Centex - Pulte Combination: When One Plus One Is Less than One

Includes: CTX-OLD, PHM
by: Luke Johnston

The announcement that Centex (CTX-OLD) and Pulte (NYSE:PHM) would join together to become America's largest home builder made the media all abuzz, causing home builder stocks to jump. Since Pulte and Centex serve different market segments and have regions of the country where they do not compete, it was promoted as a great combination. The companies' press releases and the news reports that followed appeared to convey that this was a sign that home building is going to spring back to life. But, one should take a closer look to find the real story behind the Centex-Pulte combination.

In the next two to three weeks, both companies will report earnings for the first calendar quarter of 2009. Expect the numbers to provide more insight as to why these two companies are joining together. Looking at data from the last four quarters provides an idea what to expect.

The following graph shows Sales, Closings and Backlog data for Centex over calendar year 2008.

Notice the trend of sales and backlog over the last four quarters. Centex has attempted to maintain closings fairly constant over the last three quarters to keep their revenue from falling. Revenue is reported based on the number of houses closed/delivered and not the ones sold each quarter. Sold homes go into the backlog waiting to be completed. Centex has maintained the appearance that their situation is not getting worse by keeping revenue relatively stable. However, this is not sustainable without an improvement in sales in the quarters ahead.

The following graph shows Sales, Closings and Backlog data for Pulte over calendar year 2008.

Notice the trend of sales and backlog over the last four quarters. Pulte has maintained an almost constant level of closings but this cannot continue without a significant increase in sales to improve the backlog. Pulte does prebuild houses and had 3,509 constructed houses (and 1372 models) going into the first calendar quarter of 2009. But sales in coming quarters must increase to sustain Pulte's revenue going forward. If sales were to remain flat over the next two quarters, Pulte’s revenue could fall by 60%.

If the data for Sales, Closings, and Backlogs of both Pulte and Centex are added together you get the following graph:

Notice that for the two companies combined, that sales for the last quarter of 2008 is only 25% of that for the first quarter of 2008. And the combined backlog has fallen by over 60% over the same period.

If the sales data for Centex, Pulte, and the combination of the two are all placed upon one chart, one can see that the total sales for both companies combined for the last quarter of 2008 is less than the sales of either company in the first quarter of 2008. Therein lays the meaning of 'one plus one is less than one'.

Even the backlog data for the combination of the two is lower in the last quarter of 2008 than the backlog of either company at the beginning of 2008.

It should be obvious from the sales and backlog data that the two companies are combining to reduce overhead. Neither is selling an adequate number of houses to support their overhead.

Sales for either company have likely not improved much in the first calendar quarter of 2009. The numbers to be reported for the first quarter of calendar 2009 will reveal the truth about the direction of sales and backlog. If sales and backlog have not improved this quarter, expect future revenues to fall and losses to increase for both companies. And once they combine, one should expect more losses for restructuring. One can expect write-offs for employee headcount reduction and for expenses associated with the closing of offices where the two share territories.

Also, according to the investor presentation given by the two companies, if the companies are combined on a pro forma basis, they would own 159,636 lots and have options on 32,816 more for a total of 189,452. The combined sales rate for both companies last quarter was only 2,843 homes. Even if they double this sales rate in the quarters ahead they still have enough lots to last over eight years. Both companies have heavy debt partially as a result of the large number of lots they carry. Failure to sell more houses means less cash flow to cover interest expenses. Therefore, if sales do not increase significantly, expect reported losses to increase because of the carrying cost of their debt. A return to profitability looks illusive for the quarters ahead.

As a side note, the Alt-Z scores for the two companies as of April 1, 2009, are Pulte: 1.06; Centex: 1.08. The Alt-Z scores indicate that both companies are still under significant financial stress. Alt-Z scores will fall further unless sales improve. While combining the two companies into one may reduce overall operating costs, future profitability depends on sales. Both companies have tended to focus on closings in their quarterly announcements, as closings represent revenue. But what both companies need going forward is improved sales. So the sales numbers will be the numbers to watch in the quarterly announcements for both companies.

Neither company should be considered for investment until sales shows a significant upward improvement.

Disclosure: I do not have a position in either stock.