NVR - NVR Inc.

[KJP]

 

However there's a big real world offset which is that if the stock price is weak and the options expire out of the money, more options are issued, at a lower price. I believe the system is set up to get money in employees' pockets, plain and simple. If options keep expiring out of the money, employees will demand compensation in another form -- that's just my experience.

 

So if NVR had a weak stock in that period, I believe a huge number of shares would have made it out there anyways.

 

 

As I noted earlier in this thread, NVR issues a large number of options in four-year cycles, and then fewer options in other years.  Did management and the comp committee deviate from that cycle during the housing bust or otherwise issue "extra" options at low prices to make up for expiring worthless (or low value) options?  The stock also suffered a long, prolonged decline during the housing bust, going from ~875 in mid-2005 to the low 300's in 2009 and stayed under 850 until 2012.  Were any options recut during that period or did the employees and management take the hit?  More broadly, we have a relatively recent example of a substantial, prolonged stock decline.  What "real world" actions would you point to during that period to support your beliefs about NVR's equity compensation program?  I'm not saying you're wrong; I just don't recall such actions. 

 

You're plainly correct that the higher the stock price goes the more expensive prior options grants look.  But don't you want the share price to rise? 

 

They issued 387,000 options in 2005 at $743, and then 290,000 three years later in 2008, at $515. That's my point -- they issue them regularly, and at whatever price the stock is at the time -- the stock decline means one or two years of options are forfeited, but not the new ones, which are even more valuable than the expired ones (because the price is down). The options from 2008 forward have pretty much all been in the money, as you know.

 

But look, the only way to actually know the value of an option is indeed in hindsight. NVR is a valuable, growing company -- it's just a lot less valuable if they issue 5% of the company in options every year. We agree that a successful company will end up having very valuable stock options -- that's exactly my point. I don't believe Black Scholes captures that at all.

 

As an example, in 2014 they issued a huge package (almost 700k shares, or 17-18% of the company) of 5-year options at $1,095/share. Black Scholes said they were worth $236 - a breakeven of $1,331. I don't agree with that. The company earned $200 per share in 2019 on the 2014 share count.

 

Here's my question: Would you rather NVR issue 150k options this year at $2,250 or pay the employees $90 million cash? Because that's about the B-S value. I sure as hell would prefer they used cash.

 

Based on your response, I think we agree on their past practices:  Every four years they issue big grants at whatever the price is, and alot fewer shares in other years.  They don't recut old out of the money options or deviate from the four-year cycle to game the system.

 

There seems to be an inconsistency in your reasoning.  On the one hand, you assert that employees demand the "excess" comp from the stock option program and would get more comp if the options didn't turn out to be as valuable as initially thought.  But on the other hand, you posit a world in which the company could get the exact same operational performance if it used only cash comp at the Black-Scholes value, which you believe vastly underestimates the amount of comp employees actually receive (and by one half of your hypothesis, would extract one way or the other). 

 

To answer your question, if I could get it, I would prefer your hypothetical world in which the company's operational performance was exactly the same, but all comp was paid in cash.  But that's a hypothetical world.  Here's what's happened in the real world (I pulled this quickly off yahoo, so it should be split-adjusted, but might contain errors):

 

From January 3, 1994 - March 17, 2020:

Lennar:  $11.06/share - $34.79:  ~2x return in 26 years

Toll Brothers:  $$4.25/share - $15.75/share:  ~3x return in 26 years

NVR:  $9.63/share - $2,275/share:  ~230x return in 26 years

 

Are the very size of the equity comp grants a factor driving the company's culture and (out)performance?  I don't know, but why mess with what's worked?

 

EDIT:  By the way, I don't intend to be flippant or sarcastic with my responses.  You're right to think hard about and examine closely an equity comp program that's as large as NVR's.  I believe many managements use them to rip off shareholders.  But NVR's equity comp program appears to have actually fit the purpose of them, i.e., aligning management with the long-term interest of shareholders.  (I'm going from memory, but I believe NVR issues relatively long-term options, which may help in this regard.)

