Backlog and Market Cap to Debt Ratios for Major Homebuilders

Following up on posts One and Two about homebuilder ratios.

Debt-to-backlog. Having debt that is a higher multiple of backlog (the dollar amount of outstanding orders for homes) is troublesome. Consider that the amount of cash for paying down debt is going to be a fraction of the backlog

Debt-to-market cap. A measure of the amount of financial leverage.


One thing to keep in mind is that the data not consider off-balance sheet debt, so the amount of debt is understated. The understatement is not necessarily equal - certain builders use more joint ventures to control land. Also, certain builders have more contingent liability for their off-balance sheet debt.

Also, significant numbers of orders in the backlogs will probably cancel. Some builders are better than others at converting the backlog into cash.

Homebuilder Ratio Analysis

In September, I put together a ranking of public homebuilders by their debt to backlog, enterprise value to market cap, debt to market cap, and Altman Z-Score ratios.

I am going to update that ranking, but first I wanted to measure its efficacy at predicting changes in stock prices.

This is a scatter plot of the relationship between the debt to market cap ratio on September 18, and the decline in price since then.


Similar scatter plot showing the relationship between price decline and debt to backlog ratio.

No Bids for SoCal Land

This is an interview published on the OC Register site with Tom Reimers, executive VP at land broker O’Donnell/Atkins from Irvine.

What’s the market for raw land in SoCal and Orange County today? What’s the outlook?
Tom: In general, the residential raw land market is non-existent. Land values and deal flow for other types of product are more stable right now, but the credit/financing crunch is squeezing those values as well.

How are prices?
Tom: It’s hard to say. With few to no buyers, it’s hard to say what land is worth. There are no transactions to set a benchmark. In some tertiary markets, the land is worthless from a residential development standpoint due to costs to develop being higher than the land value.

Related: Homebuilders Liquidate Assets in Desperation Sales.

Hovnanian spokesman Jeff O'Keefe said the company offered discounts as high as 30 percent.

D.R. Horton also threw in a washer-dryer and $2,500 toward closing costs, Moran said.

``Adding a credit toward closing costs still allows them to show the highest selling price they can,'' Moran said.

Next, Mortgage Slump Hits Home Decor Industry.

At the Annual Furniture Mart, Worried Manufacturers See the Mortgage Slump's Effects.

HIGH POINT, N.C. (AP) -- Doug Schock shook his head in disbelief while gazing at the empty bank of elevators, typically full as they shuttle thousands of buyers between dozens of showrooms filled with the latest styles in sofas, bedroom sets, and dining room tables and chairs.

Debunking Another Absurd Stephen Kim Homebuilder Rally

Wondering why the homebuilders are up huge this week? Surprisingly simple explanation:

NEW YORK (AP) -- Housing stocks rallied for a third consecutive day Wednesday, as sentiment increased that the long-battered shares may have reached a bottom, even if the beleaguered housing market has not. With no industry data to guide them, investors appear to be taking their cue from an analyst who earlier in the week upgraded the entire sector.

Citigroup Global Markets analyst Stephen Kim wrote in a client report Monday he does not foresee the stocks falling much more. However, he does not expect conditions in the industry to improve anytime soon.

"We are not trying to suggest that trends in the homebuilding sector are about to get much better," he said. "It is precisely when things have gotten this bad that the stocks start looking good."

For a moment, I thought I had been transported back in time to December 6, 2006, date of a previous Stephen Kim research report.

Citigroup recommended that investors buy shares of homebuilders now as order trends are expected to turn positive in the first quarter of 2007. "While many wait for an improvement in fundamental data such as prices or inventory to signal an 'entry point' in the stocks, we urge investors to look back to prior cycles, when the group rallied far ahead of fundamentals," Citigroup analyst Stephen Kim said in a research note. The brokerage firm raised its price targets on the following companies:

