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Lennar Corp. (NYSE:LEN)

F2Q08 Earnings Call

June 26, 2008 11:00 am ET

Executives

Stuart Miller – President and Chief Executive Officer

Scott Shipley – Director of Investor Relations

Bruce Gross – Vice President and Chief Financial Officer

Diane Bessette – Vice President and Treasurer

David Collins - Controller

Analysts

Dennis McGill – Zellman & Associates

Carl Reichardt – Wachovia Securities

David Goldberg - UBS

Michael Rehaut – JP Morgan

Tim Jones – Wasserman and Associates

Stephen East – Pali Research

Analyst for Nishu Sood – Deutsche Bank North America

Jim Wilson – JMP Securities

Megan McGrath – Lehman Brothers

Dan Oppenheim – Credit Suisse

Jay McCanless – FTN Midwest Research

Rashid Dahod – Argus Research

Stephen Kim – Alpine Woods

Alex Barron – Agency Trading Group

Operator

Thank you for standing by and 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 a question-and-answer session. Today’s conference is being recorded. If you have any objections please disconnect.

I will now turn the call over to Mr. Scott Shipley, Direct of Investor Relations for the reading of the forward-looking statement.

Scott Shipley

Good morning and welcome to Lennar’s second quarter earnings conference call.

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. These forward-looking statements represent only Lennar’s estimate 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 10K for the most recently completed fiscal year which is on file with the SEC.

Please note that Lennar assumes no obligation to update any forward-looking statements.

Operator

I would like to introduce your speaker for today’s conference, Mr. Stuart Miller, President and CEO. Mr. Miller, you may begin.

Stuart Miller

Thank you and good morning everyone. Thank you for joining us for our second quarter 2008 update. I am joined this morning by Bruce Gross, our Chief Financial Officer; Diane Bessette, our Vice President and Treasurer and David Collins, our Controller.

Bruce is going to give some additional detail on our numbers as is traditional and David is going to give you an update on our asset review and impairment, a report that we have now given for over two years. Diane, of course, will be available to participate in our Q&A.

Just as a housekeeping item before I start I’d like to request that in our question-and-answer period that will follow our opening remarks that you please limit to just one question and one follow-up so that we can be as fair as possible to all of our participants. We of course welcome you to rejoin the queue if you have additional questions and we will attempt to answer as many as possible in the hour, more or less, that we have allotted for the call.

So let me begin. The housing market has continued to deteriorate throughout the first half of 2008 and as I noted in our press release this morning we expect this trend is going to continue for at least the remainder of the year. The deterioration that unfolded so quickly in the housing market so quickly in the past years has now spread to the overall economy. While there are some who still suggest we might avoid a recession and believe the economy will continue to grow, though at a slower pace, their case is becoming more and more difficult to make in the face of rising unemployment data, record low consumer confidence figures and a credit crisis that is constraining the movement of capital.

Even as the FED spoke yesterday and noted that the threat to growth had eased, that is until the stimulus checks are spent, it is apparent that inflation moves as a driver of potentially higher interest rates if not sooner than probably later. This is the simple reality of the market in which we are operating and these conditions are likely to persist for some time.

I am asked regularly as to whether or not we are at the bottom. I feel overall that we are not there yet. A little over a week ago our senior management team visited with each of our divisions over a two week period as we did our Ops review. We reviewed each of our divisions in detail and evaluated the dynamics of each market in which they operate. Generally speaking there are not yet signs of stabilization in the field. Demand patterns are inconsistent and erratic and we find that there is a constant and increasing flow of foreclosures that are maintaining downward pressure on prices and appraisals. In many markets it is apparent that the flow of foreclosed homes is expanding rather than subsiding.

There is a silver lining in all of this, though it is currently of limited consequence. The positive news from the field relative to some markets is that inventory of finished homes is coming down. The number of open, competing, new home communities is declining and the number of builders is also declining.

In spite of this rather sobering market information that we learned in our Ops review, we also learned that we are making a great deal of progress in adjusting our business to not just survive but to succeed in this difficult environment. We are focused on a quarterly progression of positive trends in this down market environment. I’d like to walk through some of the elements that will contribute to these trends that we saw as we visited each of our divisions.

First and foremost every one of our divisions has made the transition from being primarily focused on asset management to being primarily focused on their manufacturing business. Assets have been sold or written down; joint ventures have been re-structured or resolved. In fact we have reduced our number of joint ventures from 270 at the peak to about 163 currently. Our overall land asset is down similarly and additionally each division brought tremendous focus on inventory homes in the second quarter and reduced completed inventory by almost 50% sequentially.

Great progress has been made on the asset side of the business so management can focus on sales, construction and inventory. Our divisions are back to the basics of blocking and tackling pure home building. We have gone back to the basics on product. In our reviews we have found that every division as re-worked its product for the current market environment.

That means simpler product, fewer plans and a fresh look at scaling back included features. Each division has positioned product to offer excellent value and to be able to compete head to head with our toughest competitor, foreclosure sales. Square footages are generally smaller and product design is simpler. This competition is based on pure value.

We reviewed sales and marketing efforts. On the sales front we are using the Internet sales machine more effectively and extensively than ever. Division presidents are personally immersing themselves in our Internet sales program and driving up the learning curve. Currently each division is treating the Internet sales team more like a general realtor with the ability to cross-sell across Lennar product offerings in the market.

