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This is Matt Russell and today we are breaking down DR4K. Our guest is Ed Wackenheim
founder of Greenhaven Capital. Now to bring you behind the curtain a bit here,
when I heard Ed was in for a Breakdown, I did my best to treat this professionally.
But I will let it be known I am a major fan of Ed. In 2016, Ed wrote a book Common Stocks
and Common Sense. And in the forward to that book, Ed laid out his framework for how he approaches
investing. Now I will spare you my reinterpretation of those words and just recommend the book to anyone
or any investor that hasn't read it yet. But in the same way that Michael Mobison grounds you
in the foundation of fundamental investing, Ed did this in his own form. And if you ever hear
me on the show saying, uh, average company should trade at 15 or 16 times, Ed really laid out the
reasoning for that in his book. And if I had any concern that Ed would live up to my high expectations,
that was quickly squashed. But you will hear is an incredible discussion walking through DR Horton
and the homebuilders broadly. And just how much has changed with this business model over the years.
Ed stories with a management teams are enough to fill an episode and entertain you. But to my
extreme joy, anytime I would ask Ed to quantify point, he had the number handy and he brought a lot
of those numbers proactively into the discussion. So it's an excellent conversation and excellent
glimpse at how someone like Ed approaches his investments. And without further ado, please enjoy
this breakdown of DR Horton. All right, Ed, I am excited to have you here to talk about homebuilders,
DR Horton. And I was thinking about where we start and I thought it would be silly not to capture
some of your experience looking at this sector over time. And in preparation of the discussion,
it was mentioned that you've been looking at this space since the 80s, which I think is
incredibly unique. And I thought maybe we could go into the way back machine and talk about what
it was like looking at homebuilders in the 80s. And we can just evolve over time because I think
a big piece of this is the evolution of the business model. But maybe you can bring us back to the 80s
and what it was like to be looking at these stocks at that period of time.
The great Matt and you've just given away my age a little bit, but it's great to be here
and speaking to you. Yes, it goes back to the 1980s. I was on the board of a company called Interstate
Brands located in Kansas City. The CEO of Pulti, which is now the third largest homebuilder,
was on the board also. And between committee meetings, and between committee meetings,
in the board meeting, I used him as my professor. I called him Professor Jim with Jim Grossfeld.
And I said, Jim, would you teach me something about the homebuilding business? And I bought some
beers and I bought some coffee. And I got a good understanding, I think of the fundamentals of
the industry at the time from the professor, which I owe a lot to. I'm sure. And were you an active
investor in the space in that decade in the 90s? Was that something that you were frequently
invested in? Good question. No, it was a tiny industry at the time, probably not
investible in terms of the size of the companies. But in the mid 1990s, I was screening for stocks.
I think on the Bloomberg looking for stocks with selling at low P ratios, low prices to book.
And I came across a company called US Home. And it was selling at about 0.6 times hard book value,
and less than six times earnings. And those ratios, of course, are adrenaline flows for
value investors. So I just didn't work on the company and we ended up on the stock. And then
over the subsequent years in the late 1990s, I noticed that it and the other public homebuilders
were going considerably faster than the economy and then the homebuilding industry in general.
And I tried to figure out what was going on. And what was going on was that many of the very small
homebuilders couldn't compete any longer, either because they did not have scale, but particularly
during that period of time, there was the thrift crisis, the savings bank crisis. Many of the very
small homebuilders were dependent on the thrifts for financing. And as the thrifts went out of business,
the very small homebuilders found difficulty finding financing and they were going out of business.
So the larger companies, particularly those that were public that had availability of financing,
were growing at the expense of the very small homebuilders. So it was a consolidating industry.
And in fact, one, the large homebuilders were growing very rapidly. And that was a great opportunity
to, I thought, make considerable amount of money in the homebuilders. So we bought the homebuilders
very heavily under year 2000. And they did very well. And the stocks went up several fold.
They reached the point at about 2005 where their risk reward ratios were no longer attractive to us.
And we sold them, and then we bought them back in about 2014 and have held them ever since.
That's our history.
It's quite some discipline to be on the sidelines for that nine-year period.
Can you talk a little bit about the 90s and early 2000s? You mentioned the consolidation of the
industry fragmentation. I gathered from the basic research that I was doing that there were some
pretty material tailwinds just in terms of build out. And obviously some dynamics of that
played into what happened in the financial crisis. But just from a business model perspective
in that time frame versus what you're looking at today. And I think this will shape a lot of the
conversation. But can you talk about the business model then? And what maybe the main characteristics
are that would look different than what it looks like today?
The business today is completely different. The business model is completely different.
At that time there were thousands and thousands of builders in the country. The largest
builder I think was Sentex at the time and they had about a 1% market share. And the second or
third largest builder and the fourth largest builder were a fraction of 1%. So what a builder would do
would be to go out and buy some land, get the land permitted, get the land developed, and then
build some model homes on the land. And then using the model homes as a selling tool, then
would go out and try and sell homes. It would get a deposit, build a home, and when the home was
completed then the home would be sold and affect money would change hands. The builders would
then tend to take the proceeds from the sales and go out and try and buy more land. So it was a
land intensive business. Sella House go out, buy more land. And as a result these companies
continually had leverage balance sheets because they had a considerable amount of land on the
balance sheets to the effect that in some cases they had to go out and not buy the land directly
but option of land. So optioning of the land which is not prevalent at that time was a necessity
not a choice. So if you look at the industry at that time many players tended to have ROE's below
10% because they had large investments in land. When you think about it a land is not a good investment.
