GLG News by David Keller

Implications: The housing bust is not over and trends continue to be negative.  The only positive activity is that homebuilding stocks have gone up, without a good reason.  We still have a ways to go to work through all this.

Analysis: Continued Housing Difficulties

This article suggests housing is starting to stabilize.  This seems premature for a number of reasons:  foreclosures continue to add to the existing inventory of unsold homes,  auctions of new homes continue to apply downward pressure on home prices for the overall market, financial institutions are desperately attempting to move through their foreclosures, a number of real estate joint ventures are on life support, land bankers are trying to dispose of land and other real estate assets, there is no public confidence in housing or the overall economy, the mortgage market continues to be very difficult, recent and upcoming bankruptcies by homebuilding companies and lenders place added pressure on the market, etc.

In short, the news isn't good and there are a large variety of downward mitigants that suggest the housing market has not hit bottom.  This time around there are more and greater external factors causing the recovery to be delayed such as economy, mortgage difficulties, foreclosures, bankruptcies, etc.  These events have a large role in the continued downturn and are becoming increasing difficult to deal with.  All of this is illustrated by the poor sales results in the first calendar quarter and the fact sales backlogs starting the second quarter are often half of what they were a year ago.  This means greatly reduced revenues and additional losses due to the inability to reduce overhead to match up with the much smaller revenues.

In summary, the recovery has no started and it likely will not occur until well into 2009, if then.

Implications: Not capitalizing interest in inventory causes acceleration of losses and deterioration of book value.

Analysis: Direct Expensing of Interest by Homebuilders

Traditionally, homebuilders interest costs have been capitalized in inventory accounts and end up being expensed through cost of goods sold as the inventory is sold.  Such interest costs have been capitalized under generally accepted accounting principles because the active inventory has exceeded the aggregate amount of debt on the homebuilder's balance sheet.   In these situations, aggregate interest costs are allocated prorata over aggregate active inventories and capitalized therein.  "Active inventory"  would include developments in the planning or development phase and homes with construction occurring.  Raw land, finished lots and completed homes would not be "active inventory" and would not be subject to interest capitalization, while in these categories.  And, capitalized interest in inventories typically will be around 3-5% of the total inventory, depending upon financial leverage.  Interest income is not netted against interest expense to determine the pool of capitalizable costs.

The sharp contraction in homebuilding has changed this.  Recently, and in the near future, we will see instances where aggregate debt exceeds "active inventory" and interest expense will be a separate line
in the income statement.  Most recently, Meritage Homes and Centex have recorded direct interest expense.  WCI traditionally has incurred some interest directly.  Such treatment will cause near term losses to increase as there will not be a built in delay for some of the interest that is currently incurred.  Rather a portion of the current interest amount will be recorded directly on the income statement as such and not through cost of goods sold.  This will further delay the turnaround of current losses and further impair book value until the debt is "right sized" through debt reductions or homebuilding production increases.

Implications: Recently, stock prices of most public homebuilders have increased 20-30 percent.  This despite no visible signs of improvement in the overall housing industry.  It seems early in the cycle for these stock price upward movements, as it appears the housing market has not yet found bottom.  Equity buyers at the present stock prices must be patient and have a mid- to long-term perspective on their investments. There may be several reasons for the recent price appreciation including: 1. Short sellers covering positions as hedge funds encounter increasing risks in other parts of their portfolios or simply decide to concentrate their efforts in another sector. 2. A perception the government enacted or proposed initiatives will cause significant improvement in homebuilding activities, including sales and financing of homes. 3. A belief the housing downturn is at or nearing bottom and this is the appropriate time to purchase homebuilder stocks.

