SELL SHORT Beazer Homes (BZH)—shooting fish in a barrel
Posted by intelledgement on Tue, 18 Sep 07
OK, it’s not news that the housing market is in rout mode after the bubble popped nearly 18 months ago. The combination of the collapse of the subprime credit market—which took marginal borrowers out of play—and the degradation in credit power of consumers—which took some heretofore “good” borrowers out of play—has resulted in a steep decline in demand, which in turn has resulted in a drop in prices, which in turn has hurt consumer credit more, which in turn has lowered demand still further, which in turn…well you’ve heard of a feedback loop, right? What we have here, folks, is a feedback noose. And the necks lined up for the noose include the housing industry, the lenders who made aggressive loans and investors who are long mortgage-backed securities, and homeowners.
Our sister portfolio, the Intelledgement Macro Strategy Investment Portfolio (IMSIP), has purchased two “short” ETFs that benefit from this situation: the Ultrashort Financials (SKF) and the Ultrashort Real Estate (SRS). In our view, this situation will get a lot worse before it gets better. So, we want to look at homebuilders to see who is the most vulnerable. Which brings us to Beazer.
Actually, most of what you need to know about Beazer is illustrated in this chart of the stock prices of a half-dozen homebuilders since April 2006. As you can see, shorting housing stocks since then has been a shooting-fish-in-a-barrel proposition: you can’t miss. The best performer—Toll Brothers (TOL), a ruthlessly disciplined company that caters to high-end buyers who have been less affected by the credit crunch—is down 35% in 17 months. All the others are down 55% or more in the same time frame…and BZH is the worst of all, down 85% between April 2006 and yesterday’s close.
The point here is, that the combined market intelligence of investors over 18 months has concluded that BZH is the biggest fish in the barrel. So that’s our starting point.
LOL ok, now that we have our conclusion—well, at least our hypothesis—let’s see if we can find any evidence to support it. Let’s start with their quarterly report from their 3Q07 (for the quarter that ended 30 Jun 07). Oops…little problem. It seems management have had to delay the filing of this report with the SEC due to the possibility that they may need to restate their numbers. Turns out the CFO may have made some mistakes. Actually, in fact, the company had to fire him in June for shredding documents related to an FBI investigation of shady lending practices in Charlotte, first reported in March by the Charlotte Observer. Seems Beazer not only marketed their homes aggressively to marginal buyers but they set up a lending division which created Venus fly trap-like lures, such as a deal where the buyers put $500 down to secure their purchase and then had got a $499 check from Beazer at the closing (of course all these promotional costs were built back into the back end of the loan which the homeowner had to pay later). Most of the mortgages were federally insured, so that when 77 buyers lost homes to foreclosure in one 406-home Beazer-built subdivision, the Federal Housing Authority—that is to say, we taxpayers—ponied up $5MM to Beazer to cover the defaults, according to the newspaper.
Beazer management at first maintained the company strictly adhered to all laws and did nothing wrong. Presumably excepting the fired CFO. Then on 10 August, when they notified the SEC about the need to delay filing their 3Q07 financials, BZH cited as a reason that their BoD investigation had turned up “certain evidence that the Company’s subsidiary, Beazer Mortgage Corporation, violated U.S. Department of Housing and Urban Development…regulations and may have violated certain other laws and regulations in connection with certain of its mortgage origination activities.” So that internal investigation, the FBI investigation, and an SEC investigation into possible securities law violations that was disclosed in May are ongoing.
Anyway, later last month, BZH management issued “unaudited” 3Q97 results. Among other problems, the company may have been understating expenses, and so these numbers and potentially earlier quarterly results statements may ultimately have to be restated. But we can say with reasonable authority that at the end of June 2007, the company had approximately $123MM of cash on hand (down from $219MM last quarter) and $1.8B of debt. We can say that the company lost $3.20/share in the quarter (compared to a profit of $2.37 in 3Q06) and has lost $5.86 for the year so far (compared to a profit of $6.70/share in the first nine months of 2006). The losses include $159MM of writeoffs for abandoned land options (no point building more homes when the ones on hand aren’t selling) and property purchased for more than it is now worth. We can say that revenue for the quarter ($761MM) was down 37% from 3Q06 and home sales (2,666) were down 36%.
And while we are on the subject of unaudited results, BZH are now preemptively suing their own bondholders ($1.4MM of debt) in Federal court to prevent them from declaring that the company is in default because of their failure to file their 3Q07 10-Q with the SEC. According to Beazer’s court filings “vulture investor” bondholders who purchased the paper at a steep discount from bondholders worried about the company’s travails “are now improperly seeking to secure a windfall by demanding accelerated repayment in full” (quotes from this Forbes report). This demand (which actually no bondholders have made as yet) would be improper, BZH lawyers contend in the complaint, because the company, while required to forward a copy of their 10-Q with the bondholders within 15 days of filing with the SEC, is under no obligation according to the bond agreements to file the 10-Q with the SEC on time, or ever, for that matter. LOL if BZH win this case, a lot of corporate bondholders who depend on timely reporting from the companies to whom they have loaned money are going to be pretty nervous. In any event, if the bondholders could and did demand immediate repayment of the $1.4MM, it would bankrupt the company, and as that is not in the bondholders’ interest (possibly excepting any vulture hedge fund bondholders who are also short the stock), this is not likely to happen—most likely, before this case is even tried, there will be some sort of settlement. But in the meantime, fighting this battle is one more drain on BZH’s limited supply of money and management cycles.
In short, these are not happy times in housing industry land in general, or at Beazer in particular.
Ah, and speaking of short…clever as we are, shorting BZH is not an idea unique to Intelledgement. Short sales of BZH stock amount to about 70% of the float, which lands Beazer on the top ten list of the most-shorted NYSE stocks for September and means that if something really good happens, there is a very high potential of a “short squeeze” event as most everybody who has sold short attempts to buy stock to cover their position. The stock price could rise dramatically quickly, which makes shorting BZH a potentially risky play. Such is the way of speculative plays. (If you are not familiar with short selling, you may want to check out our recent discussion of the tactic.)
And speaking of unhappy times, you will have noted that BZH has been having them for quite awhile now, and indeed that the stock is down 85% in the last 18 months. So why are we shorting it now? Well, the ISOP has only been around since the beginning of 2007, so we could not have shorted anything in April 2006 (when it was north of $60). Ideally, we should have gone short on BZH in January…say instead of buying TMY which has lost 40% for us…or maybe a compromise and just shorted TMY! LOL The fact is that we were focused primarily on launching our investment advising service and secondarily on getting the IMSIP—which is our model investment portfolio—up and running. We did pay more attention that we had intended to this portfolio but that was mostly because of the Dendreon (DNDN) drama.
We’ve been eyeballing BZH as a short for some time now—we didn’t just research and write all this today!—but were looking for a decent entry point. There was a rumor that Beazer was going bankrupt that sent the stock tumbling 42% on 1 August (from $13.99 down to $8.10 although it recovered to close at $11.37) and we were thinking we had missed the boat entirely here. However, today’s “shock and awe” 50-basis-points rate cut has afforded us just the opening we’ve been looking for, as BZH is trading 20% higher here on volume that will be close to 3x normal. It is totally irrational for The Street to imagine that lower interest rates can fix the subprime credit crisis when the problem is a lack of credit-worthy borrowers, not a lack of funds to loan. LOL it was easy credit (in part) that got us into this mess in the first place! Primarily what the Fed is accomplishing here is to fan the flames of the fire that is immolating the dollar—we think it is a panicky, bad move—but Beazer’s house is mos def burning here too, and we are betting it collapses first.