 

[coc]

 

However there's a big real world offset which is that if the stock price is weak and the options expire out of the money, more options are issued, at a lower price. I believe the system is set up to get money in employees' pockets, plain and simple. If options keep expiring out of the money, employees will demand compensation in another form -- that's just my experience.

 

So if NVR had a weak stock in that period, I believe a huge number of shares would have made it out there anyways.

 

 

As I noted earlier in this thread, NVR issues a large number of options in four-year cycles, and then fewer options in other years.  Did management and the comp committee deviate from that cycle during the housing bust or otherwise issue "extra" options at low prices to make up for expiring worthless (or low value) options?  The stock also suffered a long, prolonged decline during the housing bust, going from ~875 in mid-2005 to the low 300's in 2009 and stayed under 850 until 2012.  Were any options recut during that period or did the employees and management take the hit?  More broadly, we have a relatively recent example of a substantial, prolonged stock decline.  What "real world" actions would you point to during that period to support your beliefs about NVR's equity compensation program?  I'm not saying you're wrong; I just don't recall such actions. 

 

You're plainly correct that the higher the stock price goes the more expensive prior options grants look.  But don't you want the share price to rise? 

 

They issued 387,000 options in 2005 at $743, and then 290,000 three years later in 2008, at $515. That's my point -- they issue them regularly, and at whatever price the stock is at the time -- the stock decline means one or two years of options are forfeited, but not the new ones, which are even more valuable than the expired ones (because the price is down). The options from 2008 forward have pretty much all been in the money, as you know.

 

But look, the only way to actually know the value of an option is indeed in hindsight. NVR is a valuable, growing company -- it's just a lot less valuable if they issue 5% of the company in options every year. We agree that a successful company will end up having very valuable stock options -- that's exactly my point. I don't believe Black Scholes captures that at all.

 

As an example, in 2014 they issued a huge package (almost 700k shares, or 17-18% of the company) of 5-year options at $1,095/share. Black Scholes said they were worth $236 - a breakeven of $1,331. I don't agree with that. The company earned $200 per share in 2019 on the 2014 share count.

 

Here's my question: Would you rather NVR issue 150k options this year at $2,250 or pay the employees $90 million cash? Because that's about the B-S value. I sure as hell would prefer they used cash.

 

Based on your response, I think we agree on their past practices:  Every four years they issue big grants at whatever the price is, and alot fewer shares in other years.  They don't recut old out of the money options or deviate from the four-year cycle to game the system.

 

There seems to be an inconsistency in your reasoning.  On the one hand, you assert that employees demand the "excess" comp from the stock option program and would get more comp if the options didn't turn out to be as valuable as initially thought.  But on the other hand, you posit a world in which the company could get the exact same operational performance if it used only cash comp at the Black-Scholes value, which you believe vastly underestimates the amount of comp employees actually receive (and by one half of your hypothesis, would extract one way or the other). 

 

To answer your question, if I could get it, I would prefer your hypothetical world in which the company's operational performance was exactly the same, but all comp was paid in cash.  But that's a hypothetical world.  Here's what's happened in the real world (I pulled this quickly off yahoo, so it should be split-adjusted, but might contain errors):

 

From January 3, 1994 - March 17, 2020:

Lennar:  $11.06/share - $34.79:  ~2x return in 26 years

Toll Brothers:  $$4.25/share - $15.75/share:  ~3x return in 26 years

NVR:  $9.63/share - $2,275/share:  ~230x return in 26 years

 

Are the very size of the equity comp grants a factor driving the company's culture and (out)performance?  I don't know, but why mess with what's worked?