Analysis: There are many signs that do not suggest a bottom has been achieved thus far.  This is particularly true when considering recent home sale and sale backlog announcements from public homebuilders.  For the last quarter, KBH sales declined 75%, while sales backlog was down 60%.  LEN sales were down 57%, while sales backlog declined 65%; just to mention two. Home foreclosures are escalating in many markets causing additional pressure on the market.  These foreclosed homes likely will sell first as financial institutions are willing to accept large discounts in an effort to remove the foreclosure wave from their books.  Auctions are becoming commonplace in certain markets as a way to deal with the excessive inventory levels.  This removes many potential buyers from the new home market. Recent bulk sales of homes (TOUSA – Cape Coral), (MHO – Palm Beach) with large losses, land sales approaching 30-40% of cost (CTX, LEN), and departures from certain markets (BZH – Cincinnati, KBH – Chicago, New Mexico, SPF – San Antonio, Tucson) suggest a level of desperation still exists among homebuilders. Several large homebuilders are in bankruptcy (TOUSA, Levitt, Newman, Kimball Hill) or approaching it (WCI, SPF), which may cause inventories to be liquidated at low prices further straining the market. The mortgage market continues to be very difficult, strangling access to capital.  Homebuyers with marginal credit will have increased difficulty in obtaining financing. Several homebuilders who have indicated they are participants in some very large joint ventures involving the Focus Group and other situations are experiencing financial difficulties.  The outcome of these issues is unknown at the moment, but could result in significant losses and additional pressure on inventories as lenders attempt to liquefy recently acquired portfolios. There will be an excellent opportunity for a rebound in the stocks of homebuilders.  However, with the current gross margins, revenue contraction and high overhead rates, homebuilders cannot operate profitably.  When sales information and operating results for the first quarter are announced, there may be widespread disappointment, resulting in the stock prices backpedaling.  If you elect to buy homebuilder stocks at the present levels, you must be patient to be rewarded.

Implications: Homebuilders have recorded large inventory impairments over the last couple of years.  Most of these impairments have been for land and lots.  As these previously impaired lots are built on and a completed home is delivered, the land component as a percentage of Cost of Goods Sold may decline significantly.

Analysis: Traditionally, the components of Costs of Goods Sold are:  Land (20-25%), capitalized interest (3-5%), materials and labor (65-70%), and capitalized indirect costs such as insurance, property taxes, construction superintendents (4-5%).  However, these traditional relationships change when the land portion has been written down for impairment, particularly considering the impact of present value discounting that occurs with impairments.  In this scenario, the land component of Cost of Goods Sold could be 5% or less of Cost of Goods Sold, causing an overall improvement in the gross margin from the home sale. Thus, as homebuilders begin to work through previously impaired land, it will be important for investors to understand the impact such impairment reversals have had on the reported gross margins.  In some cases, much of the reported gross margin may have come from such recoveries.  This is important to know when evaluating overall gross margins and whether, in fact, operating results are improving or whether the improvement is due to accounting. My expectation is we have and will begin to see some significant reversals occur.  Lennar’s last quarter contained significant, yet unquantified boosts to the gross margin when listening carefully to their conference call.  These recoveries will be spread out over the next 2-3 years and then the impaired land should have worked its way through the system.  In the meantime, it will continue to be important to measure this impact.

Implications: There are risks associated with homebuilding assets and contingent obligations.  This article alerts the reader to areas of interest.

Analysis: ANALYZING HOMEBUILDER RISK

Many investors are familiarizing themselves with homebuilding as a source for potential profits due to its present distress. This article summarizes some areas to consider when evaluating individual homebuilding companies from a risk perspective.

Joint Ventures

Does the homebuilding company invest in joint ventures and if so, what is the amount of the investment and advances? It is important to understand many things about this activity including: the number and size of joint ventures; who the joint venture partners are and their capacity to support the joint venture or fulfill their commitments; whether there are guarantees to the lender to the joint venture for capital infusions under remargining agreements or other types of guarantees such as completion of the land development, firm commitments to buy lots from the venture,etc. Many joint ventures are financed by the same lenders involved in the homebuilder's line of credit. This relationship may cause a reluctance for the homebuilder to walk away from a joint venture.

Option Deposits

Is there a large asset on the balance sheet associated with deposit under land/lot option purchase contracts? It also is important to evaluate whether standby letters of credit were used as option deposits in lieu of cash. These will not be recorded on the balance sheet and must be determined from the footnote disclosures to the financial statements. Such standby letters of credit will either be replaced with cash or result in funding under the bank revolving credit facility. Again, it is important to understand the number of option agreements and the gross amount associated with exercising options as these represent future cash requirements, if consummated. The number of option agreements with the same party is a consideration as there may be implied performance with multiple relationships with the same entity.InventoryGeographic diversity is important to evaluate given that certain markets(CA,AZ,FL) are particularly stressed today. Whether individual subdivisions are large in size could indicate the amount of flexibility to move to other locations, redesign product, etc. Certainly the components of inventory are important. A greater percentage of land suggests a longer conversion period to cash and greater risk verses a large component of finished homes and work in process that can be converted to cash at some price.

