Dominion Homes is a small public homebuilder that I believe will go bankrupt.  The stock has already fallen precipitously of late, appears on face like a “steal” as a multiple of book value, is highly illiquid, and is difficult to borrow.  Nevertheless, I recommend shorting it because I believe it is terminal.

 

DHOM primarily builds lower- and mid-end homes in the Columbus, Ohio market (where it had ~23% market share in 2005), and to a lesser extent in the Louisville and Lexington, Kentucky markets.  These markets have been and continue to be exceptionally weak.  Permits in the Columbus market as a whole were down 11% in 2004, 28% in FY05, and 27% in H1’06; in 2006, Columbus is forecasted to see its lowest number of homes starts since 1996.  Even a well capitalized homebuilder that hadn’t binged on land at the market top would find it very hard to perform well under such market conditions.

 

DHOM owns far too much land relative to its run rate of operations.  It has a 9.1 years supply of lots based on LTM closings, and 11.1 years based on LTM orders.  Only 9% of lots are optioned, 91% owned.  The vast majority of its land (79% of lot count) is completely raw and undeveloped, therefore extremely illiquid.  There are minimal buyers for land these days, particularly for raw land and in these markets.  That land will be very difficult to monetize without first spending significant capital to develop it and then build homes on it.  Moreover, its bank covenants limit its ability to monetize the land by building “spec” homes.  It is difficult to get a good sense for the quality of DHOM’s land positions, but I have heard anecdotally from a veteran in that market that many are poor.  According to a trade magazine, Big Builder, DHOM in 2002 began to engage in “a land grab now conspicuous for its questionable value”, leveraging up to buy lots of land that allegedly cannot be utilized other than for low end homes targeted at customers who would otherwise be renters. 

 

A look at the historical financials tells much of the story.  Land and land under development inventory $ went from $157.2mm in 2002 to $307.7mm in 2004, nearly a double.  At the same time, net debt to EBITDA more than doubled from 2x to over 4x (and this is prior to EBITDA margins falling off a cliff).  In hindsight, DHOM bulked up on land almost precisely at the top in its markets.  Instead of the business growing into its larger land position, net orders from 2002-2004 were flattish, closings were up modestly, and backlog dropped precipitously.  Operating results since then have only gotten worse.  H1 2006 revenues are down 48% and backlog units down 49% from H1 2004.  Of course, there are not many companies that can cut deep and fast enough to offset the evaporation of half their business!  Likewise, gross margins have been cut more than in half, while SG&A as a % of revenue has predictably increased.  So EBITDA margins are now firmly negative. 

 

DHOM is also in a very difficult position because it inherently (due to its markets and its price point) has such a short backlog and high backlog conversion.  Therefore, changes in orders quickly flow through to deliveries and thus revenues.  A drop in backlog makes it particularly difficult to monetize land because covenants limit the amount of “spec” homes that can be built.  So in the face of a drop in orders, production levels cannot be sustained by offsetting the lower orders with increased “spec” homes.  The last 6 quarters have shown yoy changes in net unit orders of: -34.1%, +28.4%, -27.6%, -41.3%, -24.1%, -45.6%.  It is very hard to cut the business quickly enough to offset such dramatic erosion in orders.  Likewise, it is very difficult to sell land off quickly enough to get the years supply back in balance when orders and thus deliveries are falling so fast.

 

DHOM is overleveraged.  EBITDA is only marginally positive in the last twelve months (comes nowhere close to covering interest incurred) and is negative in H1 ’06.  Of course, the net debt / EBITDA ratio has ballooned to ridiculous levels from the drop in EBITDA.  Net debt to cap of 53.7%, while on the highside , may not sound crazy at first glance.  But there is a major difference between a builder like KBH with a similar debt to cap but with adequate liquidity, healthy margins, and a less lopsided land position.  And it is next to impossible to get leverage back to reasonable levels unless the business starts growing significantly, instead of shrinking dramatically.  For instance, even with LTM revenues of $355.5mm (I’ll be surprised if we end up seeing FY06 revenues of much more than $300mm), and even at a 6% EBITDA margin (a lot higher than I think we’ll see at DHOM for a long time), that would translate to $21.3mm of EBITDA.  Even at a 3x net debt to EBITDA multiple (probably still on the high side), that would translate to a reasonable debt load on the order of $64mm vs $216mm today.  Seen another way, LTM interest incurred is $14.6mm, so even on the generous assumptions above, EBITDA coverage of interest would still be below 1.5x.  So pretty clearly, DHOM needs a tremendous land sale or a big increase in its ongoing operations if it is to have any hope at paying down or growing into its debt load.  And in contrast to most of the other public builders who enjoy predominantly long term, fixed rate, unsecured bond debt, DHOM’s debt is short-term, variable rate (though partially swapped to fixed), secured, bank debt.

