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  • Time for Another Homebuilder Consolidation? Don't Bet on It! 7 comments
    May 3, 2010 11:00 PM | about stocks: PHM, NVR, KBH, BZH, DHI, HOV, SPF, LEN, MDC, MTH, RYL, TOL
    Given the recent run up in homebuilder stocks over the last several weeks, I have begun to wonder why we have not seen more consolidation in the homebuilding industry since the Pulte-Centex merger that was announced almost a year ago. Besides the recent bevy of positive housing data this past month, most, if not all, of the large public builders have significantly increased their cash positions over the past year, extended maturities on their long term debt and have started to reload their land positions. One might think with stream of positive news, the inevitable appetite to grow big and the perceived economies of scale that the combination of another two housing giants would make logical sense. Well, not so fast! Stock prices have far exceeded current fundamentals of the business. If you look at the top publicly-traded homebuilders, they are all trading at a premium to book value. Beazer (BZH) trades at 1.06, which is on the low end, and NVR (NVR), trades at 2.4, which is on the high end. Further, when you reduce for any outstanding goodwill and arrive at a Price to Tangible Book Value, three builders are trading above 2.0. Those are NVR at 2.36, KB Home (KBH) at 2.20 and Pulte (PHM) at 2.17. The average for the group is 1.75. In looking back at the Pulte-Centex merger, Pulte (PHM) acquired Centex at a price to book of 1.4, based on the Centex book value at the time of the announcement.
    The impact of such a premium over book value in a merger may not be obvious. When a company is acquired, regardless of whether it is a cash transaction or a stock-for-stock transaction, the purchase price is allocated to the assets and liabilities based on fair value. This is purchase accounting. The days of using the pooling method are long gone. Therefore, the individual assets, such as the real estate inventory, would be marked-to-market, typically based on a discounted cash flow analysis. Generally, you don't see much adjustment to the remaining assets and liabilities. For example, cash, payables, and other similar types of assets and liabilities typically represent their fair value so they generally get recorded at the basis in the financial records of the acquired company. If the company has a significant number of leases, you may have to set up an asset or liability for any below or above market arrangements. However, this is generally not significant for a homebuilder. If there is any excess of the purchase price over this allocation, it is required to be recorded as an intangible asset, which includes goodwill. Generally, in the homebuilding industry, there aren't as many specifically identifiable intangible assets such as patents, trademarks, customer lists or intellectual property that you find in acquisitions in other industries. Therefore, the excess of purchase price over allocated fair value is generally recorded as goodwill. If a transaction were to occur at these current Price-Book levels, this premium, which is quite large, would have to be either used to mark up the real estate inventory or recognized as goodwill. From an investor’s perspective, you can accept a modest amount of this premium, or goodwill, if you can argue that you will realize cash flow improvements or provide you entrance into a market that otherwise would have cost you significant start up costs. Regardless, the proof of whether it makes sense or not will be determined if the cash flows will support this additional premium. In fact, companies are required to analyze goodwill annually to determine if it is impaired. This analysis is generally based on projected cash flows. 
    In looking at the details of the Pulte-Centex merger, Centex’s price to book value of 1.4, equated to approximately $350 million of premium which had to be allocated. This amount represented approximately 11% of Centex's real estate inventory at the time of the announcement. Pulte, instead of marking the Centex inventory up, by some portion of the premium, actually wrote the inventory down by in excess of $1 billion, or approximately 1/3, and instead recorded approximately $1.5 billion in goodwill on the transaction. This represented approximately 40% of Pulte's equity at the time of the transaction. This would indicate that Centex’s assets, despite being subject to impairment analysis, were not considered to be fair value. That is not a criticism of Centex. As we discuss later, it just dispels the belief that while companies have been taking impairment adjustments, their assets in total are not at fair value, just those that were impaired. Further, in the 4th quarter of 2009, less than five months after completing the transaction, Pulte wrote off $563 million of the goodwill or over 1/3 of the amount initially recognized. In other words, Pulte has determined that the premium paid over the book value was impaired in less than 6 months. It should be noted that this was at a time when homebuilders had already taken the majority of their impairments and the reduction in the carrying value of their real estate had begun to slow down. Pulte effectively overpaid by approximately $4.65 per share ($563 million divided by the Centex shares outstanding). When you reduce the price paid, by the per share write off of goodwill, the true fair value was .77X Centex’s book value, or almost half of what Pulte actually shelled out!
    Given the level of impairments the homebuilders have taken on inventory over the last three years and the fact impairments in the last quarter are almost nonexistent, one would assume that a builder’s assets should approximate fair value today. However, the amount of goodwill and the subsequent impairments taken by Pulte in their acquisition of Centex should be an eye opener that this is not reality. Yes, it is true that the accounting rules require these builders to record their land and inventory at the lower of cost or fair market value.  However, that is only true when the assets are impaired. If the accounting rules truly made companies mark their inventory to fair value, then how would it be possible that Pulte would end up writing down Centex’s inventory at the time of the acquisition, considering the $1+ billion of impairments Centex had previously recognized over the 3 years preceding the transaction? The answer is very simple. In accordance with the accounting rules, a homebuilder analyzes its real estate inventory based on cash flows it expects to generate from developing and building it out over time. If the UNDISCOUNTED cash flows exceed the carrying value of that asset, there is no impairment. In other words, if a homebuilder projects that it can generate one dollar of positive cash flow, excluding the assumption of any interest costs or return on equity, it does not record an impairment writedown. Even if it takes ten years to generate that positive cash flow, as long as a homebuilder can legitimately support their cash flow assumptions, no impairment will be recorded. Homebuilders are carrying assets that may be providing substandard returns, but if they are generating a positive cash flow, then they are not required to write down the assets. Is this really fair value? Not quite.
    So, how likely is it that we see another Pulte-Centex like combination given the run up in builder stock prices and the resulting unsupportable premiums over book value?  Unless you know a CEO that likes to overpay for land and repeat the sins of the recent housing debacle, don’t count on it anytime soon. 