By doing this we have increased our Internet sales results by more than triple. On the market front Kay Howard has initiated a series of corporately generated and coordinated sales events that have gotten our divisions to engage in a friendly competition within the company. We have found that every division has been thoroughly engaged in these programs and enhanced their sales performance with participation. Focus was brought through these programs to manage a lower cancellation rate and this contributed to a cancellation rate that has been more than a 3-year low of some 22%.

With simpler products we have seen tremendous results in reducing construction costs. With the leadership of Mike Foster in Tampa we have revamped our purchasing efforts to benefit from regional and national efficiencies as we have moved across all divisions to disassemble labor and material contracts and begun purchasing on a unit basis for labor and materials separately.

We are seeing costs come down by as much as 20%, some of which is flowing through our numbers today and some will be coming over the next quarters. Because our standing inventory levels are extremely low and current, less than 100 homes per community, new home construction costs are defining the cost structure of most of our deliveries especially as we get into the third and fourth quarters.

Our divisions are using purchasing practices and product simplicity to become the low-cost producers in their market.

On the SG&A front, SG&A will be at 10% of revenues or lower in each division by year-end. This is our focus and our directive and there are no excuses. We found that many of our divisions are already there or below. Practically speaking a few might not make it but overhead is coming down quickly and every division was impressive in displaying their attention to this metric.

So with construction costs coming down and overhead reduced, products repositioned and land costs at proper levels where are margins going? Our net home building margin is beginning to improve with a positive net margin of 0.5% excluding valuation adjustments. While this margin is decidedly weak we expect we will continue to see improvement in margins that will begin to market trend. Of course the wild card is going to be sales pace and sales price and right now we are in what I call a price taker business with no pricing power.

With market conditions as they are we recognize that some things are just out of our control and we’re simply not going to be able to control those elements. But the items that are in our control we are all over them in each of our divisions.

On the corporate side we have complemented the progress in the field. Our balance sheet remains strong with a substantial cash position of $880 million plus. While this is down some $200 million from the first quarter we are decidedly using cash to seize opportunity where distress creates unique value rather than walk away from that opportunity. We anticipate we will continue to use another $200-300 million of cash over the next quarters for additional opportunities as they arise. We are building our business for the future.

Additionally there is nothing borrowed on our revolver and we have a responsible debt to total cap position at 39.5%, net of cash under 30%. In the wake of the meaningful re-statements of assets we have undergone, and the re-positioning of many of our joint venture properties this is meaningful progress.

While we continued to lose money in our first quarter with a loss per share of $0.76 and a home building operating loss of approximately $140 million, aggregate levels of impairment and losses are more the nature of clean up rather than reconciliation to unknown market conditions. We have done the heavy lifting on impairment and are now situated with stated assets that can and will produce improving margins when the rate of declining market pricing subsides. We are very confident that even with continued degradation of market conditions our stated asset base will not suffer nearly the levels of impairment we saw in 2007.

We have re-worked or are close to a re-work on most of our non-performing joint ventures. The trend on joint ventures is positive. As I noted earlier the number of joint ventures has come down materially and Bruce will give some additional color on some of the financial metrics.

While we will not and cannot comment on specific ventures, we have held true to our conviction that we do not support the debt of non-recourse obligations and we are not excusing partners from sharing partnership losses. While the negotiation process can be difficult and time consuming, many of our partnerships have presented us with an opportunity to actually enhance our investment position.

Let me briefly comment on the Land Source joint venture that many have asked about. As the press has reported, that venture has now gone into bankruptcy and the judge will consider a plan of re-organization. As much of this is ongoing, I will not comment specifically on the case but as it relates to Lennar one should recall that the $1.2 billion of debt is non-recourse and that Lennar’s investment on our books is zero. So as large as this asset might seem the potential impact to the company is not material.

In conclusion let me say that we have made a great deal of progress in this very difficult market. We have prepared our company for market conditions as they currently exist and we are not projecting a material improvement for some time to come. This should not be confused with abject pessimism. In fact, I remain quite optimistic about our business and about the housing market in general. This market will rebound. It will have to rebound in order to stimulate the rest of the economy back onto its feet.

Whether over the next month, or after the election, steps will be taken out of necessity to facilitate home ownership’s leadership out of the economic doldrums. The indicators keep coming and while there is discussion and disagreement back and forth on how to fix things, it seems that we are quickly approaching the time where decision makers will reconcile to the reality that positive, decisive steps need to be taken to properly support weakened markets and enable them to recover. We believe that an integral part of the answer that will emerge is that fixing the component of the economy that has led us into economic contraction (i.e. home building) will be the first and most important step in leading us out.

This fix is the bright light that I see at the end of home building’s dark tunnel. As I noted already, the home market is faced with increased supply and suppressed demand, home inventories, primarily existing homes, are expanding and will have to be absorbed before pressure is relieved from sales volume and from price. At Lennar we have been heads up throughout the downturn in the housing market and we have prepared our company to succeed in the current market conditions and to thrive when the market ultimately corrects.

With that let me turn it over to Bruce.

Bruce Gross

Thank you Stuart and good morning. I’ll be providing some of the financial details supporting the significant progress that Stuart just outlined with our balance sheet strategy, our JB recourse debt reduction, and our return to positive operating margins.

Starting with the results of our balance sheet strategy we remained focused on aggressive asset management and maintaining ample liquidity. We have continued to carefully manage our inventory levels as they have been reduced by 47% from $7.3 billion in the prior year’s second quarter to $3.8 billion during the current quarter excluding consolidated inventory not owned.