Land might appreciate and value three or four percent per year. The home builders needed to keep
five or six or seven years of land supply relative to the number of houses they're selling in order
to have an adequate supply to have time to get the land permitted and developed and then ready to
build on. So they had these large investments in land. They were real estate companies that happened
to build houses and that's the way it looked. Their cash flows mainly went to buy more land and
were not available for the shareholders. So it was not a good business. We called them stick builders
which is not a favorable name and they probably deserve to sell low multiples. I mean highly
leveraged with debt low ROEs and not very good cash flows. The turnaround was and the optimistic side
was they were growing rapidly. So they were good investments because they were in his per share we're
growing double digits at the time because of the gains in market share. It's interesting the way
that you describe that brings me very much to the oil and gas world of leasing land producing wells
mostly taking the cash that comes out of those wells and then plowing it back into more wells.
And it's a model that theoretically works as if the demand for your output is growing in which case
housing and the market in the late 90s and early 2000s was incredibly strong. But when that
demand dries up and you have land exposure, levered balance sheets, I can understand the challenges
and what happened there. And I think that's a fairly well told story. Putting a bow on this piece
of it in that era, how long did it take from that initial purchase of the land until you were
actually seeing sales? You mentioned the permitting process and then there's the building process and
then there's the marketing the model homes. What did that look like in terms of dollars being
outlaid and then dollars coming back in? Was there a conversion cycle in terms of years that it
took to see that cash come back? So the best way to look at it if you go back to Horton for example
10 years ago, 2013, for every dollar of sales, they had more than one dollar invested in inventory
that inventory could be divided into how does under construction and land. And close to two thirds
that would be land. So they had a very large percentage of their invested capital tight up in land.
Now we started thinking and occasionally we get proactive not against managements but in terms
of ideas and as early as 2005, I was in a meeting with a syntax, Tim Ella was the CEO of
Centax and I bought Jim Grossfeld, my professor in on the meeting and we started talking about
the nature of the business. My argument and Jim Grossfeld's argument was why do you need
Wallace to land on the books? Why don't you option the land you're optioning some already?
Make this an asset like business. Take down the land just before you need it and it'll completely
change the nature of the business. One, much less capital intensive. Therefore, a large percentage
of earnings will come to the shareholder in terms of free cash flow. You will not need much debt
on the balance sheet. AROEs will increase dramatically because building homes was a good business
for owning land five years supply of land when land appreciated three or four percent and you had
to finance that land was a bad business. And Tim Ella for us, you know, on the stand of business,
we've been very successful, don't criticize us. We had a little of an argument which I actually
wrote about the book he referred to that I wrote in 2016. But what happened was there was one home
builder, NVR, that always was land light. Had an excellent balance sheet, high AROEs,
what backstock and typically sold at 16 times earnings. As a matter of fact, the average
BE ratio of NVR in 2015 to 2019, we go to the pre-COVID period because it was a more normal period
was 16 times earnings. In the meanwhile, Horton was selling at 12 times earnings. The NVR model was
a much, much better model. And what has happened is, and frankly, we were a little proactive
and speaking to the management to do this, the management's have, I would say, gotten religion,
and they have gone to the asset light, don't own a lot of land model. So Horton today,
their option land is 75% of the total land they control. Hennor was about the opposite of that,
it was 25%. If you go back 10 years ago, and that has completely changed the balance sheet.
If you go back 10 years ago to 2013, they had $2.3 billion of net debt in their home building
business. Today, I will say that was September 30th, which was today because that's the end of
that fiscal year. They had $600 million more cash than debt in their home building business,
completely different business. If you go back 10 years ago, the ROE was about 10%,
last year was 22%. So the business has transitioned really from being a real estate business
to being a manufacturing business. Horton today is a high volume manufacturer of homes.
It's completely different business that it was in the 1990s.
You mentioned NVR, and I would be remiss not to bring up one of the better or most known
stock pitches ever that sits on value in Pestridge Club. In 2001, Ish Range talks about NVR
and how their model is different. It's a great place in time right up because you know what ended
up happening there. You mentioned a little bit of the pushback that you got on why they didn't
have the model, which didn't seem to carry much logic. It was just simply, you don't know how we
operate and we've had success over a period of time. Were there any good reasons to not move
towards the optioning of the land and continuing to be landowners before we move on to Horton
specifically? Was there any good reason to consistently own the land rather than have an option
on the land? No, it was a metal attitude. It started when builders were very, very small builders,
and they simply went out and said they had friends with a local banker. Okay, fine. I see this
plot of land coming up. Were you finance with me? Yes, okay, fine. They buy the land. And of course,
because of their size, they had not developed the relationships with land banks and land developers
that the larger companies like NVR developed. So it was partially sized and it was just partially
a metal set. I had many conversations with Bob Toul who was the founder of Toul Brothers along
with his brother and he had a mindset. I just don't bother me with this. I just want to buy the
land and own it. I will define it. That was the attitude. It was only after he passed away that
Doug who's a new CEO completely changed the model and now they are becoming asset light.
It really is the way to go. And manufacturing homes and a consolidating industry is turned out
to be a very good business for the very largest players who have the scale and the scale advantage is
huge that Horton has it on the North has. And they're continuing to gain market share as you know.
Yeah, it's a good opportunity to transition to Horton. The largest home builder is how it's
marketed in the US. But maybe you can just introduce us to the name in terms of what you would
describe as differentiating about DR Horton as a home builder relative to any others. Maybe size
is the main factor. But just the brief description on who DR Horton is. Sure. And let me go back to
the beginning. There is a man, DR Horton, Don Horton, the stole lives. It came from a small town in
Arkansas. His father was in the real estate business and raised cattle. This is a real world town.
And Don went to the University of Oklahoma, got married while he was in school, dropped out to
support his wife, worked for his father for a while, was more ambitious than the opportunities in
a small town in Arkansas would present. So he moved to Fort Worth and worked for a home builder there.
