Lennar's Insolvency: Enron Redux?

Required reading for this blog post is the fully consolidated Lennar Corporation (LEN) 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 download 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 their 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 reduce 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 (even though 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 (CTX), Beazer (BZH), Hovnanian (HOV), 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 puts 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 insolvent. Included in the calculations is:

1. An 18% FAS 144 impairment factor to bring inventory mark to makret as a result of inventory valuations available from the recent asset sales. We have provided this factor instead of a one time charge, but included both for the sake of comparison and chose the one that would have the least impact according to GAAP rules, to be as conservative as possible. I obviously don't feel this would be either one time or extraordinary, hence probably belongs in FAS 144 category.
2. During 4Q2007, Lennar sold properties at sales price of $525 million with a net book value of approximately $1.3 billion. As a result I expect Lennar to write-down a minimum loss of $775 million in 4Q2007.
3. During 4Q2007, Lennar has sold 8,300 homesites to Metro Development Group and 11,000 sites to a strategic land investor. As a result, total home sites have been reduced by 31,108 to include the effects of these 2 transactions.

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 covenants, 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's 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 their customers. The problem is that Lennar funds acquisitions 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 specific phenomenon) with a extremely sensitive and leveraged connection with land values 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 sensitivity 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 their insolvency.

These are the comparative Census regions to assist in making the following chart on gross margins more coherent.

Now, knowing that their 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 opportunity, 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!" Unfortunately, they won't see what is 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!

Comments

[sjdiii:]

Reggie,
Thanks for doing such an extensive analysis on this company. I for one would like to see them go out of business along with the others mentioned in your article. They have ruined it for the smaller mom & pop builders in our area. LEN bought up thousands of acres of farm land in our area causing hugh price increases on available land. Thus making it impossible for the small builders to compete.

2007 Dec 31 11:18 AM

[Fighting Yoda:]

Great Analysis. I am short housing.
However if the market turns around, not likely in the near future, all the values will go up. So the question is can the home builders hang on for a while?

2007 Dec 31 09:00 PM

[Arizona Hom...:]

From the macro to the micro...

Arizona seemingly missed the earlier nationwide Lennar sell-off of lots. As my husband and I shopped for a new home, we took this to be a hopeful sign for our area. However, only a few weeks later, in Phoenix, Lennar let go a significant part of its sales force the week before Christmas. The range of estimates we get from gossip gathered in our home shopping are from 30-60 agents, or 30-90 percent of total staff was let go. Nothing at all has been reported in local papers.

What does this look like in real terms to us? When we visited the largest new premium Lennar lakes development in Phoenix (metro area), the professional "tenured" sales agents we had spoken with were "no longer with the company." They had been replaced by "college freshmen" types who were good at repeating the neutral "company-speak" line.

The sales offices will be closed Wed/Thurs each week. The new sales person said it would have absolutely no negative impact on sales because buyers would read the sign on the locked door and call the agent on her cell phone to arrange a time to see the models.

This relates to the premium "Signature" series of homes which have had approximately 1 home sold per month since Sept. We had been told by the professional agent (now without her job) that one of the sales might revert back to Lennar, but the new agents have not been able to confirm this with us. "She's still checking on it."

Lennar is the master developer for this lakes community. Their partner company is Engle Homes, part of TOUSA. No water is yet in the lakes, and roads are still being completed.

We have spent 6 months hoping to purchase one of the Signature homes. During that time, we encountered many hard-line policies Lennar has in dealing with new homes sales. These policies mirror those described in your article when they were initially working to sell their land. Perhaps the policies worked well in a thriving, competitive sales market. But these policies are clearly out of step with the overall depressed housing market where most builders are surviving on building and selling Spec homes, the niche Lennar had carved out for itself in the new homes market.

It also seems that they refused to lower prices (needed the cash? from the higher prices) until they are now priced higher than comparable homes sold by other competing builders, leaving the development largely brown dirt with a few pockets of homes here and there.

We had questioned the viability of this project for several months and whether we should purchase there or not. Any guesses about our current answer to that question?

When the sales people left and they locked the models for 2 days of the week...our fears were confirmed. We have no desire to live in the only home on a 1000 acre patch of dirt.

If we had any hope that Lennar could survive, I wouldn't pour salt on their wounds. However, I feel very sorry for the lone buyer who just moved into their brand new home, surrounded by empty land and 5 partially completed homes. They may likely be the only residents in their project for years to come in the sad event that Lennar is not able to complete this development.

Buyers beware.