Income Taxes

Large income tax refunds receivable by homebuilders represent the carryback of tax losses and the recovery of previously paid income taxes. However, there are limitations on the ability to do this. Many homebuilders have very large deferred tax assets. If tax losses are not realized in 2008, there may be significant issues associated with the ability to continue to carry these deferred income tax assets or to recognize additional income tax benefits from future losses.

Summary

Certainly, there are many areas of risk when evaluating the current homebuilding industry. This article attempted to highlight a few for consideration when evaluating investment opportunities.

Implications: Homebuilding impairments and tax valuation reserves provide future accelerated income streams, when the recovery occurs.

Analysis:  HIDDEN HOMEBUILDING ASSETS

Although, the homebuilding decline has not reached bottom and it will be some time before a recovery occurs, those surviving the onslaught, will emerge with accelerated earnings in the first several years of the recovery.  One cause for this is the nature of the large impairments that have been recorded.  A very large portion of these impairments relate to land holdings that homebuilders will continue to own as the recovery commences.  The method of calculating impairments includes discounting anticipated future cash flows from this land at rates approaching 20% per annum.  These discounts are not recovered until the underlying property is disposed of.  In many cases, this will occur only when the land is developed and a home is constructed on it.  Upon the sale of the home, the discounting factor will enter into the calculation of the gross margin on the home, increasing the gross margin.  If the lot/land has been discounted by 20% annum and was held four years before disposition, the underlying lot cost would approach 20% of its original cost.  Thus, there would be a very low cost land component in the home cost of goods sold. (Land as a component of cost of goods sold could vary from the normal 25-30% to 10-15%).   This effect, in turn will cause oversized gross margins as the impaired property is delivered to a homebuyer.  SPF is a current example of how this works.  They have recently reported gross margins from home sales of around 20%.  However, if you remove the impact of previous impairments that are “recovered” during these periods, the true gross margin approaches 12%.  It seems logical that when housing recovers and these impaired properties are built out and sold, gross margins and resulting pretax earnings will be artificially high before naturalized results settle in.  

Many homebuilders have/are/will establish income tax valuation allowances in significant amounts, during their downturn.  KBH recently established a $500 million tax valuation reserve, HOV, SPF, CTX and others have also established such reserves.  As the recovery commences and profits return, these valuation allowances will be reduced.  This means that for many homebuilders there will not be a charge against earnings for income taxes until these valuation reserves reverse.  As a result, the earnings will be “oversized” for some time.  

Homebuilding is far from a recovery.  However, for the survivors, when it comes the combination of increased gross margins on home sales and no charges for income taxes will cause temporary (around two years) earnings escalation.  After these reserves are absorbed, earnings will normalize (around 20-22% gross margins, 12% overhead, 10% pretax, income and 6-7% net income).  Many investors may overreach during this time period and stock prices could respond with rapid increases.  Investors should consider the impact of these items before finalizing their investment decision.  If investors chose to participate in these stocks during the recovery, they should cautiously measure the impact of the items discussed in the article and evaluate how long these benefits will continue.  Based upon “income”, stock prices could soar for several years before returning to earth.   

Implications: Issues associated with loss of income tax benefits result in accelerated reduction of book value in homebuilders.

Analysis: Accelerated Reductions in Book Value

A number of large homebuilders recently have provided significant income tax valuation reserves against their deferred tax assets. (eg. CTX, SPF, HOV, KBH). These deferred tax assets previously arose from inventory impairments that were recorded for financial income statement purposes, but are not currently deductable on the income tax return. If there are issues concerning the recoverability of deferred tax assets, valuation allowances to become necessary.  As these valuation allowances are created, they have resulted in large financial statement income charges, significantly reducing stockholders’ equity and the corresponding book value per share.  KBH as an example, reducing equity by $500 million due to an income tax valuation reserve.  

