D.R. Horton: Invest In Value Like Buffett (NYSE:DHI)

Investment thesis

Warren Buffett is betting big on the U.S. homebuilders this year. The reason is on the surface: there is a massive shortage of homes in the U.S. due to the substantial underinvestment in the industry in the Great Recession aftermath. It is unsurprising that D.R. Horton (NYSE:DHI) was one of the companies in which Buffett invested, considering the massive scale and geographic presence of this company across the U.S. My analysis suggests that DHI’s large scale and wide profitability metrics make it well-positioned to benefit from the shortage of homes in the country. The company can easily offer price incentives to homebuyers and still generate positive cashflows and expand its market share at the cost of smaller players. DHI worked hard to improve its balance sheet in recent years and it made the company strong enough to weather the current environment of high interest rates and looming credit crunch. Last but not least, the valuation is very attractive, with about 40% upside potential. All in all, the stock is a “Strong buy”

Company information

D.R. Horton, Inc. is the largest homebuilding company in the U.S. as measured by number of homes closed. DHI constructs and sells homes through its operating divisions in 106 markets across 33 states under multiple brand names.

The company’s fiscal year ends on September 30. DHI’s reporting segments are its homebuilding reporting segments, its Forestar lot development segment, its financial services segment, and its rental operations segment. Homebuilding is by far the largest segment, comprising 95% of the total sales. South Central and Southeast geographically represent about half of the Homebuilding segment’s revenue.

Financials

DHI’s financial performance has been stellar over the long term. The company’s revenue growth has been massive over the past decade, with a 20.5% CAGR. Profitability metrics improved significantly as the business scaled up. The gross margin expanded from 21% to 30% over the past ten years and the operating margin more than doubled.

The free cash flow [FCF] margin ex-stock-based compensation has been volatile over the past decade and frequently negative. I do not see a big problem here because a substantial portion of the company’s operating cash inflows was allocated to strengthening the balance sheet.

DHI’s financial leverage ratio has decreased notably, and the current net debt position of $3 billion is lower than at the end of FY 2013 despite the business scale expanding significantly with a five-fold revenue increase. Short-term liquidity is also vital. The company faces the current harsh environment with a healthy balance sheet and wide operating margins, which is crucial to weather the storm. I think the environment is harsh due to the broader economy cooling down as a result of the highest interest rates since the beginning of this century. High-interest rates also push up mortgage rates, which is unfavorable for the demand in the homebuilding industry.

The latest quarterly earnings were released on July 20, when the company smashed consensus estimates. Revenue grew 11% YoY, which is impressive amid the weak macro environment. The homebuilding segment’s revenue was up 5% YoY, which is also a solid bullish sign amid the current housing market turmoil. The strength in homebuilding reflects an 8% growth in the number of home deliveries. Increased demand was achieved with the help of price incentives as the average selling price declined. That was why the profitability metrics suffered, with the gross and operating margins narrowing YoY by more than six percentage points. Price incentives move looks sound to me amid the increasing mortgage rates considering DHI’s wide profitability margins.

The upcoming quarter’s earnings release is scheduled for November 9. Quarterly revenue is expected by consensus at $10 billion, which means a 3.7% YoY growth. The adjusted EPS is expected to shrink from $4.67 to $3.88. Reasons weighing on the bottom line are the same as in fiscal Q3.

The major secular tailwind for DHI as the largest U.S. homebuilder is a massive shortage of homes in the U.S. According to CNN, U.S. housing is short 6.5 million homes. I think that DHI is well-positioned to benefit from this shortage. The supply-demand balance affects prices, and when the supply outnumbers the demand, the price surges. That is precisely what happened to the U.S. housing market in recent years. With home prices and mortgage rates increasing, buyers are becoming more price-conscious. Considering its massive scale, DHI enjoys best-in-class profitability metrics. Having wide margins means the company has substantial room to provide price incentives to buyers and expand its market share, while smaller competitors have less power in this price war.

It is also important to take into account demographical tailwinds. Millennials, the largest age group in the U.S. with more than 72 million people, will be the major driver of the U.S. housing market in the upcoming decade. Born between 1981 and 1996, the majority of Millennials are entering the housing market by trying to buy their first homes. And DHI’s offerings mostly fit to these first-time value-conscious homebuyers with 66% of the company’s homes sold below $400 thousand.

Valuation

The stock rallied 32% year-to-date, which is a substantial outperformance of the broader market. Seeking Alpha Quant assigs the stock a solid “B” grade, meaning the stock is attractively valued from the perspective of the valuation ratios. Indeed, multiples are substantially lower than the sector median across the board. On the other hand, most of the valuation rations are in line with the company’s historical averages.

The stock offers dividends to its investors, so the dividend discount model [DDM] looks like a good option to proceed with my valuation analysis. I use a 9% WACC as a required rate of return. Consensus dividend estimates project the FY 2024 payout at $1.05. DHI has a solid dividend CAGR track record, far above the required rate of return over the last ten years. To be conservative, I use the sector median’s five-year dividend CAGR and round it down to 8.4%.

According to the DDM formula, the stock’s fair price is $175. This indicates a massive 46% upside potential, which is very attractive. To get more evidence, I also want to simulate the discounted cash flow [DCF] model with the same 9% discount rate. I have consensus revenue estimates projecting a modest 2% revenue CAGR for the next decade. I use a 4.8% TTM FCF margin for my base year and expect it to expand by 50 basis points yearly as the management focuses on cost efficiency.

DCF also suggests the above 40% upside potential, even considering the very conservative approach to choosing the underlying assumptions. To conclude, the stock looks attractively valued based on several valuation analysis approaches. My target price for DHI is within the $165-175 range.

Risks to consider

The company is vulnerable to cycles in the U.S. housing market, which is highly dependent on the broader economy’s health. That said, DHI’s earnings are inherently volatile and dependent on the economic cycles. The current environment of high interest rates weighs on the housing demand.

The housing market is also highly dependent on the availability of lending. While there have been no notable bank failures since the panic in Spring 2023, there is still almost no room for optimism. Recently, Moody’s downgraded the credit ratings of some notable names in the banking industry and warned that new cuts are possible. This news does not add optimism to lenders and might mean that the U.S. credit crunch challenges might deepen further. It seems that the Fed is not done with its rate hike cycle yet, since last week, Jerome Powell signaled that more hikes are probable.

Bottom line

To sum up, DHI is a “Strong buy”. The company demonstrates stellar profitability, and it is the company’s biggest competitive advantage amid the current environment of high mortgage rates. DHI can maintain price incentives over multiple quarters and capture a bigger market share at the smaller competitors’ expense. The company’s wide range of offerings in the affordable housing segment makes it well-positioned to serve Millennials, the largest age group in the U.S. which are now entering the housing market. The stock is very attractively valued and also has a strong track record of dividend hikes.