I never expect to leg into a short position at the very top of a trend - especially when I take short positions in volatile stocks with a high level of existing short interest in them, like the homebuilders. I always give myself room to double down - or "double up" in the case of shorting.
The homebuilder stocks have spiked up this morning on the back of PulteGroup's (NYSE:PHM) third quarter earnings report (10-Q pdf link). Despite PHM's implementation of two significant GAAP earnings management devices which made earnings appear far higher than they really were, PHM's stock has popped 7.6% today and the Dow Jones Homebuilder Index (DJUSHB) has spike up 4.3% in sympathy. As I will outline below, I am recommending selling long positions into this move and establishing or adding to short positions, as a careful analysis of PHM's earnings report reveals several troubling aspects and bounce in the builders is therefore unjustified.
PHM reported a whopping $5.87 in earnings per share for the quarter, most of which was derived from taking a deferred tax asset valuation allowance (discussed below). Net of this non-cash net income "benefit," PHM's net income was .45/share, beating consensus estimates by 8 cents. However, the Company also disclosed that it had repurchased 5.3 million shares during the quarter using $83 million of shareholder cash. Adjusting for the buyback, we find that the buyback added 8 cents per share to its EPS which means that, not including the earnings management device implemented with the buy back, PHM's earnings were in-line with consensus estimates.
Even more troubling to me than the blatant application of what I consider to be excessively inappropriate non-cash accruals to earnings, thereby distorting the real, economically generated net income from the Company, is that fact that PHM reported that new orders fell 17% in Q3. This is a fact that is now being consistently reported by homebuilders, as discussed here with KB Home and reported on Monday by NVR. Furthermore, PHM's new order decline was significantly higher than was reported by both KB Home (NYSE:KBH) and NVR Inc (NYSE:NVR). To be sure, part of the reason orders declined was higher interest rates. But higher interest rates are likely here to stay, which means homebuilders in general can expect a lower level of orders vs. 2012, as the monthly mortgage payment is less affordable. The price action in PHM's stock today tells me that market is completely ignoring the double-digit decline in PHM's new orders. Furthermore, the dollar value of the backlog of orders declined 8% from last year's Q3, the Company's "active communities" is down 15% from last year's Q3 and PHM's new order cancellation rate jumped up to 18% to it has been since 2011. These are all bearish attributes.
However, more disconcerting is the fact that PHM blames the Government shutdown on its new orders decline. Recall, PHM's Q3 is comprised of July, August and September. July and August are two of the biggest months for home sales, and September is typically the 5th or 6th biggest. The government shutdown did not occur until October 1st. The shutdown wasn't even on anyone's mind until mid-September, at which it would seem that anyone thinking about buying a new home would want to get their FHA/FNM/FRE (that would be 99% of the mortgages issued) in place and contracts signed before October 1st. If anything, the shutdown threat should have "pulled forward" some contract signings and PHM's new orders should have been stable to slightly lower (lower from higher interest rates). I point this out because, at least me for me, it calls into the question the credibility of PHM management, as I consider this excuse for the drop in new orders to be disingenuous, and it increases my willingness to reject any part of their use of the deferred tax asset valuation reversal.
Speaking of the deferred tax asset valuation reversal allowance, it added $5.42 to the company's reported net income per share (fully diluted). Without digging too deeply into the mechanics of this complicated GAAP accounting entry, the asset entry enables a company to recognize net operating loss carryforwards in one shot for GAAP accounting purposes, by creating a deferred tax asset account on the balance sheet and a one-time incurrence of income on the income statement. At the time it is taken, it does not generate any actual cash flow for the company's bank account and it is not an operations-based source of income. In order for a company to determine if the deferred tax allowance should be recognized, it must be highly confident that it will be able to generate the operating income required to take advantage of the benefit as recognized. In other words, PHM's management better hope that new orders stop declining and that the company will be able to sell enough new homes in the next several quarters in order to justify the $2.1 billion GAAP income benefit it took this quarter.
Given the extreme volatility over time of homebuilder sales and earnings, I'll leave it to the reader to decide if PHM's decision was justified. I will point out that PHM's net income without the tax asset benefit was $174 million for the quarter, or a mere 8% of the accounting benefit recognized by PHM. I will also point out that this latest quarter will likely be a peak earnings quarter in what I believe is the end of the latest housing market bull cycle. And therefore PHM management's decision to utilize an accounting benefit of this magnitude reflects poor judgment and reeks of earnings management techniques designed to juice the stock price. I will point out that if you review the company's insider activity SEC Form-4 report, going back at least to March insider direct open market stock sales heavily out-number purchases, with most of the "purchases" being either zero-cost compensation shares or compensation options exercised. The heaviest selling occurred in the spring, ahead of the peak home selling season when the stock was in the low $20's ($17.87 as write this and it's been as low as $14.23 recently).
With this analysis of PHM's earnings and its effect on the homebuilder stocks gains today, and in the context of my macro theme that the housing bounce of the last 18 months has run its course and the market is headed much lower, I am recommending that anyone with a position in PHM should unload it today. Although I am not going to short PHM right now as I'm already short DR Horton (NYSE:DHI) and KBH, I did sell short January DHI 21-strike calls ($1.10 avg). This is a less risky technique to express a bearish view on a stock or index, as I collect $1.10 premium per contract that I keep until expiration or I decide cover them. If, for some reason (like the Fed increases QE before the January expiration) DHI closes above 21 and I decide to let the buyer exercise the calls, I am effectively short more DHI at $22.10 ($21 strike price + $1.10 put premium collected). I anticipate that the puts will expire worthless and I will be keeping the entire put premium.
Again, as a caveat, the homebuilder sector is extremely volatile and several homebuilder stocks have a high degree of short interest in them, which adds even more to the volatility. However, I am more confident with every homebuilder earnings report and every monthly existing and new homes sales report that my bearish view of the housing market is correct. Although it is likely that the Fed and the government will attempt to implement additional taxpayer-funded programs to try an re-stimulate home sales, and therefore there will occasional spikes up in the stock prices of homebuilders, I believe that the market will ultimately see this as futile desperate measures in attempting to generate economic growth and traders and investors will use any bounces to sell/short homebuilder stocks.
Disclosure: I am short DHI, KBH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.