Bye Bye Book Value

DR Horton (DHI) reported earnings this morning and is the first of the homebuilders to finally recognize reality - that its main asset - land, is not worth anywhere near what it says it is. They took an impairment charge of $823.8 million to the value of the land on its balance sheet. As a comparison, last quarter DHI wrote down only $ 67.3 million for inventory impairments. While it may seem that DHI just reported a "kitchen sink" quarter, remember that total inventory on its balance sheet is $10.6 billion, and home and land prices are still dropping in many states.

The conventional wisdom on Wall Street has been to buy Homebuilders at book value, which incidentally, virtually every analyst said would never happen. But here we are about 18 months into the downturn and many of them are bouncing off tangible book value, with some well below. This belief that book value is the bottom is ingrained in the industry as well. I remember attending a Homebuilding marketing tour in Atlanta about 5 years ago and during the question and answer period an investor asked the management if they would consider making any acquisitions. The group was trading at around 1.5-2.0 times book value at the time.

The speaker looked dumbfounded for a minute and then said simply that the only value to him in a competitor was the value of its land – he already had a brand established and the infrastructure to support it – so why would he pay two times what its land is worth? Now did it occur to him at that time, that this was exactly what he was asking us as investors to do? To pay twice what his book value was? I’ll never know the answer to that and I can’t recall which homebuilder it was.

So is it time to get in the group? Investors need to get their hands around several issues before jumping in here. It will be tempting because you will start reading articles soon about how Value investors are “sniffing” around the industry. Value investors love to sniff around stocks and industries. There are stocks that I have been watching for years without buying. I stalk them, watching and waiting for the 100-year flood to come.

The first issue is book value. It’s great to buy something at book value because it makes you feel warm and cuddly at night but what happens when you wake up and type that stock ticker into the box and you find out that the company just wrote down 20% of its book value? Oops. Sorry, you no longer own a homebuilder at book value anymore. An analyst report released last week from Deutsche Bank says that on average a group of 13 publicly traded homebuilders have written off 11.1% of its equity base. Is this enough for what may become the worst cyclical downturn in the last 50 years? My opinion is no.

The second issue is what sort of hidden bombs are there that are not on the liability side of the balance sheet of homebuilders. Homebuilders utilize off balance sheet partnerships and joint ventures fairly frequently. Have these all been disclosed to investors and do we understand completely the ramifications of them?

Third, the biggest boom in the history of residential housing deserves the biggest bust. The excesses need to be washed out of the system before things get back on track.

Fourth, the sub prime reset wave has not peaked. What happens when these hapless homeowners go to refinance, as they were promised, but they have negative equity so can't get a lender to touch them. Back to renting I guess and the house is put up for sale. Inventories have not peaked.

Fifth, the industry can trade at a much lower price to book value than the conventional wisdom believes. Stocks traded down to 0.5 times book value back in 1991. I think we can all agree that this downturn is worse than that one.

Homebuilder Debt to Capital Ratio - Be Careful Out There

Lennar Inc. (LNR) just released its quarterly earnings report and highlighted what it considers its low debt to total capitalization of 31.6%. Investors should note, however, that the numerator of this calculation only includes the on balance sheet debt and Equity of Lennar. Lennar has not filed its 10-Q for the May quarter as of the day I wrote this, but the company has the following debt according to its 10-Q from the previous quarter (ended 2/28/07).

$ 278,232 - 7 5/8% senior notes due 2009
$ 299,766 - 5.125% senior notes due 2010
$ 249,461 - 5.95% senior notes due 2011
$ 345,719 - 5.95% senior notes due 2013
$ 247,559 - 5.50% senior notes due 2014
$ 501,851 - 5.60% senior notes due 2015
$ 249,694 - 6.50% senior notes due 2016
$ 300,000 - senior floating-rate notes due 2009
$ 109,212 - Mortgage notes on land and other debt

$ 2,581,494

This total debt number is close to the number in Lennar's press release of $2,585,286,000 for the May quarter, which when divided by total debt and equity of $8,168,841,000 gives us the 31.6% number. However, if you dig into the 10-Q for February you will see that Lennar calculates the debt to total capital of its unconsolidated entities as follows:

Debt of Unconsolidated Entities $5,619,394,000
Total Equity of Unconsolidated Entities $3,299,991,000
Total Capital $8,919,385,000

Debt to total capital of Unconsolidated Entities 63%

To be fair to Lennar, there is a footnote that says the Equity is carried at book value and the market value is $1.3 billion higher than book.

If you do a weighted average of the on balance sheet debt to capital and then the unconsolidated entities, then you get

Debt $8,200,888,000
Equity $9,074,972,000

Total Capital $17,275,860,000

Debt to Capital 47.47%

I believe that Lennar has a reputation as one of the more open and transparent Homebuilders so it may not be possible to calculate this for the other publicly traded Homebuilders, but investors should look twice at the official number that come out in press releases.

Now when I contacted investor relations to get the company opinion on this matter they said that:

"it would not be accurate to add the equity and debt from our JVs. Most of this debt is non-recourse to Lennar or has recourse via maintenance guaranties."

Well, now I am even more confused and need to do a little more work on the entire concept of these structures. I will come back to this at a later time. If anyone has encountered these structures before and has a more complete understanding of them, please comment.