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Executives

Scott Shipley – Director, IR

Stuart Miller – President and CEO

Jeff Krasnoff – CEO, Rialto

Bruce Gross – VP and CFO

Rick Beckwitt – EVP

Analysts

Allan [ph] – Zelman & Associates

Joshua Pollard – Goldman Sachs

Michael Rehaut – J.P. Morgan

Jay Chadbourn [ph] – Merrill Lynch

Adam Rudiger – Wells Fargo Securities

David Goldberg – UBS

Dan Oppenheim – Credit Suisse

Stephen East – Ticonderoga Securities

Jade Rahmani – KBW

Megan McGrath – Barclays

Lennar Corporation (LEN) F2Q10 (Qtr End 05/31/10) Earnings Call Transcript June 24, 2010 11:00 AM ET

Operator

Welcome to Lennar's second quarter earnings conference call. At this time, all participants are in a listen-only mode. After the presentation, we will conduct the question-and-answer session. Today's conference is being recorded. If you have any objections, you may disconnect at this time. I will now turn the call over to Scott Shipley, Director of Investor Relations, for the reading of the forward-looking statement.

Scott Shipley

Good morning. Today's conference call may include forward-looking statements that are subject to risks and uncertainties relating to Lennar's future business and financial performance. These forward-looking statements may include statements regarding Lennar's business, financial condition, results of operations, cash flows, strategies, and prospects. Forward-looking statements represent only Lennar's estimates on the date of this conference call and are not intended to give any assurance as to the actual future results.

Because forward-looking statements relate to matters that have not yet occurred, these statements are inherently subject to risks and uncertainties. Many factors could cause Lennar's actual activities or results to differ materially from the activities and results anticipated in forward-looking statements. These factors include those described under the caption Risk Factors contained in Lennar's annual report on Form 10 – K most recently filed with the SEC. Please note that Lennar assumes no obligation to update any forward-looking statements.

Operator

I would now like to introduce your host, Mr. Stuart Miller, President and CEO. Sir, you may begin.

Stuart Miller

Great. Good morning. Thank you for joining us for our second quarter 2010 update. I'm joined this morning, as always, by Bruce Gross, our Chief Financial Officer; Diane Bessette, our Vice President and Treasurer; David Collins, our Controller. Additionally, we have Rick Beckwitt here, our Executive Vice President, who will be available to answer question; and, Jeff Krasnoff, the Chief Executive Officer of our Rialto segment.

Now I'm going to begin with some opening remarks about the current housing market in general and the progress that we've made on managing our balance sheet and our joint ventures. And since we've just finished our quarterly operations review, I'm also going to share with you our views on our homebuilding operations as well. Then Jeff is going to comment on our Rialto segment positioning for 2010 and beyond. And finally, Bruce will provide additional detail on our numbers. And then, of course, we'll open the phones to your questions. And as always, I'd like to request that in our Q&A period, everyone please limit to just one question and one follow-up so that we can be as fair as possible to all of the participants.

So let me begin and make just a few overview comments about the market and about our second quarter. To begin, let me say that we're very pleased that our second quarter results represent a fundamental return to profitability for Lennar, with earnings per share of $0.21 versus a loss of $0.76 last year.

We posted solid operating performance from our homebuilding segment, our financial services arm, and we saw our first profits from our newly formed Rialto segment. And at the same time, we saw valuation adjustments or impairments substantially reduced from just under $100 million at second quarter last year to $6.1 million this year. Accordingly, we remain confident that we will be profitable in 2010. But while we feel comfortable that we positioned the company for current market conditions, we realized that the greater focus of the investor community is on questions concerning the road ahead.

In my remarks in last quarter's conference call, I noted that the recovery in housing is not presenting itself as a V-shaped return to better time. But instead, it's proving to be a rocky, stabilizing bottom, with visibility obscured by more questions than clear answers. At that time, while the housing market seemed more stabilized than today, we knew and expected that the end of the $8,000 tax credit in April, that it kick-started the housing market back to life would draw demand forward and leave a void that would have to be filled by free market forces driven by low affordable home prices and historically low interest rates. We knew at that time that this void would not feel good, and it doesn't.

Today's reality is that the new home market and housing in general still face serious headwinds from current economic and legislative conditions. Nevertheless, we are still confident that the housing market and the overall economy are continuing to stabilize and are generally in recovery.

With that said, the current reality is that the overhang of foreclosures and the prospect of additional delinquencies ahead continue to moderate this recovery as shadow inventory continues to be absorbed and even replenished. Unemployment and a generally sluggish economic bounce back combined to hold demand the traditionally low levels, while the reality of the pull-back driven by the elimination of legislative and fiscal incentives limit visibility and create pending uncertainties about the immediate future of the strength of the market. And finally, debates over whether inflation or deflation lies ahead and the impact of sovereign credit risks continue to add uncertainty to the view ahead.

Over the past couple of days, we at Lennar have carefully reviewed our operations with our regional and our division presidents. After careful review, we continued to be inclined to believe that the current pull-back in demand is temporary and the void left by the expiration of the tax credit will be filled in the upcoming months by purchasers looking to take advantage of historically low interest rates supporting the purchase of extremely well-priced homes.

As we reviewed our operations from the field, geography by geography, we heard some common themes that continue to appear to validate the overall trend towards stabilization of the housing market. First, prices are not free-falling in the face of a moderation and demand. And in fact in many markets, prices are continuing to stabilize and even modestly recover. This is primarily because inventories of new homes are low and have remained in check. In most of our division, there continues to be a meaningful reduction in the incentive use – incentives used in the sales process. And that fact is reflecting itself in higher gross margin.

For the company overall, incentives were 11.5% this quarter, down from 12.5% last quarter and 17.3% last year. And margins improved on a pre-impairment basis to 21.4%, from 20.3% last quarter and 14% last year.

