Rebuild Your Post-COVID Portfolio With This Industry Leader

It’s not often investors get the chance to buy leading businesses at significant discounts. Investors willing to see through the (inevitable and steep) dip in economic activity can find great value. Investors overlooking D.R. Horton (DHI: $41/share) are in the Danger Zone. Those willing to look beyond the dip in economic activity should consider adding this Long Idea to their portfolio.

DHI’s History of Profit Growth

DHI is down 26% year-to-date (YTD) and trades at its cheapest valuation, as measured by price-to-economic book value (PEBV), since 2006. For investors willing to look past the current crisis, DHI represents a great buying opportunity.

DHI has a strong history of profit growth. Since 2010, DHI has grown revenue by 17% compounded annually and core earnings[1] by 23% compounded annually, per Figure 1. Longer-term, DHI has grown core earnings by 11% compounded annually over the past two decades. The firm increased its core earnings margin from 6% in 2010 to 10% in the trailing-twelve-month period (TTM).

Figure 1: DHI Core Earnings & Revenue Growth Since 2010

Sources: New Constructs, LLC and company filings

DHI’s rising profitability helps the business generate significant free cash flow (FCF). The company generated positive FCF in each of the past five years and a cumulative $1.5 billion (11% of market cap) over the same time. DHI’s $1.1 billion in FCF over the TTM period equates to a 6% FCF yield, which is significantly higher than the Consumer Cyclicals sector average of 1%.

D.R. Horton’s Balance Sheet Provides Ample Liquidity to Survive the Crisis

Companies with strong cash positions are better positioned to survive macro-economic uncertainty. DHI has the cash to survive the current disruption to operations. The firm recently announced that it ended fiscal 2Q20 (period ended March 31, 2020) with $1.0 billion in unrestricted cash with an additional $1 billion of available capacity on its revolving credit facility. This cash position gives the firm $2 billion of liquidity with only $400 million in debt due within the next twelve months.

In DHI’s latest quarterly filing, the firm spent $456 million ($152 million/month) on selling, general and administrative expense (SGA). In a worst-case scenario where DHI pays down its current debt, generates no revenue, and continues to cover its full SGA expenses, DHI could operate for nearly 11 months before needing additional capital. It is very unlikely that DHI’s revenue would go to zero since the firm is currently building homes. Additionally, DHI would be able to reduce its SGA should a worst-case scenario begin to emerge.

DHI’s Profitability Ranks Highest Among Top Three Builders

COVID-driven disruptions may drive some weaker companies out of business for good.

However, DHI’s profitability was trending higher at a faster pace than its competitors before the crisis. This superior profitability is a testament to DHI’s strong business model, which leverages its economies of scale across the homebuilding industry. With leading profitability, consistent cash flows, and a strong balance sheet, DHI can not only survive the downturn but is well-positioned to grow profits and market share when the economy recovers.

Lennar Corporation (LEN), D.R. Horton, Inc. (DHI), and PulteGroup Inc. (PHM) are the largest home builders in the country based on 2019 revenue. Per Figure 2, DHI’s invested capital turns, a measure of balance sheet efficiency, has improved from 0.9 in 2015 to 1.1 TTM. Meanwhile, the market-cap-weighted average of LEN and PHM’s TTM invested capital turns is much lower at 0.8.

Figure 2: DHI’s Invested Capital Turns Vs. Competitors

(Click on image to enlarge)

Sources: New Constructs, LLC, and company filings.

DHI has increased its NOPAT margin from 8.3% in 2015 to 9.6% TTM. Meanwhile, LEN and PHM’s market-cap-weighted average has decreased from 10.3% to 9.9% over the same time.

The combination of rising margins and invested capital turns drives DHI’s ROIC higher. DHI has improved its ROIC from 8% in 2015 to 11% TTM. Per Figure 3, the market-cap-weighted average ROIC of LEN and PHM, while improving, has increased at a slower rate than DHI.

Figure 3: DHI’s ROIC vs. Competitors

(Click on image to enlarge)

Sources: New Constructs, LLC, and company filings. 

Bear Case Assumes Homebuilding Industry Never Recovers

All the recent negativity has bears anticipating the Housing Crisis 2.0 and driving DHI’s price down to levels that imply the current crisis is not temporary but will result in a permanent and severe decline in economic activity. After all, the industry is hampered by excess supply and the challenges of operating while social distancing on construction sites. Demand is also slowing. Preliminary readings of public home closing records indicate that the week ending March 29, 2020, saw a 30% decrease in home sales year-over-year (YoY).

But, we believe these declines and disruptions are temporary, not permanent. Along with the International Monetary Fund (IMF) and nearly every economist in the world, we believe that U.S. GDP growth will be higher in 2021 than expected before the pandemic. Accordingly, it is safe to assume the homebuilding industry will return to something, at a minimum, approaching historical levels.

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Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.

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