8/19/2010
By David Urani, Research Analyst

It's beginning to look a lot like acquisition season these days with the high-profile negotiations between BHP Billiton (BHP) and Potash (POT),  and Intel (INTC) and McAfee (MFE), among others. And why not? We've seen it coming as the market feels out a bottom and large corporations sit on large piles of cash. Like the NBA this summer, this year could be one for the record books for the equities free agency. So, with the housing situation seemingly as bad as it can get (we stress seemingly), it's reasonable that speculation has begun to swirl about potential deals in the homebuilding space. As bad as business has been, some of the bigger players are in a more than adequate position to pick up a straggler or two for rock bottom prices. Then again, in an industry like housing one has to be very watchful for falling knives. We'll separate the Shaqs (yeah, he's way past his day) from the LeBrons in this year's housing free agency.

Big deals aren't a new idea in the homebuilding sector, as we've seen some pickups already. The biggest story was the mega deal in which Pulte Homes (PHM) bought Centex for $1.3 billion in an all stock deal last summer. Back in May 2008, Private Equity firm MatlinPatterson dumped $530 million into Standard Pacific (SPF) for a controlling position in the Company, which significantly turned the homebuilder's fortunes around. And then there's Lennar (LEN), who in February strayed a little from the beaten path and snapped up $3.05 billion worth in balances of FDIC mortgages for $1.22 billion.

Certainly the market is in awful shape at the moment, as the loss of the federal homebuyers' tax credit sank new home sales to record low levels and demand has hardly shown any signs of life since. That being said, homebuilders have done some major book-clearing over the past couple of years and have largely moved more towards a build-to-order business model to protect themselves for times like these. The problem is homebuilding takes time and with inventories down to the bone, pouncing onto a potential rebound in demand won't be as easy as flipping on a switch; it would be convenient for the major builders to have pre-built homes and other land on hand for such a situation. The current post-tax credit hangover period might just be seen by some of the bigger fish as a good time to catch the market snoozing and to pick up a bargain.

Teams with Cap Space:

D.R. Horton (DHI)
• Cash: $1.7 billion
• Debt: $2.2 billion
• Inventory: $3.6 billion (7.8 months supply MRQ)

Pulte Homes (PHM)
• Cash: $2.8 billion
• Debt: $4.3 billion
• Inventory: $4.9 billion (11.5 months supply MRQ)

Lennar (LEN)
• Cash: $1.2 billion
• Debt: $2.9 billion
• Inventory: $3.7 billion (15.7 months supply MRQ)

NVR (NVR)
• Cash: $1.1 billion
• Debt: $81 million
• Inventory: $421 million (1.3 months supply MRQ)

KB Home (KBH)
• Cash: $986 million
• Debt: $1.8 billion
• Inventory: $1.7 billion (13.5 months supply MRQ)

Market cap leader NVR recently made a $170 million offer for bankrupt Orleans Homebuilders, which had approximately $440 million of assets at the end of 2009. Therefore we know it's in the hunt for some more assets, and with minimal inventory on its books it is going to need some more supply in the event of a demand rebound. On the other hand, D.R. Horton, with the second largest market cap in the space, is beginning to run a little low on inventory and will want to expand into the big fish in the industry. Pulte also trails close behind NVR and Horton in market cap, and while it would like to keep expanding, it does harbor a bit more of a debt burden and more inventory as well. Lennar and KB Home are on the smaller side, but still have the resources to acquire stragglers if they see fit.

The Shaqs:

Hovnanian Enterprises (HOV)
• Market Cap: $246 million
• Assets: $2.0 billion
• Liabilities: $2.2 billion

Beazer Homes (BZH)
• Market Cap: $289 million
• Assets: $2.0 billion
• Liabilities: $1.5 billion

Although they look like discounts right now, their knees are about to blow out. Beazer and Hovnanian have well documented issues regarding their debt loads and their ability to fund both new development for sales as well as their debt payments. If any of these companies are potential falling knives, these would be them. Despite a relatively strong selling season with the culmination of the tax credit in the second quarter, neither was able to turn a profit while many of their competitors were, owing to their relatively high risk exposure and generally less profitable operations. While someone could pick up these companies and cover their debts in the process, there is a sense that the recovery is going to be a long process and that these companies could struggle further in the months ahead, especially if prices double dip (which is a very real possibility in our view). Perhaps any deals for these two would be held for later when either there is proof the market is recovering, or when the vultures really start to circle and bring values down more.

The LeBrons:

Standard Pacific (SPF)
• Market Cap: $387 million
• Assets: $2.0 billion
• Liabilities: $1.5 billion

Ryland Group (RYL)
• Market Cap: $719 million
• Assets: $1.7 billion
• Liabilities: $1.1 billion

Given their relatively recent investment into the Company, I don't necessarily see MatlinPatterson as being willing to sell their Standard Pacific stake so early, but otherwise the Company is a relatively attractive buy. After being hit hard by the market collapse in California, MatlinPatterson picked up the pieces and turned the struggling homebuilder around well. It is currently running at a profit despite continuing hard times in California and seems to have a good handle on sales execution; at $387 million in market value this would be a good pick up for anyone willing to brave the California market.

Finally, there is Ryland, which at over $700 million in market value before potential premiums would take some heavy investment. However, it boasts a lean inventory placed in lower-risk areas like Texas, and throughout the downturn it has proven that its assets are less apt to devalue in the case of a double-dip in pricing (which as we said earlier, is a very real possibility in our view). The Company ran at a $6 million profit in its second quarter even after $19 million of debt retirement costs, owing to its sales savvy and risk aversion. Although its homes typically run at a lower gross margin, its value shows on the bottom line.

David Urani
Wall Street Strategies