Gussied-Up Land-Flippers?

The first thing I learned in this business that I had never grasped from the accounting books we “studied” in between games of foosball at Smuggler’s Tavern came during a trip to a furniture plant in Altavista Virginia.

In those days, America actually manufactured quite a bit of the furniture bought by American consumers, much of it in plants in the general vicinity of High Point, North Carolina, where the annual furniture mart is pretty much the whole point of going to High Point in the first place.

Since then, of course, a lot of furniture plants have closed—including, I’ll bet, every one I visited back then, although not necessarily for the reasons put forth each night on CNN by Lou Dobbs in his hysterical, How-America-Is-Prostituting-Itself-to-Foreign-Mercenary-Scum-Sweatshops tirades.

The fact is that some of those plants I saw even in their heyday were so out-of-date and inefficient it was hard to imagine anybody could competitively manufacture anything in them except workers comp claims. One I remember in particular actually had a multi-story manufacturing line—they moved partially completed wood furniture from floor-to-floor on a big old rickety elevator. Not exactly “world class,” and not long for this world even back then.

Still, the companies in those days were generally pretty smug about their central role in furnishing America’s bed rooms and living rooms and dining rooms—after all, who could possibly make a big, bulky dining room table in Asia and ship it all the way to Los Angeles for profit? And even if somebody could, who’d want to buy it? A lot of people, it turns out. Imported furniture is now more than half the U.S. business, up from next-to-nothing back when I was sitting in an old-fashioned office just off the long-gone production line of the Lane Company in Altavista, Virginia, getting my first real lesson in free cash flow from an actual Chief Financial Officer.

I don’t recall what year this was, but business in general was slowing down after a long period of prosperity, and what surprised me was this: not only was the CFO not upset about the slowdown, he was actually getting pretty excited talking about all the cash he’d be able to generate from inventory and receivables now that sales had leveled off.

Being a slow learner, I asked for specifics, and he gave them so clearly that even I could grasp the mechanics of how, when you collect receivables and work off inventory, the difference goes into the bank. (Back in those days a CFO could talk to you about these things without putting out an 8-K and going on CNBC to explain himself.)

And that was how I learned how much cash a business can chew up when it expands, and how much cash it can generate when it contracts. Not exactly the secret of life, for sure, but good to know at an early age in this business.

Which is why the most puzzling part of yesterday’s conference call with Hovnanian Enterprises—the homebuilder whose business has slowed quickly after a decade or so of non-stop growth—was the discussion of free cash flow, or rather, the lack of free cash flow, now that things are easing up.

“For the full [fiscal] year, we generated adjusted EBITDA of $753 million, which covered interest 4.5 times,” management said on the call. So far, so good. But then:

“Due to the slowing velocity of deliveries…our inventory turnover and thus interest coverage is expected to decline in 2007.”… Not only will inventory not decline as you’d expect in a slower environment, this company expects inventories to grow in the near future:

“Our inventories are expected to grow through the first two quarters of fiscal ’07 as we invest in new communities and the associated land development and home construction. But for the full year, we expect the net change in inventories to be close to zero, and thus we expect to be marginally cash flow positive for the full year.” If they’re not going to be cash flow positive now, when are they ever going to be? The company can’t even buy shares back beyond the dilution from stock options:

“Although we believe our stock remains undervalued, we intend to maintain only the current pace of share repurchases at this time.” Somehow, Hovnanian’s financial model negates every known benefit of a business slowdown: the ability to reduce working capital and generate free cash flow not needed for reinvestment when growth opportunities are lacking. How is this possible? I can think of no explanation aside from one. Could it be that homebuilders—profitable though they may appear to be during a long upturn—are no more than gussied up land flippers?

Informed rebukes are welcome.

Jeff Matthews I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.