Tangible Net Worths

Cash and liquidity are all the rage these days. As we look near-term at our public company universe and conduct a revolver and liquidation analysis, there's bad news and slightly-less-bad news. First, the better tidings: At the end of the day, we believe that bankruptcies or negative credit events among our group are not likely. Still, worsening housing trends and the fact that the group still trades above prior troughs lead us to look for a better near-term entry point for investors.

Michael Rehaut Amid credit tightening in the mortgage market, we believe fundamentals will continue to worsen throughout the second half of 2007. More expensive, harder to get loans will reduce the number of qualified buyers and further slow the overall market, which could drive inventories higher and prices lower. This will lead to a rise in cancellation rates. As a result, we believe this will drive solidly negative order growth.

Also, in contrast to 2H06's rally in which lower inventory levels sparked hopes for a better 2007 spring selling season and housing market rebound, we believe this time that inventories–while still possibly set to exhibit some degree of a seasonal decline–will remain at elevated levels overall, which should in turn continue to put pressure on prices and result in continued material land impairment charges in 2H07.

While third quarter charges may lessen somewhat, given our view that many builders "cleared the decks" this quarter, we note inventories remain at elevated historical levels, with existing home inventories rising to an 8.7-month supply in June–the highest level since 1992. Existing home prices, which have not yet declined materially from peak levels, may continue to prevent a significant reduction in inventories over the next few quarters. In turn, we believe this should drive continued weakness in pricing and material impairments in 2H07.

Worst Case

Analysis of builders' minimum tangible net worth covenants in their credit facilities reveals that most builders exceeded their requirements by 15 percent to 30 percent in 2Q. These covenants require that builders maintain a tangible net worth (typically defined as equity-goodwill or simply equity) of a base amount set at the time of the credit agreement plus 50 percent of cumulative positive net income from that date (losses are not deducted). After examining borrowing capacity under the revolvers, we note that eight out of 11 builders have at least $800 million of available credit.

While we are concerned about Standard Pacific and Hovnanian, we expect continued cooperation from lenders to amend covenants and credit facilities, as we believe these builders can generate cash flow and pay down debt.

While Standard Pacific currently has only a $120 million cushion over its tangible net worth requirement, we believe the company will be able to renegotiate this downward with its lenders, albeit with a likely lowering of the overall size of its credit facility. The company previously lowered its interest coverage requirements in April. Standard Pacific generated positive cash flow of $152 million in 1H07 and has also reduced its revolver balance from $594 million in 3Q06 to $257 million in 2Q07.

Given our outlook for positive cash flow of $300 million in 2H07, we believe Standard Pacific will be able to pay off the remainder of its revolver balance. What's more, we believe Hovnanian will remain above its requirements in 2H07 and should begin to pay down its revolver as it becomes cash flow positive in 4Q.

Lastly, recent concerns regarding Beazer's liquidity are unfounded. While its available credit under its recently reduced $500 million revolver (as opposed to its prior $1 billion facility) is only $300 million, we expect Beazer to generate positive cash flow in 4Q and FY07. Nothing is currently drawn on its revolver; moreover, its next debt maturity is not until 2011. Stay tuned.