Pulte Homes Inc. - $45 [now $16.25, off by 64%]
D.R.Horton Inc. - $48 [now $14.84, off by 69%]
Lennar Corp. - $88 [now $25.90, off by 71%]
Centex Corp. - $83 [now $29.28, off by 65%]
Toll Brothers Inc. - $42 [now $22.79, off by 45%]
KB Home - $92 [now $28.60, off by 69%]
MDC Holdings Inc. - $85 [now $43.52, off by 49%]
Ryland Group - $95 [now $25.5, off by 73%]
Beazer Homes USA Inc. - $80 [now $10.08, off by 87%]
Hovnanian Enterprises Inc. - $63 [now $13, off by 79%]
Standard Pacific Corp. - $43 [now $6.24, off by 85%]
Meritage Homes Corp. - $87 [now $16.62, off by 81%]
Technical Olympic USA Inc. - $18 [now $1.94, off by 89%]

Stephen Kim sounds like a guy you should listen to if you want to lose two-thirds of your money.

Here's how the builders have done since he called the bottom on December 6, 2006:


See that tiny blip upwards on the very far left? That was the effect of his report. The bullishness carried through until it became clear that the "spring selling (buying?) season" was never going to materialize.

I worked in the industry and I remember what people were thinking. They honestly thought that spring of 2007 would come and the real estate market would kick right back into high gear.

That didn't happen, and now there are key problems that make it even less likely that we have reached the bottom of the housing market.

• Lending is tight. Homebuilders do great when there is no-questions-asked lending.
  
• Prices are still too high. High relative to rents, high relative to median incomes, high relative to other goods' historical increases, high relative to building costs. They need to come down much further - and the Case-Shiller HPI futures markets are predicting it.
• Inventory is huge in absolute numbers and in number of months' sales, and keeps getting bigger by both measures.
  

Given these challenges, and the tarnished balance sheets of the builders (with high debt, loads of difficult to sell homes, staggering amounts of lots and land, and problematic off-balance sheet vehicles loaded with land and debt), it's unlikely that the builders' stocks have reached bottom.

Mr. Kim: We have not reached the end of the housing bust. We are only now reaching "the end of the beginning."

Standard Pacific Troubled; Hovnanian Almost as Bad

Standard Pacific announced today that they are going to offer $100 million of convertible notes.

The Company intends to use the net proceeds of the notes offering to repay a portion of the outstanding indebtedness under its revolving credit facility.

The notes will bear interest at a rate of 6.0% per year... an initial conversion price of approximately $8.75 per share of common stock...

Concurrently with the offering of the notes and the convertible note hedge transactions, the Company intends to enter into a share lending agreement with an affiliate of Credit Suisse, pursuant to which the Company will lend shares of its common stock to such affiliate. Under the share lending agreement, the share borrower will offer and sell the borrowed shares in a registered public offering and will use the short position resulting from the sale of such shares to facilitate the establishment of hedge positions by investors in the notes to be offered.

On September 14, 2007, and in contemplation of the proposed notes offering, the Board of Directors of the Company eliminated the Company's quarterly cash dividend. This action will save the Company approximately $10 million per year.

It looks like an extremely ugly way of raising money. SPF is going to lend its own shares to whomever buys the notes, so that the buyer can sell the stock short. I don't think SPF is long for this world.

Standard Pacific is one of the worst homebuilders based on three key metrics:

• Debt-to-backlog. Having debt that is a higher multiple of backlog (the dollar amount of outstanding orders for homes) is troublesome. Consider that the amount of cash for paying down debt is going to be a fraction of the backlog, and that significant numbers of orders in the backlog will probably cancel.
  
• Debt-to-market cap. A measure of the amount of financial leverage.
  
• Altman Z-Score. Lower scores are worse; used to forecast the likelihood of bankruptcy.
  

(click to enlarge) Z-Scores are from this article.

One thing to keep in mind is that this table does not consider off-balance sheet debt. Standard Pacific, for example, has loads of debt in special purpose joint-ventures that they may be liable for.

Also, it looks like Hovnanian is the next worst of these builders after SPF. (Not counting TOA, BHS, or BZH, since they are so difficult to short.)

Finally, I took a stab at what SPF's equity would be after hypothetical markdowns.
(Keep in mind, they amended their Consolidated Tangible Net Worth covenant to require "the sum of (a) $1,000,000,000 plus" a proportion of net income and equity sales.)

