Accelerated Reductions in Book Value

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.