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Lennar Insolvent: Enron redux??? |
| Written by Reggie Middleton | |
| Sunday, 30 December 2007 | |
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Required reading for this blog post is the fully consolidated Lennar analysis on my site. That analysis was performed right before Lennar started selling off bulk assets at a sharp discount, which spawned this follow up analysis. Insolvency: a financial condition experienced by a person or business entity when their assets no longer exceed their liabilities, commonly referred to as 'balance-sheet' insolvency I am now delivering on the long ago promise to make public the granular calculations of my opinion on Lennar's (the nation's largest home builder) recent property sales to raise cash. I looked at the date the models was completed by the analysts, and yes, it has been over a month. Well, here it is. It has not been proofread yet, so forgive any typos. To begin with, I alleged Lennar was near insolvent over a month ago. Events since then have simply validated my opinion, and intensified them as well. I believe that Lennar did the right thing by selling the assets. They simply waited too long. I have heard from at least two, unrelated private equity parties who both said, unbeknownst to each other, that they have been trying to buy land from Lennar but Lennar had been unrealistic with their expectations in terms of the valuation of the property. Now they are selling at 50% discounts. This should have been done last year. The cost to their net worth will now be astronomical, and as you can see they have already stepped into the realm of insolvency. I will have the full 60 page analysis ready for dowload in a day or two, free for registered users and super free for those who have used the invite tool in the user menu to invite thier friends to visit the blog. In the Lennar model, I backed into the valuation write down (impairment) it would take to push Lennar's fully consolidated financial statements (not the stuff they have been reporting, but the real deal with all assets and liabilities taken into consideration) into a debt to capital ratio in excess of 100%, or in other words - insolvency. The magic number is anything above 8%. At 8%, Lennar's assets no longer exceed the value of thier liabilities. This is excluding all non-recourse debt and anything that does not contractually bind the company to explicitly extend capital such as maintenance agreements, performance agreements, etc. This is telling, as you may know, since they recently sold large parcels of land and work in process at a 50% discount to reported book (that is 60% as reported in the press, less rights of first refusal and partial ownership of the new venture). This wasn't their tertiary properties (like this one in Chicago) either. Thus, any write down on much of the existing properties will probably be worse since macro conditions are worsening and a significant amount of the properties left are inferior to what they just sold. We haven't gotten very far into this story and already it doesn't look good. I've decided to make this update as conservative as possible, so I will apply the greatest possible benefit of doubt towards Lennar's favor. For instance, the largest property sale was reported at a 60% discount. I reduced it to 50%. I will assume that that reduced discount is 100% overshot as compared to the rest of Lennar's current inventory and further reduce it by 50% to apply it as a mark to market at 25%. Now, I will redcue that even further for work in process and finished homes and assume a 15% discount on those properties since they are more liquid than raw land (eventhought the original sale included whole finished communities, work in process and raw land and still came out to a 50% off sale). So let's assume we have a weighted average of about 18% discount to current inventory book values. I feel this is extremely conservative, particularly if you read A note on mortgages, overly optimistic recovery rates and recent events... , where in California a 33% price reduction would not move a finished existing REO. Centex, Beazer, Hovnanian, et. al. are having similar issues despite some discounts considerably over 30%. Alas, let's stick with our 18% mark, and consider it the mark that will be fed into the Lennar model.
This 18% combined with the relatively heavy debt load Lennar carries put's roughly 10.2% past the level of insolvency. Now, I truly believe that the 18% mark is definitively on the low side, but it is more than enough to surpass the 8% needed to make Lennar insovent. Included in the calculations is:
Thus, not only is Lennar currently insolvent, but according to Alman's Z score analysis, they are nearly assured to be heading into bankruptcy, sporting a score considerably below what it would take to consider them a bankruptcy candidate, and trending considerably lower the next 8 quarter where it will slightly improve in a lateral trend. It is unlikely that Lennar will be able to survive like this for such an extended period. I need to check to see if my team has discovered any tripped covenenats, but chances are they either are tripped or will be tripped within a year.