Once an income tax valuation reserve has been established, it is very difficult to record future income tax benefits associated with operating losses.  Based upon present gross margins, backlog levels and overhead rate, it appears doubtful many builders will be profitable in 2008 and possibly even 2009.  Failure to be able to record a tax benefit against such losses will mean the gross amount of losses will flow to the bottom line, further impairing stockholders’ equity and corresponding book value per share.  It is probable most homebuilders will record additional future impairments, which further increases losses, contributing to even greater reduction in stockholders’ equity and book value per share.  

Since many homebuilding stocks are selling based upon book value, it would seem such stock prices will continue to deteriorate as book value continues its descent, for some at an even accelerated pace.

Implications: Unforseen risks associated with homebuilder joint venture agreements and accompanying completion agreements.

Analysis: Joint Venture Completion Agreements

Most homebuilding joint venture loan documents contain a sponsor guarantee that the development of the project will be complete.  In most cases, this relates to development of the underlying land.  The loan typically contains funding for costs associated with performing this work and interest reserves to pay interest on the loan until the project cash flows.  Slow home sales have caused issues for joint ventures with regard to cash flows.  

Events altering the original timeline estimated in creating funding for the project can cause problems within the joint ventures.  Slow absorptions of lots in a multiphase development may cause the interest reserve to be used up due to a longer funding period.  If the project is complete, but absorptions are behind plan will cause larger loan amounts to be outstanding over longer time frames, further causing issues with interest reserves and loan repayments.  

The need for the joint venture to generate cash to meets its obligations can be solved several ways, but most cause difficulties.  One short lived alternative is to restructure the joint venture debt.  Another alternative includes the sponsor (homebuilder) purchasing lots from the joint venture regardless of whether these end up being “parked” in the homebuilder’s inventory of land and lots.  Finally, the homebuilder and other joint venture partners can make loans or capital infusions into the joint venture, whether required under remargin agreements or not.  

As long as developments stayed on schedule and lots absorption occurred as predicted, homebuilders had little exposure under completion agreements.  However, the large decline in home sales has caused issues with cash flows in joint ventures, where completion agreements may result in increase expenses for the homebuilder participating in joint ventures.  

Implications: What will happen in 2008 for the homebuilding industry? Will cash be generated? Will there be failures? Will there be profits?

Analysis: 2008 OUTLOOK FOR HOMEBUILDING

The homebuilding industry continues to struggle. What will happen in 2008, to this industry? This article expresses a view on the near term future.The homebuilding industry has not yet hit bottom as housing inventory levels are high, foreclosures are looming, mortgages continue to be in turmoil and home sales are languishing (existing home sales for November declined 27 percent year over year in major markets). 2008 will see continued decline in revenues and operating losses for the major homebuilders. Losses may not be as large as 2007, because the magnitude of impairments likely will decline. Cash flows should develop and improve for some and company failures in the larger builder ranks are on the horizon.

Revenues

Beginning sales backlog levels at the beginning of the current quarter are much smaller for most homebuilders than the same point a year ago. PHM has not experienced as large a decline as most ($5.8 b to $4.1b). Others (DHI $5.2b to $2.7b, CTX $5.1b to $$2.7b, MDC $2.1b to $1.2b, RYL $1.7b to $1.2b, etc.) have beginning backlogs approaching half of the prior year. This clearly indicates a reduction in near term (2008) revenues. And, recent sales rates are not good. These factors indicated 2008 revenues for most large homebuilders will decline by 30 percent or more. Average home sale prices are declining due to competitive factors and homebuilders' efforts to make homes more affordable. Homes are becoming smaller, simpler to build and have lower quality cabinets, carpet, fixtures and other components in an effort at reducing the price. Granite countertops are being replaced with less expensive alternatives. Thus, as the average sales price declines, the homebuilder must sell more homes to maintain revenues constant, which is not happening.