While in the short term, incentives might creep up, the general consensus among our divisions was that the use will be limited. While this trend is vulnerable to the gyrations of the stabilization process, it seems that the momentum provided by consumer confidence are generally improving and stabilizing economy, low interest rates that are likely to remain low, and home affordability will likely equalize their impact over a short period of time. The free market seems well-positioned to take over from stimulus in a fairly orderly fashion.

Next, inventories of new homes, as I said, remain significantly reduced. While there's been a great deal of talk about spec building of new homes to beat the end of the tax credit, we found, from the field, that this was limited to a very few markets. In most markets, new homes were, and are, still being built to order. And for the segment of the market that wants a new home, there are really limited immediate opportunities to choose from. And that's helping prices and incentives to stabilize.

Next, we heard that while foreclosures continue to be a significant driver of absorption and pricing, the effect continues to decline as the bulk of foreclosure activity is situated in areas that should not compete with new home construction, such as the inner city and the extreme outskirts of the markets in which we operate. As I've noted many times before, housing is a very localize business, and inventories in micro markets, not broad markets, are most important in considering demand trends.

In our reviews with our divisions, we are finding – we found that there are very few foreclosures in the communities in which we – in which we are building or in direct competition – or are in direct competition with our product. The better situated foreclosure homes had been, and are continuing to be, absorbed in an orderly fashion and the market is clearing the inventory overhang in many locations. The $8,000 tax credit facilitated that clearing process. And we think that low prices and low interest rates will facilitate a continuation of that process.

Finally, we also heard from our division heads that the employment rate in many of our markets continues to be at least stabilizing, and in some instances, beginning to recover. Accordingly, a general sense of confidence is continuing to return to the consumer. And there's a tangible sense that with prices and interest rates low, now is the right time to purchase as home for future security. This is perhaps the most important element driving the future of the housing market as the threat of losing one's job has deterred many from the housing market for some time now.

Even with the current pull-back in demand, we feel that our strategy of focusing on high margins and controlled volume, controlled cost, and controlled G&A will continue to benefit us and enable us to remain profitable as the grounds continues to find stabilization beneath us. We've continued to make carefully underwritten strategic acquisitions in well-positioned markets that support our homebuilding business going forward. And we've been able to find acquisitions of home sites to build new communities where homes can be delivered at a responsible profit level at today's price level and given zero market appreciation. Our homebuilding machine is operating very well in these difficult market conditions.

Additionally, as noted in our press release, our balance sheet remains fortified with a homebuilding debt-to-total capital ratio net of homebuilding cash of 42.2% and homebuilding cash of approximately $1.1 billion. We also fortified our balance sheet this quarter with a strategic combination of convertible notes, eight-year bonds, and debt repurchase that Bruce will review in just a few minutes.

We've also continued the process of reducing the number of our joint ventures, which has fallen to 53 currently and down from 58 last quarter. Many of these remaining joint ventures are good ventures that have already been reworked and have solid assets that are positioned for the future. And we expect to continue to reduce these numbers as we go forward through 2010.

Additionally, we've continued to reduce the maximum recourse debt to the company, which is now at a level of $234 million, and is down from $275 million just last quarter.

Finally, on the opportunity side, our first strategic investments in the Rialto segment of our business are beginning to show the value of this business opportunity. As I noted in prior quarters, we've been preparing to be a significant participant in the distressed opportunities that naturally present themselves in down cycles. We've been incubating an operating team of experienced professionals for the past three years. The team is formed. And it's operating. And our first investments are really proving up.

While I'll let Jeff Krasnoff update you on this program, I will note that we've made a meaningful investment – that we've made meaningful investments. And we believe we will add significant shareholder value as we go forward. This is a tough business that we do exceptionally well.

Earlier this week, we had our weekly asset manager's meeting. And as I review – and as I've reviewed each week our assets with our asset managers from around the country, I continue to become increasingly enthusiastic to see just how comfortably we operate and manage this very unique segment. We're clearly beginning to see more opportunities present themselves in this area. And with our unique expertise, we expect to be an active participant in this part of the market recovery as we feel these investments can add outsized returns to our recovering homebuilding operation.

At the end of the day, we're very pleased with the progress that we've made to date and are very excited – and are very excited about the position that our company is in even in these difficult market conditions and uncertain times. Our balance sheet is strong and well-positioned with liquidity to support investment for the future. Our core homebuilding operations are lean, right-sized, and well-positioned for success as they are beginning to grow again, adding communities and leveraging our overhead. And our Rialto investment segment is now fully operational and investing capital to create strong returns as we build profitability.

While we recognize that the current economic environment is fragile, we feel today that we are extremely well-positioned to navigate the rocky bottom and ultimate recovery that continues to lie ahead. And we continue to feel comfortable that we'll be profitable in and in each quarter in 2010.

Now, let me turn over to Jeff Krasnoff to give you some additional color on our Rialto segment, and then over to Bruce for additional color on our numbers.

Jeff Krasnoff

Thanks, Stuart. Good morning, everyone. While we started building the Rialto team here inside Lennar almost three years ago, it was just last quarter, coinciding with the closing of our first two distressed asset portfolios in partnership with the FDIC, that Lennar announced the new Rialto investment segment. And now, as Stuart has already indicated, the Rialto segment is profitable.

As Bruce will walk through in a minute, the main contributors to this is our 40% share of the FDIC transactions, our public-private investment fund activities with Alliance Bernstein and the US Department of Treasury or PPIP, and the management fees from both these programs.

Some of you may be familiar with the disciplined process that we've employed over the years for looking at large portfolios of assets based on a careful review of underlying collateral value, loan documents, and borrower and guarantor capabilities on an asset-by-asset basis. Our detailed due diligence reviews, combined with our resolution process and real estate operating capabilities, allow us to look at these portfolios on a wholesale basis, and through our operations bring value to individual assets on a retail basis. And because of a high content of loans made to developers, having Lennar's unique view, we believe, gives us a distinctive advantage in our evaluation of these assets.

