Homebuilding Gross Margins May Not Be What They Seem

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.