The finished homes and construction in progress inventory was reduced 39% from $3.6 billion to $2.2 billion year-over-year and land under development was also reduced 56% from $3.7 billion to $1.6 billion. This quarter we continued to cleanse our balance sheet as we aggressively reduced our unsold completed homes by 70% from 1,441 in the prior year to 428 in the second quarter and sequentially it was also down 47% from the first quarter of 2008.

We have continued to manage starts to today’s demand levels and as a result homes under construction declined 42% from 11,200 in the second quarter of last year to about 6,500 in the second quarter of 2008. Our home sites owned and controlled were reduced by 61% since the peak in 2006 from approximately 346,000 to 134,000 home sites in the current quarter. That break down is 73,000 home sites owned; 15,000 controlled by option of third-party land sellers and 46,000 options from joint ventures.

Land purchases during the quarter were $162 million and that is a 72% decline from the prior year. Any land purchases that we are making are very strategic. They are priced to generate high returns, taking current market conditions into account, and they are structured to protect us if there is further decline in the market place.

Our continued balance sheet focus continues to position us with excellent liquidity. In the second quarter we returned to a positive EBIT margin before valuation adjustments of about $2 million. As Stuart mentioned our liquidity position was strong with about $882 million of home building cash on the balance sheet and additionally there were no outstanding borrowings under our revolving credit facility.

Inclusive of impairments our net home building debt to total capital improved to 28.7% this quarter from 29.6% in the second quarter of last year and our home building debt to total capital was 39.5% versus 31.6% in the prior year’s quarter. Our debt level is down $275 million since the prior year’s second quarter.

There has been significant progress made in both the reduction in the number of joint ventures as well as the reduction in joint venture recourse. The company has focused aggressively on reducing the number of JV’s which was at a peak of approximately 270 JV’s in 2006 and now there are 163 joint ventures as of the end of the second quarter.

Of these joint ventures, however, only 57 have recourse debt. 31 have non-recourse debt and 75 have no debt. Our primary focus has been to reduce the joint ventures with recourse debt which is already down from approximately 100 in 2006 to the 57 remaining joint ventures with recourse debt at the end of this quarter.

The maximum recourse JV indebtedness was approximately $1.8 billion at the end of fiscal 2006. That has been reduced aggressively by about $1 billion and we ended the quarter with $807 million of recourse indebtedness in joint ventures. Sequentially this was also reduced significantly from $917 in the first quarter. Lennar’s net recourse JV exposure was also reduced to $613 million at the end of the quarter.

There has been a lot of attention directed to our joint ventures and I would like to emphasize that in addition to very significant reduction in JV recourse indebtedness, these joint ventures were conservatively financed at the time when the debt was put in place and these JV’s with net recourse debt exposure to Lennar have a total of $1.2 billion of partner’s equity in place at the end of this quarter.

We are confident that we will continue to significantly reduce the JV recourse debt exposure in each of the next several quarters. There was also significant progress in the reduction of financial letters of credit which were cut by more than half from the $728 million outstanding at the end of 2006 to $337 million at the end of this quarter.

Turning to the operating results for the quarter, we had a $0.16 loss for the quarter which excludes $137 million of pre-tax valuation adjustments, which David will walk through in a few minutes. Revenues from home sales decreased 62% to approximately $1 billion. That was driven by a 58% decrease in home deliveries and an 8% decrease in average sales price to $274,000.

The average sales price is net of sales incentives which averaged $48,700 per home during the quarter which increased about $5,000 per home compared to the prior year. The average sales price by region is as follows: East $254,000 which was down 11% from the prior year; Central $210,000 which was up 1%; West $364,000 which was down 16% and the “Other” region was $302,000 which was down 5%.

In the second quarter of 2008 we achieved the first positive operating margin since the first quarter of 2007. Our gross margin was 15.9% before valuation adjustments and selling, general and administrative expenses were 15.4% resulting in a 50 basis point positive operating margin. The pre-impairment gross margin improved 230 basis points over the prior year and the improvement in gross margin is primarily due to a lower land basis but additionally as Stuart mentioned our focus on repositioning and re-designing our product to meet market demand while continuing to aggressively focus on reducing construction costs in all areas of the company.

The East segment of the company experienced the largest improvement in margin during the quarter. We have acted aggressively to right-size our SG&A during the downturn and we have made significant progress on reducing the variable component of SG&A and now we are beginning to see the results of our progress on the fixed component of SG&A.

We are at the back end of division consolidations and head count reductions as our associate head count has been reduced from the peak in 2006 by approximately 60% through today. SG&A was reduced by $239 million during the quarter which is a 60% reduction from the second quarter of last year. As a percentage of revenue SG&A was up 70 basis points compared to last year’s second quarter but sequentially from the first quarter of this year it was down 300 basis points.

The progress that has already been completed and the actions taken give us the confidence to say our divisions are on track to achieve the future annualized SG&A run rate of 10% by the end of our fiscal year.

New orders were down 45% during the quarter compared to the prior year. The number of homes in backlog declined 52% year-over-year and in this quarter we delivered over 100% of our backlog. Our backlog conversion rate this quarter was 113%. We had a 22% cancellation rate compared to 29% in the prior year’s quarter.

Our financial services profits decreased from $14.2 million profit to a loss of $3 million. Mortgage increased from $4.6 million of profit last year to $8.1 million in the current year and that was primarily due to the prior year having a $14.4 million land note receivable write down. This quarter our mortgage capture rate improved from 72% to 85% year-over-year and almost all of our loans in this quarter were fixed rate, conforming loans. The percentage of government loans increased to approximately 60% this quarter, up from 19% in the prior year. This is the first quarter that the higher FHA mortgage loan limits went into effect.