Profitability

A by-product of the battle for home sales is that competition is causing reduced gross margins. As sales become even more difficult, further deterioration in already low gross margins in anticipated.Homebuilders have not been able to reduce their infrastructure as rapidly as revenues have declined as evidenced by 2007 overhead costs around 15 percent. Considering the anticipated reduction in 2008 revenues, it becomes more problematic and suggests it will not be possible for most homebuilders to operate profitability. If anything, overhead costs are likely to increase as a percentage of revenues in 2008. The easier cost reductions have been made, increasing the difficulty for future cost savings.One bright spot is the amount of inventory impairments taken to date will likely abate somewhat. Although there will be continued impairments, the magnitude of these writeoffs should decline. In other cases, some homebuilders will show improved gross margins due to the recovery of previous impairments. Overall, this impact will be spread out over a number of years, although there are selected homebuilders where the impact will be significant (refer to article Homebuilding Gross Margins May Not Be What They Seem).

Cash Flows

Lennar created a rush to do tax motivated inventory sales at the end of 2007 as they realized an income tax loss that allowed them to recover previously paid income taxes. (see article Income Tax Update for Homebuilders). MHI, Orleans and several other homebuilders consummated year-end transactions with the same objective. More of these transactions are likely, but the window to carryback tax losses and recover cash generally is limited to income taxes paid in 2006. Some large homebuilders are beginning to generate significant cash flows from inventory reductions and asset sales. For most, this should accelerate in 2008. However, several homebuilders have large cash commitments to joint ventures, option contract takedowns, debt maturities, etc. that will make it difficult to retain cash that is generated. Operating losses that are expected across the industry will reduce cash availability for other purposes.

Failures

Several large homebuilders will be forced to undergo restructurings and or bankruptcy filings in 2008. Depending upon how these transactions occur, they could put further pressure on weak demand for homes.Several large joint ventures are having difficulty and defaults on debt covenants are likely. Some joint ventures will require capital infusions that all joint venture partners may not be able to make.Future compounding all the stress on home and land prices is the deterioration of financial capacity of land bankers that financed option contracts. Those land banks that were leveraged by third parties will receive increased pressure for debt repayment, when many projects are not cash flowing. As a result, there will be additional land/finished lots for sale.

Summary

The homebuilding industry is experiencing a crises and 2008 will not be easy. However, there will be cash generation by some and clarification that other industry participants will not survive. Ultimately, the best-managed and capitalized companies will emerge with increased market share.

Implications: What are the econonmic and cash impacts from a tax standpoint of large impairment losses recorded by homebuilders?  How/when can cash be recovered from these losses?

Analysis: A number of recent questions about homebuilding concern the ability of homebuilders to recognize cash from operating losses that are carried back on prior years" tax returns.  While not an exhaustive discussion, this is a quick overview to issues associated with realizing cash from net operating losses.

Many homebuilders have recognized large losses for financial statement purposes and have established large deferred asset accounts associated with income tax benefits.  In some cases, homebuilders have recorded income tax receivable assets.  The recognition of a financial statement loss (most recently from inventory and other impairments), does not automatically mean there are income tax return losses.  Rather, impaired inventory must be disposed of to trigger a tax return loss.  If the impaired asset is land, this loss can be realized by either selling the raw land or by building a home on it and selling the completed unit.  Writeoffs of option contract values would trigger tax return loss realization as such action would consumate a transaction in that an option contract was cancelled or expired.  Goodwill and other intangible asset impairments normally would not be deductible currently and may only result in increased tax basis in an acquisition that can be amortized over time or realized only if the subsidiary is sold.

The reason for attempting to trigger losses for income tax return purposes is so such losses can be carried back two years and be used to recover income taxes paid.  This recovery comes in the form of a cash refund.  For many large homebuilders, substantial amounts of income taxes were paid that might be recovered, creating a potential infusion of much needed cash.  Lennar recently created such a transaction by selling impaired land in an effort at recovering previously paid income taxes via net opeating tax return loss carrybacks.  Any income tax return losses that are not able to be carried back to recover previously paid taxes are available to be carried forward up to 20 years to offset future taxabel income.

