Saturday, 09 February 2008 12:47

Lennar, Voodoo & the Year of the Living Dead!

For those that wondered what my stance on Lennar is after raising cash through property sales and tax refunds, here is my update to the Voodoo analysis.


The worst housing slump in recent history has taken its toll on US home builders, with most of them reporting consecutive quarterly losses in the second half of 2007. Lennar, in particular, reported negative earnings for the fifth consecutive quarter in 4Q2007, witnessing a negative EPS of $6.08 compared with a negative $1.23 in 4Q2006. Its large inventory write-down of approximately $2.4 bn in 2007 along with losses on land sale deal with Morgan Stanley Real Estate significantly impacted its operating performance in 2007. As the US housing woes deepen amid deteriorating US and global economic fundamentals and the economy edges definitively closer to the hard landing that we I have been anticipating I believe that declining consumer confidence and buying power will continue to impact housing demand. This should further depress Lennar's new home prices in 2008 and 2009 and significantly impact its operating and net profit margins..

Key Points
Disappointing 4Q2007 results - Lennar's revenues declined 49.0% to $2.2 bn in 4Q2007 versus $4.3 bn in 4Q2006. Revenues from the homebuilding segment declined 50.5% to $1.9 bn in 4Q2007 from $4.0 bn in 4Q2006, primarily off a 50.4% decline in home deliveries and a 2.1% decline in average sale price. Lennar's new home orders declined 50.4% to 4,761 units in 4Q2007 from 9,606 units in 4Q2006. As Lennar reduced its existing inventory through price incentives, its order backlog declined 65.5% y-o-y to 4,009 units at the end of 4Q2007 with an operating backlog of 64 days. In addition, Lennar also reported a $1.8 bn charge relating to valuation adjustment write-off including $0.17 bn for goodwill write-offs. Overall, Lennar witnessed its highest quarterly loss in 4Q2007, with diluted earnings of a negative $6.08 per share compared to a negative of $1.23 in 4Q2006.

  • Lennar inching closer to bankruptcy - The current downturn in the US housing sector, which has resulted in large scale cut backs in new home construction and prices, has significantly impacted Lennar's financial position. Lennar witnessed a loss of $1.9 bn in 2007, which had the impact of eroding its equity nearly 33% to $3.8 bn at the end of 2007 from $5.7 bn at the end of 2006. Lennar's Z-score has declined to 1.69 at the end of 4Q2007 from 2.32 at the end of 3Q2007, indicating that the homebuilder is approaching insolvency. Although the company's current cash and other liquid assets suggest reasonable liquidity position as of the end of December 2007, expected losses in 2008 and 2009 on account of fast declining home prices and subdued demand will significantly impact its financial position.

Large inventory impairment and write-down - In 2007, Lennar recorded a huge $2.4 bn charge on account of inventory impairment under FAS144 in 2007 compared with $501.8 mn in 2006 owing to fast declining home prices in its key markets. With the US residential sector not expected to recover over the next couple of years, we believe Lennar would continue to write down its inventory until 2010. We expect Lennar to record $221 mn and $139 mn of inventory impairment in 2008 and 2009, respectively to accurately reflect the market value of its inventories in view of further decline in U.S residential housing prices.

  • Decline in order book - In 4Q2007, Lennar had 4,761 new order units while it delivered 7,044 units, thus reducing its order backlog to 4,009 units from 6,367 at the end of 3Q2007. Lennar's order backlog declined from 18,565 units at the end of 2005 to 4,009 units at the end of 2007, primarily owing a to decline in new orders coupled with Lennar's attempt to lower its inventory levels through sale of existing inventory through price incentives to maintain liquidity in the ‘cash squeezed' global credit market. As a result, Lennar's order backlog in operating days declined to 64 days at the end of 4Q2007. A reduction in order backlog in conditions of weakening demand would put pressure on the company's revenue growth in the near-to-medium term.
  • Dismantling joint-ventures agreements - As the housing market continues to deteriorate, Lennar is re-evaluating its joint venture arrangements and reducing the number of joint ventures, particularly those with recourse debt. At the end of 4Q2007, the number of joint venture agreement was 210 versus 270 at the end of 4Q2006. Additionally, Lennar had also reduced ownership interest in joint ventures to an average 34% in 4Q2007 from 39% in 4Q2006. As a result, Lennar reduced its total debt in joint ventures to $5.1 bn at the end of 4Q2007 from $5.5 billion at the end of 3Q2007 while also reducing its exposure to recourse debt in joint ventures to $1 bn from $1.8 bn at the end of the 4Q2006. To meet the conditions under the amended credit covenants, Lennar further plans to reduce its JV recourse debt by $300 mn and $200 mn in 2008 and 2009, respectively. However, Lennar's expected (high) debt-to-total capital ratio of 52.9% and 58.8% by the end of 2008 and 2009 (including JV's debt), respectively, could negatively impact its financial position in case the housing woes worsen in the coming months.

Financial engineering by Lennar - By concluding the deal with Morgan Stanley Real Estate towards the end of FY2007 involving the sale of 11,000 lots for $1.3 bn at a 60% discount, Lennar could claim losses of $775 mn from the transaction and obtain a tax refund of $270 mn (part of overall refund of $852 mn) against taxes paid in successful years of operation (2005 and 2006). Further, the possibility that the two year carry-back period under tax rules could get extended to five years would bail out Lennar from potential liquidity problems to some extent since it could claim refund of taxes from 2002 onwards and resultantly, may not opt for selling its land at current lower prices.

  • Lennar's sizeable cash balances as at end of 4Q2007 - At the end of 4Q2007, Lennar had cash of $795.2 million. Of-late Lennar has improved its overall cash position by generating cash through lowering of its inventory levels and sale of land. Besides, Lennar also sold $1.3 billion worth of assets for $525 mn to a joint venture established with Morgan Stanley Real Estate. In February 2008, Lennar's joint venture LandSource admitted MW Housing Partners as its strategic partner and obtained $1.6 bn of non-recourse financing. The above transaction resulted in a cash distribution of $707.6 mn to Lennar. Subsequent to 4Q2007, Lennar had also collected $852 mn by recovering taxes paid in prior years through losses generated in 2007.
  • Lennar's large mortgage operations are now truly feeling the pain of the credit squeeze - During 2007, Lennar originated approximately 30,900 mortgage loans of approximately $7.7 bn. Substantially all the loans the Financial Services segment originates are sold in the secondary mortgage market on a servicing released, non-recourse basis. However, Lennar remains liable for certain limited representations and warranties related to loan sales. We believe that difficult conditions in the credit market will impact the spreads for Lennar. In 4Q2007, Lennar's margins in the financial segment deteriorated drastically from 26.2% in 4Q2006 to a negative 23.2% in 4Q2007. We expect Financial Services revenues to decline 50% and 6.1% in 2008 and 2009, respectively, and margin to be negatively impacted with a negative margin of 36.4% and 28.4% in 2008 and 2009.

Although the end of 4Q2007 saw Lennar with sizeable cash balances, we believe that the company is still considerably leveraged with debt-to-equity of 74.2% at the end of 4Q2007. At the end of 4Q2007, Lennar had net debt of $2.0 bn as a stand alone entity while as a consolidated entity including JV's recourse debt was $2.5 bn. Moreover, we believe that the cash balance will be eroded by operating losses in the coming years, requiring the company to raise further debt amid conditions of deteriorating housing sector.

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