From a purely fundamental perspective, it is easy to see how Lennar got to this point. Let's browse through the numbers and compare to the macro backdrop.
As you can see, there earning have deteriorated horribly. Lennar' earnings are a function of their margins, which are highly correlated with housing values. That shouldn't be the case since they can pass lower and higher costs off to thier customers. The problem is that Lennar funds acquisistions with debt, and the processed is lagged. So, when the market is rising, Lennar benefits wth cheap inventory and productive leverage. When the market is falling, they have overpriced inventory that won't move, negative margins and the leverage strangles them. This relationship leaves Lennar (as well as other builders, this is not a Lennar specfic phenomenon) with a extremely sensitive and leveraged connection with landvalues as you can see in the chart below.
The chart below is a dated example of my housing value forecasts. I was more pessimistic than most pundits in terms of the severity of the housing downturn, and it appears that even I undershot the mark. Although I feel that these projections may not be accurate in terms of being slightly optimistic, they still can easily illustrate a trend for the purposes of showing the predicament of Lennar. Using the sensitivty of Lennar's share price comparison above with the value forecasts below, you can guess where the market will push Lennar's share prices. This is not taking into consideration thier insolvency.
These are the comparative Census regions to assist in making the following chart on gross margins more coherent. Now, knowing that thier margins are highly sensitive to housing value fluctuations, where do you think those are going, and what effect do you think that will have on Lennar's solvency? Even if we exclude the impairments (which drive everything deeply into the negative), Lennar's operating margins are heavily negative in almost all operating areas. Revenues look no better.
Which brings us round robin back to the issue of Lennar's solvency.
Now, Lennar and the homebuilders in general have become a trading commodity, and thus their share prices don't necessarily directly reflect the fundamentals on a day to day basis. In the case of Lennar, I have felt that this has offered me an oppurtunity, since I believe this company is truly done for. Even if they raise significant cash by selling off assets, if they sell them off for anywhere near what the most recent market transactions have priced them at, they will still be balance sheet insolvent. I am betting that their creditors don't perform the level of analysis that I do, and as long as they are not reading this blog now, they will not be pulling credit right now. Since these have become trading commodities and traders look at price and not value, I ignore daily price fluctuations except as oppurtunities to increase a bearish standpoint. But those who fancy themselves fundamental investors and trying to go long are most likely doing so by attempting to measure book value and trying to find a bottom. Bottom fishing is gambling and not worth the risk in my opinion. In the case of Lennar, the bottom is either bankruptcy and/or liquidation. Like I said, a dangerous gambit - there are easier ways to make money. The bottom fishing value guys look at Lennar, and probably see this:
They then say, "Hey, anything below $14 is a B-U-Y!" Unfortunatey, they don't see what's below if they are not careful. I am all for value investing and buying on the cheap. It is just that sometimes, you get what you pay for!
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Comments (22)
  written by Reggie Middleton, December 30, 2007
You have to read the full report, my friend. This is an update for the regular readers of the blog. In addition, I don't see Lennar going in and out of balance sheet insolvency. Just in. It looks as if it will take at least 3 to 4 years for them to see postive numbers, and with the negative cash burn, intense rate of asset value impairmet and jittery lenders, I just don't see 'em lasting that long. The z scores tell a similar story. Once insolvent, the prudent lenders start pulling their financing, then things get even uglier. Would you lend to someone on a secured basis where you know the collateral was impaired to the point that you could not fully collect in the case of a liquidation? I haven't reviewed the results of the covenant analysis in a while, but I am sure we can all guess what's in there.
 written by CapitalGain, December 30, 2007
I hear you Reggie, but I need more convincing. I believe there are AT LEAST two or three major builders that will croak before LEN.