Some builders with large deferred tax assets (these would be created by losses recognized for financial statement purposes that are not currently deductible for income tax return purposes), may encounter issues with continued recognition of such large balances unless income tax return losses are triggered and carried back creating tax refunds.  When deferred tax asset recognition becomes in doubt, tax valuation reserves will be established and the effective tax benefit rate on the income statement will be reduced from the normal 35-40 percent rate.  Thus, it is important to read the income tax footnote in the financial statements for an explanation of the effective tax rate and whether there are valuation reserves for financial statement tax benefits.  Hovnanian is a recent example of a someone that established tax valuation reserves.

In summary, many homebuilders will realize cash due to income tax return losses.  However, to do so, income tax return losses must be realized.  An inability to realize such income tax losses may result in limitations on a homebuilders' ability to recognize income tax benefits from financial statement losses.

Implications: Some reported gross margins from home sales may appear to be higher than they really are.  Investors should be alert for situations where reported gross margins are inflated by prior inventory writedowns.

Analysis: There have been huge inventory impairments recorded in the homebuilding industry during the past two years, with more yet to come.  Depending upon what the impairments relate to,  gross margins
on home sales could be artificially inflated.  This will likely become more frequent in the future.

If standing inventory(homes) has been written down(impaired), these homes likely will convert to closings(revenues) fairly quickly.  Under impairment accounting, the original impairment charge included a discount factor associated with the asset holding period that reduces the basis in the home.  This discount is not recoginzed over the holding period, but is a factor in determining the net asset cost used to determine the gross margin on the home when sold.  For example, if the holding period was assumed to be six months and a discount rate of 16 percent was used to calculate the original home impairment, the gross margin on the ultimate home closing would be inflated by 8 percent(1/2 times 16%). 

As a result, when evaluating homebuilder gross margins on home closings, it will be important to understand how much the current gross margin was aided by previous impairments to obtain a true picture of the overall health of the home sales.  Standard Pacific (SPF) is a case in point.  Absent current period impairments, SPF reported a gross margin on home closings of 20.2 percent.  This seems illogical considering what is happening in the housing industry today.  The answer is during the quarter, SPF closed homes that had been subject to prior impairments, which improved the current quarter gross margin by $48 million.  Removing this impact from the last quarter results in a gross margin of 12.5 percent, which is a better measure of how the Company is really performing.

Compare this impact with D.R. Horton(DHI), who indicated during the last quarter prior impairments improved gorss margins by $49 million.  This had the effect of improving DHI's home sales gross margin from 14.4 percent to 16.4 percent.  This smaller improvement is despite DHI having recorded much larger aggregate impairments than SPF.  The reason for the differences in margin impact primarily is the nature of the original inventory that was impaired.  DHI explains their impairments primarily relate to land, which will not be disposed of for some time.  This suggests that SPF impaired a considerable amount of homes that convert into revenue in a much faster manner.

As time passes, there will be more instances where gross margins receive a lift from previous impairments.  It will be improtant for investors to be alert and evaluate the impact of this effect and whether the adjusted gross margins represent sustainable rates for the longer term.

Implications: Consolidation will occur in the industry The strongest companies will survive the downturn five years from now there will be significant changes to the industry  

Analysis: Housing--2012 Review

Despite all the current dire predictions on the demise of the homebuilding industry and its leaders, the industry will continue five years from now,albeit in an altered state.  The long predictied consolidation will occur and the number of household  housing names will diminish.  A look into the future.

The current housing issues will cause some oermanent changes to the overall housing industry.  a handful of very large National builders will emerge with significant size differneces between the top five or six and the remainder.  Most of the present public homebuilders that are in the middle to smaller size range will be acquired in one form or the other.  The current housing crises will accelerate this much discussed consolidation as the "haves" and "have not's" become more distinguishable.

Some of the many factors that will cause the consolidation include:
1.  Inability to compete due to permanent damage to infrastructure caused by the current environment.  Scaling back operations, loss of key talent, reduced ability to raise capital, etc.
2.  Aging of management/ownership teams and a willingness to leave the limelight.  An appetite to cash in when the market begins to improve.
3.  Reputatioal issues concerning potential insolvency, regulatory concerns,etc.  An overall loss of public trust.
4.  Shareholder activism demanding improved performance and structural changes.
5.  Reduce expectations on the part of sellers, thereby making transactions more reasonable.
6.  Solvency issues.