2008 Jan 01 12:10 PM

[User 4374:]

I have many homebuilder model's and think you should also take the alternative approach of the best case scenario ex. flat sales, prices etc. and then an '09 recovery. My model is not as aggressive as your's, so i would like to see if your results would differ under a better scenario.

2008 Jan 01 10:25 PM

[Ranboz:]

I agree and have been short on Lennar since June. I believe that buying stock option puts on homebuilders and/or mortgage related companies will continue to be a reasonable hedge against real estate related potential losses. My general stance is as follow.

Markets often behave irrationally and tend to return to fundamentally supported levels over time. The housing market is no different.
- It is reasonable to expect that U.S. national REAL housing prices could fall by about 50% from their December 2005 peak back to their historically normal level.
- It is reasonable that national NOMINAL prices could also fall significantly (10%-45%) over the next eight years or so unless the U.S. experiences a greatly increased rate of inflation* (6-11% for the next 4-8 years).
* Because national deflation (housing) is often considered to be a greater economic threat than inflation, the Fed will likely pursue an inflationary policy.

(Inflation/housing numbers created from projecting the data from the "irrational exuberance" graph located at irrationalexuberance.c...

2008 Jan 02 12:17 AM

[EX-LEN:]

I recently quit Lennar after I differed with the compnay philosophy of how their layoffs were structured. The upper management with the heaviest salaries have kept their jobs and the lower levels have been let go. I personally would like to see the upper management namely Division presidents, Regional VP's and VP's of the different departments take a 50% paycut in their hefty salaries (they would still be overpaid) it would save the lower salaried employees who actually DO the work could stay on to turn some of the things around. In either case, it seems to me that after reading the articles the upper managers would lose their jobs anyway!

2008 Jan 02 06:18 PM

[Reggie Midd...:]

It is interesting to see the feedbackto this article. For those who are interested in more, I have the Lennar report and model expanded available for dowload on my site (registration required): boombustblog.com/compo...,/

I have a followup article that is not as optimisic as well - available both on seeking alpha and on my blog.

2008 Jan 03 03:08 PM

[EX US HOME:]

I left US Home/Lennar going on three years ago and I can safely and happily say that I made a great move. When Lennar bought out US Home, the writing was on the wall. The way Lennar handled every aspect of the homebuilding process was completely wrong and the only person that profited was Stuart Miller. They treated and still treat their employees like crap and just like the EX LEN said, they RIF the people that actually get the work done while the upper management rake in their overpaid salaries and their bonuses that are usually more than one "pee-ons" yearly income. I personally cant wait for Lennar to go under, even though I have some great friends that unfortunately still work there. Hopefully they get out while they still can.

2008 Jan 04 08:24 PM

[Two Cents:]

To clarify Lennar is the largest homebuilder in revenue not volume. That honor belongs to D.R. Horton. But I'm sure that's what he meant.

2008 Jan 07 05:45 PM

[EX Lennar:]

I was fored for no reason from Lennar Phoenix 2 wks before the layoffs began costing me to lose the insurance for my 2 small children. I was blamed for the AP problems that we caused by a lying deceptive controller who knew nothing about AP. I was blamed for bills not being paid well these bills were never submitted for payment. How can a bill be paid if it does not have the proper approvals? This controller also started a policy of paying past due bills with the current date so it looked like they were being paid on time. First Lennar homes bought out US Homes, then merged them with Greystone causing many good people lose their jobs. Having an Accounting Manager that knew nothing other than being a yes man. The have a community in Phoenix that no one lives in and they are paying all utility bills for those that are still there because the screwed up construction and caused homes to flood when it rained. Some of this goes back as far as the 1990's!. That was when the name Lennar was changed to Greystone from Lennar. The old controller form Greystone was a workaholic who expected the same from her subordinates. Family dammed if it was monthend you needed to be available at all times. Year end was even worse. I could go on but they are getting what is due them. I also agree with an earlier post saying how none of top management was laid off but all lower end people were.

2008 Jan 19 09:56 AM

[User 391433:]

Great aritcle! I am a Vallejo, California resident. We are in Chap. 9 as well. Lennar is now selling off the parcel on the former Mare Island Naval Shipyard presently leased to Touro University back to Touro. They were given 650 acres for a buck to develop based on the costs of environmental remediation to develop the 650 acres, most of which was funded by the Navy anyway.
The Touro parcel was not part of the industrial activities of the Navy, and already developed as a former Navy schools activity, which Touro essentially just moved in to.
The City of Vallejo is not in line to receive anything from this sale to the best of my knowledge and our council will discuss it soon.

Apr 08 12:48 PM