And then after working for the home builder about one year, decided to start building his houses
himself. He had $3,000 of personal net worth. He went to a banker and borrowed $30,000.
The banker had faith in Don Horton and Don built his first house in 1978. It's successful. 1979.
He built 20 houses in 1980. He built 40 houses. And the company went public in 1992. At a time when
they built 1200 houses. So that's an example of 1200 houses with.2% market share. They
operate in a limited number of markets. The years went on. Horton grew by increasing the market
share and existing markets and also by diversifying it to other markets. Today, there are 118 markets.
Some market might be Jacksonville or it might be Atlanta or it might be Orlando. And there
are 33 states. They grew partially through acquisition. But when they acquire companies,
they're usually acquiring companies in trouble because of financing that own land. And with
their really acquiring as a land. So the beauty of this industry, it is a rolling up industry.
It still is rolling up companies still gaining market share. But they're doing so through acquiring
land at book value as opposed to acquiring other companies and paying a large premium. So if you
look at the homebillage in Horton, they have almost no goodwill in the balance sheets.
Lennar is the exception. They brought a company called Carol Annex. They have $3 billion of good
will in the balance sheet. Still a very strong balance sheet. Horton is virtually no goodwill
in the balance sheet. Don Horton was very good. And I think one of the correlations is,
there's a correlation between the size of the company and the quality of management.
It's almost Darwinism. The best management for the ones that grew of the thousands of thousands of
homebillers, the were, and Horton today became large because of good management. They do have a
niche as such. A niche is the first time buyer. So they tend to buy land in more outlying areas
where land is cheaper and build less expensive houses. Their average house sells for about $375,000.
Lennar is the second biggest home builder. Their houses are more like 450,000. Pulty, the third
largest is about $550,000. So though at the lower end, they also, for manufacturing efficiency,
tend to build houses on what's called spec, which means they will build a house and start a foundation.
Then as the foundations compete, they will start the next step, which is usually putting up
the timber, the wood, the frame. And at the same time, they're doing that. They might start the
next house, the next house, the next house, the next house. Most of these houses are sold before
they're completed. But the houses are not sold before they're completed. If they're building more
houses, then they sell enough slow down the process. If they're selling more houses than they're
building, they'll speed up the process. But the beauty of this and one reason why scale really
matters is that they can hire a subcontractor. So they hire the plumbers and the basins and the
framers and the roofers. These subcontractors can go from house to house to house to house and
not have any downtime with their employees. It is highly efficient for the subcontractors,
which means that Horton can build houses in this manufacturing almost assembling on process,
cheaper than smaller companies. And what's happened in the industry is the large companies have
a major advantages and costs over the smaller companies. And they continue to gain scale
for that reason. They continue to gain market share. I'm sure it's difficult to put a number
on that. But if you had to guesstimate what that cost advantage would be on a $350,000 house,
do you have any sense of what percentage cost savings they might get relative to the
mom and pop home builder? I actually do. Oh, perfect. Horton and Lanar over the last five years
had average operating margins of 16%. They are the two largest. If you go to mid-size builders,
which are not small, that have 12 or 13 or 14,000 homes per year sold, Horton has,
it could be 90,000 this year to get an idea of the difference. But if you go to the mid-size ones
their operating margins are about 12% in the last five years. That's Taylor Morrison, for example,
its KB homes and its Maritosh, those three. So the average about 4% less. And those are still
pretty sizable companies. They're large companies by some standards. If you start getting into
the companies that build 1,000 or 2,000 houses a year, the margins probably are well below 10%.
And then you get to the question, are the returns, particularly after interest expense,
worth it? Can they make money at that? I have spoken to numerous small builders. And of course,
the returns for the very small builders vary tremendously. You've got some very scrappy small
builders that do well. But many small builders really struggle. When they're struggling and not
running good returns and have the risk of debt because they cannot option land when they're small,
they don't have the way we're all to do so. Many of them are simply saying, I know we're going
to need to be in business. And we either build out the land we have and disappear, or I will sell
land to a Horton, Oral and Ar. And with the industry development, you mentioned Horton has this
niche at the first time home builder. If I were to guess how the market was going to evolve,
I would have expected maybe there was more of a geographical focus rather than a demographic
focus or a specific place in the market. How did that evolve over time? Was there ever geographical
concentration for the home builders? Has that completely gone away? Is that still a dynamic in
the market? There's a huge geographical concentration. If you look at the northeast,
there are not many new homes built, particularly in communities that sort of one by one by one.
If you look at the upper Midwest, there are not many new homes built. We used to call it the smile.
It really starts saying Maryland goes down the east coast, down the Florida, which is a very big
state. Alabama is a big state. Louisiana. Texas is huge. And then Arizona, Nevada, those states,
New Mexico, and Idaho are really growing. It used to be California very heavily. It's still
this California because of the size of the state. But California slipped because of tax issues and
economic issues. And it used to be more Oregon and Washington. And they're slipped a little bit.
But it very much is the southeast and Texas. And then I would say Arizona and New Mexico are
really hot right now. So there is a very heavy geographic concentration for the home builders.
There's no question about it. When you think about the geographic dynamics, I think in the
07 to 2010 timeframe, a lot of the overbuilding or the most stress was felt in those sand states
that you mentioned. And that was a category. How do you frame that in terms of whether it's a risk
or whether it's an opportunity to see that geographical concentration? Is that something that you
consider to be a risk or maybe a secular tailwind? Just how do you put that in terms of framing
into the investment thesis? Every situation's unique. And you have your unique situation now,
and you had a unique situation near 2005, 6, 7, and 8. The situation then was you had high
interest rates in the 1980s and 1990s. After 9, 11 interest rates came down and you had a little
little recession in near 2000 also. So houses are more affordable and you started to get an increased
number of individuals wanting to buy a new house. One of the characteristics of the home building
industry is you cannot increase production very quickly. So demand exceeded supply and the
prices of houses rose very sharply at that period of time. People were even camping out to get
online to buy a house, individuals in retrospect with a prime cause of a housing crisis.