For our first two FDIC portfolios, for instance, we worked for over four months on the underlying due diligence. During the quarter, we finished the process of bringing all 5,500 of the loans in these FDIC transactions on board from the 22 different receiverships. We also made great progress in reaching out to borrowers, while at the same time building out the core of our operations team to create value from these assets.

We now have 70 associates focused on our portfolio operations, including loan work out, property asset management, servicing, finance, and back – office operations in three offices located in Miami, Atlanta, and New York. And our team contains a lot of familiar faces, a number of whom were here a couple of decades ago when we did something very similar.

By leaning on Lennar, we clearly had a head start in being able to set up our infrastructure very quickly. We've also been able to employ the servicing and small balance loan collection resources of Clayton Holdings, a company in which we made a small investment in 2008. We're already deep into the portfolios. We have our operations teams focused on the top 550 borrower relationships, which makes up over 85% of the total $3 billion of unpaid principal balance in these two transactions.

We've already had direct conversations with about 90% of these borrowers and related guarantors by balance and have had meetings with over half of them to resolve their loans. A number of relationships have already been resolved, and many are in progress. With our early activities, we've collected over $60 million of interests and principal, about 20% of which were full pay-offs at par, plus accrued interests. The cash flow has been used to pay the operating costs of the portfolio, including fees to Rialto for managing the process. And as of the end of the first goal [ph] quarter, we had already reduced the FDIC financing by $34 million to $593 million.

Our PPIP program continues on course as well. During the quarter, our team wrapped up our private equity rates topping out at $1.16 billion. With the matching equity from US Treasury and advantageous LIBOR plus 1% 10-year financing, our fund has $4.6 billion of purchasing power. We have committed $75 million of equity to the program, which is now 85% drawn. With our disciplined approach to focusing on resilient cash flows, we have now acquired approximately $3.3 billion of residential and commercial mortgage-backed securities. We are also very pleased with the underlying performance of our portfolio, and believe we are on track to achieve the types of returns we anticipated when we purchased them.

With the stepped up efforts of the FDIC, and more recently, some of the banks themselves, the pipeline of opportunity, as Stuart mentioned, continues to expand. Our due diligence team is currently evaluating several billion dollars of opportunities today, assisted by our core operations group, that is deeply involved in many of the markets working on the assets, and of course, the one on our own homebuilding team.

As we go through this process of reviewing distressed assets, we also look forward to finding new opportunities for the homebuilding side of the business. And along those lines, we've already helped to tie-up of over 700 home sites in nine different communities for the Lennar homebuilding division. The Rialto team is very excited about our position today. And we look forward to reporting to you on our progress in the future quarters.

Now, I'm going to turn it over to Bruce.

Bruce Gross

Thank you, Jeff, and good morning. Our road back profitability this quarter included positive operating earnings contributions from all three of our business units. Our homebuilding business unit had operating earnings of $29.5 million during the quarter. And that's compared to a loss of $116.5 million in the prior year.

Revenues from home sales decreased to 12% to $695 million due to an 8% decrease in home deliveries, excluding JVs, and a 5% decrease in average sales price to $240,000. The overall average sales price decrease was partially due to fewer deliveries from the West segment, which had a higher average sales price than the company's average.

The average sales price changed regionally year-over-year as follows. The east region was up 1% to $222,000. The central region was up 1% to $198,000. The west region was down 9% to $318,000. Houston was up 8% to $217,000. And other was down 7% to $253,000. Our gross margin increased 1,100 basis points, inclusive of impairments, to 20.6%, compared to the prior year. This improvement is primarily due to a significant reduction in sales incentives and the decline in valuation adjustments that Stuart mentioned.

Sales incentives declined from $53,000 per home in the prior year's quarter to $31,000 per home in this quarter. That was a reduction from 17.3% of home sales to 11.3% of home sales revenue. The sequential improvement was also 100 basis points from the first to the second quarter, looking at sales incentives as a percentage of revenue. And the lower sales incentives for home delivered is a result of not only the improved selling environment that we had in the first part of the year, but our repositioned product strategy as well as fewer completed unsold homes.

Additionally, the impairments were down from $99.1 million to $6.1 million in the current year's quarter. We're continuing to realize the benefits from our aggressive cost – cutting measures and lower non-recurring expenses in areas of legal and occupancy costs, which helped as to reduce SG&A costs by approximately $15.7 million or 14% year-over-year.

SG&A, as a percentage of revenue from home sales, was 13.9%, which improved 40 basis points from the prior year and 190 basis points sequentially from our first quarter. The fundamental success with our improved gross margins and reduced SG&A led to an operating margin of 6.7%. And that's the highest start operating margin that we have seen in four years.

Turning to our financial services business unit, they generated operating earnings of $13.7 million versus $16.5 million of profit in the prior year. This was a result of lower volumes in both our mortgage and title operations, mortgage pretax earnings was a profit of $9.3 million versus $14 million in the prior year, and our title company had a loss of 400,000 versus a $3.2 million profit in the prior year. Additionally, our financial services segment recorded just over $5 million of profit relating to the collection of the deferred payment from the previous sale of the cable system.

Following up on the Jeff's description of Rialto, our third business unit, we generated operating earnings totaling $5.1 million during the quarter. When you look at our income statement, the $5.1 million is the netting of $14.7 million of Rialto operating earnings, less the $9.6 million included in the line that's called net earnings attributable to non-controlling interests.

As we reported last quarter, we consolidated the FDIC portfolios. And therefore, our second quarter numbers reflect all the activity from the FDIC portfolios with an offset attributable to non-controlling interests. The summary of Rialto's $5.1 million of operating earnings is $9 million of earnings from our 40% share of the FDIC portfolios, plus management fees relating to the FDIC portfolios, plus $1.6 million of earnings from PPIP, less approximately $5.4 million of G&A expenses.