 

DHOM’s credit facility was amended on March 30, 2006 to grant the banks security on substantially all of DHOM’s assets and to reduce the line from $300mm to $240mm.  The amendment further reduced availability to $225mm at 9/30/06 and $200mm at 12/31/06.  There was $207.6mm outstanding at 6/30/06, $7.3mm of LOCs, and less than $1mm of availability after adjusting for borrowing base limitations.  Less than $1mm of availability and only $705,000 of cash for a company that did $355.5mm of LTM revenues and $542mm of revenues as recently as 2004!  The facililty matures in May 2007, but DHOM has been in negotiations with the banks to extend or refinance it by December 2006.  DHOM expects to be in violation of bank covenants for the 9/30/06 and 12/31/06 quarters. 

 

(The following was added as a risk factor to the latest 10-Q:  “We believe it is unlikely that we will be able to satisfy certain financial covenants in our bank credit facility at September 30, 2006 and December 31, 2006. If we are not able to satisfy these covenants, or obtain waivers of or amendments to the covenants, our lenders could declare a default and demand repayment. Our current bank credit facility requires that we maintain a ratio of uncommitted land to consolidated tangible net worth of 1.70 at September 30, 2006, and 1.55 at December 31, 2006, and a minimum interest coverage ratio of 0.60 at September 30, 2006, and December 31, 2006. Unless we are able to reduce our projected operating losses in the third and fourth quarters, reduce our land holdings, or obtain alternative sources of financing in the short term, we believe it is unlikely that we will be able to satisfy the interest coverage ratio covenants at September 30, 2006, and December 31, 2006, and the land to tangible net worth covenant at December 31, 2006.”)

 

On August 10, 2006, DHOM’s credit facility was again amended.  The definition of “Borrowing Base” was modified to increase the borrowing base by $10mm from 8/11/2006 through 9/30/06 (presumably DHOM would have otherwise run out of liquidity in the next day or two).  The amendment also lowered the aggregate line availability to $220mm from 8/11/06 through 12/30/06, and maintained the reduced availability of $200mm at 12/31/06. 

 

The amendment indicates that DHOM is now prohibited from acquiring any new parcel of real estate without the prior written consent of the Required Lenders.  DHOM will be required to pay for the services of an advisor or other consultant for the banks relating to audit, appraisal, valuation, out of pocket costs, etc.  DHOM is required to submit a weekly cash flow report to the banks by 9/15/06.  DHOM also must perform and observe the terms of a letter agreement with the banks dated 8/10/06 (but the contents of this letter agreement appear not to be publicly disclosed). 

 

All of these requirements sound representative of a company that is already in or else right on the precipice of bankruptcy.  It sounds to me like the banks just continue to tighten the screws and to incrementally extract more from the company – first security and lowering of the line, now reimbursement of costs for an advisor.  Interestingly, in this latest amendment the banks did not adjust the covenants for 9/30/06 and 12/31/06 that DHOM expects to violate.  So as long as the perfection period on their liens has passed, it seems the banks are getting close to the end of the line in terms of their patience.  I’m not sure what else the banks can still extract from DHOM outside of bankruptcy.  Perhaps the banks can get a marginally better collateral position and take some fees by forcing the company into bankruptcy and replacing the bank line with a defensive DIP.

 

The founding Borror family owns ~50% of the company and is obviously in a tough position.  Of course they will do what they can to salvage the company, but I’m not sure there really is much they can do at this point.  In theory they could inject new equity into the company to pay off some debt and salvage their existing equity.  However, that strikes me as a very foolish decision given how much equity they would have to inject in order to move the needle in deleveraging the company.  Furthermore, the bank group may simply want out.  Presumably the family is quite wealthy given that they’ve been building for over 50 years and DHOM was the largest builder in Columbus for years.  That said, my read of insider sales filings going back to 1997 shows the family sold less than $20mm of stock since then, including its sales in the 2002 follow-on offering.  I’m not sure if the family sold any secondary shares back in the 1994 IPO, but it is possible.  In any event, even assuming the family has the means to inject equity into the company, it seems like it would largely be throwing good money after bad.  After all, the company’s underlying business is out of whack with reality given its current land pipeline relative to sales pace, its ratio of owned/optioned land (nearly entirely owned at this point), and the vast majority of its land is raw.  It obviously doesn’t help that its markets are in poor shape and the housing bubble in other parts of the country has begun to burst.  DHOM’s reputation with both buyers and realtors has been damaged severely in the wake of HUD investigations, lawsuits from buyers, and negative press coverage focusing on its above-average foreclosure rates in its communities and alleged high pressure sales tactics from company sales reps.