Because they paid much more for houses than they were sold at three or four years before
and much more than they were worth. And then what happened was the value of houses came back down
to normal. A lot of mortgages therefore were underwater. That was a unique situation. It's a good
prelude into what happened today. After that mortgages were difficult to get and for some reason
people were getting married and having children at an older age. There was a big transition during
that period of time. The prime time in life to buy a house as opposed to living in an apartment
is when you get married and have a child. So for those two reasons, the demand for houses
was relatively soft from 2007 really until very recently. And as a result of that,
the nation became underbuilt. We have a basic demand in the United States for about 1.5
million new housing units per year. And you can divide that into two parts. About 1.1 million
is just population growth. So to put that in perspective, there's 145 million housing units
in existence and the increase in demand is about 1.1 million a year or about 0.7%. And that's
population growth basically. So you've got that growth and then about 400,000 houses a year are
torn down either because of age, because of fire, because of flood, because people just don't like
the design and like the property and they want to tear down the house and build a new house on
the property. So there's a basic need of about 1.5 million a year. We substantially underbuilt
for about 12 years. And as a result of that, there's a shortage of estimated between three and
four million housing units in the United States. And the situation today, which is very different
than the situation, then is there simply is not an art opinion, the capacity to build much more
than 1.5 million housing units. Maybe you can get to 1.6, maybe you get to 1.7. But there's a shortage
of labor, there's a shortage of some materials and it's very difficult to get land permitted and
developed at the current time. There's just not the resources in this country. Now maybe over 5
or 10 year period of time, more resources will be available. But just for example, right now,
it's hard to get transformers. So you can't sell a house and you can't build a development
unless you can get transformers. So in home building, if there's one material or one part of the
labor or one part of the process of getting land developed, that you can't do, you can't build a
house. The way we see things, we think that the number of housing starts and that's complete
units, including apartments, can go back to maybe 1.6, 1.7 million per year, but can't get much higher.
Since the shortage is 3 or 4 million housing units in the United States and the normal
demand is 1.5, if you could get to 1.7, you'd be reducing the shortage by 200,000 a year. It would
take 20 years to eliminate the shortage. So this is a very different and optimistic scenario
for the home builders. They really have a long runway ahead of them where demand should exceed
supply. And a important consideration is yes, the home building industry is cyclical, but people
have to listen well. And if you're married and you have a child, you don't want to live with your
mother-in-law. At least I don't want to live with my mother-in-law. And you probably don't either,
Matt. So there is this basic demand of 1.5 million a year. It could be a little more some years,
it could be less some years, but this is a unique feature about the home building industry.
You've got a firm demand. And because we are so underbuilt, the home builder should do very well
over the next 5 or 10 years. And it is cyclical, but one has to be very much less concerned about
a down cycle of any long period of time. Yes, interest rates could spike to 10 percent. And for a
while it could be stuck a shock, but eventually somebody still has to own a house. And if you go back
actually to the eight 1980s and 1990s, believe it or not, mortgage rates average 10 percent.
About 1.3 million housing units were built per year on average during that period of time.
And the population in the United States at that time was 250 million. If you adjust the population
in the United States to the 330 million today, that's equivalent of a demand of 1.8 million
housing units per year with 10 percent mortgage rates. So you can see this the basic demand is
there and was there during a 20 year period of time of high mortgage rates and lack of affordability.
So yes, you could get stuck a shock. Yes, you could get a recession. And there might be a short
period of time when housing turns down. It is cyclical, but the long term looks very, very positive.
And the large home bill is not only have the tailwind of strong demand, but the continuity game market share.
So this becomes a growth industry. Very interesting thesis just laid out right there and a lot of
different angles that I want to cover. For someone like DR Horton, when you have this type of
environment where there's a shortage of supply and there is still strong demand and a need for housing,
do they benefit from what would basic economics would say strong demand,
capped supply pricing would go up. Are they beneficiaries of pricing going up in the financial model
of the R Horton, do they capture a lot of that economic benefit?
pricing has gone up a lot. There was supply constraints in 2021 and in 2022,
prices went up quite a bit and it just rates it up. So affordability is an issue. And that limits,
I think the amount of price increases they can get going forward. But I don't think we need them.
I think if prices stay where they are for the next couple of years and then probably
prices will increase with inflation as they have in the past, 2% per year, 3% per year, 4% per year.
But we're not counting on that in our models for the next several years.
And you did mention before there's challenges with labor and just general supplies.
They're beneficiaries relative to the rest of the market given their size. So there's economies of
scale. But do they get squeezed on the margin side if you have pressures on the cost side of
the equation, but maybe an inability to pass through on price? What has that looked like maybe
the 2020 through today timeframe in terms of the margin profile of the business on those homes?
They, I think, will be able to maintain their margins, not increase their margins,
but maintain their margins. And that's our premise. Courses going up, but they are getting some
price released. Put it this way. It was a test. The test was last year.
Mortgage rates about two years ago were about 3%. They went as high as 8% after prices of houses
increased substantially. And the West Dicacock demand for houses temporarily went down sharply.
The home building industry did very well. They held the margins and yes, they sold fewer houses
in 23 than they did in 21, 22. But their earnings were very strong. They were put to the test
and they passed the test. If you speak to the companies, they are getting increased efficiencies
and they are being able to offset a lot of the costs. The biggest cost concern would be land.
I think in terms of materials, material prices had grown up very sharply in 21 when the
resorted. And material costs, if anything, are coming down a little bit. If you look at labor,
there was a shortage of labor in 21, 22. And contractors were charging more than they had been.