On a National basis, the five or so remaining companies will compete in major and secondary markets each offering a broad range of price  points, including detached, attached, adult communities, etc.  Those presnetly lacking this breadth will supplement it through acquisitions or initiating new activities.  This National presence by a few will result in heady competition causing the days of thirty and fourty percent gross margins to disappear.  Rather, aggregate gross margins will settle out in the lower twenty's.  Combined with twelve percent overhead, pretax earnings will approach ten percent.  In aggregate, these remaining homebuilders will have a significant market share( over 50%) where they operate.  Furthermore, these large homebuilders will approach twenty five percent of the annual new home starts.

Recent developments have cemented the housing industry as being cyclical, despite protestations otherwise.  The companies left five years from now will find their stock trading on a multiple of earnings per share, but the multiple will not expand beyond the traditional five to eight times earnings.  Those left will be large in scale closing at least 40,000 homes annually.  These companies will be very substantial in size with revenues exceeding $15 billion..

There will continue to be a place for the true custom homebuilder and small regional builders.  However, it is my belief there will be large systemic changes to the homebuilding industry five years from now as it matures.

Implications: Payment requirements under land option contracts are an important consideration when evaluating the cash flows of homebuilders.

Analysis: HOMEBUILDING--THE HIDDEN CASH REQUIREMENT

Analysts are attempting to forecast cash flows for homebuilders to evaluate their ability to service debt.  The general consensus is that the contraction in the housing market will lead to reduced inventory levels, thereby generating cash.  Overall, this should be a reality.  However, to date, the cash generation has not occurred as, exclusive of writeoffs, the looked for inventory reduction has not occurred.  This cash generation should commence during the back half of 2007 and increase significantly in 2008 as the current glut of finished homes finds lower levels.

As analysts work through their cash flow models, they must be alert for cash requirements associated with option contracts, particularily those financed with land bankers under "current pay" scenarios.  A "current pay" option contract requires that the homebuilder spend monthly cash flow to pay the land banker for his investment in the underlying lank.  This means that a homebuilder with a 15 percent cash deposit with a land banker on land with cumulative purchase and development costs of $10 million also is paying the land banker up to 1 percent monthly on the $10 million investment, net of the cash deposit.  To further illustrate the point, if there is $1 billion in aggregate "current pay" land bank exposure, the homebuildermay be spending $8.5 million( $1 billion less $150 million cash deposit) per month to carry these options. And, the aggregate amount of exposure under option contracts can easily exceed $1 billion.   It is difficult to analyze this, as these "current pay"  payments are hidden by being capitalized on the balance sheets as deposits or land under development. 

Therefore, to evaluate future cash flow requirements, it is important to know the aggregate exposure under this form of option contract, to know the extent of "current pay" contracts(estimated at over 50%) and to evaluate the rate that may be paid on a monthly basis(1% was common).

In evaluating the aggregate exposure, it also is important to consider all option contracts, including those deposits secured by standby letters of credit rather than cash.  In this situation, if a standby letter of credit rather that cash secures performance, the monthly cash payment would be $10 million under the earlier example($1 billion times 1%).

In summary, homebuilders should begin to generate cash flows as their inventories actually decline.  However, these cash flows will be partially offset the continued monthly payments made to some land bankers that can be quite significant in aggregate.  Thus, it is important to evaluate this comitment in projecting future cash flows.

Implications: There is widespread interest in the housing industry, housing stocks and bonds, etc.  This impacts many industries and companies.  The article offers my point of view about the current state of the homebuilding industry and suggests when and why things will turn around. 

Analysis: WHEN WILL HOUSING RECOVER?

Recently, Pulte Homes announced a restructuring where they are eliminating a significant number of their work force.  This follows similar actions across the homebuilding industry.  Additionally, homebuilders continue to report inventory impairments and losses.  Newspaper articles suggest home sales will continue to languish for some time.  Such announcements have become and will continue to be commonplace for at least the next year.   This article offers support behind the current situation and suggests future outcomes for the overall homebuilding industry.