Our title company experienced a $10.7 million loss that compares to an $8.1 million profit in the prior year. This was the result of fewer transactions as well as $6.7 million of non-recurring expenses primarily related to severance and lease termination costs as we focused on right-sizing our operations to current market conditions.

As we indicated on the first quarter conference call our tax rate will fluctuate through the year based on results. This quarter we adjusted our tax rate to 36% year-to-date tax rate. Some of you have called last night or this morning asking about the shelf registration filing yesterday. This is a routine filing to reinstate our shelf that was in place for several years and expired last week.

With that I’d like to say that we have made significant progress again this quarter and we look forward to discussing additional progress again next quarter.

With that I’d like to turn it over to David.

David Collins

Thank you Bruce and good morning everyone. As is tradition during our conference calls we are once again providing an update of our impairment process to provide further clarity. In this morning’s release we outlined our second quarter valuation adjustments of $137 million. We continue to remain actively engaged in our rigorous process of division by division asset reviews to ensure that our assets are properly stated.

We started this impairment process about two years ago and were diligent early on in reviewing our asset base and reporting impairments. As we have previously disclosed we believe that most of the heavy lifting regarding impairments is behind us and that we are at the tail end of the impairment cycle.

Let me quickly summarize our second quarter impairments.

First, on the home building side of our business we once again applied the standards of FAS 144 to land that we intend to build homes on and recorded a valuation adjustment of $74 million. The segment detail is as follows: East $34 million; Central $17 million; West $20 million and “Other” $2 million.

The second bucket is land that we sold or intend to sell to third parties. Consistent with our strategy of converting inventory into cash we identified land that we sold during the second quarter or intend to sell subsequent to the second quarter. We applied the standards of FAS 144 to that land and recorded a valuation adjustment of $2 million. The segment detail is as follows: East $1 million; West $1 million.

The third bucket relates to land, option deposits and pre-acquisition costs. We continue to evaluate, re-evaluate and re-negotiate deposits on land under option as markets remain challenged. For those option contracts where we were not able to adjust or readjust the terms to a level that we believe would lead to an acceptable return based on current market conditions we made the decision to walk away from the contract as we have done in past quarters. As a result, we wrote off $7 million of option deposits and pre-acquisition costs which represented approximately 2,100 home sites. The segment detail is as follows: East $3 million; Central $1 million; West $1 million and “Other” $2 million.

The fourth and last bucket is our joint ventures. As we do with all of our assets we continue to evaluate and re-evaluate our investments in joint ventures. During this impairment cycle we have reported cumulative adjustments to our investment in JV’s of $726 million. In our review we focused on the recoverability of our investment relative to the market conditions that exist today. We applied the standards of FAS 144 to the assets in our joint ventures including the evaluation of discounted future cash flows. Additionally, we applied the standards of AVB 18 to our investment balance related to those joint ventures. In the second quarter we recorded a valuation adjustment of $55 million. The segment detail is as follows: East $12 million; West $43 million.

So after that overview we would like to open it up for questions.

Question-And-Answer Session

Operator

(Operator Instructions)

The first question comes from the line of Dennis McGill – Zellman & Associates.

Dennis McGill – Zellman & Associates

Bruce I think I heard you correctly but on the FHA side did you say that was 60% of the volume?

Bruce Gross

That is correct. The government loans were 60% of the mortgage loans that our mortgage company originated which was 85% capture rate.

Dennis McGill – Zellman & Associates

So that would be on closing for that?

Bruce Gross

That is correct.

Dennis McGill – Zellman & Associates

Can you elaborate on that a little bit? I think there might have been some promotions related to that in the quarter but would you say that is abnormally high? Would you think that goes higher in the coming quarters based on what you are seeing in backlog?

Bruce Gross

Yes I think we have been saying for a couple of quarters now there has been an increase in the FHA loans and the FHA loans which require a much smaller down payment are the attractive financing source that is available out there today. We do believe that the higher FHA percentage is likely to continue at this point.

Dennis McGill – Zellman & Associates

Just because it has been in the news flow related to the down payment assistance, is that something that you guys participate in any meaningful volume?

Bruce Gross

We have had down payment assistance for several years now and there are a percentage of our buyers that do use the down payment assistance. It was about 1/3 of the loans we originated during the quarter but again I think one of the things to highlight is the difference between down payment assistance and FHA is about $6,000 of down payment on our typically priced home.

Dennis McGill – Zellman & Associates

Switching gears, maybe this is best suited for you Stuart, but just thinking of your top level view and how the shrinking of capital from banks for both residential and I guess even commercial lending is taking place what your view is over the next year as more land comes to market via foreclosure similar to what has happened on the house side and what that might mean for both land values going down and potentially opportunities for well capitalized builders?

Stuart Miller

I’m not sure I fully got the question but I think what you are asking is with available capital somewhat constrained are there going to be dollars available for people to buy homes. The answer is I think there will be dollars for people to buy homes. It will be primarily through either FHA programs or GSE programs.

Dennis McGill – Zellman & Associates

I’m sorry for mixing the two themes up but I was referring more to on the lending side to builders and developers themselves and builders that are struggling with the capital structure and not able to perform on their loans and forcing some of that back on the market on the repossessed side…builders that do have capital how you see that playing out.

