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Broad Run 2Q17 Letter – NVR & O’Reilly Automotive

Broad Run Investment Management Second Quarter 2017, July 20, 2017

  • For the quarter, returned 3.2% compared to 3.0% for Russell 3000
  • YTD, returned 8.1% compared to 8.9% for Russell 3000

NVR, Inc (NVR) – New Position

  • Top 10 homebuilder doing business under the NV Homes, Ryan Homes, and Heartland Homes brands
  • Company operates in 14 East Coast states with a concentration in the Baltimore-Washington region (43% of 2016 revenue)
  • In general, homebuilding is not a business that we find appealing; it is cyclical and capital intensive, with limited competitive differentiation
  • NVR is an exception – employs a unique business model that enables a much higher ROIC / ROE and more stable earnings / cash flow
  • Unique business model and superior economics are built on 3 pillars:
    • Outsources the ownership, entitlement, and development of land to third parties, making it asset-light and flexible. Company signs contracts with land developers giving NVR the exclusive option to acquired finished lots within certain communities. Land and lot development is a capital intensive, multi-year process, so this approach relieves NVR of these capital requirements while also enabling renegotiation or abandonment of land commitments during difficult times. In exchange, NVR pays developers a premium price for finished lots. Further, for developers, upfront cash deposit NVR pays covers a meaningful portion of project startup costs, and the contract helps facilitate alternative development financing from lenders
    • With the operational and capital burden of land development outsource, NVR has had the bandwidth to focus on becoming very efficient at constructing homes. It applies lean manufacturing to home construction, stripping out waste and expense from the process. This efficiency is illustrated by its best in class “cycle time” – it takes NVR about 3 months to deliver a completed home to a customer versus an industry average of 4 months
    • NVR has built leading market share in its oldest markets, and seeks to be the dominant builder in each market in which it competes. Scale and market share enable NVR to leverage its management and marketing expense, secure attractive terms with vendors, and get good access to quality land deal flow
  • NVR has lower gross margins, offset by lower SG&A expense, netting to a similar overall operating margin. However, has much less capital invested allowing it to earn about a 15-20% ROIC and 20-30% ROE versus about 8-10% and 12-14% respectively
    • NVR was the only public homebuilder to maintain positive earnings during the housing bust
  • Structurally and culturally, vast majority of homebuilders hold land ownership and development in high regard, as illustrated by the industry saying, “we build homes to sell land”
    • Despite NVR’s success, does not have anyone of note emulating its business model
  • Homebuilding is a cyclical industry but we believe that the US is only partway through the recovery from the housing bust so there is more upside for the market
  • Believe that country needs about 1.5-1.6 million new housing units per year to accommodate population growth
    • Today, US is producing single-family units at only a 0.8 million rate, requiring 35-50% unit growth just to get back to a normalized level
    • As millennials join the ranks of homeownership, there is the potential that unit production rates will exceed normalized levels for many years until the US gets back into housing equilibrium
  • We give management credit for pivoting to an asset-light business model and fostering a culture and processes supportive of that strategy. They have been aggressive in repurchasing their own stock and opportunistic during the housing bust by renegotiating lot option contracts and moving into new geographies
  • Over a full housing cycle, expect NVR to expand revenue about 7-12% per annum, composed of 5-10% organic unit growth and about 2% pricing growth
    • With a 20%+ ROE, NVR should have significant FCF to direct toward share repurchases, pushing total EPS growth to about 13-16% per annum

O’Reilly Automotive (ORLY) – Update

  • Shares of ORLY and its brick and mortar competitors have declined materially this year as disappointing same-store sales stoked fears of market share loss to Amazon
  • Believe that Amazon’s growth had a de minimis impact on same-store sales and that the sales weakness was instead a product of 2 consecutive warm winters and the lapping of significant increases in vehicle miles driven in 2015 and 2016
  • As weather normalizes and we anniversary these sales trends beginning in 1Q 2018, expect the company to return to 3-5% same-store sales growth and mid-teens or better EPS growth
  • Commercial side of the business requires “hot shot” delivery of more than a hundred thousand different SKUs – this is challenging without a significant store level, hub store level, and distribution center level inventory investment
    • Difficult for Amazon to stock that much slow turning inventory close to the customer without a substantial brick and mortar investment and without a large base of commercial business
    • Much of the retail do-it-yourself side of ORLY’s business is immediate/same day need in nature, requires significant customer service, has a large portion of customers that pay in cash, and involves frequent product returns
  • Developments at ORLY over the last couple quarters have had only a modest negative impact on our EPS estimates five and seven years out
  • We had modeled some multiple compression over our investment horizon, but expected it to layer in over a periods of years, not months, and our scenarios did not include the stock trading as low as its current 14x forward multiple
  • Believe that Amazon fears are overblown but acknowledge that once Amazon enters the daily conversation about a traditional retailer/distributor, the market values that company at a step function lower multiple
    • We suspect it will be difficult for ORLY to ever fully shake this concern, so lowered future valuation multiple assumptions accordingly

Image Source: Broad Run Investment Management

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