Altruistica

"Altruistica": Seeking a return to full financial disclosure and regulatory oversight. A financial market analysis blog for "entertainment purposes" only by an experienced CFA seeking new hedge fund engagements for investment writing and analysis. The author has experience investing internationally, running a hedge fund, making angel investments, and helping launch five startup companies. Investors should do their own due diligence.

21 November 2006

KB Homes in Chaos- But $47 a share? November 2006

When the CEO and some of the management team of the nation’s fifth largest homebuilder, KB Homes (KBH-NYSE), resigned this week, and admitted to misappropriating shareholder assets through options fraud, one might expect the shares to suffer. CEO Bruce Karatz admitted to manipulating the options award and pricing since 1998 by having "selected grant dates under the company's stock option plans", at a time when he has been paid more than a quarter a billion dollars in salary and …um..options. So the board is recovering $13m in excess option awards but now Karatz can dump his remaining $150m in stock (2.5% of outstanding shares). The KBH Board fired Gary Ray, head of human resources, and accepted the resignation of Richard Hirst, executive vice-president and chief legal officer.. Wow, that’s not good news.

Karatz was one of the highest-paid executives in 2005, making $155.9 million, mostly from exercising options, according to the Wall Street Journal. The board’s press release claimed that, “the company's review didn't reach any conclusion about whether there was intentional wrongdoing on Karatz's part.” Now the board is looking for an independent non-executive chairman. In the meantime, Kenneth M. Jastrow II, a director of KB Home since 2001 and Chairman and CEO of Temple-Inland, will serve as the board's lead director. And KB Home is searching for people to fill the”newly created positions of chief compliance officer and risk assessment officer.” No, certainly not intentional and nice to close that barn door…

Yet, in this otherworldly market where all news is bullish, regardless how much shareholders are being ..umm..disadvantaged. More than 188 companies U.S.-wide have disclosed their stock option practices are under internal review or being investigated by the government, according to Glass Lewis & Company, a research firm that advises investors on shareholder issues. KBH shares initially rose and even the 5.1% decline in third quarter same store sales at Home Depot (HD-NYSE) might be just shrugged off, but the average check-out invoice dropped for the first time in four years. Atlanta-based Home Depot and Lowe's have both cut their outlook this year as higher borrowing costs and weaker U.S. home sales cooled big-ticket purchases. Home Depot said per-share profit could fall as much as 16 percent in the fourth quarter.

Secondly, a recent UBS housing study forecast that homebuilder industry EPS will decline 22% in 2006, UBS is now forecasting a further decline of 46% in 2007, and a 28% decline in top line revenue. According to Yahoo Finance, KBH is expected to see a 40% fall in EPS from $8.12 to $5.09 in 2007, putting KBH at a not-so-compelling 9.2x forward price/earnings multiple. KBH has already warned that orders fell 40% during its non-reported third quarter, which it expects to report NEXT FEBRUARY (see later).

Thirdly, even the historical housing stock price support, the book value, is sliding at KB Homes from $37.66 per share in Q2 to a target closer to $30 from contract writedowns, land purchase option dispositions, and other write-offs. With $2.46B in long term debt and a $1.5B surge in inventory in the last reported quarter (Q206), there look to be further book value writedowns. More good news.

Fouthly, investors who think they are being contrarian by buying homebuilders shares may have a rude awakening- the recession of 2007 will bring losses for these firms. KBH is a LA-headquartered homebuilder and housing finance firm focusing primarily on the low end, first home buyer segment, but the bulk of its operations are in the riskiest, most over-extended housing markets: California, Nevada and Florida. In September, existing home sales slowed for the sixth straight month, and new home sales were off 14 percent from year-earlier levels, according to government and housing industry reports. And even the National Association of Realtors (NAR) has been steadily cutting its estimates for key metrics.

  • Existing Home Sales: 2006 sales slipping from a 6.5% decline in the summer to now down 8.6%, 2007 forecast is a very conservative decline of 0.6%;
  • New Home Sales: 2006 sales falling fast from a 12.8% drop forecast August to a 16.8% drop, 2007 sales are already expected to drop 8.7% but will be worse; and
  • Housing Starts: 2006 starts will slow from a 9.1% decline to a 10.6% decline.

Moreover, the NAR’s basic affordability index is approaching parity (100) even with its absurdly low assumptions of average housing prices ($232K). In short, that means home prices are becoming even less affordable as the recession approaches. And UBS is forecasting a further 10% decline in home prices over the next year, as a staggering 870,000 homes are unoccupied in the U.S.

Recently, KBH received consents to amend the indenture governing all five series of its $1.65 billion of outstanding senior notes, which it was technically in default due to the failure to file a SEC form 10-Q (quarterly report) with the SEC. So now KB has until late February 2007 to file its August 30, 2006 Q3 results, soon after it pledged to file by December 22, 2006 ? Robert Curran, a senior home-building analyst at Fitch Ratings, said offering a cash payment to bondholders ($7.50 per $1000 in debt?) in exchange for additional time to file financial reports “wasn't unexpected”. Standard & Poor's Ratings Services placed KB's corporate credit, senior unsecured, and senior subordinated debt ratings on CreditWatch with negative implications. S&P said the move affected the $1.65 billion of senior notes and $750 million of senior subordinated notes. Is the SEC serving investor interests here?

The quintuple whammy for this firm is the loss of transaction-related revenue. KBH wants clients to use their financing arm. Its Financial Services segment, which provides mortgage banking, title, insurance, and escrow coordination services to the company’s U.S. homebuyers, has been rolling over. Cash-out refinancing by U.S. homeowners in 2005 took a net $345 billion in equity out of their homes, and another estimated $400 billion this year. Accordingly, the fastest-growing component of the earning assets of U.S. banks was home-equity loans, in which houses are put up as collateral. These totaled $399 billion in 2005, up $118 billion from a year earlier. In 2005 and 2004, 46% and 42% of mortgage assignations, respectively, had piggyback loans to cover down payments and transaction costs, twice the proportion of 2003. What happens to KB Homes’s stock if it faces massive financing writedowns which no shareholder will discover until next spring?

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