I have been bullish on homebuilders since last November. Thus far, that investment has not paid off but the builders are selling at historically low levels and I continue to view this sector as a good long-term bet. Of course, I’d advise anyone buying in to be prepared for an emotional rollercoaster and a ton of near term heartache.
That said, there are certain builders I like, certain builders I’m intrigued by but remain skeptical of, and then there are a few builders that I’ve kept a mile away from. Beazer Homes (BZH) has fit squarely into that last category. Hedge fund manager John Paulson has moved in the opposite direction, however.
Paulson, best known for his stint shorting the housing market (documented in Greg Zuckerman’s book The Greatest Trade Ever), has been betting on Beazer for the past year. His firm, Paulson & Company, held 5.8 million shares of Beazer’s common stock as of its last 13-F filing. That’s 7.8% of the shares outstanding, in case you were wondering. On top of that, Paulson & Co. also owns some of Beazer’s debt.
Given Paulson is well-known for predicting the collapse of the US housing market, I find it difficult to bet against him here. And maybe I’m not really “betting” against him, per se, as I have no intention of shorting Beazer or even buying puts on the company. But as an investor who follows the homebuilders, I have to wonder how long Beazer can hold on without seeing significant improvements in its operating performance.
Beazer and Its Monstrous Debt Load
It’s important to compare the debt load of some of the other public builders with Beazer to put BZH’s predicament in perspective. The chart below attempts to do that. Here’s a look at Beazer’s debt load and interest burden compared to six other major public builders:
[Click to enlarge]
Some of the above might need some explaining. I calculated all ratios using only tangible assets, so goodwill and intangibles are discounted. Interest payments were calculated by using total interest incurred, which can be found in the notes of the financial statements for the builders. The weighted-average interest rates were calculated by looking at interest on senior notes and similar securities. I ignored rates on instruments that appeared atypical.
Looking at this chart, we can see how Beazer is in a more difficult position than its competitors. Its debt to equity is horrendously high at 6.17. This almost makes it look more like a bank than a homebuilder. At 9.26%, the firm’s weighted-average interest rate is also significantly higher than all of the other firms here. But the most troublesome stat is the “interest payments as a percentage of revenue.” It’s on this metric that Beazer looks particularly scary at 24.1%. None of its competitors is even close to that.
Indeed, Beazer’s revenues have plummeted over the past year, falling roughly 43% year-over-year. And this is what makes Beazer more frightening than all the other builders.
Beazer’s executives would no doubt respond that they have no debt maturities coming up till 2015. This does lessen the odds that the company will fall into a sudden liquidity trap, but it may not ultimately save BZH from insolvency. When 24% of your revenues are getting eaten up by interest payments, things can deteriorate rather quickly.
The Balance Sheet and Asset Impairments
Below, I have a very short and simple version of Beazer’s balance sheet, focusing on debt, equity, and housing inventories.
I post it mostly so we can see how further asset impairments could push Beazer into negative equity territory. Below is an impairment chart, that shows the adjusted shareholders’ equity, factoring in further declines in inventory values.
As you can see, Beazer drifts into negative equity territory with around an 18% write-down. It may seem unlikely that home prices could fall another 20% from here, but it’s possible. More importantly, Beazer’s assets might be overstated as it is right now, meaning real prices wouldn’t have to fall quite that much.
The other issue here: What happens if Beazer is running low on cash and needs to sell off assets quickly? It’s likely the firm is going to have to take prices well below what may seem ideal. If Beazer’s cash flows were more impressive than earnings results, this might be a different story, but the cash flow statement manages to be even uglier than the income statement -- a difficult feat.
So what does Beazer have going for it? Well, the no-maturities-till-2015 is a big plus, as mentioned before. At least it buys the company some more time. The $275 million cash balance is also a huge positive. My estimation is that the company is paying about $130-135 million in interest per year, so the cash balance is actually twice that amount. There’s something to be said for having a lot of cash lying around in bad times.
I’m also intrigued by the company’s plan to start renting out some vacant houses. It’s an interesting experiment and I’m surprised we haven’t seen more builders resort to unconventional tactics in order to try to weather the housing slump.
How Things Could Get Worse
So we have a firm that has an ugly balance sheet, but that also has a good amount of cash and doesn’t have to worry about debt maturities for awhile. It’s protected in some ways, but there are still significant risks here.
The biggest one is that the depressed housing market lasts another two-plus years. Beazer can probably weather things for another year, even if things stay very horrid, but at some point it’s going to bleed out so much cash that it can’t survive any more. If in three years the housing market is still under 700,000 housing starts per year, Beazer could be in major trouble.
There’s also the issue that a very large chunk of Beazer’s properties lie in poor submarkets. When one thinks of Beazer, the image of a McMansion in a deep exurban area, 40 miles away from a city core, and a miserable two-hour commute to downtown should stick in one’s mind. Truth be told, some of these properties may have virtually zero value. There is such an abundance in supply in these deep exurban areas that the actual values of these holdings could conceivably still require a 30% to 40% haircut. It may not even be possible to recover the costs of the building materials in some of these submarkets. In a worst case scenario, some of these houses may never get sold.
Which leads us to the final issue: If Beazer wants to remain viable, it absolutely must come up with a better business model. The buying cheap land in the middle of nowhere and creating mini-mansions strategy is probably not as viable moving forward. But changing strategies is also a risky endeavor; particularly when you have a weak balance sheet to operate with.
The Final Analysis
Overall, I have no plans to invest in Beazer, even in spite of the fact that it’s selling at half its book value. The risks are too high with the firm and I think some of the other builders offer much more attractive risk-reward prospects. However, the firm may yet be able to survive over the next few years if there is at least a minor rebound in the housing market.
I’d assess Beazer as having a 30% probability of bankruptcy within the next three years. Those aren’t terrible odds, but they aren’t great odds, either. Beazer would have to get significantly cheaper than it already is for me to even consider buying in; even at that, I might find the stock to not be worth the risk at any price.
One way or another, Beazer will be one of the more interesting major builders to watch over the next few years.
Additional disclosure: I own long-dated call options on a few homebuilders.