This is the first quarter of revenue contribution from the FDIC portfolios acquired in February. Management fees and accretable interest income, net of expenses from these portfolios, totaled $9 million. Revenue recognition from these portfolios is recorded based on the expected cash flow from the portfolios to calculate accretable interest income. These cash flows include both expected loan pay-offs and interest income.

As Jeff mentioned, the cash flow generated during the quarter was used to defuse [ph] the debt. And we did reduce the FDIC debt from $627 million to $593 million during the quarter. PPIP management fees and interest income was $1.6 million. And the PPIP fund has already started distributing cash flow from these earnings back to the partners.

Included in the summarized numbers are approximately $2 million of startup expenses relating to the two FDIC portfolios. These are non-recurring costs and are included in both the FDIC and G&A numbers I mentioned above.

Turning to corporate items, other expense includes $10.8 million of expenses associated with our $289 million debt tender during the quarter. And that was partially offset with the gain on retirement of bank debt at a discount of $4.3 million. Corporate G&A expenses were reduced by $7.5 million or 25% over the quarter versus the prior year. And the reductions were a result of successful cost reduction initiatives in the personnel, occupancy, IT, and legal categories.

Taxes, if you look at our tax line, you'll see that that there was $11 million benefit during the quarter relating to the resolution of uncertain tax positions previously recorded.

And as we turn to the balance sheet, our homebuilding cash inclusive of restrictive cash totaled to $1.2 billion during the quarter. We issued $250 million of 6.95% senior notes due 2018 during the quarter and $276.5 million of 2% convertible debt, up 38% with a conversion price of $27.64 [ph] during the quarter, and that's due 2020, while repurchasing through tender $289 million of aggregate principal amount of senior notes that were due between 2010 and March of 2013. These transactions enhanced our balance sheet strength by pushing out near term debt maturities and adding liquidity to the balance sheet.

In addition to the tender, we repurchased $38 million of senior notes due 2010 and 2011. Our leverage remained low. As Stuart mentioned, homebuilding debt-to-total cap was 42.2% in the second quarter net of our cash. And we made tremendous progress on the joint ventures. Of those 53 joint ventures Stuart discussed, 23 have no debt, 14 have non-recourse debt, and only 16 have any recourse debt at all. We made tremendous progress on reducing our joint venture recourse indebtedness with the joint ventures reducing it by $545 million sequentially from last quarter to $234, million and net of reimbursement agreements that was down to $146 million.

We continued to carefully manage our inventory. And we ended the quarter with very few completed unsold homes averaging between one and two per community. We closed on approximately 3,000 home sites during the quarter, totaling $109 million of purchase price in well-located, ready-to-go communities.

Additionally, we put approximately 1,400 home sites under option contract during the quarter. And our overall inventory dollars remain flat with the prior year at $3.7 billion, excluding consolidated inventory not owned. There were approximately 3,300 starts during the quarter, which was up 20% over prior year. And there were 2,000 – I'm sorry, 82,000 home sites owned and 22,000 controlled at quarter-end, totaling 104,000.

The company's strategies have positioned well to continue to generate profitability in all three of our business units. And our balance sheet is financially strong to capitalize on additional new investment opportunities.

With that, let me turn it over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Ivy Zelman of Zelman & Associates.

Allan – Zelman & Associates

Good morning, guys. It's actually Allan [ph] on for Ivy. I appreciate your commentary on May there. I was wondering if you could chat a little bit about the upcoming deadline for the closings of the tax credit. When you think about your backlog of about 2,500 homes, what would you estimate is potentially at risk of not closing in time for the June 30th deadline that maybe previously would have thought – would have closed? I know the NAR was – at this week, was an estimate that 180,000 or so home buyers who thought that they were getting credit that may not close in time. So I was curious if that's a problem that you foresee.

Rick Beckwitt

Yes, this is Rick Beckwitt. We've carefully mapped out construction schedules associated with anything that was sold with the tax credit in mind. And across the board, we have maybe one or two, or a handful of things that are at risk. And I believe that all those will close within the deadline.

AllanZelman & Associates

Okay. Great, got it. That's very helpful. And then, just on your commentary, a little bit, Stuart, about incentives maybe creeping up a little bit in the near term, how would you expect that to flow through to the margin over the next couple of quarters? Do you think that that's going to have a downside impact on margin or is there enough impact from maybe some new projects coming on line to offset that? In other words, do you think margin continuous to move higher from here despite the higher incentives in the near term?

Stuart Miller

We have a lot of discussion about this with our division people. And we really drove down on their view given what has been a moderating traffic pattern and demand in May, and even flowing into June. And the perspective is that there might be some movement on incentives just to keep the market moving forward, but that it would be fair – it would be pretty limited.

I think you properly highlighted that we do have new communities that has started to come on line and contribute a little bit more to our margins. And we would expect – I don't want to give a projection, but we would expect pretty good stabilized and even an improving margin picture as we go forward.

Rick Beckwitt

The thing that I'd add to that is we are getting a ton of script with construction costs going in on our direction. We've seen an improvement in lower cost of lumber and some other of the materials that we're incorporating into the homes. So I think some of that potential price declines on the incentive side will be offset by some of the cost to build.

AllanZelman & Associates

Great. I appreciate that color. Thanks, guys.

Operator

Our next question comes from Joshua Pollard of Goldman Sachs.

Joshua PollardGoldman Sachs

Hey, good morning, and thanks for all the detail. You talked a little bit about June, but I was wondering if there was – somehow you could characterize what you're seeing throughout June. Is it improving as the month is going along? Are you guys not seeing a ton of – how would you characterize your de – stabilization for June?