Stuart Miller

I think that exists right now today. I think that constraint is out there and it is creating what I refer to in my comments as some of the distress that is in the market. We are seeing it probably first in the joint venture arena and it is creating opportunities even today at today’s depressed pricing and sales pace levels. It is those kinds of opportunities we think are going to mark the future for the industry. For the well capitalized builder there will be those opportunities to re-build their business around. These opportunities aren’t out in the market right now. They haven’t surfaced yet but they are coming. I think that as market conditions continue to weaken over the next year and especially the credit side of the business gets more difficult there will be more opportunities to start making purchases where healthy margins can be garnered.

Dennis McGill – Zellman & Associates

Thus far you haven’t been active in any type of bank owned properties yet?

Stuart Miller

We have been very active but Dennis we are going to have to move on to the next person.

Operator

The next question comes from the line of Carl Reichardt – Wachovia Securities.

Carl Reichardt – Wachovia Securities

I had a question the specs down at less than one per community, is that relatively concentrated regionally or is that kind of a more average across the board? Then what was the rough fall in communities year-over-year this quarter versus last?

Bruce Gross

Let me first address the spec inventory level. There has been a focused effort in every division in the company and every community to reduce the level of spec homes. We have seen that success throughout the company. It is not concentrated in any one particular geography.

In terms of the community level, Carl, the community count isn’t a number that we have given out for the quarter.

Stuart Miller

Bruce is stumbling because we just don’t give out community count as you know, Carl. The fact is our community count is down materially. In terms of the spec level no there is not concentration. In fact what was really very positive message take away from the quarterly Ops reviews was the fact that each division had really focused in on spec levels and in every single one of our divisions spec levels were down materially.

Carl Reichardt – Wachovia Securities

The one follow-up to that is then looking at backlog conversion being triple digits, are you sensing you are through this process enough given the assumption we don’t see a significant negative change in absorption pace? That is we look at backlog conversion the next several quarters we ought to see that come down relatively materially as you start to replenish the backlogs? Is that the way I ought to think about it?

Bruce Gross

I think over the next quarter you are still going to see very high backlog turnover conversion ratio, Carl. Our focus is to make sure the inventory levels are being managed tightly and we are not ending up with completed homes at the end of the day but I think you will see that conversion ratio stay at a high level over the next couple of quarters.

Stuart Miller

I think that is reflective of both construction time frames coming down and keeping our sales and construction pace very tightly tied together. I would expect it stays where it is.

Operator

The next question comes from the line of David Goldberg – UBS.

David Goldberg - UBS

My first question is a little bit theoretical but you talk about taking the business from focusing more on regions on asset management to home building now and more efficiency. I guess what I’m trying to figure out is how does that impact the business over the long term? When things eventually do normalize do you think you transition somewhere in the middle? How easy is it to bring that specialty or ability back on?

Stuart Miller

As you know, David, at the highest level of the company we have maintained our management team intact and we think that is where the real franchise on the asset management side of the business is. What we have really done and we are really pretty excited about this, is at the division level we have our divisions focused on being real manufacturers. So as the market returns I think we are going to be at the forefront of being able to uncover some of the most sizeable and interesting opportunities because our top level management team is really expert at that. But in the field we are focused on sales, starts, closing, inventory levels and asset base making sure that our divisions are really focused on becoming a pure manufacturing machine.

One of the questions Doug was asked earlier by Dennis was are you participating in some of the bank deals that are out there. I think that is one of the unique things that does exist here at Lennar, the fact we are looking at just about every deal that is hitting the market. As you know Jeff [Kraznoff] is back with the business. Jeff and I have a long history looking at those portfolios. Likewise John, Rick and Neal. I think that there is an important balance between the manufacturing focus in the field and what the corporate office can bring to bear on more sizeable and more interesting deals that are lot more opportunistic.

David Goldberg - UBS

I guess the second question talks to the impairments and the testing for impairments. How do you guys get comfortable that the last couple of quarters it has mostly been clean-up on impairments. But if you expect deterioration on the operating environment, certainly the order base is coming down, pricing is coming down and incentives are going up…how do you get comfortable that you are not going to see more impairments or sizeable impairments as you move forward? Maybe as a corollary to that is it correct to assume that the reason there haven’t been more impairments is that you have done a great job on the cost side of the business and that has offset some of the other inputs that have been more negative?

Stuart Miller

Okay, well there are a few things that combine in that. Number one lets remember that our asset base itself has shrunk materially so the amount of impairment that can possibly be out there is materially shrunk. Number two, when we did our impairment analysis as we did the past year we have anticipated the market would not be improving but instead would continue to decline. So the market conditions that I described in my opening comments are market conditions that we have anticipated. We have not had our head in the sand on this. To the contrary we have written our assets to a place where we are comfortable the statement of the assets will be properly positioned for the future even as the market continues to deteriorate.

Another element is the fact we have brought down our pricing in the field quite a lot. Probably more than the existing home market has. I think that there is less correction ahead for the new home market than there is for the existing home market.

The final point is that you were absolutely right, David, our cost structure is changing. We are bringing down construction costs at a very impressive rate. What I saw in the field with some of the initiatives that a gentleman named Mike Foster is spearheading across the company for us, is that both at the local, regional and corporate levels we are finding ways through unit cost pricing to bring down construction costs at an accelerated rate even where you have commodity prices going up. This is very important in the underwriting of future impairments. We think we are going to be able to be profitable in almost every one of our land positions going forward even in this declining market.

Operator

The next question comes from the line of Michael Rehaut – JP Morgan.