 

EDIT:  By the way, I don't intend to be flippant or sarcastic with my responses.  You're right to think hard and examine closely an equity comp program that's as large as NVR's.  I believe many managements use them to rip off shareholders.  But NVR's equity comp program appears to have actually fit the purpose of them, i.e., aligning management with the long-term interest of shareholders.  (I'm going from memory, but I believe NVR issues relatively long-term options, which may help in this regard.)

 

Fair point. On this, we disagree. If NVR had issued 1/2 or 1/3 as many options, would they have performed just as well? I think the answer is clearly yes. Tons of companies issue tons of options without achieving success -- if it was that easy, everyone in Silicon Valley would have it made. I think this is a spurious correlation.

 

However even if I'm wrong, my core point is not that the employees would alternatively demand some exact $$ amount in cash were it not for options - it's that NVR is a heavy, heavy issuer no matter what is going on with the stock price, and that they give away much of their value creation. And finally, that the amount given away is simply not reflected in the Black Scholes estimates. They're too low. (Buffett has commented similarly in the past, if I recall.)

 

You say you'd rather they give cash -- it's because you intuitively feel that the shares they are issuing are worth a lot more than the cash.

 

In the end, my argument is not necessarily that NVR should change (although I certainly wish they were less generous), but that their earnings are overstated. Last year alone, they spent a net $424 million on repurchases and their share count went up! All of that money went to the employees.

[KJP]

 

However even if I'm wrong, my core point is not that the employees would alternatively demand some exact $$ amount in cash were it not for options - it's that NVR is a heavy, heavy issuer no matter what is going on with the stock price, and that they give away much of their value creation. 

 

 

I take it you would prefer to give cash when the company is trading at 10x earnings and options when the company is trading at 25x earnings.  But do you think that's fair way to deal with employees?  Or is the fairer approach to do what NVR actually does -- issue the options at whatever the price is, so sometimes employees appear to get a bargain and sometimes they don't?

 

And finally, that the amount given away is simply not reflected in the Black Scholes estimates. They're too low. (Buffett has commented similarly in the past, if I recall.)

 

Yes, B/S may misprice LEAPs, particularly if a company has a lasting competitive advantage.  But I note that the ex post calculation only looks particularly expensive if shareholders also do well. 

 

 

You say you'd rather they give cash -- it's because you intuitively feel that the shares they are issuing are worth a lot more than the cash.

 

 

No, what I said was I'd rather give cash if I could get the same performance.  I don't think the performance would be the same.  Instead, I'd think you'd have performance closer to Toll Brothers and Lennar.  Alternatively, if I'd get the same performance, I'd like to give cash at 10x earnings and options at 25x, which you also seem to prefer.  But again, I don't think performance would be the same; I think you'd just alienate employees. 

 

At the end of the day, some people (perhaps fairly) think "2 and 20" is robbery, no matter what the performance is.  Others look only at their net gains.  The long-term returns for NVR shareholders have been great, even after management's cut.  But perhaps the future will be different.

 

[coc]

We’ll have to agree to disagree on this. I don’t think NVR should issue options sometimes and cash sometimes as you imply. I think they should issue many fewer options and pay cash. But if you’re happy with it I can’t tell you otherwise - that’s your prerogative.

 

I do not however hear a counter argument on the main and original point which is that their earnings are overstated if BS is undervaluing the options. I (believe) we agree on that - and think anyone evaluating NVR ought to account for it. It isn’t just a hindsight observation - and it is a real uncounted cost, even if you are correct that it improves productivity.

[KJP]

 

I do not however hear a counter argument on the main and original point which is that their earnings are overstated if BS is undervaluing the options. I (believe) we agree on that - and think anyone evaluating NVR ought to account for it. It isn’t just a hindsight observation - and it is a real uncounted cost, even if you are correct that it improves productivity.

 

I don't agree with the statement above, but there's no sense rehashing what I've already said.  Thanks for the discussion.  It's good to hear contrary opinions, and I hope others found our dialogue useful.     

[dabuff]

Norbert Lou (of VIC fame) exited the stock again in Q2 2020. Thoughts?