In lesson 9 I stated I would walk through a financial model in lesson 10 to show the huge reduction in book value (that isn’t being taken by the builders). I got sidetracked and gave a macro view in lesson 10. So in lesson 12, I am going to walk you through all the moving parts (inputs) in a financial template and show you why book is substantially impaired.
Notice how almost every builder now is trading at 0.25 to 0.70 of book. If their land actually were worth closer to 1.00 of book like EScrooge thinks, then how come a private equity or hedge fund doesn’t buy these companies at such huge discounts to book? Why are builders trading at liquidation or below liquidation prices? Why were hedge funds and private equity taking positions in builders earlier this year at higher book (0.8) and now you are not seeing it anymore at such low ratios? People the word is out on the street and yours truly is doing my part in educating people with substantial capital of what is really going on. I am not stating that I am moving the market, but I am educating my sphere of influence and everyone on Wall Street has a huge rolodex (talks). Wall Street hedge funds, institutional investors, private equity, etc… are picking up on this before the banks. The banks still are not in tune with what is going on.
Illusion #1 – Methodology. Remember I said that there is no Accounting standard on how to impair land assets. So each builder has complete freedom to be conservative or look the other way. The more you write off your land, the more you are in jeopardy of breaking different F/S bank and bond covenants (debt to equity, etc.). So your saying, “well Bill” why would anyone write off land in the first place… ahhh yesssss. This is why I am going to show you all their tricks.
Illusion #2 – Timing. Remember I pointed out in a previous blog post how all the write-offs magically occurred in the 4th quarter of 2006. I suggested maybe this was for compensation reasons, but that was just a mere suggestion with no basis. Look at DR Horton and Pulte the two biggest land barons. Notice how they both took huge whopping write-offs in their most recent quarter, but the quarter before there were almost none? So what? In one quarter their land went through the floor and the other it didn’t? Or can a builder impair land using the timing he chooses? Look at the unevenness of when a builder writes off land. Very bumpy ride isn’t it? So if you can choose the timing and methodology and not communicate it is that a good thing for the investor and bank whom rely on your financial statements?
Illusion #3 – Straight Line vs. Specific. Let us use DR Horton (DHI) as our first example, the biggest and the best right? In the quarter ending 6/07 they impaired $835 million in land. Not a large amount, merely a flesh wound. Especially when you consider that on 3/07 they had $6.7 billion in residential land and lots. That comes out to 12.5% of their land holdings on 3/07. Boy I feel stupid… I have been telling you that most builders are at 50% loss on their land holdings and DR Horton is only at 12.5%. Gosh I’m an idiot. Wait a minute! You are not stupid enough to buy stock in a company without reading its 10Q are you? As I recall, my former builder along with other builders wrote off land on a community specific basis. The auditor is not going to allow you to just straight line your write off. Think about people, when you impair land and the auditor has to review your methodology is he going to just let you straight line across every piece of land you own? Of course not. You have to show proof using a financial model / methodology. You remember the one the builder created. So Bill, are saying that the $835 million write off was against specific communities that were impaired? What happens if only 25% of DR Horton’s communities were impaired? What was the value of those communities prior to the $835 million write off? Not the value of all the land holdings ($6.7 billion) just the ones written off? OK class, lets move along to Pulte Homes on their 6/07 10Q (pg 8) tells you that they wrote off $603m on 139 communities (notice how they don’t tell you the starting value before write-off). Now, go through Pulte’s 10Q and write down total land positions and total community count (I’m not doing all the work for you). Extrapolate. Am I making you nervous Mr. Institutional Investor with your large position in any homebuilder? Unless you know what that $835 million DR Horton impaired against you really don’t know what the true % write down was…. Hint, it was significantly and materially higher than 12.5%. Let us move on to Centex’s 6/07 10Q page 10. They state a $146 million write off in only 29 communities!!!!! leaving a remaining value of $346 million. That was a 30% write-off. People, get in your car… and drive every Centex, PHM, Dr Horton community…. Are any of them bustling? Every community is getting its arse kicked. The builder controls the write down method and timing. Get it now? Are you to assume only in those 29 communities are there impairments?
Illusion #4 – Future vs. Current. In past down turns when a builder wrote off land he wrote off future land and not current. Again, using my previous employer and a few contacts as reference points. Why? Because the Executive management could significantly lower the cost basis of future land, offer themselves large compensation packages for improving earnings and then when the downturn was over, they made mountains of money for the company and compensation for themselves. However, the homebuilder crisis is so bad (see my blog 10 of 20) that many builders don’t even know if they have a future. So they are writing off land on current positions. Why? Because many are in such distressed situations (I will prove this in blog 12 of 20 using my financial modeling) that they need to show operating profit immediately or else banks and bond holders are going to make a money grab and pull credit or loans because of more broken covenants. They need to create the illusion that things are getting better. So they are going to take massive hits on land in current communities vs. future communities to buy them time. They are hoping they can keep the illusion going until the market turns. Tie in Illusion #3 to Illusion #4. So do you still think I am a fool when I say land values are 50 cents on the dollar and that builder equity for many is completely wiped out?
Illusion #5 – Land Sales $1 for $1. Qtr ending 6/7 SPF sold $129m in land for $111m. Qtr ending 7/07 HOV sold $30m in land for $34m. If you go through enough 10Qs you will find that builders are providing you the illusion that they are getting $1 for $1 on land sales… maybe they are who knows… but ask yourself these questions using logic. If they are getting $1 for $1 that doesn’t jive with the huge writeoffs. Could it be that they are writing down assets first, then selling them at the lower basis making it appear that their land is dollar for dollar? Also, if their land is really worth what they say it is on their books then riddle me this. Why are the write-offs of builders huge, yet the dollar amount of land sales at a $1 for $1 are so low? Because there are no buyers!!!! When there are no buyers you can only get liquidation prices at best. Look at the cash positions of all the builders… nothing. Yet billions in land that they can’t sell. Why doesn’t Horton or Pulte sell a billion in land, get a mountain of cash and improve their credit rating and make their bond holders and bank creditors happy and improve their stock price? Because no one is buying land except at 50 cents on a dollar. Their equity would dry up instantly even with all that cash.
Write down these 5 magic tricks and tear open a nice 10Q from your favorite builder. Once you peel back this onion you will realize this… the write-offs are huge on a community by community basis… the builders control the method and timing (hiding the truth)…. The builders are buying time through axing current inventory costs and saying their future is still 100% LMAO… and the builders cannot find any buyers thus they are stuck with a mountain of inventory and no cash… selling large $s of their inventory would expose the huge reduction in value of their remaining land. I love no win situations… I get it, Wall Street finally gets it… the banks don’t get it but when they do you will see the plugs being pulled and forced bankruptcies occur in both private and public builders… lots of them