This week’s releases on existing home sales and new home sales have ignited a sharp rally for home builders. The momentum seems un-stoppable, as more and more investors looking to participate in the government-assisted housing recovery.
According to Google Finance, year-to-date, the shares of Hovnanian (HOV) have gone up more than 80%, while Standard Pacific (SPF) has gone up more than 70% and Lennar (LEN) more than 60%. The sharpest rally has been in the month of April, especially this week.
I have turned bearish on Hovnanian based on valuation concern. For Standard Pacific, I like its business model and its dominating exposure in California and in the South. But at $6-7/share, there is a massive potential share dilution hanging over its head.
When Standard was teetering on the edge of bankruptcy two years ago, a private equity firm MatlinPatterson from New York came in with a several hundred million dollars infusion. It saved the company. Moreover, the turn-around management team it installed has been successful in restructuring the company’s debt structure. At the same time, the team led by Ken Campbell was focused on controlling costs, selling off non-performing assets and other areas that are crucial for profitability. The company has also been early in acquiring lands in promising locations and communities. Impairment has stopped, and the company is now well-positioned.
All this did not come cheap. As of December 31, 2009, MatlinPatterson owns 450,829 shares of Series B Preferred Stock which are convertible into 147.8 million shares of common stock (as a point of reference, the current shares outstanding is 106 million). The conversion price is $3.05. As the stock heading higher, it’s only a matter of time before MatlinPatterson converts this massive amount of holding in preferred.
On top of that, the private equity firm also holds a warrant to purchase 272,670 shares of Senior Preferred Stock at a common stock equivalent exercise price of $4.1 per share, which is exercisable for Series B Preferred. And the shares of Series B Preferred will initially be convertible into 89.4 million shares of the common. The warrant may not be exercised in full before the stock reaches $10.5. But at this point, it is already quite far in the money.
A comparison in dollar value will help us understand just how much dilution the share holders will be subject to. For this purpose, let us fix the common stock price at $6.5/share. The current market cap is $689M.
If the preferred is converted into common right now, its value is $147.8*(6.5-3.05)M = $510M.
If the warrant is assumed to be fully exercisable and converted into common, its value is about $89.4*(6.5-4.1)M = $215M.
Add these all up, the if-converted total market cap would be $1.414B. Given the book equity of $435M, we’re looking at a potential market-to-book ratio of 3.25. That’s usually associated with high-growth stocks (Google’s (GOOG) is about 4.5, Cisco’s (CSCO) is about 3.8).
Just two months ago, when SPF was trading in $3-4 range, this was not a big concern yet. But now in the $6-7/share range, MatlinPatterson’s massive holding is becoming much more valuable than the current market cap. It’s only a matter of time before they flood the market to exit their astute investment.
For investors at large, it’s not a great idea to bid up the shares too much ahead of earnings. At this point, the company only has the potential to deliver, but has not consistently delivered the earnings that would justify the high multiple.
Other home builder stocks, especially the still-highly-levered Hovnanian (run by the same management that drove it into the ground), also appears to be running too much ahead of their earnings.
(I want to thank Seeking Alpha member Searsdog for bringing up this important issue. I’ve earlier put out a warning on my blog after Standard Pacific’s Q1 earnings release.)
Disclosure: Long SPF, LEN, Short HOV