Michael Rehaut – JP Morgan

My first question if you could just give us a little bit more detail on JV’s and it was good to see the recourse continues to come down. I was wondering if Bruce or Stuart could describe how much cash out went this quarter for JV’s, for debt pay down or on lines and where your total balance sheet investments stand?

Bruce Gross

Let me talk to the point of how much went out to joint ventures. The total contributions during the quarter to joint ventures were between $50-60 million and a smaller portion of that went to re-margining relating to joint venture debt. As far as the joint venture investment balance for the quarter that number is approximately $870 million at the end of May.

Michael Rehaut – JP Morgan

So the $50-60 million includes any type of debt pay down as well as the recourse debt came down?

Bruce Gross

That is correct. Any contributions to joint ventures are in that line. The re-margining amount is a subset of that $50-60 million.

Michael Rehaut – JP Morgan

Before I move onto the second question a small subset question on the JV’s if I could. Any update on Kyle Canyon or Heritage and where your exposure stands for those two ventures?

Bruce Gross

There is no update relative to Kyle. We don’t have any investment in Kyle. There is no update there. Heritage we still feel very good about. It is a very strategic joint venture for us that is [El Toro] and we are still going forward as we talked about in the past.

Michael Rehaut – JP Morgan

My second question on land investment. I found that pretty interesting you spent $162 on. I was wondering if you could kind of break down how much of that was option take downs and how much of that was more opportunistic purchases and if you can give any color in terms of where those were and you also mentioned they were structured to protect Lennar from future declines. I was wondering if you could go into a little bit more detail there.

Stuart Miller

Mike we are very clever here. We know that you have now asked three questions and that third question had six parts to it. We see you. Mike, I think that what I’d have to say is that every dollar we spend right now is opportunistic. All of the dollars out. If we are not an option deal finding that we are buying into a good opportunity we are walking and we have done that aggressively. So when you look at the dollars we are spending on land and you are asking how much of that is opportunistic and how much is option, each of those option deals have either been re-worked or they have been walked from and they have been re-worked to a point where we feel that we have a good and solid opportunity. We are not land banking take downs and supporting deals and ventures and stuff like that. Each deal we are taking down today is opportunistic so I’d have to say all of it.

Operator

The next question comes from the line of Tim Jones – Wasserman and Associates.

Tim Jones – Wasserman and Associates

Let’s go back to home building 101. Gross margins and SG&A. First of all on the gross margins of 230 it is a remarkable improvement you had. You said part of that was to a lower land base. How much of that was coming through a reversal of previously impaired projects and how much was related to your cost savings in materials and labor?

Bruce Gross

You know something Tim, we knew that question was going to be asked and we suspected it would be asked by you. We spent a lot of time thinking about the answer to that question and given the size of the impairment we have taken it is really hard to delineate that in a meaningful way because when I come down to that evaluation I would almost have to say that all of it is attributable to land write downs because so much of our land write downs affects every community we are in. So, unless we are taking down rolling option home sites. So it is not only hard, it is impossible to delineate where the margin improvement is coming from. What we can tell you is that what we have done is across the board re-written our land to a point where we can produce margin. As we go forward margin improvement will continue to come from construction cost reduction and from SG&A reductions.

Now, back to home building 101. On the construction cost side, as I said earlier, we are seeing construction costs that are coming down as much as 20%. Now that doesn’t mean 20% across the board but in many instances we are seeing that kind of improvement. If we look back over the past year and we look year-over-year we are probably seeing something short of….somewhere in the 7-8% range in terms of construction cost reduction. But as we look ahead we see more and more cost savings coming through. Now the land price is remaining fairly stable.

Finally on the SG&A level we are looking at an SG&A level that is really coming down from somewhere in the 15-18% range.

Tim Jones – Wasserman and Associates

The question though on the second one, did you say…I couldn’t believe my ears…did you say you expected the SG&A rate as a percent of sales to be 10% in the fourth quarter?

Bruce Gross

At the division level we are expecting every division to be at that level by the fourth quarter. Now as I said, realistically and practically speaking there are going to be some divisions that don’t quite get there. But the amount of progress that has been made in that direction is striking and a number of our divisions have already gotten there and every one of them has a plan to get there by the fourth quarter.

Tim Jones – Wasserman and Associates

When is the last time in the company’s history you had that?

Bruce Gross

Well these are different times. I don’t remember. I will say that is our focus today. Each of the components of the manufacturing business starting with SG&A is absolutely where we are focused.

Operator

The next question comes from the line of Stephen East – Pali Research.

Stephen East – Pali Research

If you can talk a little bit, you talked some about the unique opportunities you were using your cash for, are those primarily attractive JV’s you would prefer to consolidate or would these be purely independent deals you are seeing coming down the pipeline?

Stuart Miller

Primarily right now JV’s and that is because that is where we are seeing distress turn into current opportunity. In the market at large we haven’t seen that much actually come through the pipeline. I noted before Steve that we are underwriting a number of deals and portfolios that are out there. Frankly the reality of market conditions has not yet really filtered through to the sellers so I kind of look at these as what I call warm-up exercises. What we saw in the late 80’s and early 90’s was it took some time for people to really reconcile.

Within our joint ventures where distress exists right there with us within our partnerships it is a straight negotiation where we can figure out where the opportunity exists and where common ground exists for the partner.

Stephen East – Pali Research

On those JV’s are you agnostic as to whether or what the debt loads are? Whether they are debt free or have meaningful debt?