HOV RYL SPF
written by Reggie Middleton, December 30, 2007
Hey, I'm certainly not disagreeing with you. HOV, SPF, and BZH just might go first. Ryl is real tight on cash, but they have a much cleaner balance sheet than the others. Not so many skeletons in the closet, if you know what I mean. Trust me, I looked. There is a consolidated report on Ryland available for download. Once it comes to JVs, they are clean as a whistle. Their problem is they have about $85 million in cash, and are burning about that much a quarter - yet refuse to stop playing the dividend/buyback faux stock elevations game that seems so prevalet these days on the street.
The reason I put this much energy into LEN is because they are the biggest, with the most resources. If or when they go, it will be real ugly. These big mortgage banks and homebuilders are at ground zero of the entre real estate melee. If a big one with a lot of bad, overpriced inventory goes bust, I doubt it will be a cute, orderly liquidation. There won't be fire sale, there will be inferno sales, for we already see the stuff won't move with a mere 30-40% haircut. With discounts such as that, if you think MBS derivatives were behaving badly in '07...
written by CapitalGain, December 30, 2007
Yes, how could I have forgotten BZH, one of the absolute worst.
But here's the problem with these monolines and builders who are on the bubble: This last down-leg in price was relatively easy to see coming and profit from in the market. Even a schlump like me got fat. But they eventually reached a point of diminishing returns, beyond which only outright bankruptcy will drive them lower. This will cause a sudden and massive drop such that you will have to ALREADY be there and well rested as they say. And that, my friend, is an issue of pure timing that will be very, very difficult for the average Joe to profit from. You know how much it costs to carry a short position for more than six months or more. Also, when you are talking about profiting from a company going BK, there's another problem. It then becomes a zero-sum game. If you put trades on that worked so well that you bankrupt your counterparty, you will not collect on those trades. So, you not only need to be there and well rested when the shit hits, you also need to get out while you still can.
written by Reggie Middleton, December 31, 2007
Actually, there are ways to be in there profitably, but I do not (and can not) dispense investment advice so we have to leave it there. Remember, this is a digital diary of my opinions and experiences, not an investment advisory. I just want to make that clear so there is no misunderstanding.
PS, you seem like a pretty smart Schlump to me.
written by Bumbie, December 31, 2007
Good work here....believe BZH will BK first, that will significantly change attitudes....credit market still locked down tight IMHO...nothing will change that anytime soon......plenty of $ here on short and may pan out sooner than you'd think. FED is done; further cuts will exacerbate downtrend and duration
written by Paul, December 31, 2007
If you had told me a year ago that no publicly-traded HB would go BK in 2007 I would have been shocked. But the game has to end soon for several. I think it's real hard to analyze these guys from their balance sheets - a year ago LEN looked relatively OK compared to others, and they have been more proactive in their strategy than several others.
The question is: Who can cash out inventory and who can't? But after that, even the largest homebuilders are relatively small entities. Once two or three go down (they will) there will be some interest from the remaining solvent financial companies, overseas, or, say, Buffett. I've seen relatively small capital infusions keep bankrupt biotech companies going for five years and more. Thus, we can't pronounce LEN dead if it's not one of the first to die, and I don't think it will be first, even among the top five names.
written by Bumbie, January 01, 2008 While there may, key word may, be an effort to salvage a high visibility builder like LEN, from a national public relations stand point... wall street and gov't types don't care for high profile failures and the like to spew black clouds over the country for 6 months, periodically one is, in fact, allowed to crash and burn to let the behemoth entity be redistributed into many smaller entities for the "good of the country".......we'll just have to see what happens here, but IMHO it will happen much sooner than later
written by Reggie Middleton, January 01, 2008
@Paul
Len may not be among the top 5 names, but that's not because they are not in a lot of trouble and about to go soon, it's because the top five names are in worse trouble will go sooner. As it stands now, Len is running negative cash flow. In order to raise the cash it needs to continue as a going concern it will need to devalue its assets to the point of total insolvency (where it is now). No lender worth their mettle would feel comfortable lending on a secured basis with such impaired collateral. Technically, the equity shares/stock of Lennar is worthless (as in less than zero), because assets and discounted valued of future cash flows are worth less then existing debt. At $18 per share, those that buy the stock are getting ripped off, as they would be at $6 per share. @ Bumbie I don't know about saving a home builder. I don't see it happening, and even if it does - you have so many to choose from. Who are you going to bail out? HOV, BZH, LEN, CTX, RYL, SPF, TOA, LEV, the list is just too long. And once they would get bailed out, what would have been accomplished? The assets are still overvalued and unwanted in the current environment. The asset prices must correct and intervention would simply prolong the inevitable, if not make it worse.
