to prevent a large number of major banks in
the US from being declared insolvent. In the late 80s, “HLT” loans (Highly Leveraged Transactions) also known as Junk Bonds and now referred to as
LBO loans (Leveraged Buy-Out) rocked the banking industry. In the early 1990s commercial banks experienced significant losses related to a downturn
in the commercial real estate market.
Banking regulation and as a result bank lending tends to be backward looking and each crisis is followed by a “Well, we can’t do that again” mentality
that restricts a bank’s ability and willingness to lend to that specific loan category (regulators never forget). As a result, the composition of a commercial
banks’ loan portfolio has evolved to exclude Emerging Market Debt and LBO Debt and there are numerous enhanced regulatory restrictions related to
commercial real estate lending. The crisis impacting Greece and potentially other nations is of little consequence to the US banking industry because
even the most “international” US banks have virtually eliminated their exposure to foreign government loans as a result of the prior LDC crisis. Also,
the lending restrictions brought about by the previous crisis related to commercial real estate lending is a major reason why the current weakness in the
commercial real estate market, while equally severe to that of the early 90s (if not worse) has not led to the significant losses for the banking industry
that many had anticipated.
This recent crisis has been the most severe, has had many causes and has affected a wide range of financial institutions. However if one were to solely
focus on the loan portfolios of the Commercial Banks (separate out those banks with Investment Banking divisions and the Mortgage Companies/Thrifts)

2. the crisis is clearly centered in residential construction lending. Beyond the obvious distress in the housing market, the nature of a distressed residential
construction loan is such that the degree to which a bank is required to charge off the loan has been well beyond what anyone imagined possible before
the downturn (if you question this statement I suggest you give Zions’ Chief Credit Officer a call). When a loan is showing signs of distress and is
backed by collateral, the bank is generally required to obtain a third party appraisal of that collateral and charge the loan down to its appraised value (or
even slightly below). The lack of documentable cash flow has caused a decline in the appraised value of residential construction projects that is
destructively severe. So much so that it is impossible to imagine a future banking regulatory environment that does not involve greater restrictions on
residential construction lending for commercial banks. The severity of loss in this category has been so high and the size of the average residential
construction loan is of sufficient size (usually many millions of dollars) that even for loans that are economically attractive and even without regulatory
restrictions a bank simply cannot afford to risk the size of the potential charge to capital if the performance of that project does not live up to
expectations. As a result, residential construction finance has been altered for a majority of the industry’s participants because banks will be materially
less willing to accept the assets of a residential construction project as collateral for a loan. Just yesterday, a Citigroup analyst released a survey of private
homebuilding companies that included the following quote: "the vast majority of survey participants reported that acquiring AC&D (Acquisition
Construction and Development) financing from banks remains difficult if not impossible to source." Lending conditions for private builders are not
likely to improve any time soon.
Even the most pessimistic housing bears acknowledge that population and demographic trends dictate that our country will need to build homes at a rate
that is ultimately 2 to 3 times greater than the current pace. However, the eventual material increase in demand for new homes will not be accompanied
by a similar material increase in the availability of financing for new home construction (at least from the banking industry). As a result the large public
builders that finance residential construction via substantial equity and debt that is based on their credit rating as an operating company (not
collateralized by land) are in a position to reap a lion’s share of the rewards related to a housing recovery.
Not only is DR Horton one of a small group of public builders that have widened their competitive advantage in relation to smaller private builders, DR
Horton has also widened its advantage over its public competitors. DR Horton’s point of differentiation comes from the fact that it starts the vertical
construction of a home before it has a buyer. The industry refers to this strategy as “spec” (speculative) building. Most homebuilders either do not
engage in the building of “spec” homes or do so in a much more limited degree. The majority of homebuilding companies operate a “Built to Order”
strategy in which vertical construction is delayed until the home has been sold.
As one might infer by its name, DR Horton’s “spec” strategy is often categorized as the riskier of the two strategies (even chaotic) by analysts and the
industry. This is incorrect, as the assets of a homebuilder tied to vertical construction are its most attractive because a completed home is liquid and can
be converted to cash within just a few months (even in a weak real estate market) and because the payback period for the investment is short and the
return on capital is high. In contrast, assets related to Land Development (which is a homebuilder’s alternative capital requirement) are illiquid
(especially in a down market) and the payback period usually extends out over many years. The incremental investment required for a builder to
commence vertical construction in anticipation of future sales is not only minor in relation to the capital a builder commits to the land and land
development of a project but it also enhances the liquidity of the asset and shortens the length of its payback period. As a result, the bulk of DR Horton’s
public competitors operate in a manner that is penny wise but pound foolish as the relative pennies saved by delaying vertical construction are small
compared to the gains in sales volumes and the better operating efficiencies that DR Horton achieves via the “controlled chaos” of its spec strategy.
