Home Builder Inventory, Cash Flows, and Stock Prices

The most important number on any home builder's balance sheet is inventory, especially when the market turns south. The inability to sell houses can cause a cash flow crisis for even the most stable company, which leads me to an article found yesterday at Marketwatch:

"'Based on our detailed analysis of inventory trends, we do not think investors should be overly optimistic regarding the home builders' ability to generate cash flow in the next 12 to 18 months,' analysts Nishu Sood, Lou Taylor and Rob Hansen wrote in a lengthy report this week."

The article discusses the job of the analyst to determine which homebuilders have the largest inventories. They go a step further than I did here, differentiating between "standing inventory" and "remaining land investment". The former includes unsold homes already built and land in the process of being built on, while the later includes all other vacant land:

"'In arguing that standing inventories are generally less risky from a future cash-flow perspective, we contend that the much shorter time horizon of standing inventories implies a much higher probability of near-term conversion to cash,' the analysts said."

"'As a result of its dramatic decline relative to overall inventories, standing inventory went from being 52% of balance sheet-inventory at the first quarter of 2006 to only 34% at the first quarter of 2007,' the analysts observed."

The drop in standing inventories wasn't the result of selling it off. It was the result of declining market values of the properties. In other words, actual inventory didn't decline but the value of that inventory did.

"For example, if a builder purchased a lot for $200,000 that's now valued at $150,000, generally accepted account principles require the balance sheet to reflect that decline. The result is lower book value, which is used to determine a stock's valuation."

This is exactly the point I made here:

"Their respective inventories will continue to decrease in value as the housing bust runs its course and prices subside. Inventory makes up 73 percent of total assets for KB Homes, 77 percent of total assets for Lennar, and 83 percent of total assets for DR Horton. As inventories decrease in value, so should the stock prices."

The inflated price of real estate, particularly land for housing, has caused the price of homebuilder stocks to be equally inflated, which is precisely the reason I'm so bearish on them. Even now, the companies haven't accepted the fact that the downturn will be long and arduous:

"They have to spend significant time and money just to get land entitled and approved for building. 'Housing generally has momentum -- if the market turns, builders have to follow through on starts; they can't abandon things midway,' said Sood, the Deutsche Bank analyst.

'Does the builder assume the worst and walk away or does the builder hold out hope for a recovery and continue to invest in the project? We suspect that the latter scenario has been the more common one recently,' the analysts said in their report."

The homebuilders didn't learn the lesson from the early nineties. They're at it again; their heads in the sand, their divisions overbuilding, flooding the market with even more supply. Instead of doing that, they should be more focused on aligning supply with demand. Until they do this, supply will out pace demand and cash flow from operations will remain in the red.