Wednesday, December 20, 2006

Gussied-Up Land-Flippers?

The first thing I learned in this business that I had never grasped from the accounting books we “studied” in between games of foosball at Smuggler’s Tavern came during a trip to a furniture plant in Altavista Virginia.

In those days, America actually manufactured quite a bit of the furniture bought by American consumers, much of it in plants in the general vicinity of High Point, North Carolina, where the annual furniture mart is pretty much the whole point of going to High Point in the first place.

Since then, of course, a lot of furniture plants have closed—including, I’ll bet, every one I visited back then, although not necessarily for the reasons put forth each night on CNN by Lou Dobbs in his hysterical, How-America-Is-Prostituting-Itself-to-Foreign-Mercenary-Scum-Sweatshops tirades.

The fact is that some of those plants I saw even in their heyday were so out-of-date and inefficient it was hard to imagine anybody could competitively manufacture anything in them except workers comp claims.

One I remember in particular actually had a multi-story manufacturing line—they moved partially completed wood furniture from floor-to-floor on a big old rickety elevator. Not exactly “world class,” and not long for this world even back then.

Still, the companies in those days were generally pretty smug about their central role in furnishing America’s bed rooms and living rooms and dining rooms—after all, who could possibly make a big, bulky dining room table in Asia and ship it all the way to Los Angeles for profit?
And even if somebody could, who’d want to buy it?

A lot of people, it turns out.

Imported furniture is now more than half the U.S. business, up from next-to-nothing back when I was sitting in an old-fashioned office just off the long-gone production line of the Lane Company in Altavista, Virginia, getting my first real lesson in free cash flow from an actual Chief Financial Officer.

I don’t recall what year this was, but business in general was slowing down after a long period of prosperity, and what surprised me was this: not only was the CFO not upset about the slowdown, he was actually getting pretty excited talking about all the cash he’d be able to generate from inventory and receivables now that sales had leveled off.

Being a slow learner, I asked for specifics, and he gave them so clearly that even I could grasp the mechanics of how, when you collect receivables and work off inventory, the difference goes into the bank. (Back in those days a CFO could talk to you about these things without putting out an 8-K and going on CNBC to explain himself.)

And that was how I learned how much cash a business can chew up when it expands, and how much cash it can generate when it contracts. Not exactly the secret of life, for sure, but good to know at an early age in this business.

Which is why the most puzzling part of yesterday’s conference call with Hovnanian Enterprises—the homebuilder whose business has slowed quickly after a decade or so of non-stop growth—was the discussion of free cash flow, or rather, the lack of free cash flow, now that things are easing up.

“For the full [fiscal] year, we generated adjusted EBITDA of $753 million, which covered interest 4.5 times,” management said on the call. So far, so good. But then:

“Due to the slowing velocity of deliveries…our inventory turnover and thus interest coverage is expected to decline in 2007.”…

Not only will inventory not decline as you’d expect in a slower environment, this company expects inventories to grow in the near future:

“Our inventories are expected to grow through the first two quarters of fiscal ’07 as we invest in new communities and the associated land development and home construction. But for the full year, we expect the net change in inventories to be close to zero, and thus we expect to be marginally cash flow positive for the full year.”

If they're not going to be cash flow positive now, when are they ever going to be? The company can’t even buy shares back beyond the dilution from stock options:

“Although we believe our stock remains undervalued, we intend to maintain only the current pace of share repurchases at this time.”

Somehow, Hovnanian's financial model negates every known benefit of a business slowdown: the ability to reduce working capital and generate free cash flow not needed for reinvestment when growth opportunities are lacking.

How is this possible? I can think of no explanation aside from one.

Could it be that homebuilders—profitable though they may appear to be during a long upturn—are no more than gussied up land flippers?

Informed rebukes are welcome.

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


Desiderata said...

I don't think you can quite say they are just land flippers. Working in banking in Florida, we know land flips - and true land flips add no economic value except adding a holding period (which may or may not add positive value). While it may be only marginal, there is a "value-add" component to homebuilders activities. Seems to me this is more about HOV thinking the downturn is temporary and phasing up for future growth post lull. Whether that's true or not is another matter entirely.

Tim said...

Interesting post. Is the issue that developing communities takes a few years, versus a dining room table which takes a few hours? I don't know much about the real estate business, but I'd assume that there's a big fixed cost associated with each new community and lower costs associated with each unit in the community. So the profit lies in the sale of the units as the community starts to fill up.

So if they committed to several communities while times were good, they're economically "forced" to continue building when times are tough. Combined with slowing sales, this leads to a big inventory build.

Complete speculation on my part, though it seems to fit.

russell1200 said...

It varies with the jurisdiction, but in many areas the developer has to go ahead with a project once it reaches a certain stage. They may also have a lot of sunk costs which they will lose if they do not proceed.

So what you are seeing is the home builders finishing out projects that have gone too far to stop. Obviously they are going to put the best face on this problem that they can.

You will note that many of them have talked about canceling their land options. That is the input pipeline being squeezed shut. Given normal development times, and that they probably started slowing up last June, you would not expect them to get to the live on the inventory stage until some time next spring or summer.

stealthelephant said...

Rather harsh, Jeff. After all, land flippers flip until the music stops then flip to flipping something else. HOV will be around for a while. I doubt that should the real estate slowdown get worse, they will turn themselves into a dot com. Since when did you become a deliberate provacateur?

wcw said...

Seconded, and this from a homebuilder short.

A homebuilder can't actually predict what the market will do. He learned from the '89-to-RTC debacle (if not before) that what you want to do in downturns is to spend that "free cash" acquiring more land so you can keep building and pyramid into the inevitable bounce.

HOV is effectively family-run and -owned, still, and they have taken this lesson to heart. So have the other builders. Until you get a market that is so bad it simply wipes the floor with everyone -- the kind of market that US residential housing has not seen in living memory, '89 included -- this is how they'll behave.

Long story short, it'll work until it doesn't. Even as a bear, I can't say HOV is wrong to play it this way. If it's 1986 instead of 1989, the last thing you want to do is generate cash working down inventory.

SCProfessor said...

I think a key point that may go a long way to explaining how home builders operate has to do with the fact that construction loan borrowings include as line items in the cost breakdown "profit and overhead." So as they continue down the path of building that house, they are causing to be disbursed to them by their construction lender "profit and overhead."

Putting it another way, they do not profit from the sale of the house all that much, having pulled much of the profit out during the construction phase. So if they quit building, well the money to cover "profit and overhead" ceases to flow.

Jim Chanos said...

Jeff-I made this exact point at Whitney Tilson's Value Investor Conference last month. And it's not just HOV...the entire publicly-traded homebuilder group is going to throw off little-to-no cash in the downside of their cycle. JC

SD_Trojan said...

This doesn't have anything to do with a project "having" to go forward due to sunk costs, permits...

KHOV is trying to monetize their land holdings by developing them. Raw land has dropped so precipitously in value, that they don't want to take a loss on it, so they're trying to move it up the value chain by developing it. If the housing market continues to soften, watch out.