Remember neither DR Horton nor its competitors engage in the business of building luxury homes that intuitively favors a “Build to Order” business
model. DR Horton and its competitors primarily target first-time homebuyers (and first-time move up buyers) who are more likely to prefer the ability
to move quickly into a home over the ability to customize it.
DR Horton endeavors to always bring homes to market at a price point that is below that of its competitors and to always have homes available at
various stages of construction so that a buyer is able to close on a new home sooner than the three to six months it takes to build that home from scratch.
The end result is that DR Horton builds and sells homes at a faster pace and at a lower cost than its competitors (it really is just that simple). DR Horton’s
unique strategy which is the homebuilding equivalent to Sam Walton’s mantra to “price it low, stack it high and watch it fly” is a major reason why DR
Horton rose from relative obscurity in the early to mid 1990s to become the largest homebuilder in the United States at the height of the housing boom.
% of Total Homes Sold by the Top 5 US Homebuilders
1996 2000 2005
DR Horton 6.5% 19.1% 24.2%
Pulte/Centex 54.9% 40.4% 40.1%
Lennar 15.7% 18.6% 20.0%
KB Home 19.0% 20.0% 14.7%
The boom in housing caused all homebuilding companies to grow and DR Horton’s oversized growth rate was often viewed to be more the result of
greater risk taking (in part because it built on spec) than due to a superior business model. However the opposite is true. DR Horton’s superior business
model caused its competitors to aggressively pursue land and increase leverage to compensate for their competitive shortcomings. This has further
distanced DR Horton from its competitors and DR Horton has not only maintained its industry leading position during the downturn, it has expanded it.
In 2007, the four largest builders in the US were DR Horton, Pulte, Centex and Lennar all with similar sales levels. Despite the merger of Pulte and
Centex in 2009, DR Horton closed 49% more homes in the 1st quarter of 2010 than its next closest competitor and DR Horton’s 1st quarter sales were
only slightly less than Pulte, Centex and Lennar combined. DR Horton is dramatically outperforming its peers.
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3. % of Total Homes Sold by the Top 5 US Homebuilders
Last 12 Q1 2010 Q1 2010
2006
Months (Closings) (Sales)
DR Horton 24.8% 31.0% 37.4% 42.2%
Pulte/Centex 36.1% 36.6% 33.3% 28.3%
Lennar 23.2% 18.7% 17.6% 16.9%
KB Home 15.0% 13.8% 11.6% 12.5%
The most common argument for why builders utilize a Built to Order strategy as a means to convert renters into homeowners is the claim that it
produces better gross margins. However DR Horton’s operating margins have always been equal to or better than any of its competitors partly because
the higher sales volume leads to greater operating efficiencies (DR Horton’s sales per employee is also nearly 5 times greater than Wal-Mart). DR
Horton’s long standing strategy that uniquely emphasizes volume and speed over gross margin has also brought a new added benefit that is further
separating DR Horton from its competitors. DR Horton is one of only a few builders that is willing and able to fund “spec” construction (with a long
history of doing so) and as a result the company has emerged as the preferred partner for land sellers who wish to maximize the value of their residential
land assets by building homes as opposed to selling the entire property for pennies on the dollar in an illiquid land market. While all builders boast of an
ability to capitalize on the opportunities brought about by the collapse of the housing market, it is becoming readily apparent that no other builder is
more uniquely positioned to do so than DR Horton. And the proof ultimately lies in the numbers as no other builder has entered into more contracts to
open new communities since 2009 than DR Horton (it’s not even close). If fact despite DR Horton’s already comparatively larger size, it is the only
public homebuilder that is conclusively growing its “community count” (the homebuilder equivalent to stores for a retailer) and is likely to continue to
do so for many years into the future. In addition, the percentage of DR Horton’s current sales derived from newly (2009 or later) acquired communities
is significantly higher than that of its peers.
