Why We Sold Our Homebuilder Stocks: Dilution, Complexity And Valuation

May 29, 2013 11:07 AM ETLEN, TOL6 Comments
Brian Gilmartin, CFA profile picture
Brian Gilmartin, CFA

Like a lot of investors, we were long the homebuilders too early from 2009 forward and suffered through the volatility of the sector. Today, we were long both Toll Brothers (TOL) and Lennar (LEN), although after doing our homework on the companies, there remains plenty to be nervous about. In fact we sold all our Toll Brothers and Lennar today, as well as a small position in the XHB.

Frankly, although I am not a sell-side analyst, we do a lot of fundamental homework on all our holdings, and analyzing the homebuilders always leaves me scratching my head for a number of reasons.

1.) The operating structures are complex: we take time to read the Qs and Ks and the VIEs (variable interest entities) are numerous and add to the homebuilders risk, although the SEC filings do try and detail the risk and exposure to the investor.

2.) No cash-flow, or at least the Statement of Cash-Flows (SCF) is not meaningful disclosure. We spend a lot of time looking at the SCF for all stock holdings, and with the homebuilders the SCF and the balance sheet are both Frankenstein-ian.

Neither TOL or LEN has generated meaningful cash-flow from operations, in this latest upturn. Now the statement of cash-flows is less meaningful for the financial sector, and homebuilders could be part of that, but here is a chronology of the 4-quarter trailing cash-generated from operations for both TOL and LEN for the last few years:

4-qtr trailing cash-from-ops TOL and LEN

Qtr end TOL LEN
2/13 ($313) ($614) ml
11/12 ($169) ($425)
8/12 ($221) ($555)
5/12 ($246) ($343)
2/12 ($122) ($327)
11/11 $53 ($259)
8/11 $3 ($126)
5/11 ($47) $7.5
2/11 ($97) $141
11/10 ($146) $274
8/10 ($39) $311
5/10 $68 $347
2/10 $176 $384
11/09 $283 $421 ml

* TOL and LEN report on different quarter ends. Some of this data is the 10-K data, divided by four to simplify the long-term trend.

You would think with a full 12 - 16 months into the housing recovery that the homebuilders would be generating positive cash-flow. Not so much.

The other aspect to the Statement of Cash Flows, which is perplexing is "capex," or the dollars invested to sustain the long-term economics of the business. For a homebuilder, you would think that would be the "investment' in undeveloped land every quarter, but for the life of me, I can't find this data from looking at the financials or the SEC filings.

That worries me.

3.) Both TOL and LEN have recognized their deferred tax asset (DTAs) in 2012, which boosted earnings per share (EPS) significantly, but is a non-operating item. A deferred tax asset is an asset that is a function of the homebuilders' operating losses from the housing depression, and in effect is an earnings or net income shelter, once recovery has started. The losses from prior years can offset present operating profits in good years such as 2012 and forward.

In fiscal, 2012, TOL reported $2.86 in actual EPS, but only about $0.80 of that was thought to be operating, while LEN reported $3.11 in EPS of which $1.86 was thought to be recognition of the previous operating losses.

Last quarter LEN had a State DTA that added $0.08 to the $0.26 EPS number or almost all of the upside surprise.

The point here is that the DTA is likely vastly overstating current EPS, and there still might be more to come.

4) Effective tax rates:

TOL / LEN Operating Income and Effective Tax rates


op inc




op inc



1Q '13 $16 40% $85 4%
4Q '12 $1 47% $144 13%
3Q '12 $53 -1% $91 14%
2Q '12 $31 -44% $81 6%
1Q '12 ($1.4) -8%% $33 -5%
4 Q '11 ($19) -57% $40 -34%
3Q '11 ($3) 1% $47 1%
2Q '11 $10 979% $46 2%
1Q '11 ($24) 34% $60 -4%
4Q '10 ($10) -120% $64 -6%
3Q '10 ($136) ml -50% $63 1%
2Q '10 ($174) ml -97% $58 -19%

* Source: earnings reports and 10-Qs, Ks

Cumulatively, TOL has lost $257 million over the last 3 years, while Lennar has earned $812 ml.

5.) Dilution of shareholders

The most worrisome aspect we see to our two homebuilders every quarter is the consistent dilution in shareholder equity from additional share issuance every quarter.

TOL / LEN Fully diluted shares outstanding

Q1 '13 177.8 ml 226.0
Q1 '12 166.3 213.8
Q1 '11 168.1 194.9
Q1 '10 165.2 182.7
Q1 '09 160.7 ml 158.6 ml

LEN's dilution is far worse than TOL's, which might explain why LEN has not generated the upside despite the consistent profitability as seen in the above table under No. 4.

LEN's dilution is significant: LEN has 42% more shares outstanding as of the February 2013, quarter than February 2009.

Put another way, and purely as a hypothetical, let's assume LEN generated $158.6 million in net income in 2009, or $1 in EPS.

In 2013, assuming the exact same amount of net income, that same amount is worth just $0.70 in EPS because of the greater number of shares outstanding.

This seems to be common throughout the sector and might be partly a function of the high debt loads and low credit ratings a lot of homebuilders carry, which necessitates equity raising to offset debt levels.

TOL's dilution is far less than LEN and that could be because TOL has the highest credit rating and is thought to have the safest balance sheet in the sector, albeit still a BB credit. Since TOL has some cash, and less leverage, it may feel less of a need to sell equity to bolster the balance sheet.

Commentary: There is no question there is a robust real estate recovery taking hold in the USA today, after the worst housing depression since the 1930s.

Orders, prices, backlog and deliveries are all trending positively and robustly for the homebuilders over the last 12 - 15 months. Part of the effective tax rate and deferred tax asset (DTA) issues are a function of the heavy operating losses taken between 2007 and early 2012, so I don't think we have yet to see "true" EPS numbers.

The dilution issue is a major concern.

The current EPS estimates for TOL and LEN are $2.58 and $2.91 for 2015, which are the only estimates where the stocks look reasonably valued at 14(x) those estimates.

Thought to be reasonably valued at 1.5 book value, the homebuilders, at least TOL and LEN are trading well in excess of those valuations today. LEN is trading at 2.33(x) book, while TOL is trading at just over 2(x) book.

With the 10-year Treasury yield breaking above the 2013 high of 2.09% from March 8, 2013, the homebuilders are lagging, even after TOL reported good numbers last week, and after the "white hot" Case-Shiller numbers reported this morning.

Good fundamental data and bad price action, as well as the above issues, caused us to take profits in the sector and step aside. (We have kept smaller positions in TOL and LEN in one long-term account.)

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This article was written by

Brian Gilmartin, CFA profile picture
Brian Gilmartin, is a portfolio manager at Trinity Asset Management, a firm he founded in May, 1995, catering to individual investors and institutions that werent getting the attention and service deserved, from larger firms. Brian started in the business as a fixed-income / credit analyst, with a Chicago broker-dealer, and then worked at Stein Roe & Farnham in Chicago, from 1992 - 1995, before striking out on his own and managing equity and balanced accounts for clients. Brian has a BSBA (Finance) from Xavier University, Cincinnati, Ohio, (1982) and an MBA (Finance) from Loyola University, Chicago, January, 1985. The CFA was awarded in 1994. Brian has been fortunate enough to write for the TheStreet.com from 2000 to 2012, and then the WallStreet AllStars from August 2011, to Spring, 2012. Brian also wrote for Minyanville.com, and has been quoted in numerous publications including the Wall Street Journal.

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