written by Reggie Middleton, January 01, 2008
It has been brought to my attention that I may overlooked a couple of things in my review of Lennar. I particular, the specific financial drain that their JVs are putting on them.
Quote from the source, hat tip by the way: "One thing I don't think you have mentioned yet but is important is the money Lennar has had to pay due to the fact that the collateral backing some of its JV loans has dropped below a specified percentage of the loan balance. This is called a remarging payment and has been especially painful for Standard Pacific. The amount Lennar has had to pay in remarging payments in Q3 2007 was $21 mil and for the first 9 months of 2007 has been $81.3 million. This is a drain on precious liquidity and will only get worse for Lennar. Lennar's remargining payments can be found on page 11 and page 12 of their latest 10Q. I have just started looking at Centex because the market has not paid much attention to their jv exposure and also because they have the largest mortgage lending operations of the home builders." This guy is right about Centex. I did a light review of Centex and say more than enough for a bearish position, and noticed that they were second up of JV and mortgage exposure, but due to limited resources I had to divert attention to the commercial sector due to the amount of attention it has been getting in the media lately (don't want too much competition). If I finish the commercial sector quickly, I will revisit Centex with the detail that I have paid to Ryland and Lennar. In regards to CRE, we are almost finished with one company, and I believe it will be an eye opener, but since it is not finished yet, to comment would be premature. I have also started taking a hard look at the banks, and as you read in the Bullsh1t post, I don't like what I see there, either. There are more than a few insolvent or close to insolvent banks in the US and Europe. The first and second week of the new year will have some fairly hard hitting analysis from this blog that you probably will not be getting anywhere else.
written by Reggie Middleton, January 02, 2008
The $911 mn of recourse debt on unconsolidated JVs added to Lennar?s balance sheet includes the company?s maximum exposure on the maintenance guarantees which amounts to around $847 mn ($465 mn $382 mn). The $81.3 mn paid by Lennar during the nine months ended Sep 30, 2007 towards remargining payments has been made under these maintenance guarantees of which we have included the maximum amount in our model.
Our underlying assumption in including the entire recourse debt of unconsolidated JVs as part of Lennar?s debt is that in the event of Lennar being called upon to honor all its guarantees (including completion and maintenance guarantees) on unconsolidated JVs debt, the company would raise additional debt of the same amount to make these contributions. We have hence not assumed any immediate impact on the company?s liquidity from these contributions. The impact of the inclusion of recourse debt is thus depicted through an increase in the company?s debt-to-equity ratio to 133.4% in comparison with 102.6% when excluding JVs debt.
written by anonymous, January 03, 2008
Very interesting analysis. I spoke last week with a Lennar accountant in charge of creating the models that determine impairment of assets in the phx area. He mentioned that in some communities, LEN has written down the property to obsenely low levels, but cannot build profitably even at those levels.
written by Reggie Middleton, January 03, 2008
The combination of excessive leverage and an adverse market that moves against you is devastating. Do a search on the site for "land is worth zero" and you will see how this was foretold awhile back.
written by Pelican, January 12, 2008
Great work on this. One of the more remarkable things to me is that many on the Street continue to use reported book value as a basis for their valuation models. For example, after SPF came out with their last quarterly, I read how several analysts used a discount to reported book value of $20 to come up with their price target (e.g. $10). Only a few others such as yourself have pointed out that if marked to market book value is negative. And as you know, SPF is now around two bucks and teetering on bankruptcy. Why do you think many analysts continue to use reported book value when it seems like a farce? Don't they and respected investors like Bill Miller see that? Mind you, I'm not complaining because I've shorted these stocks and done pretty well but at times I feel like I'm missing something even as they decline.