Current finished, unsold housing inventory levels should peak around the end of June.  This is due to several factors, the most significant of which is the is the homebuilders starting many homes last fall in anticipation of the Spring selling season.  The "selling season" has been a bust and by March, the homebuilders realized they should reduce their starts and many did so.  However, the speculative homes that were already under construction are nearing completion, which will result in unsold finished homes peaking around the end of June.  Other factors contributing to the high home inventory levels include: lack of consumer confidence that home prices have stabilized, continuing inventory writedowns, investors attempting to exit speculative properties and ongoing pressure on the mortgage approval process, especially in the subprime area.  Additionally, there is uncertainty about the extent of upcoming foreclosures adding to the current glut.

This all means homebuilders will continue to be very aggressive in trying to move unsold, finished homes over the next six months and heavy discounting will occur.  This point should be further accentuated by homebuilders that did not understand the status of the industry initially and continued to start speculative homes.  By now, everyone should understand the solution is to reduce the current excessive supply of finished homes and new starts should continue to decline.

Gross margins on new home sales will continue to decline at least through the end of 2007.  Assuming some contraction in inventory levels by early 2008, pricing will only begin to improve in the second and third calendar quarters of 2008.  By the end of 2008, some normalization of gross margins to around 22% should begin to occur.  However, the industry has changed significantly and a return to the robust gross margines exceeding 30% that were experienced in the early 2000's is very unlikely.

During the next year and a half homebuilders will find it very difficult to make money, ignoring the likelihood of further deposit writeoffs and inventory impairments.   This is due to the rampant discounting  of current and future home prices.  Homebuilding gross margins for the next 18 months are anticipated to be in the mid teens, before consideration of selling and overhead expenses.  Selling expenses have risen dramatically as the cost of external and internal sales commissions have risen significantly, in an effort to capture the modest customer traffic.  Additionally, marketing efforts have been increased and are being absorbed by fewer sales.  For the near term, it is possible sales and marketing costs will average 8-10% of revenues. Combined with the inability and/or unwillingness to reduce overhead, selling, general and administrative costs could approach the gross margin level of 15% resulting in no earnings.

The challenge at hand is to convert inventory to cash, maintain just enough overhead to remain a viable player in desirable markets and to manage cash outflows, particularly situations with land bankers where decisions must be made about buying lots under option contracts.

In summary,  do not expect real improvement in homebuilding earnings for over a year.  Additionally, the days of high gross margins may not return.

Implications: There has been considerable recent press coverage about alleged mortgage abuses by Beazer Homes.

This appears to be compounded by overall concerns about subprime mortgage activities.

It is important to maintain perspective on this issue as it relates to Beazer

Analysis: The recent probe into mortgage lending activities in Charlotte as they relate to Beazer Homes has caused considerable discussion with regard to the Company's operating methods and the likelihood this is widespread across Beazer and possibly the overall homebuilding industry.

It is my understanding that the allegations to date have been restricted to the Charlotte location of Beazer.  There are several investigations underway, which are undoubtedly distracting the management team at Beazer.  This is further highlighted by the departure of the general counsel and the chief financial officer.  However, these departures appear to be unrelated to the current investigations.  The general counsel was terminated for unnamed violations of Company policies.  Separately, the CFO announce his resignation to accept a CEO position with a company where he has served on the Board of Directors.  This departure appears to make sense, although the timing is unfortunate.

It is possible that an individual mortgage office or officer in a decentralized environment with numerous divisions could circumvent procedures and perform some inappropriate acts.  However, Beazer is a large company and it is difficult to imagine a widespread pattern of abuse company-wide, particularly in light of the very active home sale market until the last year.  Simply said, there was no need to push to make sales until recently because the overall homebuilding market was so good.  Beazer was making record profits and it is not logical they would have systematically performed fraud on a wide scale to enhance already excellent earnings.

My view is that Beazer is in the wrong place at the wrong time and it us unfortunate they are a poster child for subprime lending for what I believe will prove to be an isolated instance. And, it is possible other builders could have a rouge operation in any division.  I believe it is more likely that subprime abuses were commonplace on a broad scale with certain smaller mortgage brokers that originated such mortgages and sold them off to a consolidator.

In summary, Beazer will suffer reputationally and will endure a significant distraction factor which will hurt them overall.  However, I would be very surprised to see this as a widespread activity that caused a large disruption in the overall operations of the Company.

Implications:  

Analysis: