Neither segment reporting nor the controversy surrounding it is new. But what is new is the Securities and Exchange Commission's (SEC) push to crack down on the enforcement of certain industries' disclosure requirements under Financial Accounting Standards Board Statement No. 131. That means that despite home builders' historical reluctance to reveal the full Monty, investors clamoring for more details on the origin of a company's earnings and cash flow are likely to get their wish.
During a June meeting, the SEC staff announced it was issuing more comment letters related to Statement No. 131. They declined to identify particular industries at that time but noted that “some industries are experiencing more issues than others.”
“[The SEC statement] was kind of done in a ‘you know who you are,' sort of way,” notes a home builder source. According to analysts and investor relations executives, home building is definitely one of the industries in the SEC's crosshairs. Many of the sector's public companies already have received comment letters specific to this issue this year.
First adopted by the SEC in 1998, the guidance in Statement No. 131 requires companies to report descriptive financial information about their operating segments. These segments are defined as “components of an enterprise about which separate financial information is available” and are regularly evaluated by the “chief operating decision maker” when allocating resources and assessing segment performance. In other words, a company needs to report its business in the same manner that its head honcho evaluates it.
Almost every industry CEO evaluates the financial performance of his business on a various planes, including the regional, state, city, and community levels. However, because the segments share characteristics “so similar that they can be expected to have essentially the same future prospects,” builders historically have claimed a compliance exemption.
They reason that no matter what the region or segment, it's all the business of home building and, therefore, it can be aggregated as such. This justification is no longer pacifying the SEC.
“We were the first to go to regional reporting,” acknowledged Beazer CFO Jim O'Leary in a September investor presentation. “It wasn't because we woke up and just said, ‘You know, today is the day.' We had an ordinary recurrent review from the SEC and they debated this. What used to be [was] that every division was homogenous enough [that] we could lump them all together. I think we collectively recognized that wasn't the case anymore.”
WHAT'S THE FUSS? According to a fund manager who owns home builder stock, segment reporting helps investors more accurately forecast. However, he acknowledges that the increased transparency could work out to be either beneficial or potentially damaging to the company. “They don't like to do it because, it's either more work or it gives away details to their competitors–or even for suppliers.”
For some companies, a reluctance to report more finite financials stems from a distorted view of diversification. “Some builders are not going to look as diversified as their footprint might appear,” says one source. “It will be obvious that the majority of earnings are more concentrated than their activity and that some regions are just adding to unit count.”
The impending speculation over write-downs also is a probable factor. “We went to Mid-Atlantic, Florida, Southeast, West, and Other” says O'Leary of the way he segmented regions to better show profitability. “Other includes the Midwest, Colorado, and Texas. Those markets have much lower margins. So if you take write-offs or you have operating losses, you don't have a heck of a lot to cushion it now.”
On the flip side, aggregate reporting can dilute profitability in some cases. “If there is a segment that is losing money, [aggregate reporting] is actually masking the profitability of the others that are making money. I'm looking at what they net and putting a multiple on that,” notes a fund manager. “One of the things I like to look for in segment reporting is a losing segment where management has the option to get out. If they decide to shut down the [operation] that's losing money, now you immediately have a more profitable company and you get a higher valuation.”
DIGGING IN Although there is no specific new guidance currently mandated, it stands to reason that once a new parameter and lack of tolerance for aggregated reporting is established within the industry, other companies within the sector will have to submit to the same degree of transparency.
According to SEC spokesperson John Heine, “It's been said that the SEC regulates with the arch of an eyebrow … and there aren't that many publics in this industry.”
Margaret Whelan, home builder analyst at UBS, also speculates that all public home builders will be reporting some form of a segment breakdown by the end of 2006. “Some have been required to do it, and others we have talked to say they have gotten the requests and [they] will start complying,” she says.
WCI enacted new segment reporting last quarter. “Before we started, we definitely got a lot of questions about it,” says Steve Zenker, who handles the company's investor relations. Zenker says the company now breaks down revenues and gross margins into three geographic regions. “But you want to make sure that the information that you are putting out there is informative and not overkill. We obviously found the right balance because now the questions have stopped.”