Rick Beckwitt

Yes, it's Rick. We typically don't like to give any color on the quarter that we're about to enter into. But we know that there's a lot of focus on June and what's going on. I can tell you, on a seasonal basis, it's the slower quarter on just the annual year. We have seen a modest improvement over May. And right now, we're running, let says, 20%, 25% off of the prior year.

It's choppy. We don't have a lot of data right now. We're back from the fact that we've a good stable backlog going into the quarter. As Stuart said in his remarks, we think that buyers will re-emerge. And it's just been a temporary slowdown in the market.

Stuart Miller

I think you (inaudible) that there was a sizeable pull forward of demand in April in order to accommodate the 8,000 tax credit and its termination. But as we've gone through May and as we're coming in to June, we're feeling that demand is starting to make a modest recovery. The sense from the field – there's no certainty in this. But the sense from the field is that as we go forward, it's really going to be low interest rates and the affordable pricing of homes are going to – that will enable the free markets to takeover and stabilize.

Joshua PollardGoldman Sachs

That's extremely helpful. My other question is on Rialto. We've had conversations at a lot of FDIC loan purchasers. And one comment was about a barbell approach to the revenue recognition. Upfront, there were folks you hadn't talked to in a while, who hadn't heard from their loan servicers for months or even years.

When you guys come in and send the hello-goodbye letters that actually accelerate some of the revenue upfront, and then you see another acceleration of revenues towards the end. Is that what you're expecting? Or should we think about revenue trajectory that you guys have printed in this first quarter to be somewhat of a run rate going forward?

Jeff Krasnoff

Yes, I would – my first comment, this is Jeff, is that is – what you described is fairly consistent with what we've seen, I guess, really over the last 20 years or so in doing this – in doing this work at business that upfront, there are some guys that do come in with cash. And we're just waiting for someone to call them. But over time – and then there are some assets that eventually might come back in foreclosure and might get resolved a little bit later in the process. So there is somewhat barbell – effect.

From the accounting perspective, the way that the literature works, it's really recorded over a period of time based on – what you called, Bruce, the level of yield assets?

Bruce Gross

Accretable is what I said.

Jeff Krasnoff

Accretable yield in assets. So that's really built-in. We have an underlying business plan. We go for asset-by-asset. We have a business for each and every asset, which is then verified by whatever modification we go through with each of the individual borrowers. So it's not unexpected.

Joshua PollardGoldman Sachs

So is it – is a way to think about it, even if you get additional cash flows above what you were expecting that it would actually turn into – there would be no effect on revenue, you guys, or almost straight lining it?

Bruce Gross

Well, what we would do there, Josh, is we would adjust our expected cash flow. So to the extent of receiving more than expected, you would adjust those expected cash flows and you would increase the revenue recognition in the current quarter.

Joshua PollardGoldman Sachs

Okay, great. Thank you very much. That's helpful.

Stuart Miller

And on a go-forward basis.

Bruce Gross

And on a go-forward basis.

Joshua PollardGoldman Sachs

Okay, understood. Thank you very much.

Operator

Our next question is from Michael Rehaut of J.P. Morgan.

Michael RehautJ.P. Morgan

Hi, thanks. Good morning, everyone.

Stuart Miller

Good morning.

Michael RehautJ.P. Morgan

First question, I was wondering if you could review, and we appreciate all the colors in terms of May and June, any distinction across the different markets you operate in. We were recently in California and saw or believe that that market is held up on a relative basis somewhat better than the nation in terms of pace and price. Any markets that is stronger or weaker relative to this post-tax world?

Stuart Miller

Let me give you a general answer. Maybe Rick will think about it for a second and drill down a little bit more. But the answer to your question, Michael, is that all of the markets are reacting a little bit differently. It's a real micro-market-driven business right now. Where the foreclosures are makes a different. Where the builders might have built some inventory makes it different. And there are submarkets that have held up very, very well. There are submarkets that are faltering. I think there are parts of California that are doing pretty well. But contrary to what some people think, there are parts of Florida that are doing pretty well as well. Probably one of the leaner markets right now would be some of Texas markets and primarily Dallas.

So, Rick, maybe you'd want to add to that?

Rick Beckwitt

Yes. Surprisingly, Florida's some of our stronger markets right now. I think we're benefiting from the fact that we put under contract a fair number of communities that were attractively purchased or contracted. So we're getting some good traction there. As Stuart said, Texas is somewhat soft. It went into the downturn on the tail end. Dallas is a pretty tough market. Houston is a little better. And you're seeing probably one of the strongest markets in Texas is San Antonio.

The Carolinas are our next bag, Raleigh better than Charlotte. In the Mid-Atlantic, we're seeing continued strength stemming from the government spending in Maryland and Virginia. Jersey's pretty decent. And California is very, very community-specific and their communities are doing better. And the once better Mortursuria [ph] are dragging along.

I think across the board, we have seen what I would call quality traffic. People understanding that affordability is at a level where it makes sense to buy a home and are just really trying to make a determination as to when they're going to pull the trigger. And that's the sense, really, across the nation right now.

Michael Rehaut – J.P. Morgan

Great. That's a great rundown. I appreciate it, Rick. Second question, in terms of communities, I know you guys don't break it out typically. But I was wondering if you could give us a sense of at least where you are in terms of your community count relative to last quarter and last year, and where you expect that? Do you expect communities to be up year-over-year by the end of your fiscal year? And how are you starting to think about 2011?

Stuart Miller

Sure, Mike. Community count ended at about 426 this quarter. It was up about 40 from last quarter. So we are seeing, with the land purchases that we've made, we're continuing to open new communities. And we would expect to open new communities throughout the year. And that number will grow and will be somewhat dependent on which deals we go forward with. But we would expect that number to grow throughout the year.

Michael RehautJ.P. Morgan

And what was it a year ago?

Stuart Miller

A year ago it ended at 435 at the end of the second quarter. But keep in mind, during the second quarter last year, it was declining. So we had reduced that number by 20 or 25 during the quarter last year.

