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Saturday, September 23, 2006

Heh, Suckers

Apparently somebody decided that homebuilders were getting to be a good deal. There may be one or two of them that are, but I looked at the balance sheets for several and they definitely weren't. Seeking Alpha has a decent article on the P/E fallacy, but it doesn't go far enough.

I know the profits look good now (as of last quarterlies), but look at cash flow, debt restrictions and the change in positions versus last year. See, for example Horton D R's cash flow as of June 30.Another problem is that most of these companies are providing mortgages and incentives to potential purchasers and are subject to risk and loss from that. Some of the types of incentives being offered by these companies in markets with sales resistance include paying HOA for 12-24 months, forward-looking credits, etc. These will be a drag on future profits. Many of these companies have gotten into the funny-money loan business, and they may be selling the debt, but they aren't selling the debt totally without recourse.

Homebuilding companies provide warranties and are also subject to legal action for certain defects. When they are coming off a high building period, such as at this time, any bad estimates may lead to insufficient reserves for these costs and drag profits down for years into the future. (Often they use subcontractors, and quality may or may not be sufficiently controlled, because rates paid to subcontractors have often been falling while building has been increasing.) Decreased sales, walking away from land options, increased cancellations (would-be buyers unable to sell first home), increased sales incentives that seem to be suspiciously concentrated for recognition in the future (credits for landscaping/decorating after purchase, payment of first-year utility bills, etc), the need to walk away from their land options, and reduced future and current cash flow amount to a very uncertain operating environment.

A very uncertain operating environment should be red flag for potential investors. It is not safe to buy these companies for book value, because the book value of their assets will likely be falling. Their future profits are unknown, and so are their future costs. However, it is logical to believe that their future costs related to this surge in activity are likely to be higher than in 2001, and the ratio of (future cost for past sales/future sales) is likely to be higher than in 2001. The analysis in the Seeking Alpha article is a bit too sanguine for my tastes.

One thing I don't like about these companies getting into the mortgage business in this environment is that they have much less ability to balance their risks than banks or financial companies which engage in this business on a much wider scale. Many have pointed to WaMu's exposure to option ARMs, but a company that can make money off refinancings is able to shift its portfolio more in compensation for defaults. It's going to be hard for these builders to do the same. Scroll down to the bottom of this post and read the information about Beazer's loan offering, and you will get an inkling of the potential problem. Beazer is not alone in doing this.

"It is not safe to buy these companies for book value, because the book value of their assets will likely be falling"...on the other hand, land--which is a major asset class for many of these companies--should be carried at purchase cost. So if it was bought last year, it probably *will* fall in value--but if it was bought 10 years ago, it is probably still worth more than it's being carried at.

I can't think of any obvious way to determine the average age of the land from reported data, though.
David - well, usually they do revalue their assets. It's much like property taxes - you reassess when things go up. Usually they don't carry most of their land for that long.

I presume after a year or so that this will settle out and then everyone will know better where they stand.
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