And labor costs have stabilized. Land costs are still going up.
All land is about 10% of the price of a house and costs. And develop lands about 20%.
You buy land for 10%, and you spend another 10% of the price of the house developing the land.
So that 20% of the cost of the land is still going up. But they're offsetting it heavily through
efficiencies. The big companies are getting better and better and better and manufacturing homes.
It's just mass production. I think you mentioned it before. But can you remind me that
normalized margin that you would assume for this business going forward?
It's about 16%, which was the average of the NAR and Horton for the past five years.
And if you break it down a little more, I think the gross margins for Horton should be about 23 and a
half percent. I think there'll be about that this year. This is higher than they were 10 years
ago. But they are benefited tremendously from efficiencies and scale. They can buy their land better.
They are able to offer advantages to the subcontractors. So the subcrategors can pass some of that
on to them. When they go to buy materials, they're buying in large quantities. Horton buys its
appliances from Whirlpool. They're now buying 90,000 dishwashers a year. They used to buy 30 or 40,000.
They're getting a better price. So I think a lot of the gains of gross margins are permitted and
they may even go up from here. So I would look at gross margins staying around 23 and a half. If you
go back pre-COVID, they were about 21%. So they've gone in at least about 2 and a half percent.
And that is largely scale. It's some efficiencies. They're just doing things better. When you look at
SG&A, which for Horton should be about 7% and maybe a little higher than that this year because
they're growing rapidly, it used to be 9%. And that simply is scale. They used to build 40,000 houses.
They now build 90,000 houses. They obviously don't need more than twice. They don't need twice as
many employees, etc. That is pretty permanent. So I look at it that their margins should be 23 and a
half percent, less 7% SG&A and maybe a little over 16%. And we don't increase that. They make it
lucky because of a power and certain markets get certain advantages and increase their margins
from here. But we're not building that in any of our models. We're sticking to about a little over
16%. From a top line perspective, there's going to be cycles. But you mentioned this longer term
tailwind in the market. How do you frame the revenue opportunity or revenue growth over a normalized
period? So Horton says for the foreseeable future, they'll be able to grow close to 10% per year in
units. And if you look at it, a large percentage, that not all because I think the housing
industry is not returned to normal yet. We're operating in terms of single family homes being sold,
not the 1.5 million, but this single family homes being sold was about 660,000 last year. And we
think it was about 825,000. It should get back at least normal. And if the capacity is there,
maybe something above normal. But if you look at market shares and you go back to 2013,
Horton was building 5.6% of those single family sales. You go back to 2018 and went to 8.4%
and you go to 2023, it was 12.5%. So they have more than doubled their market share in 10 years.
And there's no sign that that is being diminished. I would say that small builders today have had
problems getting supplies, including labor. If the shortages, the large home builders are going to
get the refrigerators, they're going to get the transformers, they're going to get the contractors.
And with the regional banks pulling back, many of the very small builders have been
dependent on the regional banks for financing. And that financing is becoming more restrictive.
So I think you're saying if anything, acceleration of problems for the very small builders.
And I think the market share gains will continue. So Horton looks in terms of units that something
close to 10% per year, we use 8% in our model, not including any price increases for the next
several years in our model, but it then should go up to 2 or 3 or 4%. And that would take growth,
everything else being equal up to 10, 11, 12% or something like that. In addition to that,
they are generating large amounts of excess cash and they're buying back stock. Now Don Horton is
more conservative and I have this argument with him than I am. Right now, there's more cash
in debt on the balance sheet for their home building operations. They have a few other operations.
They will keep building cash to the point. I don't know what they probably are buying back 2 to 3%
of their shares each year. They should be buying back more. But if you take and I'll be conservative
here, 8% unit growth the next several years, no price appreciation. So top line growth of 8%,
2 to 3% share repurchases, you get something like 10, 11% gains in earnings per share per year.
They earned $13.82 last year and 10% gains would take you to $18 per share in 2026. We look at
two years. So we're looking at 2026 at this point. Plus the fact that they were building a balance
sheet that's going to have too much cash on it. Incidentally, Don Horton keeps on his desk.
A model of NVR has a company and the price of their shares and the PDRatios. Because you have a
situation, and this really is the bottom line to the home builders. You've got a situation today
where Horton is probably going to earn about $14.50 this year versus the 1382 last year. And this
dark is like a 10 times earnings. So NVR is like a 16 times earnings. NVR is an excellent company.
Horton is probably equally or more excellent because they are much larger, have efficiency
and scale and geographical reach. NVR is heavily concentrated in the Washington DC area.
I think the opportunities for growth for Horton are much greater. And if you look at market share,
I mentioned between 2013 and 2023, Horton's market share went from 5.6% of houses being sold
to 12.5%. During that same period of time, NVR's market share only increased from 2.8% to 3.1%.
They grow much lower. They just are not expanding geographically. So it's an excellent company.
But my argument is, if NVR sells at 16 times earnings, Horton and Lunar being the two largest
home builders being superbly positioned, should sell at 16 times earnings. And let me look at it
another way. Over the last 50 years, the stock market has sold at an average of 16 times earnings.
It sells more than that today. The question is, is Horton in terms of its growth and
terms of its management and terms of its strength, an average company? Or in my opinion,
a better than average company? It's got higher than earnings growth potential than the average
stated in course 500 stock. It's got a pristine balance sheet with more cash than debt.
It's got a very large free cash flow. Cash that I don't even know what they're going to do with the
cash. And in addition to that, by definition, almost the management is excellent because the
manager wasn't excellent, Horton wouldn't have become the company it was today. On a qualitative
quantitative sense, but deserves to sell at more than 16 times earnings. And that is our case.