Stuart Miller

We underwrite everything looking at it as a pure opportunity and if there is debt or no debt we are going to deal with it the same way. We are not interested in taking on additional obligations where there isn’t meaningful opportunity for our future.

Stephen East – Pali Research

If volume stayed at roughly the level we are running now how long do you think it would take you to get to a normalized operating margin looking at sort of what you talked about with the improvement in gross margin from your impaired land and moving your SG&A into a 10% type level?

Stuart Miller

What do you mean by normalized operating margin?

Stephen East – Pali Research

Let’s call it a single point number, 8% for lack of a better point.

Stuart Miller

I can’t guess. You are embedding in your question a lot of assumptions. The market is staying where it is right now and there is no more downward trend and sales pace where it is now? I’m not even sure where it is now. As I said, you get very erratic weeks in terms of sales pace in the field so it is kind of hard to make the assumptions you are laying out. We do anticipate given a fairly steady trend line we do anticipate improving net margins as we go forward. How quickly we get to a net 8% is just too hard to call right now.

Stephen East – Pali Research

One last question, your land supply you have now is fairly heavy for current volumes. Are you comfortable with that or would you like to bring that down over the next year or two?

Stuart Miller

No, I think we are comfortable with that. I think at some point, I’m not much into projecting right now, but at some point our production levels are going to come back up and the land that we have is going to be absorbed at a faster pace. I think that as we look at our land asset right now I think we have a sizeable land asset from the standpoint of number of home sites available but that is going to hold us in good stead going forward because I think that the business is going to come back. There is going to come a time where this foreclosure problem starts to subside and there is going to come a time where the demographics of this country start to kick in again and there is pent up demand. I think the swing is going to be strong. It just doesn’t happen to be in the next couple of quarters.

Operator

The next question comes from the line of Nishu Sood – Deutsche Bank North America.

Analyst for Nishu Sood – Deutsche Bank North America

I just wanted to try and get an idea of what percentage of your lots are fully developed?

Bruce Gross

I don’t have an exact percentage as to how many are fully developed but in terms of dollars I can kind of give you a rough order of magnitude that finished home sites are lets say approximately $900 million to $1 billion of our total inventory numbers we gave out earlier.

Analyst for Nishu Sood – Deutsche Bank North America

I just wanted to see if you could elaborate on the foreclosure competition. Are these in your direct neighborhoods or adjacent areas?

Stuart Miller

It is an interesting question. We really focused on exactly that question within each of our divisions. What we have found is with the remaining communities we have, that is the communities we have not walked from, the number of foreclosures actually in our communities are fairly low. I’m going to give you some numbers and they are probably not good numbers but they are kind of indicative of the order of magnitude but we found there weren’t really situations where we found more than 20% of a community that had gone through elements of a foreclosure. By the way the term foreclosure seems to be confused throughout the industry right now. The foreclosure is sometimes referred to as loans in default or loans under judicial process or homes that have actually been taken back as REO or have been sold. So we’re looking at the whole span of homes that have either been sold as REO or homes that are actually in a default process right now, so that whole spectrum. It has been a smaller percentage than we thought it would be. Generally in the 20% range.

We are also finding that the clearing price for foreclosed home has not taken as big as a dip as we thought they might and in fact they are selling at least in our communities selling somewhat close to the sales price we are offering for new homes.

Operator

The next question comes from the line of Jim Wilson – JMP Securities.

Jim Wilson – JMP Securities

I don’t know if I missed it but in the California impairment on the JV’s is there anything there related to Land Source like for the management contract or anything or is it all from other JV’s?

Bruce Gross

No that would all be from other JV’s.

Jim Wilson – JMP Securities

Anything you can comment on with the shelf filing and potential uses beyond the obvious that it could be anything? Is there anything it is targeted for?

Stuart Miller

There is nothing behind that filing. It is a filing that expired and in the normal course we are just re-filing. There is nothing to read into that Jim.

Operator

The next question comes from the line of Megan McGrath – Lehman Brothers.

Megan McGrath – Lehman Brothers

I just wanted to ask quickly about your incentives. It ticked up a little sequentially and year-over-year. I was wondering if you could just talk about how your incentives have evolved. How the newer financing incentives seem to be working, or how they have changed over the past couple of quarters?

Stuart Miller

The question of incentives is a very locally driven question and what you are looking at in the corporate level is a roll up of a lot of very different programs that are working differently in different markets. So the incentive programs are left to our divisions and are very much focused on driving sales given current levels of market conditions. Really on a day by day, community by community basis that changes around to accommodate basically competing against our biggest competitor, as I said before, and that is the foreclosure market. I don’t think there are trends we can describe to you. I think you are actually seeing a lot of erratic data points that are combining to look like a trend and they don’t really represent a trend.

Megan McGrath – Lehman Brothers

Just a quick one for Bruce. Your home building debt looked like it ticked up just a tiny bit quarter-over-quarter. Did you put a new JV down on the books or is that something else going on there?

Bruce Gross

There was a joint venture consolidation during the quarter and that is the only reason that increased overall for home building.

Operator

The next question comes from the line of Dan Oppenheim – Credit Suisse.

Dan Oppenheim – Credit Suisse

I’m wondering if you can talk a little bit more on SG&A. You are talking about the outlook continuing to worsen and weak absorption as it is right now and your goal is to mark it down to 10% SG&A as a percentage of revenue. How is it you look at managing that and clearly we are getting close to the point where you are cutting some bone in the big markets. What is it that is involved in cutting SG&A at this point where you think you can keep sort of cutting away and keep business as we are going forward here?