 

After a 14 month executive search process, headhunters finally found Jeffrey Croft to take over the top operating job as President and COO in March 2006 after Jon Donnell resigned in October 2004.  Croft previously spent 19 years at Pulte and his 2 year noncompete had recently expired.  However, he just recently agreed to waive his guaranteed minimum bonus for 2006.  Much of his restricted stock looks unlikely to vest, and if he’s been given any options they’re all under water.  His employment agreement, however, does provide for a significant payout in the event that there is a change of control, sale, or dissolution of the company.  So it would seem that at some point if things become hopeless, he may not be too opposed to bankruptcy.  Throughout the organization, in fact, employee retention is probably an issue as DHOM’s troubles are well known.

 

A potential risk to consider would be a hedge fund refinancing the bank group with a higher coupon “rescue loan”.  Given the froth in the credit markets and the amount of money that hedge funds have at their disposal to put to work, this is a possibility.  But again, there are the problems with the underlying business that remain tough to solve, regardless of capital structure, and tacking on higher interest payments certainly doesn’t help.  While such a loan may buy the equity some extra time to play out their option, it would seem to merely delay the inevitable.

 

A similar risk would be a large PIPE investment from a hedge fund or private equity firm to pay down debt.  Mitigating this is the fact that such a group would need to either gain comfort in the current management team (or bring along its own team), the cost structure, the current land position, the markets in which DHOM operates, and its lack of geographic diversification.

 

I believe the biggest risk to the short thesis would be a sale of the company (or a bulk sale of land assets) outside of bankruptcy.  Given its reported GAAP asset base of $430.7mm and total inventory of $405.7mm, against its enterprise value of $262mm, a buyer could seemingly buy a lot of assets on the cheap and instantly become the second largest builder in Columbus.  Moreover, the banks might also feel adequately secured and that they have little to lose from either putting the company into bankruptcy or forcing a firesale of the company outside of bankruptcy. 

 

Mitigating this risk, all of the large builders at this point are retrenching – walking from land options, slowing land acquisition, laying people off, and attempting to build out their existing positions to start to deleverage.  I’ve heard from private builders that many of the land buyers for the publics are under instructions from corporate not to buy anything in any markets.  In this environment, therefore, it is hard to envision the company being purchased in the near term.  Furthermore, with the company on the course towards bankruptcy as is, it would seem logical as a bidder for the whole company to first let the company file and only then make the acquisition at a lower price (why give the shareholders anything?) and at lower risk (simply buy the assets out of bankruptcy free and clear of liabilities).  The only reason I can think of to buy the company prior to bankruptcy would be out of fear that another bidder would do so first.  When I try to think specifically of potential buyers, I doubt any of them feel a sense of urgency.  Horton only has 3 small markets in the Midwest at the moment out of over 80 nationwide, Beazer has been exiting Midwest markets, M/I has excess land inventory as is, etc.  Additionally, the company has been trying to sell off land since the end of 2004 but has only been able to sell a small portion of its land supply (only 1,268 lots sold in the last 12 months and only $3mm in Q2’06).

 

Another risk would be that even if the company files, the equity could in theory retain value and not get cancelled upon an exit from bankruptcy.  This would be a particular concern if the banks don’t get impaired because there is essentially just bank debt and equity in the capital structure.  I think this is mitigated by the fact that the company continues to generate losses, is dramatically overleveraged, and the underlying business is in trouble and thus liquidation may be more likely than a simple discharge of debt and recapitalization in bankruptcy.  Of course, in a liquidation, the duration mismatch between assets and liabilities is much more important and should lead to significant impairments to book value.  An illiquid asset such as raw land should not fetch anywhere near book value in a firesale; even if it would be worth more over the long term, it may simply be untenable to make it to the long term.  (There could theoretically be a further impairment to book value from the $46.9mm of off balance sheet performance bonds making an “appearance” on balance sheet and adding to the capitalization north of the equity.  But I think this is unlikely – my understanding is that such performance bonds are issued to municipalities to ensure that a builder doesn’t leave a subdivision with improperly functioning gutters, sewers, etc, but that once a subdivision is satisfactorily completely, the performance bonds are released.)

 

There is the risk of significant operational improvement – huge costs cuts and a large increase in orders.  This risk is mitigated by the sheer size of the drop in demand in the overall Columbus market.

 

Finally, there is always the mark-to-market risk of a short term pop in the stock in the event the bank debt is refinanced or extended.  Coming off such a low share price base, such a pop could be significant.  But I continue to think the stock will ultimately be terminal.

 

The main catalyst is a bankruptcy filing as bank covenants are violated upon reporting Q3 and Q4 results.  While banks always have the option to waive and loosen covenants, it seems logical that the banks would be losing patience and getting closer to pulling the plug at this point, as discussed above in greater detail.