Last week, we ran a what if scenario assuming the greatest possible benefit towards Lennar's (LEN) favor in regards to their debt to asset situation, and we came up with insolvency. The reason for my doing such was an attempt to lend an inescapable credibility to my findings. As was stated in the earlier opinion, the mark that was given to Lennar's assets was unrealistically conservative, but was done so to prove a point. Well, now I am here to give a realistic mark, and display the scenario accordingly.
As stated in the earlier analysis, Lennar sold off a large block of assets for approximately 60% of what it was reported as on the books. This discount is to be adjusted to 50% due to some retained ownership and rights of first refusal. Since this sale included a heterogenous mix of raw land, construction in progress, and finsihed communities, it would be unrealistic to attribute the large discount solely to that of the more illiquid raw land. In addition, despite discounts of up to 56%, Lennar, Hovnanian (HOV), Centex (CTX), Pulte (PHM), and Countrywide (CFC) among several other banks hosting a slew of evergrowing REOs cannot effectively move their inventory as builder backlog decreases, bank REO inventory builds, and builder inventory remains close to static.
Although Vegas is an extreme example (it is a leading state in foreclosure rates), this graph serves to illustrate how quickly REOs are ramping up for many banks, who are now competing builders and existing home owners for sales, as was foretold in my Bubbles, Banks and Builders series. This snapshot was taken nearly 4 months ago, before things got as bad as they are now.
So, taking the 60% discount Lennar gave Morgan Stanley (MS), the troubles and foibles mentioned above, and the fact that the discount given on the other two sales weren't disclosed (if it was less than that given MS, it would have been in Lennar's best interests to disclose it), a mark of 50% is quite appropriate.
We won't get into Lennar's off balance sheet accounting since it was discussed in depth in my previous opinions, but the full consolidation of all of Lennar's assets and full recourse liabilities leaves them more than 33% underwater. That is, for every $1 of Lennar stock, Lennar owes $1.33 in debt. That is significant negative equity. It is forecast to get much worse this year, increasing to about $1.72 of debt for every $1 of equity, and trend even worse for the following two years - assuming Lennar is still a going concern at that time. Lenders, BEWARE! Those assets are a bit more impaired than you may believe them to be.
As you can see below, the Z score tells a similar tale.
For the Z score, 1.81 is the line of demarcation that denotes a historical 72% chance of a company going bankrupt in 8 quarters. While not perfect, Professor Altman's Z score analysis has historically proven to be quite accurate and is widely used. If you look at the chart above, there is significant margin for error, for Lennar score is expected to trend down to about 1.25 by year end, and is currently less than 1.5. To be clear, the Z score measures the probability of bankruptcy, not simply insolvency, which has been illustrated in the previous chart.
Now for those who really don't care that Lennar has more debt than assets, or that there is a high probability that Lennar will be headed towards bankruptcy, we still have something to talk about. After marking Lennar's assets to market, we find that their stock price has not adjusted to the new found asset value. As a matter of fact, it is also ignoring the mounds of debt buried in its JVs.
Now to be fair to Lennar, if the other builders had their assets marked to market, their book value numbers will fall significantly as well, with Ryland (RYL) being a main culprit. There stock is currently trading above the inflated value of their assets, imagine if the assets were market to reality (see Ryland Group Summary Update).
Alas, if we actually run the numbers on Lennar, even excluding the qualitative and fundamental factors of actual insolvency, they are still roughly about 37% overvalued. Bring in reality and the real world, and they have no real equity value per share, for they have not equity.