For this experiment, I made the following major assumptions:

• Land owned is worth 50% of book value. My understanding is the bids for lots and land in SPF's markets are very, very low.
• Completed and model homes are worth 80% of book value.
• They will be walking away from all land options.
  
• A generous assumption that they will be able to walk away from the JV's and such at only a complete loss, when they may actually have to pay those structures' debt, and thereby be liable for more than their initial investment.
  
• Mortgage loans in the portfolio are worth book value. If it turned out that SPF was writing shoddy loans in order to move houses, the loans would require a huge discount.

(click to enlarge)

In this scenario, their book value is negative $1.28 per share.

Standard Pacific Joint Ventures

How about that preposterous rumor (from CNBC, of course) that Buffet would buy part of Hovnanian? The giveaway was that they chose the builder with the highest short interest.

My trade was to fade that rally (17%!) by sellling stock into it and also picking up the August 17.5 puts. Worked great and I'm looking for HOV to slump further. Ditto SPF.

The housing bottom is not going to come until inventory adjusts to normal (the market starts clearing again). That will happen when sellers give up on their wishing prices and hit the bids.

This article by Mish is helpful in understanding what kind of land the builders were buying and putting in joint-venture deals.

Meanwhile, I'm looking further into SPF's JVs:

We enter into land development and homebuilding joint ventures... [We] typically obtain secured acquisition, development and construction financing, which reduce the use of funds from our revolving credit facility...

At March 31, 2007, our unconsolidated joint ventures had borrowings outstanding that totaled approximately $1,245.3 million that, in accordance with U.S. generally accepted accounting principles, are not recorded in the accompanying condensed consolidated balance sheets, and equity that totaled $816.4 million.
We and our joint venture partners generally provide credit enhancements in connection with these borrowings in the form of loan-to-value maintenance agreements, which require us under certain circumstances to repay the venture’s borrowings to the extent such borrowings plus, in certain circumstances, construction completion costs exceed a specified percentage of the value of the property securing the loan.

At March 31, 2007, approximately $658.6 million of our unconsolidated joint venture borrowings were subject to these credit enhancements by us (of which $155.0 million we would be solely responsible for and $503.6 million which we would be jointly and severally responsible with our partners). During the three months ended March 31, 2007, we were not required to make remargin payments under any loan-to-value maintenance agreement. However, subsequent to the end of the 2007 first quarter, we made an additional investment to one of our Southern California joint ventures totaling $9.7 million, which represented our 50% share of the venture’s project loan remargin requirement. [We] expect that, over the next several quarters, we and our joint venture partners will be required to make additional remargin payments with respect to certain joint venture loans and will be required to restructure or extend others.

If our joint venture partners fail to make their required capital contributions, in addition to making our own required capital contribution, we may find it necessary to make an additional capital contribution equal to the amount the partner was required to contribute. Making capital contributions on behalf of our partners could result in our being required to consolidate the operations of the applicable joint venture into our consolidated financial statements which may negatively impact our leverage covenants. Also, if we have a dispute with one of our joint venture partners and are unable to resolve it, the buy-sell provision in the applicable joint venture agreement may be triggered. In such an instance, we may be required to either sell our interest to our partner or purchase our partner’s interest.

Another issue for SPF is the performance guarantees that they and the JV's have given:

We and our joint venture partners have also agreed to indemnify third party surety providers with respect to performance bonds issued on behalf of certain of our joint ventures. If a joint venture does not perform its obligations, the surety bond could be called. If these surety bonds are called and the joint venture fails to reimburse the surety, we and our joint venture partners would be obligated to indemnify the surety. At March 31, 2007, our joint ventures had approximately $130.0 million of surety bonds outstanding...

I realized that I have been neglecting a category of capital mis-allocator besides the crazed flipper: people who only needed a 2000 square foot house but bought a 3500 sf one, because, of course, the more money you spend on real estate, the more money you make in appreciation.

This was perhaps the more pernicious type, because it was an enormous misallocation of capital.

As with any bubble, it will take a while for the effects of that misallocation to ripple through the system. See this chart for more about that.