Thursday, 11 October 2007 05:00

Straight Talk From the Homebuilder CFO: How independent are the independent auditors?

Welcome to another senior level class. As I stated before, the purpose of senior level classes is to give you a peak behind the curtain of how homebuilders operated. The good (none), the bad (lies) and the ugly (incompetence). You may ask yourself how I define a lie... incompetence is pretty easy. A lie is when I listen to a conference call of a major homebuilder, the executives tell a story to the usual cast of dimwitted characters (analysts) and a strategic picture is painted. I then call my high level friend (VP of Finance) that works for that builder and walk him through what his executive team has stated. Hmmm lots of discrepancies, lots of items missing, lots of lies.....

However, a conference call is just that, a bunch of talking heads spinning stories. Thankfully we have the trusted auditor providing us an independent and unbiased review of management's statements (the financials). Well lets look at who these wonderful auditors are.... lets start with the top 5 homebuilders... Pulte Homes (Ernst & Young), DR Horton (Ernst & Young), KB Homes (Ernst & Young), Centex Homes (Ernst & Young), whew... Lennar (Deloitte)... wow what are the odds? Ok I live in Florida and it is a debacle today... so who are some of the big Florida players, the ones who are getting the $@#@@# kicked out of them... WCI (Ernst & Young), TOUSA (Ernst & Young), and KHOV (Ernst & Young)... KHOV did 3 acquisitions at the very peak of the bubble in Florida - Cambridge, Windward, and First Homebuilders.. have you seen the write offs on these 3 acquisitions!!!! huge!!!!

Wow, what a coincidence, there are 4 major audit firms (Anderson went under with Enron) and everyone thinks E&Y is the best auditor... the big guys and even the guys who are struggling and close to bankruptcy in Florida. Well, I like to follow the money trail (see my blog 5 of 20). Don't auditors make a lot of fees - audit, tax, consulting and their partners well compensated? So what is the incentive for an auditor to pressure a builder to report the truth in a timely manner? Your being paid by the builder and if you piss him off, you lose your client. As long as the builder is not committing outright fraud you should work with them? Whoaaaa... wait a minute, as a former CPA for a big 4 auditor I was told that management prepares the financials, we do an unbiased review, and banks, bondholders, the government, and stockholders rely on these statements in their decision making process. Isn't that the purpose of financial statements? So that you as a creditor or stockholder can make a quality business decision based on TIMELY information?

So lets take a look at land write-offs and impairments... after all, in blog 5 of 20 didn't I say that a lot of land is worthless (I will have a future blog on this - since the topic of 5 was executive compensation's influence on strategic decisions). So what does the Accounting world have to say about land writedowns... here it is...

In accordance with Financial Accounting Standards No. 144 ("SFAS 144"), "Accounting for the Impairment of or Disposal of Long Lived Assets", we record impairment losses on inventories related to communities under development when events and circumstances indicate that they may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than their carrying amounts.

Wow, that was confusing. So your asking yourself, ok Bill where are you going with this? Big deal E&Y audits like every public builder. In my last post, how did builder executives (Division President and select VPs) get paid? Mainly growth models. In 2006 the market started falling apart and land values were plummetting (book < value). However, in many locations builders were still making big bucks in 2006 because they had huge backlogs with high sales prices and lower land basis. The crappy low gross margin sales were taking place in late 2006 and would close in 2007. So even with a 35% cancellation rate in 2006, the backlog was so huge you could still make a big jump in earnings growth that fit your compensation model. You will get paid handsomely in 2006 unless, of course, you took a massive write-off. In 2007 you will have high land basis + write-offs + lower selling price = no bonus. Do you really want to impair your land values to their true market value in 2006 and not get that 2x to 5x bonus? If the executive management team calms fears on the conference calls we will all get paid one last time.

Is this a conspiracy? Didn't E&Y hold the builders to the fire on FAS 144 above to be compliant with this financial rule? Here is the problem, stocks, gold, oil, bonds, currencies, etc... have market values that are readily available to mark down to the lower of cost or market if the price declines. Land, not that easy to value especially if your a 24 year old auditor. So the local team whose compensation package is determined by earnings is going to re-value the land and the methodology will be reviewed by the 24 year old auditor. Each builder is allowed to write down land using their own methodolgy, since FAS 144 doesn't define one for homebuilder land. Is the methodolgy used to be conservative and paint a transparent picture of what is taking place in the market? Or is it to take write-offs at the most opportunistic time? Let me explain... your field team (division president and select VPs) get paid the max, we'll call it 4x base, if you hit a pre-tax number of 40 million... based on the first 9 months of your calender year, you are in the bag for 55 million in 2006... how much of a write off do you take if every 5 million below 40 million you lose 1x base until you get to 20 million which is just your base salary? By the way, in 2007 you already have submitted your forecast and you won't get any bonus because it is so dismal. You take a 15 million write-down to 40 million, you get paid 4x bonus and you call it a day. After all, you are the expert at revaluing your land.

Now your saying, Bill your all wet.. no way... your saying E&Y is independent and if builder A is reporting large writedowns using a conservative method then they should coax or force builder B to come clean also and use the same method. Again, FAS 144 does not provide a method. The builder does. Lets look at the top 4 E&Y clients by sales.... Pulte Homes wrote off (all numbers are approximates) 350 million for their 4th quarter, year ending 12/06, prior to that the write-offs were minimal. This year they have written off close to 900 million because they are not getting a bonus... DR Horton wrote off 210 million for their 4th quarter, year ending 9/06, the largest write off for the year. In 2007 DR Horton has written off about a billion, no bonus there. KB Homes wrote off 380m for their 4th quarter year ending 11/06, by far their biggest charge. In the first half of 2007 they are at 308 million. It should be noted that KB is aggressively selling land. In 2006, Centex wrote off 410 million 4th quarter 3/07 its biggest write off and already wrote off 170 million in the first quarter of 2007. How is it that all these builders just happened to have their distressed asset templates tell them that their big write-offs were in the 4th quarter of their year ending? If all the builders were in the same boat, wouldn't the write-offs be consistent in the quarter taken by all builders? No, because only by the time you get to the 4th quarter are you certain as to how much profit your division is going to make, what closings should occur in the 4th quarter and how much of a write-off you can take and still make max bonus or something less than max if your division was really hurting.

In 2007 the flood gates will be open for all the builders divisions to write off as much as possible (it doesn't matter because no one is getting a bonus), so that in future years they will be able to max out again.. It is a shame that E&Y didn't warn us in the Summer of 2006 that this thing was crashing down (book value worthless and land prices declining). That E&Y didn't create a distressed asset template for all their clients for consistency purposes and transparency. Instead, they let the builders determine the methodolgy and timing of those write-offs and everyone got paid, except the real owners... the stockholders and bondholders. So much for relying on financial statements.

Last modified on Thursday, 11 October 2007 05:00