Homebuilders: Bargains or Value Traps?
By Sham Gad August 3, 2007
The past two weeks have been a nightmare for homebuilders. Shares in just about every company in the industry, from Hovnanian (NYSE: HOV) to Pulte Homes (NYSE: PHM), are selling at prices not seen since before the housing boom began.
Listen in on the USG (NYSE: USG) conference call, and you will get a clear indication of how painful things are in the housing industry. Listen in on the Countrywide (NYSE: CFC) conference call, and you will know how dire the mortgage situation is becoming. Basically, everything that could go wrong in homebuilding, is going wrong. There is an oversupply of new and existing homes. House values are dropping by rates reminiscent of what happened in the Great Depression. Mortgages, both subprime and now even prime, are defaulting at accelerating rates.
Meanwhile, Mr. Market is frantically selling homebuilders and, any other business that smells of homebuilding, at a rapid-fire pace. The homebuilders themselves are generating negative cash flow for the most part, and the land writeoffs are still coming in. As a result, even companies that have been around for a long time and have experienced their up and down cycles are trading below book value -- in some cases, substantially below. So what gives?
During favorable business conditions, the major homebuilders were generating returns on equity in excess of 20% and churning out healthy amounts of free cash flow. When the industry turns favorable again, which is now more likely to occur no sooner than late 2008, investing at today's prices may offer a satisfactory return on capital. But at this stage, I would exercise extreme caution. As investing guru Mohnish Pabrai says, it's the combination of low risk and high uncertainty that can be very profitable or, at worst, cause a minimal reduction in capital. However, that's not the case with homebuilders. Most of them face high uncertainty and exhibit high levels of risk commensurate with the current environment.
A simple illustration
Look no further than Beazer Homes (NYSE: BZH) to realize how perilous the housing industry is right now. Currently under an FBI investigation, Beazer saw its stock earlier this week plunge by more than 20% in a single day because of bankruptcy rumors. I can't comment on whether Beazer is truly close to bankruptcy. That's a whole other issue entirely. But I do know that at today's prices, Beazer is selling at less than one-third of book value and about one-tenth of sales. I wouldn't expect much from Beazer and its contemporaries in the near future, but if Beazer can ride the storm, and it manages to sell for even two-thirds of book, it looks like a potentially attractive investment.
Or does it?
Using Beazer's most recent 10-Q for the period ended March 31 and all current-quarter data I could find, the balance sheet looks like this.
Balance Sheet Analysis, As of 3/30/07
Cash
$128 million (as of 6/30/07)
Inventory
$3.3 billion
Accounts receivable
$66 million
Goodwill
$121 million
Property, plant, and equipment
$26 million
Mortgages
$10.3 million
Other assets
$132 million
Total assets
$3.7 billion
Total liabilities
$2.6 billion
Total equity was about $1.6 billion at the end of March and has gone down to $1.1 billion since the second quarter, which ended June 30. This $1.1 billion equates to approximately $28 per share on about 39 million shares outstanding, assuming all of the assets are worth the stated value -- and in a worst-case scenario, they're certainly not.
By my conservative assumptions, I value Beazer's assets at the following amounts:
Cash is cash, so its value is $128 million.
Inventory is one of the problems. With further writedowns, assuming 80 cents on the dollar, inventory is worth $2.64 billion.
Accounts receivable, after some charges, are worth $60 million.
Goodwill is worth zero.
PPE would probably fetch around $18 million to $20 million in a fire sale.
Mortgages, at 80 cents on the dollar, are worth about $8.2 million.
Other assets, namely joint-venture investments and deferred tax assets at 85 cents on the dollar, are worth $112 million.
The revalued assets come to approximately $3 billion, leaving an equity value of just above $400 million, or about $10.25 per share in book value, versus today's stock price of around $12.50 a share. These valuations are merely assumptions based on my assessment of the overall industry's economics, and they serve only to illustrate that the plunge in prices assumes further writedowns and, hence, a reduction in book value. To properly assess most homebuilders, a similar balance-sheet analysis would need to be done to fairly compare all of the companies.
Remember: A business is underpriced at one price, fairly priced at another, and overpriced at yet another. Value investing requires the disciplined investor to buy only the underpriced asset, neither buy nor sell the fairly priced asset, and avoid the overpriced assets.
There are a lot of fantastic homebuilders in the business, and Beazer could very well reach the right price. Exhibiting high uncertainty can lead to handsome profits. Yet the prudent investor must do some digging and consider only the homebuilder or homebuilders that offer a low-risk investment.
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