    Disclosure: Short MTH
    Themes: Homebuilders Stocks: PHM, NVR, KBH, BZH, DHI, HOV, SPF, LEN, MDC, MTH, RYL, TOL
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Comments (7)
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  • Great article. Very insightful. Not sure what Pulte was thinking. Seems like $500+ million of equity went up in smoke based on the goodwill writeoff. Was any due diligence performed? Whoever was in charge of that acquisition should be on the hot seat.
    4 May 2010, 03:18 PM Reply Like
  • The write-off of goodwill didn't have anything to do with the due diligence. The reason for the write off was simply due to the fact that the stock price of PHM declined rapidly after the merger and was at a much lower price during the annual goodwill impairment test (because it was a stock deal they needed to recognize goodwill impairment as a result). It was really just poor timing and the stock has since completely recovered.
    4 May 2010, 10:35 PM Reply Like
  • Author’s reply » Joe - you are correct in the fact that the goodwill impairment is primarily due to the drop in stock price, but you are missing a few things:


    1) Pulte wrote off more goodwill than the stock price drop. When they ran their goodwill impairment test at year end, they already realized the cash flows didn't support the price they paid. Just because the stock price recovered is irrelevant. They would have ended up writing it down anyway based on the goodwill impairment test.
    2) They wrote down over $1 billion of Centex's inventory
    3) They still have just under $1 billion of goodwill on the books. Why would anyone pay a $1 billion premium.


    They paid 1.4x book when the true value of Centex was below 1x book. Can anyone say with a straight face that their due diligence/underwriting was really good? I have to agree with TheStockHandicapper on this one.
    5 May 2010, 09:27 PM Reply Like
  • Great stuff and I look forward to your contributions going forward, are you guys up on a Twitter account? Only quibble is the substantial Deferred Tax Asset that had a full valuation allowance partly explains how Pulte is financing the transaction and did not actually pay as steep a price as suggested, true?
    11 May 2010, 02:56 PM Reply Like
  • Author’s reply » Good comment. Couple of things to consider. First, tax laws generally limit NOLs and Built in Losses in a change of control. Therefore, if these are included in their DTA's, they may not be able to utilize them as quickly as they would like. Second, for Pulte to actually utilize the DTA's, they will have to generate taxable income. Since they are having trouble generating profits with the assets written down (due to impairments), they are going to have even a tougher time generating taxable income with the assets at the original (tax) basis. It may take awhile. That would tell me that on a present value basis, the deferred tax assets don't have as much value. Just something to think about.
    12 May 2010, 02:59 PM Reply Like
  • Thanks for insight. Amazing the builders have been able to get all these high yield deals done over the past couple of months. Extend and pretend at the corporate level I guess.


    Here is the relevant risk factor from the 10K.


    "As a result of the merger with Centex, our ability to use certain of Centex’s pre-ownership change NOLs, BILs, or deductions will be limited under Section 382 of the Internal Revenue Code. The applicable Section 382 limitation is approximately $68 million per year for NOLs, losses realized on built-in loss assets that are sold within five years of the ownership change, and certain deductions. The limitation may result in a significant portion of Centex’s pre-ownership change NOLs, BILs, and tax credit carryforwards or deductions not being available for our use. "
    12 May 2010, 05:30 PM Reply Like
  • Author’s reply » Yeah, however in the discussion of why they originally recognized the $1.5 billion in goodwill they attributed it to the deferred tax assets. Generally, goodwill means that the hard assets do not support the price. In this environment, and with what we know about housing, why would anyone pay more than the fair value of the assets. Homebuilders are different than other industries where you have a very high percentage of fixed costs and therefore through consolidation you can eliminate it. The fixed costs of homebuilders are essentially their corporate overhead. The rest of it is very variable and in challenging times can be reduced quite easily.


    It actually makes more sense for builders to consolidate during good times when you are trying to grow and need the land pipeline and labor to support growth. In down times, there is plenty of overhead on the sidelines.
    12 May 2010, 10:16 PM Reply Like
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