After a great party comes the cleanup. In its recently reported fourth-quarter results, homebuilder Hovnanian
For Hovnavian, the story of fiscal 2006 was its $336 million in impairment charges, which pretty much wiped out the company's $569 million in full-year pre-tax income and left a meager $139 million for the bottom line.
Understanding impairment charges
Although impairment charges can seem kind of abstract, think of them as a company saying whoops. For Hovnanian to build a house, it needs land -- which you can think of as Hovnanian's raw-material inventory. If Gap has a ton of orange sweaters waiting to be shipped to its stores, and Oprah suddenly declares that wearing orange is a fashion faux pas, then Gap says whoops and takes an impairment charge, because the value of its inventory has suddenly decreased. During good times, homebuilders take only minor impairment charges, because prices are increasing and the champagne is flowing. In 2004 and 2005, Hovnanian took a combined $12 million in charges. When the music stops, land inventory suddenly isn't such a great thing to have. Whoops!
Although impairment charges aren't cash outflows -- because the cash has already been paid for land and land-option agreements -- they do reflect an economic cost and a previous cash outflow, just as Gap's write-down of its orange sweaters would be a real expense.
Peering into the housing crystal ball
Hovnanian's impairment charges are based on its estimates of future profitability. Management hinted that it hopes for market stability a couple months into 2007. It's also cautiously optimistic that contract cancellation rates, which have increased from 25% to 35% over the past year, will decrease by the end of the second quarter in April 2007.
A strong foundation?
Management has made it clear that its impairment charges, while based on an exhaustive and thorough examination of its land and land-deposit holdings, would have to be increased if its forecasts are wrong and if housing prices see a protracted decline.
A jump in long-term interest rates -- and, thus, in mortgage rates -- would cause some major damage to Hovnanian and competitors such as Pulte
Hovnanian has forecast 15,000 to 16,500 total home deliveries for 2007, down from 17,940 in 2006. The company also expects its homebuilding gross margin to fall to a more normal 18%-19% from last year's 23.1% level, and it has forecast $1.50 to $2.00 in 2006 earnings per share, which would give it a forward price-to-earnings ratio of 17 to 23. If the housing market does stabilize, these numbers are certainly reasonable, and they would allow Hovnanian to meet its New Year's resolutions.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.