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Reprinted from 10/7/07 - There is this section of Brooklyn known as "Do or Die, Bed Stuy," named for the rough and tumble character that was needed to survive it was known for back in the days (due to the housing boom, it is now gentrifying). Well, it's time to invoke the call of the ‘Stuy here. This quarter is "Do or Die" time for the home builders, and without a real fight to survive, someone will be announcing bankruptcy by year end. Actually, someone will be annoucing soon anyway, it is just a matter of who has the least fight left in them. What's funny is that their stock just might rally right up to the bankruptcy announcement just in time for those sell side analyst following investors to lose all of their money, right Mr. Kim from Citibank! Maybe Citibank's research department should pay me for this blog's research! Click the image below, if you need to enlarge it.



This is an analysis of the probability of Lennar Corp going bankrupt. It uses the multivariate formulae derived from the work of Edward I. Altman, a financial economist and professor at the Leonard N. Stern School of Business at New York University. His work has an impressive pedigree for accuracy as a measurement of the financial health of a company and is a powerful diagnostic tool that forecasts the probability of a company entering bankruptcy within a 2 year period. Studies measuring the effectiveness of his work have shown that the model has 70%-80% reliability. Notice I said "within" a 2 year period, and not necessarily 2 years. There is a substantial difference in the subtle semantics. Lennar could conceivably go bankrupt in the next few quarters! They are currently running at negative cash flow, in an increasingly negative operating environment. What does that mean? It means the banks will run on all of the other marginal builders, massive amounts of debt will get devalued (further), and land values will plummet even harder due to inventories being written down in order to compete with whoever bought the bankrupt builder's already distressed assets for mere fractions of a penny on the dollar. This will make the not so marginal builders more marginal because there debt will be under more scrutiny and their inventory will be worth even less. This will then bounce back to the banks holding the REOs (trust me, there are a lot) and the existing homeowners trying to sell.

Lennar is the largest of the US homebuilders by revenue, and is by far not the one in the worst condition. I am attempting to make a point here by illustrating that the largest homebuilder who is far from being at the bottom of the bankruptcy pile is still dangerously close to being able to wear the B word. It is all about liquidity and cash. The builders, in general, just don't have any. Many think that some of the builders who have sold off assets have a better go at it, and they do - but many of them are burning cash through operating losses fast enough to eat up all of the cash they raised before the market turns - for it is not going to turn any time soon.

Back to the original point, Altman's equation did a good job at distinguishing bankrupt and non-bankrupt firms.

Zones of Discrimination:

Score - Probability of Business Failure

1.8 or less - Very high (72% or higher)

1.81 to 2.99 - Grey Area, Unable to Determine with 90% confidence, but scores below 2.7 are considered "At Risk". A random sample of companies revealed 94% had scores less than 2.7 before they went bankrupt. In contrast, 97% of the non-bankrupt firms had Z scores above this level. Lennar's score is currently 1.84 and is deteriorating more than .25 points per quarter with REOs in its main profit (and loss) areas increasing at roughly 5%-10% PER WEEK! They just reported the worst quarterly loss in their 52 week history. Despite this, analysts are trying to call a bottom and the stocks have rallied roughly 20% in one week (click this link to see the "common sense" post).

3.0 or more - Very low

To make matters worse, the conditions that have brought about this rapid deterioration in the buider's operating environment are now significantly exacerbated. See: "Bubbles, Banks and Builders", then "Bubbles, Banks, and Builders, Pt. Deux", and for a background on how all of this came about see "For those who feel the world has decoupled from the US economically - and in the financial markets, I bring you "The Great Global Macro Experiment" and then "Thoughts on the US Publicly Traded Homebuilders" and "Correction, and further thoughts on the topic". Wheww! That's a lot of homework, isn't it? Now you know how your kids feelJ

These numbers on Lennar or open to revision, since I need to review them. I will maintain a Builder Bust List to show exactly how bad these companies currently have it, who will be most likely to go and when, and more so to show how foolish it is to attempt to bid them up or even try and by them now. In the case of a bankruptcy, the equity holders usually get zero, zilch, nada! Now if you bought this stock and got caught in a bankruptcy filing, you honestly can't say that you didn't see the writing on the wall. If anything, it was graffiti everywhere.

