August 9, 2010 / 6:23 PM / 9 years ago

Analysis: Homebuilder expenses likely bigger than they look

NEW YORK (Reuters) - As U.S. housing demand falls following the expiration of the federal home buyer tax credit, Wall Street is pressing builders to cut back yet again. The response is a mixture of real cuts and accounting legerdemain.

A construction worker works on a new home in Matthews, North Carolina in this April 15, 2010 file photo. REUTERS/Chris Keane

Analysts see selling, general and administrative expenses, which include items like sales commissions and advertising, as a proxy for a homebuilder’s efficiency.

“It’s the headline number for the sell side analysts,” said John Burns, who runs an industry consulting firm in Irvine, California. “If it’s high, the sell side is inferring that management is running a fat, lazy business.”

Homebuilders try to bring the SG&A number down, but it still might be bigger than it looks. In tough times like today’s protracted housing slump, builders hire outside companies to perform various functions, bumping the costs off the SG&A line and sometimes even the income statement.

For example, third parties sometimes manage and staff homebuilders’ sales offices and design marketing plans, said Paul Desmet, a president of Ryness Co, a builder services shop in California that has worked for Ryland Group RYL.N and D.R. Horton Inc (DHI.N).

Builders sometimes even offload field operations like subdivision clean-up and supervision, said homebuilder consultant Peter Hazeloop of Michael P. Kahn & Associates.


Homebuilders have not been shy about cutting costs since a bust four years ago followed a housing boom fueled by subprime lending and speculation. D.R. Horton, the biggest U.S. builder, is typical — employee headcount has fallen 67 percent to 2,926 since 2005.

Builder services firms can help companies control costs by keeping headcount down even as they handle various aspects of the business, said Ryland spokesman Eric Elder.

Ryland had not used Ryness Co in about 10 years and no longer hires such firms, but they can be a “fantastic solution,” he said.

“I can’t put my hand on a public (builder) that’s using one,” Elder said. “But I’m sure they are. It’s not something people publicize.”

D.R. Horton did not respond to requests for comment.

Analysts consider SG&A healthy when it is about 12 percent of revenue. But for many builders, it is around 16 percent because weak demand has crimped sales.

KB Home (KBH.N), the fifth-largest builder, reported quarterly SG&A of 22 percent in June, prompting several analysts to ask pointed questions about spending during an earnings conference call.

“We are always looking at ways to cut costs, and we will chip around the edges,” Chief Executive Officer Jeff Mezger said after the third such question.

One way to chip is to transfer services such as sales, marketing and even construction to outside providers. That changes the outlay from an administrative expense to a cost tied more directly to the construction of a house, allowing builders to move it onto the “cost of goods sold” line, Hazeloop said.

Wherever it is, the outlay still pinches profits equally. But Wall Street’s heightened attention to SG&A might lead some investors to focus on it excessively and make bad decisions, said Ticonderoga Securities analyst Stephen East.

“Even experienced investors might latch on to SG&A,” he said. “They’ll say, ‘This is a more tightly run ship. This company executes more than another company.’ Sometimes that’s true, and sometimes the costs are sitting on another line.”


What’s more, builders can shift payments to outside contractors onto their inventory by attaching them to an ongoing project, said Shahab Moreh, an accountant at New York-based Weiser LLP. In that case, the expense sits on the balance sheet until the builder sells the home.

Builders that adopt this strategy can create the perception of bigger profits in the near term because they are deferring the recognition of current expenses, Moreh said.

Malcolm MacEwen, president of a Coldwell Banker brokerage in Phoenix, said builders take this route more often during downturns.

“This is the toughest real estate market since the Depression,” said MacEwen, whose brokerage also offers services to builders. “If you eliminate an in-house expense and shift it to an external expense, it looks better.”

The decision to use a builder services firm tends to happen at the regional division level, Ryness Co’s Desmet said. As a result, the shifting can happen without the knowledge of the executives at the homebuilder’s headquarters — those who interact most directly with Wall Street.

“I see the game played a lot at the division level,” consultant Burns said. “Corporate may not even know about it. But corporate is saying: ‘Get your SG&A down.’”

But even if headquarters sometimes resists handing control of marketing and sales to outside operators, the division head prevails because top executives are transmitting the pressure they feel from Wall Street to cut SG&A.

“Local presidents buy into what we’re doing, and they’re strong enough to fight corporate,” Desmet said. “We keep their SG&A down.”

And that keeps Wall Street happy.

Reporting by Helen Chernikoff; editing by Andre Grenon and Lisa Von Ahn

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