Michael RehautJ.P. Morgan

Great. Thanks a lot.

Operator

Our next question is from John Ellis of Merrill Lynch.

Jay Chadbourn – Merrill Lynch

Hi, this is Jay Chadbourn [ph] for Jonathan Ellis. I was looking for, what was your target – what was your target then in land? And what have you been spending for 2010?

Stuart Miller

We haven't laid out a target. But in the current quarter, the land development spend was somewhere in the mid $30 million range for the quarter.

Jay Chadbourn – Merrill Lynch

Okay. And the second question I had was, what was the deferred tax valuation of allowance at the end of the quarter?

Stuart Miller

It was approximately $650 million.

Jay Chadbourn – Merrill Lynch

Okay. Thank you.

Operator

Our next question is from Adam Rudiger of Wells Fargo Securities.

Adam Rudiger – Wells Fargo Securities

Hi. Can you talk about how the orders – I think that you mentioned that June was better than May. And you said it was down about 20% or 25%, so that suggests May was down worse than that. Can you talk about intra-quarter order trends, what they were like in all three of the months on a year-over-year basis?

Stuart Miller

Yes. You saw the numbers yesterday, new home sales down 32.5% in May. I think that we saw, progressively through the quarter, better sales in March, fewer in April, and May was down materially. And then as we noted, June's got – feeling a little bit better. And that's where we are.

Adam Rudiger – Wells Fargo Securities

Okay. And then on the – I know you tried to talk about it a bit, but the Rialto revenue recognition, how much of the revenues that you recognized this quarter were cash revenues?

Bruce Gross

Well again, as you look at the revenue recognition, it's based on expected cash flows, okay? So when you look at the revenue, there was $34 million, I think, was the number of revenue. And as Jeff mentioned, we brought in approximately $60 million of cash flow before expenses in Rialto. Net of the expenses, Rialto brought in close to $40 million during the quarter.

Adam Rudiger – Wells Fargo Securities

Okay. Thank you.

Operator

Our next question is from David Goldberg of UBS.

David Goldberg – UBS

Thanks. Good morning, everybody. The first question I wanted to get into, I wanted to delve into your comment about the incentives and really the idea of keeping the market moving. I would suspect that at this point in the cycle, you had a lot more control over the incentives that you were offering, whether you are deciding to offer more incentives or fewer incentives, and how you're thinking about pace versus price at this point.

And I'm wondering how much control corporate is having in overseeing individual divisions. And specifically, are there some hard targets from sales perspective that the answer is, "Hey look, if you're not selling this many homes or achieving these targets, you need to start layering in some more incentives." Or how are you thinking about controlling that from a corporate perspective?

Rick Beckwitt

Well from a corporate perspective, we have identified what we think appropriate absorption pace should be for every community that we've got. We've got it targeted by a week, by a month, by quarter. We threw our regional presidents, review traffic trends, sales absorptions, pricing trends. And we've set pace – we've identified where we want margins to be, and as you know it, the good cake with regards to absorption in March. So we are constantly tinkering with those push-pulls.

Some of it's driven by what competition does out there. As one of the competitors drops prices or raises prices, it has an impact on what we do as well. But we are really across the nation right now, very close to trends and traffic and sales. So it's something that we monitor from the mothership up here that a lot of the day-to-day decisions are made by the guys running the divisions.

David GoldbergUBS

So just to understand, there'll be change in incentives. There's no hard and fast rule. But at this point, we feel like we're rather slowed the sales pace down. And if that means – and holding sense of steady, it's much more fluid than that. Is that the way you think about it?

Rick Beckwitt

Well, it is fluid like that. As Stuart said in his opening remarks, we are very focused on improving margins at the expense of doing volumes. We've got the SG&A down to a point where if we produced the good gross margin, we're going to make money.

David GoldbergUBS

Right.

Rick Beckwitt

That's what the divisions are focused on. They want to be profitable.

Stuart Miller

But with that said, let's recognize that the – the ability to hold margin and to measure the response to a slower market is enhanced by the fact that as it relates to new homes, there's not all that much inventory on the ground in most markets. And even the foreclosures and most of the markets in which we're actually operating are fairly light.

We really spend a lot of time with our division presidents on these past couple of days. Our perspective is, is we've had a lot of foreclosure inventory, it might be an opportunity to purchase that inventory and make money on that. The fact is that there's not that much of it in the communities in which we're operating. We're really unable to hold price and to get pretty close to our volume expectations. As Rick noted a little earlier, we are able to hold margin as we're maybe forced to bring prices down a little bit because, generally, the construction costs are going down at the same time as volume goes down. So we've really been able to maintain our volume pretty close to our targets and also hold margins.

David GoldbergUBS

Great. And then just as a follow-up question, this is a little bit more of broadly-based here. But I'm thinking about, as we look past the next couple of months, and the new Congressmen would be coming, and who knows what the make-up will be like, but it seems like GSC performance is going to be something everyone's looking at.

And I'm trying to get some perspective on where the builders should be. Should the builders have a seat at the table? Do they have a seat at the table? And what your expectations are given the amount of experience and the room in some of these topics? How the builders are thinking this might play out and what kind of precautions you're taking in case you see some hits in mortgage liquidity?

Stuart Miller

Will the builders have a seat at the table? That's a question I'm just not sure how that will present itself. It certainly seems that there will be, at some point, a lot of attention paid for the GSCs. I think that everybody's going to recognize that the builders, and frankly, the housing participants – housing market participants in general, are going to want to see a program, whether it's GSC-focused or private sector-focused, but it keeps available capital – that keeps capital available to the housing markets.

How that's going to present itself, I think that – I think everybody's going to have some kind of voice. But it's going to be a complicated task to figure out where we go from here. There's no question that at some point, the government's going to have to pull back from supporting the capital markets as it relates to housing. But it behooves everybody. And I think everybody recognizes how important it is to do it in a very orderly fashion. The free market will, at some point, take over. But doing anything too suddenly could derail the entire recovery. And I think everybody is acutely aware of that.

