Editor's note: "Bricks and Mortar" is a mock portfolio created by reporter Nicholas Yulico that is meant to help generate real estate and gaming-related stock ideas. In keeping with TSC's editorial policy, Yulico doesn't own or short individual stocks.

With the housing market still crumbling, there is a decent chance that some homebuilders are going to go bankrupt over the next year.

That means if you're eyeing homebuilder stocks, you have to be looking at the companies' debt loads and the cash flows. And in these areas, there's one builder that looks like it's heading for trouble: Standard Pacific ( SPF).

I'm adding Standard Pacific to the Bricks and Mortar mock portfolio as a flagged stock, which means I think the stock should be sold because it is overvalued and has numerous hidden dangers. Buying the stock today is a bet that the company can survive in its current form -- something I don't think is likely.

Before I delve into Standard Pacific and update two other portfolio holdings, Ryland ( RYL) and Starwood ( HOT), with news this week, let me share a "big picture" thought on the homebuilding sector.

This week, I had the pleasure of attending a lecture by Marc Lasry, one of the pioneers of distressed debt investing. He is the founder and managing partner of Avenue Capital, a $20 billion fund that generally looks for subordinated debt securities that produce equity-like returns.

Avenue has averaged about 16% annual returns in its institutional fund over the past decade by scouring the U.S., Europe and Asia for distressed bonds. Naturally, I had to ask Lasry what he thought of homebuilder bonds, many of which are already trading at distressed levels. This includes Standard Pacific.

While Lasry didn't mention specific homebuilder names, he said his firm is doing a lot of homework on homebuilders, but has not invested yet. Why?

"You have to buy at the bottom to make money," he said. "Homebuilders are not there yet."

Lasry expects the economy to slow further over the next year, forcing several builders to restructure their debt, possibly in a Chapter 11 process.

That brings us back to Standard Pacific.

Several builders are on the precipice of liquidity issues. But Standard Pacific, I believe, is one of the top candidates that may be forced to restructure, as I explained in an earlier article this week.

The stock has a 39% short interest, and it's easy to see why. The company's third-quarter report Friday highlights its ongoing problems.

Standard Pacific surprised no one by reporting a quarterly loss of $119.7 million, or $1.85 a share, compared with a profit of $30.8 million, or 47 cents a share, a year earlier. Results were hurt by $223.5 million of inventory impairment charges. Selling, general and administrative costs were 14.7% of homebuilder revenue -- higher than nearly all other homebuilders.

However, the release's most troubling piece -- which is buried on page 11 -- is the fact that Standard Pacific reported negative cash flow from operations of $18.5 million.

At this stage in the downturn, builders are supposed to be working down inventories and generating positive cash flow.

Instead, Standard Pacific's owned inventory rose $57.9 million in the quarter. The builder used up $85 million in needed cash to acquire its partners' interests in two of its California joint ventures.

Standard Pacific has $2 billion of debt, compared with an equity market cap of $341 million.

While stock recently was down 5.7% to $4.95, it still reflects very little risk of a liquidity crisis at the company.

Still Rough Times at Ryland

My other flagged builder, Ryland, posted earnings that were a bit better than those of its peers. Inventory impairments totaled $128 million, which pushed the company to record a third-quarter loss of $54.7 million, or $1.30 a share.

The impairment charges amounted to about 5% of book value, after tax. That compares with 15% from other builders in the quarter, according to a research note by Bank of America analyst Daniel Oppenheim.

On its call, Ryland CEO Chad Dreier said the lower charges result from the company having less exposure to California, which is a horrible market. About 9% of the company's inventory today is in California.

This lower exposure is nice, but it's not good enough reason to own Ryland. At this point, there is no reason to own any homebuilder stocks.

Earnings will continue to be a mess for the sector, as further impairment charges loom. And forecasting future cash flows is not an easy task. In the third quarter, Ryland generated $43 million of cash from operations.

The company, however, increased inventories on its balance sheet, resulting in a net cash outflow of $32 million by my estimates, based on the limited balance sheet data provided in the earnings release.

On the earnings call, Dreier said the purchases resulted from taking down land from option contracts. Ryland now has enough land that it won't have to buy any more going forward. Moreover, management said inventories should be reduced over the next year, which will increase cash flows.

I'll believe it when I see it. Until then, I'm doubtful that builders can sell enough homes in such a horrible market to create sustainable cash flow.

Starwood Burns

Starwood, a hotel owner and operator, also posted third-quarter results this week, and results weren't great. Revenue growth is slowing at its hotels, and the company gave a weak outlook on timeshare profits next year.

This stock has been an absolute dog in recent months. My sense right now is that shares will be dead in the water for some time, as investors fret about the health of the economy and the lodging sector.

Starwood's ability to generate a lot of free cash flow hasn't changed. In the meantime, investors must stomach the possibility of slowing earnings growth over the next year.

Over the long term, earnings growth continues to look nice, since Starwood will expand its brand globally in the next five years. With all of its free cash flow, it would be nice to see Starwood execute a big share buyback.

Starwood is down 24% since I recommended buying it in July. At around $55 today, it looks cheap. But if the market keeps telling me I'm wrong on this one, I'll likely throw in the towel.

A 30% decline in the stock since my recommendation is probably my breaking point. At some point, you have to admit you're wrong, cut your losses and move on.

Bricks and Mortar Portfolio
A Look at How Nicholas Yulico's Picks Have Performed
Rating Date Price at Rating Rating Current Price* Return**
Brookfield Properties (BPO) 1/23/2007 $28.67 Own $23.77 -17.1%
Global Real Estate ETF (RWX) 1/23/2007 $64 Own $63.16 -1.3%
Ryland (RYL) 1/23/2007 $56 Flag $27.75 50.4%
Trump (TRMP) 1/23/2007 $17.50 Flag $8.14 53.5%
Penn National (PENN) 2/6/2007 $45.56 Own $61.81 35.7%
Melco PBL (MPEL) 3/12/2007 $15.46 Own $15.79 2.1%
Home Solutions of America (HSOA) 4/24/2007 $4.98 Flag $3.15 36.7%
Starwood Hotels (HOT) 7/12/2007 $72.37 Own $55.61 -23.2%
Average Total Portfolio Return, Unweighted, (including closed ratings) 19.3%
New Rating
Standard Pacific (SPF) 10/26/2007 $5.25 Flag $5.25 0
Closed Ratings Rating Date Price at Rating Rating Closing Price*** Return**
Hilton (HLT) 3/2/2007 $34.69 Own $47.50 36.9%
Close At Start of Portfolio Current Value*
S&P 500 1427.99 1,514.40 6.1%
U.S. MSCI REIT Index 1140.36 1,000.37 -12.3%
*(10/25/07 closing prices)
**For "flagged" stocks, a drop in price is tracked as a positive for the portfolio, and a rise in price is a negative.
***Hilton exited the portfolio on 10/26/07 after being acquired by Blackstone Group

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