And if you look out just to see how much money you can make, our projection for 2026 is $18
a share, which is 10% growth. And again, that could be conservative. If the stock sold at 16 times
earnings, it's $288 stock. Stocks $145 today, and you get a dollar 20 dividend. So you come close
to doubling your money. And if the stock happened to sell at 20 times earnings, it's a $360 stock.
It becomes really a home run investment. Exactly what I loved about your book was how simply
you laid out the thesis relative to the market, average companies above average companies,
with all the numbers to back it up. I want to get into that valuation gap. But one last piece
on the income statement, because I want to transition a little bit to cash flows in the balance sheet.
For revenue growth, what you mentioned before was when they're making acquisitions, it's typically land.
So am I right to think that all of that revenue growth is generally coming from their own
production. Maybe it's land that they purchased years ago, but it's not like they're buying companies.
There's not much inorganic M&A growth assumed in that number. Is that the right takeaway?
That's exactly correct. If you look at the number of acquisitions that made over the last
several years have been very few and tiny, so tiny, the most important even disclosed.
It really is land acquisition. There's some person out there that's been building houses for the
last 15 years and has 40 acres outside Jacksonville. It's an individual. It's Matt and company.
They go to Matt and Matt is, I'm getting old and I don't want to take the risk of borrowing
this money and they sell by the land from you. They'll buy Matt and company land and they buy it.
And it never even shows up in a 10K statement. That's typically what's going on.
The company's up saying we have no need to buy anybody who is large at all. We will continue to buy
land, buy a bunch more companies. And there's an accelerated opportunity to do that today
because of the difficulty of getting supplies and labor and particularly because of the
financial situation with regional banks. So you may see some accelerated growth from Horton
and Lenore and maybe that is why they're keeping so much cash in the balance sheet just because
if they see land opportunities and they mentioned that to me, but I'm still critical of their
balance sheets. They're too strong. It's a very conservative person and usually when I
criticize management, it's for having too much debt. We just sold the shares of Whirlpool
about a year ago because they made an acquisition and put too much debt on the balance sheet.
So it's ironic that I am here speaking to Don Horton and saying we're just doing it
in Miller and Lenore and saying why do you have so much cash in the balance sheet?
The siren goes off in your head when you find yourself on the other side of an argument that
you typically have. I want to get into the valuation gap. My initial instinct from hearing something
like that is there must be a difference in the quality of earnings NVR versus DR Horton and Lenore.
And certainly that was potentially the case 10, 15 years ago, but as these business models have
changed, the earnings conversion from those earnings per share into actual free cash flow.
Is there a substantial difference in terms of earnings conversion at DR Horton versus at NVR today?
NVR has been a master at developing land development companies that will develop the land for them
and so too exactly at the last minute before they're going to build a house.
Do they own those companies like? No, they don't. They just work out relationships with land
developers and there are contractors that view going to build an apartment complex. You're
hiring somebody to build the road and build the electrical infrastructure and the plumbing and
et cetera that goes in before the apartment houses built. So they have developed those relationships
over a very long period of time. They have developed them in this geographical area. They don't have
them in other areas, which if they did expand would be a disadvantage. So NVR probably is, let me put
on a scale from one to 10. 10 is asset heavy. One is asset light. So it used to be that Horton was maybe
seven or eight or nine, relatively asset heavy. Today Horton is two, maybe three,
getting to two, maybe getting to one and a half. NVR is one. So NVR is asset lighter.
So they do generate more cash and they use that cash flow to reperture shares, but they don't
grow as quickly. So then I'll sit and I would call it even. I wouldn't say NVR's model is better
than Horton's. I wouldn't say Horton's model is better than NVR. Horton definitely is more of a
growth model and they're going to increasingly get efficiencies of scale compared to NVR.
The bigger you become, the easier it is to get land, the easier it is to get contractors,
the easier it is to get materials because if I'm selling doors and there's a shortage of doors,
I'm going to sell the Horton before I sell to somebody who's building 25 or 30 houses here.
I've got to take care of my very, very large customers. It's not quite apples and apples.
It's maybe apples and pears. No, it's a very fair counter and not that you're suggesting
negativity about NVR's model, but at least pointing out the land development company relationships
and that there is a cap to where they have those relationships and the geographical exposure.
It's not a point that I had previously heard and it actually does, I think, highlight some of the
benefits that the Horton would have just in terms of how they're operating. When you previously
mentioned that shift in mix where I think 25% of land was optioned and today it looks more like 75%.
Is that the mix that you expect to be stable going forward?
The percentage of land option has continued to increase over the years. I think when you get to 75%
and might go to 80, I think for Horton they want to have the land under their control owned
before they start building the models developing with houses. So I think that they will always
want to own some land and there are certain areas of the country and maybe certain pieces of land
were just better to own than to option financially or otherwise. So I don't think they'll get to 95%.
I think that they may get to 80 or 85% over a period of time. Their model already is so good.
I mean, they had 22% return on a tangible book value last year and 16% margins and generated large
amounts of cash flow and of excess cash. So you don't need to change the model at this point.
You've got an excellent business currently. I should have done this earlier in the conversation,
but just from the optioning of land versus the outright purchasing of land, the difference in
terms of what that cost is to actually option the land. Obviously the big cash outlay would come
at the purchase time. But do you have a rough sense of what the expense is to option land?
Yeah, I do. And the rule of thumb is that reduces gross margins by about 3% the cost.
And you can figure it out. They're paying the land back about 11% interest rate and they do
for a certain amount of time and the land is 10% of the cost of a house, a price of a house,
and develop land as 20. So you can figure out they get virtually all that back in lower interest
expense. So for the home builders, when you look at gross margins, it is after interest charge
to construction and effect. So now that Horton instead of having $3 billion of debt,
when they were much smaller, has virtually no debt and it's getting interesting. Come. Their
interest charge of construction is going down by more than 2% of the price of a house.