Lennar Reports Third Quarter Results Highlights


Revenues of $2.3 billion - down 44%



Loss per share of $3.25 (includes a $3.33 per share charge related to valuation adjustments and write-offs of option deposits and pre-acquisition costs, goodwill and financial services notes receivable)


Homebuilding operating loss of $787.7 million (includes $847.5 million of homebuilding valuation adjustments and write-offs noted above). These adjustments will be far from the last. See the links above for the REO growth rate in Lennar's key markets. These massive writedowns should have started earlier, but probably didn't in order for upper management to preserve '06 year end bonuses based on asset growth (not profitability, which would have aligned management's interest with the shareholders and bondholders - a misguided compensation system in the homebuilding industry).


Financial Services operating loss of $5.2 million (includes $9.3 million of write-offs of notes receivable). This write down tells more than appears on the surface. As detailed in "Thoughts on the US Publicly Traded Homebuilders", most of the public builders are going to get stuck with the same liquidity problems that plagued Countrywide, American Home Lending, and all of the other non-bank mortgage lenders. There funding liquidity dried up at the same time that the market for their product dried up. That not only means that they can no longer sell product, but that they are stuck with mortgage inventory on their books with short term funding. Because this stuff was poorly underwritten, much of it went bad or is going bad. Reference the rampant REOs in the Bubbles, Banks and Builders" (now you can begin to see how all of this stuff is connected), The prospect of being stuck with bad mortgages on a dying credit line produces much more than a $9.3 million problem for Lennar, who wrote more mortgages than all of the builders and most mortgage banks. Expect this problem to crop up again in the future with larger numbers and bigger problems. Look at what its doing to Countrywide!



Homebuilding debt decreased $212.8 million; homebuilding debt to total capital of 33.5%. Better, but still not good.



Deliveries of 7,636 homes - down 41%



New orders of 5,804 homes - down 48%; cancellation rate of 32%. This is less than the existing (and overstated) backlog, which is very bad.

  • Lennar was forced to renegotiate its credit line to avoid default



Digging deeper into the Lennar's numbers to find the TRUTH

Backlog dollar value of $2.2 billion - down 60%. In the links above, I explain how the stated back orders cannot and will not be fully realized and are thus overstated. In addition, this number is dreadful for THIS builder. It claims a backlog 6,367 homes (overstated since it does not take into account the tightened mortgage market), yet only had quarterly closings of 7,636. The only way left (mortgage financing is now a risky loss engine) for the homebuilders to generate cash is to sell off their inventory, which (unlike Hovnanian's representations) means actual closings. Lennar is running out of people to sell to, hence is running out of ways to generate cash despite the fact that they have so many billions of dollars of inventory to sell. After doing the math, we realize that actually have a negative yield on their overstated backlog of 1,269 homes. What does this mean? It means that they are going to closing faster than they are lining up people to close. The average time to go from contract signing to closing takes 45 to 90 days. Let's use an average of 75 days (appraisal, title, approval, insurance, etc.). At their current closing rate and due to a lack of demand for their product, they will run out of customers to close properties with approximately 83% through next quarter, or approximately 75 days from the publication of their quarterly results (9/25/07). Let me state this again, Lennar will run out of closings. Closings are the only way they have to generate cash! To put this into perspective, by the time someone who signs a contract with Lennar last week to buy a house gets to closing, Lennar's bankers and loan holders should be aggressively asking for their money back (if they have any sense).

To put this in further perspective, assume Lennar makes it through next quarter without the banks calling in their debt. Lennar's new orders are only 5,804 strong, and they are expecting a 32% cancellation rate off of that. So 68% of 5,804 is (let me pull out my calculator...) 3,947 orders into backlog. Lennar closes 7,636 per quarter. Soooo, even if they do somehow miraculously power through this upcoming quarter with no cash, generated at pure negative cash draw, they will have no customers to sell to before half of the next quarter is over. That is what their own numbers reveal! That is why the bankruptcy score diagrammed above states DISTRESSED! That is why Citibank's homebuilder analyst is out of his damn mind. Does Citibank do any work for the homebuilders? Hmmm! I wonder??? I doubt that I am just that smart and they are just that dumb.

This is the situation of the nation's largest homebuilder, and there are many who are in worst shape. Since Lennar is the biggest (and probably one of the most proactive in managing inventory), you should be expecting worse from many others.



Next up, I will analyze as many of the public builders that I have positions in that I can, and create a builder bankruptcy list.