Ah, the frightful sounds of Halloween -- the squeaking of a door as it opens slowly or a creaking step. Let's pass by homebuilder NVR
Those were the days
What NVR has offered shareholders over the last five years is no poisoned apple. From $81 at the end of September 2000, the stock skyrocketed to $947.95 at the end of July 2005. That's almost a 12-bagger. What a treat, although it has fallen back 28.5% (a decline of $270) over the last three months.
Fueling that rise has been anything but ghoulish operating results. Earnings per diluted share over the last five completed fiscal years have increased from $14.98 to $66.42 (up 343%). Net income over the same period has risen from $158.2 million to $523.2 million (up 231%).
The reason per-share earnings have grown so much faster than net income is because the company is buying back shares. Sounds great, doesn't it?
Last fiscal year (FY 2004), the company purchased 675,000 shares of its own stock. That lightened the corporate cash balance by $307.6 million (which is far less than the company's after-tax earnings). In fact, the company has spent more than $1.1 billion over the last three years buying back its own shares and shrinking the share count. This is all being done by a company that clearly has a conservative business strategy of primarily constructing homes on a pre-sold basis.
Now, cue that squeaky door.
"Overhang" as used on Wall Street has nothing to do with a man's stomach hanging over his belt buckle. Blot out the Homer Simpson image from this Halloween special and think avalanche -- as in, "Look out below!"
Consider these facts, forward-looking tricksters. At the end of 2004, there were 6.5 million NVR shares outstanding and an additional 1.4 million shares granted via stock options. That's potential share dilution (i.e., options overhang) to the tune of 21.7%.
Is this out of the ordinary? Homebuilding industry giants DR Horton
What's the big deal?
What NVR is doing is legal. Option plans are approved by shareholder vote. The dilutive impact of options outstanding is reported to the world every quarter. Many other companies are also rewarding employees through high levels of options grants. So, what's the big deal?
Earnings, for one thing. If all those shares get issued, reported earnings per share (EPS) could be watered down by, in NVR's case, 21.7%. Said another way, $1.00 in earnings, assuming no buybacks and all options are exercised, deflates to $0.78 a share. That's not good.
'Tis true that a company can buy back stock to neutralize at least part of an option overhang. Indeed, options neutralization is one of the core reasons NVR has engaged in buybacks. But such buybacks come with a price -- they reduce a company's cash flow. In NVR's case, full neutralization would require it to buy back 21.7% of its shares outstanding, a significant cash outlay. In contrast, a company like DR Horton would only need to buy back 1.8% of its shares outstanding, a much less burdensome commitment.
In times of a housing boom, a homebuilder generates plenty of cash flow that can be used to neutralize its options grants. But what happens when housing slows down? Shareholders in NVR will be the first to find out.
A company with a large options overhang is not guaranteed to underperform the market. NVR has proven that (so far). But, in general, a large overhang can transfer a disproportionate amount of the company's wealth away from existing shareholders and toward the options holders. That's a bummer, and if you open NVR's door by purchasing shares now, you may get a trick in your candy bag that you will wish you had avoided.
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