So they have all set virtually all of the extra cost of often land. And of course they're
substantially reduced risk because if anything happened to the industry or if they had a piece
of land that was really great, they thought, but then it didn't turn out to be so good before
they bought it, they could not exercise the option. Now that doesn't happen very often.
But it is an advantage that reduces risk.
Hedging in some ways. It is a hedge and the hedge is gross money.
And bringing the other potential hedge into the equation is that you mentioned they still
build a lot on spec. What type of risk does that bring into their business model? Is that different
than what you see with a lot of the other home builders? And are there any themes or trends
which would make building on spec more or less attractive? I think the old model was
Matt, you want to buy a house, come see the model. Okay, I need a 10% deposit. I'll build a house
for you and it'll be ready in nine months. And that model has become less attractive to the buyer
because most people don't want to wait nine months and less attractive to the builder
because it's a one-wolf type situation and they can't get the efficiencies of scale.
So the spec model I think is increasing in popularity is almost 100% of what Horton does
and the other builders from Lennar and Toll are going increasingly to spec.
Now, the risk would be if they didn't have a good handle on demand and they were putting more
foundations in the ground, more frames up than demand. But that really doesn't happen. They are
starting houses and building them up and normally the house is sold well before it is complete in
many cases before it's even framed or the well board goes in. If demand happened to turn down,
what they're just building too quickly in any particular community, the weather's bad or something,
they start slowing the process down and vice versa. So they have become pretty good at
pacing the spec starts to demand and it's somewhat seasonal. You start fewer during the winter
because demand is lowered in the winter and the housing industry have the spring selling season,
which supposedly starts at Super Bowl weekend but of course Super Bowl weekend was a week later,
so I kid of them. Does this mean spring season is going to start a week later? They say no,
it's going to start in early February. But early February demand starts to go up because people
start to look at houses heavily because they want to be in a school district in September and they
want to get into the house delivered in time for the school year for their child. In some cases,
in times of the summer because they have a backyard with a little bit of waiting pool in it for
their children. So you get the spring selling season and then accelerate the number of
expect strain season. The home building pretty good at this. I was going to say that time frame,
that accelerating in February for a September, the family is moved into the house. I mean,
that's an incredibly short period of time, which I would have expected it to be much longer cycle
in terms of the build out, but is this to your point, the manufacturing process, which has just
gotten that much better? Yeah, Horton now. And I say now that supply constraints in the
lower exist can build a house in very close to four months, a little bit more than four months,
from the time they laid the foundations and the houses complete. Now they got to have an inspection
and it's usually a punch list. And then they've got a close the house. So typically, I would say,
from the time they break ground on the foundation until the time is actually sold and they get the
money might be six months. So February to September, it works out that way. Now the advantages,
they do have some houses that probably have the wall board in and maybe they're starting to put
in the flooring or the carpeting. And those houses, you might be able to get the living on
in a mother too. Impressive. Tying the bow on cash flow dynamics and specifically capital
allocation. You mentioned the repurchasing of shares, which could potentially go up in terms of
using today's price and what percentage they're buying back. Is there anything else unique going
on with capital allocation dynamics that you think's important to mention here? No, you can pretty
well figure out what the free cash flow is of a builder. Horton today needs about 50 cents of
inventory for every dollar of revenues. That's about half of what they needed 10 years ago.
So if they're growing at a certain rate, you can take the growth in revenues, you can divide that
in half and you can see how much more inventories they need. You can subtract that from that income
and you can see what the free cash flow is. So the free cash flow this year should be something
over three billion dollars. They say it's going to be over three billion dollars. And to show the
conservatism here, they say they're going to repurchase one of the half billion dollars with a stock.
Now I think they're going to repurchase more than that. And it's a September year and they're
December quarter. They did repurchase more than that going rate. And they pay about 500 billion
dollars a year in dividends. So if they just repurchased a billion and a half dollars with a stock
and paid 500 million dollars of dividends, then that cash would increase by more than a billion
dollars this year. I don't think it's going to happen. I think they're going to buy back more stock
or they're going to find a tract of land and then start growing faster than the eight or nine percent,
which I talked about earlier. That's a possibility. And is there any methodology that they use for
buying back stock when it comes to thinking about valuation? Is it fairly steady percentage of
the market cap that they're buying back or anything that they use to toggle that decision-making
between buy back's dividends or investing back into the business via land?
In terms of the timing of share repurchases, early in the year, the building is more capital
intensive because it's starting more homes. The spring selling season begins and it's putting more
homes in the ground in February, March, April than they would at other times of the year. Those
homes tend to be sold late in the year and they tend to get heavy cash lows late in the year.
So they tend to buy back more stock late in the year than early in the year. Has an industry
told what back an amazing amount of stock in the fourth quarter of the last year. They said,
I recently had the cash. We had a great year and we bought back the stock. Toll and Pulti are
buying back five, six, seven percent of that stock each year. Horton and Lenara are buying back
two or three percent and that is the gap that's what's my mind. What are toll of the same? What is
Horton and what is Lenara going to do with their cash? And I don't can't that answer. The answer
may be that they may grow faster than the eight or nine percent that they see opportunities out there
to acquire many, many small builders in effect by their land.
Wind down the conversation with a few miscellaneous questions I had. When it comes to the buyer base,
we always think about home building as families looking to purchase homes oftentimes first time.
