Hidden Homebuilding Assets

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.