% YOY Change in % of 1Q Sales from
Communities (Stores) Newly Acquired Communities
DR Horton 29% DR Horton 35%
Lennar -5% Meritage 19%
KB Home -9% MDC Holdings 10%
Meritage -12% Ryland 10%
Hovnanian -17% Lennar 9%
Pulte/Centex -21% Hovnanian 8%
MDC Holdings -27% KB Home 5%
Ryland -29% Pulte/Centex 0%
DR Horton currently trades at a discount to its book value (which consists of cash and deeply discounted land) despite a potential for future growth that
is almost unmatched by any company in any industry. This should not come as a shock to anyone who has followed the company as it has been
mispriced by the market for the better part of the last twenty years. From 1992 through 2006 DR Horton grew revenue faster than Amazon.com with
operating margins 5-10 times greater than Amazon.com yet never once did DR Horton trade at a premium to the market (based on earnings). The
recent collapse of the housing market has been severe and certainly warrants a drop in the valuations of companies related to the housing market.
However, the persistent mispricing stems from the market’s past and present failure to value DR Horton as an operating company. Instead, DR Horton’s
valuation has always reflected the perceived market value of its land assets (Nike, for example is not valued based on the market value of its shoe
inventory). Due to this narrow view, metrics used by analysts and investors to assess the value of an operating company are rendered immaterial to DR
Horton’s valuation, like Operating Margin, Return on Capital, Revenue Growth and most importantly the Present Value of Future Earnings/Cash Flow.
No other company (that I know of) is greeted with such yawns after reporting a 50% increase in sales as is DR Horton. The results were almost of no
consequence to its valuation. The argument that DR Horton is significantly more valuable than the market value of its land is overwhelming supported
by fact. KB Home sold one third fewer homes in 2009 than it did in 1996 while DR Horton sold more than ten times as many homes in 2009 than it did
in 1996. The two firms compete directly against each other, yet DR Horton’s costs as a percentage of revenue are nearly half that of KB Home (13%
versus 23%). Despite of this, DR Horton and KB Home both trade at approximately the same premium/discount to their net assets. In other words, the
market assigns an identical intangible value to each operating company (zero) despite the fact that virtually every current or historical operating metric
favors DR Horton (Sales Growth, Operating Margins, Return on Capital etc . . .). DR Horton grew by 1000% over the last 13 years while KB Home grew
by -33%, the companies clearly should be valued differently.
I believe the main reason DR Horton is persistently mispriced is because the company is inaccurately classified as a “homebuilder” (analysts hate
homebuilders). In actuality, DR Horton’s employees don’t “build” anything. DR Horton’s employees don’t carry hammers, they don’t pour cement. DR
Horton employees carry pens and glossy brochures. DR Horton is a sales and marketing organization, the vast majority of its employees engage in the
business of selling homes, not building them. The bulk of DR Horton employees not engaged directly in sales work as accountants or bookkeepers. DR
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4. Horton is actually a “New Home Retailer”. DR Horton hires third party subcontractors to build its homes much like Nike hires third party
subcontractors to manufacture its shoes. DR Horton is no more of a “homebuilder” than Nike is a “shoe manufacturer” (which it is not). In truth, the
operations of DR Horton and Nike are more similar than they are different as both principally engage in the business of sales and marketing (analysts
love sales and marketing companies!). Nike does turn its inventory much faster than DR Horton, but Nike also must invest heavily in its distribution
system and is forced to carry a large amount of receivables from its retail partners (it does not receive cash immediately for its sales like DR Horton
does). The pluses and minuses largely even out and the operating margin and the return on capital of the two businesses are comparable. Nike’s
business does benefit from the strength of its brand more so than DR Horton ever will, however Nike also must invest heavily to maintain that brand.
Addias, Puma, Reebok and Converse all were at one point the premier brand of athletic shoes in the US States and yet each have declared bankruptcy or
experienced a major financial restructuring during the last twenty years, so I don’t think one can argue that Nike’s future earnings stream is any more
stable than that of DR Horton simply due to the current strength of its brand.
If you gave DR Horton’s financial results to an analyst and said it was a shoe company (or a retailer) the company would literally be perceived to be 10
times more valuable. Even if the market continues to incorrectly perceive DR Horton as a “homebuilder” the potential return on our investment is
enormous because DR Horton will likely increase its book value dramatically over the next 5-7 years. However if market ever realizes that DR Horton is
actually a “New Home Retailer” our potential return is many times greater.
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