By the way, I wanted to congratulate you on your BZR call. I remember a few months ago you said BZR is worth $6 and it got there recently (or course maybe you think its going to zero now).
written by Reggie Middleton, January 12, 2008
Methinks there is an unwritten code on the street that condones a modicum of game playing. Personally, I can't afford such games, my kids need to eat
 I forgot about BZH call. There are a lot of builders that are going to follow BZH and SPF down the road. Playing games with accounting values are worthless. Yes, you can actually sell accounting values and get loans off of them as well, but sooner or later it is going to catch up with you and if the spread between the accounting value and the market value is too wide... Look out below!
written by gregory orr, January 23, 2008
Thanks so much for the good work, and for a type of analysis that you don't often find around the net. Today ,Ryland stock price made a five-point up move, and then the company released earnings, a loss of $4.80 a share in Q4, and 6.90 for the year. I don't understand how the markets could be so generous to a company on the brink of reporting a $211 million loss, more that double the projected negative eps. Centex tomorrow. I wish I knew how to do the kind of financial analysys that you've done. I'll look to see what you post about Ryland and Centex at the end of the week. Thanks again!
Greg 
written by Tim Sprague, January 29, 2008
Really enjoy the blog. I was interested in your thoughts on LEN's recent results and the strong movement of the HBs over the past week, absent any positive news. My guess is the Street is counting on rate cuts fueling future sales down the road. I work for a national HB and to date we're not seeing anything positive to support this move.
written by Reggie Middleton, January 30, 2008
The market, now, is not trading off of fundamentals. It is packed with funds and prop desks using trading algorithms to capture short term price movements that are feeding off of each other. It is also full of amateur money trying to go short. This is scared money and is prone to cause short covering with just a little upward pressure.
I noticed that even the CEOs of the homebuilders have nothing but doom and gloom to forecast, yet analysts, traders and investors big their stock's up anyway. In the end, fundamentals reign supreme because creditors need to get paid and somebody has to pay the bills or otherwise get a margin call, foreclosed upon, default notice, etc.
written by Reggie Middleton, March 27, 2008
Lennar Corp, the No. 2 U.S. home builder, reported a quarterly loss on Thursday as both deliveries of new homes and new orders tumbled.
For the first quarter ended on Feb. 29, Lennar posted a loss of $88.2 million, or 56 cents per share, compared with year-earlier earnings of $68.6 million, or 43 cents per share. RELATED LINKS * There Are Pockets of Strength in The Housing Slump * Caterpillar CEO: US Likely Into a Recession * Homebuilder Index Holds Near Low in March Deliveries fell 60 percent, and new orders sank 57 percent. Revenue dropped 62 percent to $1.1 billion.
written by Eric Hilf, March 27, 2008
The stock is holding up. But in my memory, the recent pattern is that the builders pop on some 'not as bad as expected' or 'not as bad as it could have been' sentiment immediately after results, and then dribble down later, which leads many impatient shorts to cover. Despite the terrible macroeconomic climate, meaning results will not likely improve much in the foreseeable future, there is no 'easy money' to be made here unless you are 100% convinced LEN is a 'short to zero' case, which could take a while, and who knows intervention the government might cook up in the meantime. I own a few ug puts on LEN, but won't do anything else here -- not a strong enough risk/return.
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Yes, LEN has been a great short, and will probably go lower.
Yes, the housing sector is in for another two years or more of pain.
Yes, LEN is (I trust your numbers) BALANCE SHEET insolvent.
Yet, given all of that, you fail to make a compelling case for LEN as "truly done for". Many, many going concerns, both public and private, go in and out of balance sheet insolvency without being "done for".
Make the case for INCOME STATEMENT insolvency or a credit failure and you'll be on to something.