It seems like there's a shift or the headlines suggest that there's been the shift towards
more institutional buyers where you're seeing the large groups, the large infrastructure funds,
real estate funds, buying single families that are then converting them into rentals. But maybe
more of a shift towards institutional ownership. Is that something that you one see and two think
has a material impact on the business? It is happening but to a limited extent and I'll put it
in perspective. Horton probably is the largest builder of homes for rent. That is not included in
the 89 and 90,000 houses that going to sell this year. It's about 10% of the business. So they may sell
about 8,000 homes that they built to rent. And those are bought by institutions heavily
hedge funds. Horton is larger than that compared to the other builders. I think it's a very small
percentage of the market. It may be 30,000 homes a year are built to rent and therefore will be
owned by institutions out of the 660,000 single-family homes that were sold last year. So it's 5%.
It serves a purpose because with affordability issue particularly with mortgage rates going up.
If you live in an apartment and you just had a child and you want a home and a good school
district and you want a backyard with a barbecue and you want a little pool for your kids and
you want a house but you can't afford the down deposit. You may rent a house as opposed to
rent an apartment and get the suburban living style and get a backyard and get a good school district.
So that is happening but I think it's going to stay fairly limited.
Very interesting and you segue to bit into my other miscellaneous question which we've touched
on a few different times. But do you have a rule of thumb when thinking about how interest rates
specifically mortgage rates impact a business like DR Horton?
Yeah they do because there are two wishes and affordability one is the price of the house
and the other is mortgage rates. So if mortgage rates climbed higher from here I think
it'd be stuck a shock. People that are looking to buy a house and pay today what the mortgage rate is
6.75 and they might have to pay 9 they would sell less deferred they would mortgage rates come down
but eventually they have to listen well. So again in the 1980s and 1990s mortgage rates average
10% and housing demand was fine and then I want to look at another geography in terms of affordability
California. So where the average house in Alabama might have sold for two or three hundred thousand
dollars. Historically the same housing California might have sold for a million dollars.
Now people didn't have three or four or five times the income. So affordability has continued
to be an issue in California yet people live in single-family homes they adjust their lifestyle
otherwise. I think if mortgage rates rise from here several things will happen. One people will
buy less expensive houses maybe smaller houses maybe houses with less content. Number two home
buildings have always given incentives to buy a house. So if you come in with this house is priced
at $375,000 but if you buy a today mat I'm going to throw in this beautiful nylon carpets which
is of $15,000 extra and I'm going to put some marble in the bathroom for you and that's $10,000.
So buy the house today and you get these incentives. When interest rates were sharply the incentives
changed to with interest rate buy downs. So when interest rates were 8% they would come to you and
say Matt I know 8% is a lot for you and your monthly payments are going to be high but we are going
to give you a 6 and 3 quarter percent mortgage. Now doing that cost 1% mortgage reduction cost
4% on gross margins. So it reduced the gross margins of the company but the companies didn't give
the other incentives that then were only gave. So it was a trade off. So I think you could see creative
ways. I think other things happen when mortgage rates go up. Many people buying houses today are
buying them in the 30s they used to buy them in the 20s. They have more money because they've
been working longer. You now have large wealth in older generations and in many cases the older
generation the parents are helping with the deposit. So the deposit you put down is larger so your
mortgage payments are going to be small. So there are mitigations I think to hire interest rates if
interest rates went up sharply from here. Of course interest rates today are probably pretty normal
at 6 and 3 quarter percent unless inflation really spiked I would not think of that's a major risk
for the home builders. We close out these conversations trying to focus in on lessons. So when you think
about DR Horne maybe even the home builders more broadly and having spent time looking at this
industry again going back in time multiple decades what are the lessons that stand out from this
industry that you think you could potentially apply elsewhere when looking at other industries.
I think the lesson we learned is you have to really step back and analyze a business as to the nature
of the business. What do they really do? Not what other people are saying they really do. Not what
the analysts are saying. The analysts tend to be very short term oriented and I think they have
completely underestimated the change of the business. They consider it still a real estate
business. It's not. It's a manufacturing business. The ownership of land is incidental and I
don't think they've made that change. So I think in our case it was understanding that the
companies had the wrong model. That they had the model of owning a lot of land and keeping that
land on the balance sheet. And once we realized that it was the process and speaking to the companies
and finding out why they owned all the land what their rationale was and trying to get into change
their minds. I don't know if our little firm was largely responsible for them changing their minds
but I think we played a role. We do speak to the management. I know the CEOs of the companies
are known Stuart Miller from Lennar since the year 2000. That was a year as I remember when they bought
US home which was a stock we owned and I get it and they stole the stock from us. I wasn't happy.
They bought the company such a cheap price that I was unhappy. I would just have preferred
to keep the US home stock. The lesson is I think you have to separate yourself from the noise
in the street and really sit back and say what is the nature of the business? What are the
fundamentals? How do they make their money? What's a management like? Management is so important.
What is the cash flow like? What's in it for the shareholder? Where is the stock priced and where
should it be priced based on the fundamentals of the company? Excellent. I think there's a really
interesting thing there about challenging the conventional wisdom of how a business operates and
whether it still needs to operate that way which you reveal throughout the conversation. This has
been excellent truly taking us through time which has been a lot of fun and thank you for
sharing the knowledge. It's been an absolute pleasure and I'll end it with one comment to follow
up on what you just mentioned. To make money on the stock market you have to have a different
opinion. If you're swimming with everybody else it's very hard to make money because
stocks tend to discount the fundamentals. We have to have a differing view and that's what we
have in the home builders simply that they are worth 16 or 20 times earnings, not the 10 times earnings
the horn's selling out today. When the market realizes that I think we're going to be very happy
and I think the shareholder will be very happy. I love that. What a perfect way to end. Well thank
you very much Ed. My pleasure. To find more episodes of breakdowns ranging from Costco to Visa to
Moderna or to sign up for our weekly summary check out Join Colossus.com. That's J-O-I-N-C-O-L-O-S-S-U-S.com.
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