More Land Mines for Builders

These stocks are at risk as housing prices continue to drop.
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Homebuilder stocks' recent run has been fueled by a belief that the housing sector will get better, or at least not get worse, in 2007.

But there's a real possibility that housing prices will continue to fall in once-hot regions of the country such as Florida, Arizona and California. If they do, investors likely haven't seen the end of the big land impairment charges that have only recently reared their ugly head at homebuilders.

Land charges basically take the form of two types: option contract write-offs and land impairment charges. Both charges are one-time, typically noncash expenses that hurt earnings.

Wall Street earnings estimates -- along with the stocks' valuations -- may not be pricing in this risk. Should these charges unexpectedly mount, 2007 could be another rough year for builder stocks.

KB Home

(KBH) - Get Report

has already warned of large write-offs and impairments for its fourth quarter.

Toll Brothers

(TOL) - Get Report

,

Pulte Homes

(PHM) - Get Report

and

D.R. Horton

(DHI) - Get Report

have announced similar charges, though on a smaller scale.

Just last week,

Hovnanian Enterprises

(HOV) - Get Report

said it recorded $336 million in land charges -- the largest such charges among builders to date -- and as a result posted a $115 million loss for its fiscal fourth quarter.

Interestingly, Hovnanian said on its conference call that its fiscal 2007 guidance assumes

zero

additional impairments and land charges.

"We think it is behind us as long as the market doesn't worsen," Chief Financial Officer Larry Sorsby said on the company's earnings call, referring to the writedown issue.

While Hovnanian is optimistic, some investors believe 2007 holds more problems.

"I think there is still more to come in impairment charges," says Carl Tash, manager of Cliffwood Partners, who currently maintains no long or short positions in the builders but remains pessimistic about housing.

"After a 15-year upside cycle

in housing, I don't think the downturn is going to last 12 to 15 months," he says. "I think that's pure fantasy."

Another hedge fund investor echoed this sentiment by saying that additional housing price declines of 5% to 10% are a real possibility in some markets, which should trigger more impairments next year.

Digging Into Land Charges

Most builders control a good portion of their land through options in order to mitigate risk. When they determine that buying such land (and converting the option) is no longer economical, they write off the costs associated with securing the option contract and the option deposit (typically 10% of the purchase cost of the land).

Land impairment charges are a trickier issue. Under accounting rules, builders are required to periodically review the value of their inventories, including raw land and housing communities that are already built or are in planning.

The companies must run an impairment test to see if they are likely to recover the value of those inventories through future housing sales. In simple terms, if the projects no longer look profitable, then the builders must write down the value of the land on which the homes are being built.

"To the degree the companies are exactly following the accounting mandates, then if the market should ramp down further, you will see more write-offs of options and writedowns of land values," says Robert Curran, an analyst who covers homebuilders for Fitch Ratings.

To date, the impairment issue has been taken in stride by investors. The Philadelphia Housing Sector Index is up 25% since bottoming in mid-July but is still down 10% for the year. In early 2006,

TheStreet.com

was one of the first to

warn about the land impairment issue.

"People haven't cared," says Alex Barron, an analyst with JMP Securities. "A lot of people are under the impression that this is a one-time event, but that's not the way it works. The only communities that you get to impair are the ones that are currently experiencing losses."

More to Come

Thus far, most of the impairment charges have been for communities in California, especially San Diego, where housing prices are correcting after a scorching run in the boom years. However, Barron says more writedowns are coming for Florida and Phoenix -- which are in much worse condition than Southern California.

The reason writedowns haven't occurred much in markets like Florida and Arizona is that builders are building on older, cheaper land and still making profits. Eventually, newer, higher-priced land will flow through the income statement, eroding gross margins and making the risk of impairment higher.

"It is safe to say there will be more impairments than are being assumed by management currently, and there will be more impairments than are already taken," says William Mack, an equity analyst with Standard and Poor's.

So who's at risk?

Pulte

: In its third-quarter filing, Pulte Homes announced about $88 million of land writedown and option write-off charges. However, the company is likely to record more charges since it purchased a lot of land at high prices in recent years.

Much of the company's recent land charges occurred in California. The region had pretax homebuilding margins of 5.6% in the quarter, Pulte said. The central region, meanwhile, was at break-even.

"It's only a matter of time before those margins start to decelerate," says one buyside source who closely follows the sector.

And once margins turn negative -- through falling house prices, for example --more impairment charges will follow.

Ryland

: At 1.57,

Ryland

(RYL)

trades at one of the highest price-to-book ratios in the industry. The perception, it seems, is that the company isn't set to record a large impairment charge, and thus the book value of the company's assets aren't in jeopardy.

Ryland has spent much of 2006 maintaining its margins and prices rather than aggressively using incentives to move product, similar to moves that

Lennar

(LEN) - Get Report

has made.

At some point, though, Ryland will have to sell at the market prices. At that time, Ryland might be forced to plug new pricing assumptions into its impairment models.

Lennar

: "Lennar will probably have the biggest write-off this quarter, even bigger than KB's, I guess," says Barron, the JMP Securities analyst. The reason is that the company has written down little to date yet has been aggressively cutting prices to move homes for sale. The company reports fourth-quarter 2006 earnings in January.

Whether Lennar's write-offs continue in 2007 remains a question mark.

Hovnanian

: Even though the company says it is done with impairment charges, some analysts believe otherwise.

Mack, the Standard & Poor's analyst, believes the company will record an additional $200 million of impairments next year and $90 million of earnings (prior to the impairments). The result is that the company's book value will either stay flat or decline from the end of 2006 to the end of 2007 at the company, he says.

D.R. Horton

: While Hovnanian said it tested all of its land positions, D.R. Horton said in its recent 10-K that it tested just $750 million worth of housing communities under development.

The company, however, lists $11.3 billion of inventories on its balance sheet, which suggests further impairments are possible at other communities down the road.

Given builders' big stock gains, it seems that investors expected impairments and write-offs at the builders to finish in 2006. They could be in for a big surprise in 2007.