David GoldbergUBS

Great. Thank you for the insightful comments.

Operator

Our next question is from Dan Oppenheim of Credit Suisse.

Dan OppenheimCredit Suisse

Thanks very much. I was wondering if you can talk a little bit about the comments in terms of possibility this quarter and the tension that's out there in terms of just whether this is a short term issue in terms of demand versus something that persists a little bit longer. And that if we see the volumes flowing, it ends up creating issues in terms of SG&A. How committed are you to that profitability in the quarter as it might mean cutting the overhead more versus wanting – would be willing to tolerate higher SG&A and a short term – and sense of a lack of profitability as the latter part of this year if the lower volume persists?

Stuart Miller

I think we feel pretty strongly, Dan, that we've positioned the company for the – for market conditions that are where they are, and even for some further tightening. I think that we are operating at – as tight as SG&A level as we could operate. I think we're pretty well-positioned for the market as it moves forward to be able to maintain that profitability.

We've got a really excellent machine that's working very, very well. Of course, a significant downturn in the market could change that. And I don't want to mislead anybody. But we have a – we've spent a lot of time with our divisional people thinking about market conditions, potential size of pull-backs, potential stability, where we think things are going to go. The general sense is that we're going to be able to maintain levels of profitability as we go forward. And we're really committed to that.

Dan OppenheimCredit Suisse

Okay. And then secondly, I was just wondering about recent comments that you made in terms of that you've been able to maintain the volume close to the targets. Is that still consistent in terms of the May-June order activity? Or is that more just in terms of we're thinking in terms of closings to the much recent quarter?

Rick Beckwitt

Well, keep in mind that it's a seasonal business. And we don't just flat line what our expectations for sales are across the year. We know that as you head into June and July, people are vacationing. It gets a little hot. And people don't necessarily want to be shopping for homes all the time. That being said, we are pretty much on track with what our expectations are and what we budgeted.

Dan OppenheimCredit Suisse

So down 20%, 25% is the expectation?

Stuart Miller

No, that was from the prior year.

Dan OppenheimCredit Suisse

Right.

Rick Beckwitt

So we knew that there would be a falloff in activity when tax credit expires. And we are pretty much in line with where we thought we would be based on that demand going into the pre-May period.

Stuart Miller

Well frankly, Dan, I think that the entire market knew that there'd be a slowdown in demand as we came off of the tax credit. I think it was widely talked about and expected. It's just that the reality of it just doesn't feel good. And I think we're getting a reaction to the way that it feels right now.

I think from our vantage point, we clearly thought that there'd be a slowdown and expected that volume levels will be down. So the answer to your question is, yes, we are where we expected to be. And I think it'll find its way back from here.

Dan OppenheimCredit Suisse

Okay. Thanks very much.

Operator

Our next question is from Stephen East of Ticonderoga Securities.

Stephen EastTiconderoga Securities

Good morning. If we look at orders in Houston in the west, they were down pretty sharply. How much of that is a function of community count versus absorption rights? And if it's absorption rights, what do you think is going on there?

Rick Beckwitt

Well, as I said earlier, Houston and Dallas were late to go into the decline. Some of it is absorption pace. A fair amount of it is community count. I'm just looking up some hard numbers for you. On a community count basis, we're somewhere in the 5% to 10% range down on a year-over-year basis. So that's clearly having an impact. And some of that is also skewed by the timing when those come on. So it's the combination of the two.

Stephen EastTiconderoga Securities

Okay. Is it similar in the west?

Rick Beckwitt

That being said, we are making money as usual.

Stephen EastTiconderoga Securities

Okay. All right. It's similar in the west?

Rick Beckwitt

It's similar in the west.

Stephen EastTiconderoga Securities

Okay. If we look at – Stuart, you said in this environment, you could still make money. Roughly, where would you think is your breakeven volume? And then the other question I had was, just what you're seeing in the land environment, we're hearing that some of the public builders are starting to evacuate from some land deals, et cetera, and just wanted to get a feel for what you all are seeing.

Rick Beckwitt

Just one clarification on the west, on a community count basis, we're down about 15% to 20% in that area.

Stephen EastTiconderoga Securities

Okay.

Rick Beckwitt

Sorry.

Stuart Miller

I'm going to let Bruce talk about the first part of your question. But let me just say, as it relates to some builders starting to back away from land deals, there was a pretty good rush to buy land deals and to tie them up. There were some that went in and tied up whatever they could, and the pricing made you scratch your head. You have to see some real recovery going forward. I think that some of those land deals, as people back away, will start making noise in the market.

But a lot of it – certainly, the land deals that we've done are not deals that we want to back away from. We've focused on underwriting them to current market conditions with even some buffer. And we feel pretty good about what we've put under contract. And we're seeing some real results from some of those properties. So I don't see us backing away from the deals that we've put under contract. But there're going to be some deals that get backed away from. They just didn't make sense at the outset. And that will create a little noise in the market.

Bruce, do you want to?

Bruce Gross

Yes, your question on breakeven, Stephen, it's not a static environment. So I would say is if you go back in time, we were profitable as a company at much lower volumes. So it's really a function of what's driving lower volumes and our ability to react and either modify our product accordingly. And dependent on how much it drops down, make the appropriate SG&A adjustment as required. So it's more a function of why. But we've been profitable at much lower levels throughout our history, so we have the ability to adjust accordingly.

Stephen EastTiconderoga Securities

Sure, I understand. And one other question, on your community count, how much of that is reloaded land versus more historic land?

Stuart Miller

We have feathered in – started to feather in a couple of communities this quarter from off both lands. More of it is coming from new opportunities though.

Stephen EastTiconderoga Securities

Okay. Thanks.

