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 (NYSE:BZH) trades at 1.06, which is on the low end, and NVR (NYSE: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 (NYSE:KBH) at 2.20 and Pulte (NYSE: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