Liquidity issues plague builders

Standard Pacific's(SPF:NYSE) decision Monday to suspend its dividend is an example of how liquidity risk is now the most important consideration when looking at homebuilder stocks.

In a market in which some builders are even resorting to selling homes at a loss to create cash, it's important to determine which companies can manage to survive a downturn in housing that may last for several years.

A helpful tool in doing so is the Z-score model, which has been shown to be a very powerful tool in predicting corporate bankruptcies.

Edward Altman, an NYU Stern School of Business finance professor who is considered one of the world's foremost bankruptcy experts, developed the Z-score model in the 1960s and has been fine-tuning it ever since.

The model uses five ratios and weights them to create a single Z-score value for a company:

* where:

The higher the Z-score, the less risk of bankruptcy. A Z-score of 1.8 is considered the upper bound of distress for a firm.

TheStreet.com calculated Z-scores for the 15 major homebuilders using the companies' most recent 10-Q filings.

Only two companies had scores below 1.8, thus putting themselves in the distressed zone: WCI Communities(WCI:NYSE) (at 1.5) and Tarragon(TARR:Nasdaq) (at 0.3).

Hovering right near the distressed zone are Standard Pacific, with a Z-score of 2.0, and Hovnanian(HOV:NYSE), with a score of 2.1.

Standard Pacific plunged 12% Monday after suspending its dividend payments to shore up cash. Hovnanian does not pay a dividend for its common stock, but does for its preferred stock. The company's fire sale of new home inventory earlier this month exemplified the sad state of the homebuilding business.

Beazer's(BZH:NYSE) 2.3 score may be a bit misleading, since the numbers are based on the period ended March 31. The company has delayed more recent filings because of accounting issues. Liquidity worries continue to surround the builder.

KB Home(KBH:NYSE) and Centex(CTX:NYSE) put in lackluster Z-scores of 2.3 each. KB Home's Z-score was not adjusted for the recent $650 of debt redemptions.

Z-score Model for HomebuildersSPFBZH(*)HOVWCITOLNVRMDCRYLTARRCTXPHMMTHKBHLENDHIZ-score2.02.32.11.53.06.92.93.20.32.32.52.82.33.02.6Price/book0.30.30.50.30.92.21.00.70.30.70.70.50.90.70.8* Beazer balance sheet items are from last 10Q, for qtr ended March 30, 2007 Note: Z-score of 1.8 is upper bound of distressed zone

A few issues to note about the model TheStreet.com used: Altman's model says "total assets" should only be tangible assets. For simplicity's sake, we did not adjust for this.

But we also did not add off-balance sheet liabilities (such as debt from joint ventures) to total liabilities. The bankruptcy of Enron, the largest in U.S. history, showed that off-balance sheet liabilities are an important consideration in determining insolvency risk.

Investors looking to create more sophisticated models would be wise to make adjustments for both inputs.

As a final note, the "market value of equity input" is supposed to include the combined market value of common and preferred stock. However, since most builders do not use preferred stock, we ignored the addition of it.

Nonetheless, the Z-score model we used for the builders offers some powerful conclusions.

It shows how certain companies like NVR(NVR:NYSE), Toll Brothers(TOL:NYSE), Ryland(RYL:NYSE) and Lennar(LEN:NYSE) look better able to survive the downturn.

However, Standard Pacific, Hovnanian, WCI and Tarragon look particularly vulnerable to bankruptcy.

As a bigger picture, the weightings for the five inputs in the Z-score show that earnings before interest and taxes/total assets is the most meaningful ratio. Since most builders are reporting negative earnings, their Z-scores may only deteriorate from here.

The Z-score table also shows the latest price-to-book ratios for the builder stocks. Investors may want to compare these to the Z-scores to see where the market may be mispricing the builders' firm-specific risk.


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