Rick Beckwitt

Just on the land side, to give you a little bit more color, as we've said over the last several quarters, we were relatively aggressive early on in contracting for some new deals on an option and also a cash basis. If you look sequentially, I think last quarter, we announced that we contracted for about 5,000 plus or minus new homes during the quarter.

This quarter, we're about half of that. And that's somewhat driven by the fact that pricing is up a little bit. And we haven't been willing to chase the pricing up. We're only doing deals that since allowed a strong, respectable margin and IRR. If some of the deals that some other folks were chasing at higher price points come back to where we think they should be appropriately priced, I think you'll see a little bit more activity going forward.

Stephen EastTiconderoga Securities

Regionally, do you see one area being more rational than the other on those, Rick?

Rick Beckwitt

Yes. But I really don't want to comment on the call about that.

Stephen EastTiconderoga Securities

Okay. Thank you, guys.

Operator

Our next question is from Jade Rahmani of KBW.

Jade RahmaniKBW

Yes, hi. Thank you very much. I was wondering, could you tell us, does your impairment analysis account for the tax credit slowdown – related slowdown in May and also June as you mentioned? And is it possible that a temporary slowdown in absorption pace could trigger future impairments?

Stuart Miller

We run cash flows on our communities each quarter. And it's based on the current environment that exists. So we adjust that every quarter as we look at that. So it does take into account the real time activity that we've been seeing.

Jade RahmaniKBW

Okay. And then secondly, just regarding your capital allocation and incremental investments, I was wondering if you could just give some color into your thinking on how you plan or how you expect to allocate capital between Rialto and new land investments? You mentioned future high return investment opportunities. What kinds of returns are you targeting? And in which area do you think it's greatest?

Stuart Miller

Well, we have two competing reservoirs fighting for capital right now. And we like that position. We're looking at every land deal and stressing it, and expecting that if we're going to put money into a deal, it's going to have a solid return. And it's competing for capital against the opportunities presented in the Rialto segment.

The Rialto segment, we know, if we're going to win a bid, it's going to produce outsized returns. And we want to be investing some – we want to be investing a significant amount of capital in that business as opportunities present themselves.

The answer to your question is it's a real balancing act to the extent that we have limited dollars. We're going to be investing those dollars where we can get the most sound return. Let's remember that homebuilding today is a cash generator, by and large, with every home sold and delivered. We are generating cash to support the acquisitions of new home sites because part of the sale of the home is the land underneath it.

So there will be capital available just from the operations of the homebuilding segment to support the purchase of new land to the extent that we can find additional land that supports outsized returns we'll be investing in that as well. But we are allocating a lot of capital to our Rialto component right now because we see significant outsized returns coming from those investments.

Jade RahmaniKBW

Great. Thanks very much.

Stuart Miller

Thank you. And I think we'll take one more.

Operator

Our next question comes from Megan McGrath of Barclays.

Megan McGrathBarclays

Great. Thanks. Just two questions, the first, a follow-up to your question – the questions around your community count and the pace that we're seeing right now, I'm just trying to get a sense of – and this is for term, let's say, between now and the end of the year. How sensitive to the current pace are your plans to open these communities if we saw the flow now persists, say, into August that felt like it was beyond normal seasonal slowdown? Would that impact your plans these communities for the end of the year? Or is that – are they a longer term two, three-year plan?

Stuart Miller

Well, on the things that we put under contract or bought, I think the only thing that might be impacted by that is the pace of starts associated with that community. With regard to opening a community, we want to get the models open. There's some seasonality associated with that depending on the market. And as in the normal flow of business we gear starts to build traffic. So I don't think it would impact the opening of the community. It might just impact what the inventory levels would be.

Rick Beckwitt

Let me just add to that and say that the new communities that we've gone out and purchased have been really targeted to micro-markets that we think are underserved, but really well-positioned. So I think it's important to keep in mind that when we see national numbers, those national numbers might be cutting an opposite way from a specific community.

We think that our newer communities have been really targeted to the areas that are most likely will be able to sustain themselves even as the market might pull-back a little bit. So we expect to open all of the new communities in sequence as we're able to get them open.

Megan McGrathBarclays

Great. That's helpful. And then, just a quick follow-up on traffic, I think you mentioned some details around your traffic. We heard from some other builders that after the tax credit, in addition to a decline in volume and traffic, the quality of the traffic was getting a little worth – in other words, it would take a little longer to translate these – those fires into – that traffic into an actual buyer. Are you experiencing the same thing at the moment?

Stuart Miller

I think in the month of May, it was pretty sparse from the traffic standpoint. And all of the – I guess the – to say at the low hang and crew, it was plucked off of the tree. What we have seen in June, we have seen increased quality of traffic. And that's a really good thing for us and for the industry.

It is market specific. But as you'd expect when price points go down and affordability increases, you got some people looking that really can't buy the home without getting money from some other folks to help pay for it. So we're seeing a lot of that.

Megan McGrathBarclays

Great. Thanks.

Stuart Miller

I think this is a good place to conclude because, look, as we look ahead and as we all monitor the market conditions that are here, it's – as I've noted in the past and I note again today, this isn't the Iraqi and sloppy bottom and stabilization process. I think that it is natural that as we go from stimulus to free market conditions taking over responsibility for that stabilization process, it gets uncomfortable. The handoff is not easy or a comfortable transition. And I think that's where we are right now.

I think that there are reasons to be concerned about market conditions. But there are also reasons to see our way through, to free markets taking over and finding stability. Consumer confidence is better. The economy is – has been stabilizing. Interest rates are low. And home prices are down. And we're looking forward to seeing this market stabilize as we go forward.

And with that, I'll say thank you everybody for joining us. And we look forward to talking to you about our second quarter in just a few months.

Operator

This does conclude today's conference call. Thank you for participating.

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Source: Lennar Corporation F2Q10 (Qtr End 05/31/10) Earnings Call Transcript
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