Bruce Gross

That is a fair question Dan. Clearly as sales pace is moving around primarily in a downward direction and prices are moving down getting to a 10% level on revenues is a tricky business right now. We are only as good as our predictions and projections. You also highlight that we have cut away some of the fat and probably cut through some muscle and maybe hit some bone. But the fact is at the end of the day we are getting down to a very aggressively thin group of professionals in each division and we are consolidating divisions where possible and really bringing the machine down to its bare necessities. I think that a lot of the opportunities to cut come from the ability to eliminate communities that are not performing well. So as some of our communities bleed off it helps us bring down our SG&A and other efficiencies we see in the market like consolidating some of our purchasing effort at either regional or corporate levels or consolidating our marketing programs and having them come from a corporate level.

In each of these areas we are looking at ways to take cost out of the operating division and either combine them to generate efficiencies or to just eliminate them entirely.

Operator

The next question comes from the line of Jay McCanless – FTN Midwest Research.

Jay McCanless – FTN Midwest Research

If I look at the dollar value of your backlog from the first quarter to second quarter it is the first time it has moved up in almost three years. I know you don’t make predictions but given what the current situation is, etc. can we reasonably expect a return to that seasonal pattern where it builds first, second and third and then decreases in the fourth?

Stuart Miller

No. I don’t think that we can expect to read any or see any patterns re-emerge for the time being. I think we are going to see some fairly erratic numbers that come through the system. Really what I back that up with is just the view ahead to the foreclosure market. I think if you look at the pipeline across the country particularly in some of the biggest markets, the foreclosure pipeline and that is the homes that are in default today just entering the judicial process, it is getting bigger not smaller. Barring something being done at the governmental level I think we are going to see more pressure going forward rather than opportunity to see typical selling patterns re-emerge.

So a lot of the patterns we see are going to be dependent on the inventory levels driven by the foreclosure market. There are wild cards out there. There are legislative opportunities that are in front of Congress right now that could ameliorate some of these pressures and we’re just going to have to wait and see.

Jay McCanless – FTN Midwest Research

On the incentives I note there has been significant advertisement on your website, etc. for rate buy downs. Is that the primary incentive you are offering now or is it still a mix of option packages for the house plus the rate buy downs? How does the incentive picture look right now?

Stuart Miller

It is all of the above but the rate buy down incentive is a significant one.

Operator

The next question comes from the line of Rashid Dahod – Argus Research.

Rashid Dahod – Argus Research

In response to an earlier question you mentioned the expected correction of existing home prices and some of the other builders have reported where their new homes are priced below comparable existing homes. I was wondering what market you are seeing that in or what percentage of markets you are seeing that in as well?

Stuart Miller

I think that what is being highlighted is the new home market corrected much more rapidly than the existing home market. So what you are seeing in the existing home market is the number of homes on the market at prices that are more reflective of yesterday’s values. I think this is a national phenomenon, not specific to any particular market. Basically you haven’t seen that reconciliation in the mind of the individual homeowner to the fact that home values have diminished to the extent they have. So we see this really across the country.

Now the foreclosure market is not having as much of a difficult time pricing to where the new home market is.

Rashid Dahod – Argus Research

As existing home prices correct what impact do you think that will have on the new home sales and what is your strategy?

Stuart Miller

That is a good question. Listen I think that as existing home sales correct more and more it will put more competitive pressure just because you’ll have more legitimately priced inventory in the market place. But always remember that new homes compete very well against existing homes. They come with a warranty. It is not somebody else’s footprint on the home and so we will compete and do compete very well against comparably priced existing home and in fact the new home market typically trades at a premium to the existing home.

Now what I will say is that what you have seen over the past year or two is a quick correction in the new home market because the home builders have moved rather rapidly to reduce inventory levels. I noted in my comments one of the positives out there is that the new home market inventory level has come down precipitously and that is a real positive for pricing power in the future.

Operator

The next question comes from the line of Stephen Kim – Alpine Woods.

Stephen Kim – Alpine Woods

I wanted to see if I could ask you a couple of questions regarding what we might consider to be a normalized base. I know I’m going to get into a little bit of trouble here because you asked the other guy what normalized meant, but let me put it this way…you indicated your unsold, completed inventory was down 47% from just the previous quarter sequentially and I’ve been noticing your backlog conversion ratio has been extremely high for really the last three, in fact five quarters now, almost 100%. Given that you are not going to be delivering as many homes that were already sitting in your backlog completed I would think you might see your conversion ratio decline and therefore you would be doing more sort of a build-to-order type business. Is that what we should be expecting from you as soon as this third quarter or are there other factors I’m not thinking about?

Stuart Miller

Well at the same time that we are eliminating a lot of our inventory our production cycle is coming down pretty quickly as well. As part of our cost initiatives we are also very focused on cycle time and our cycle times have been coming down so that is going to offset some of that.

Stephen Kim – Alpine Woods

You mean your natural cycle time as opposed to being influenced by cancellations and things like that?

Stuart Miller

Right. I think that you are seeing a lower cancellation rate. I don’t know we will sustain a 22% cancellation rate but I suspect it is going to be lower than where we have been over the past three years on a consistent basis. We are absolutely more focused on selling homes that are not under construction and there is more of that but we think our delivery time on those homes is going to improve as well.

So our backlog conversion ratio will move around a little bit but we think there will be some offsetting input to that on both sides.

Stephen Kim – Alpine Woods

That result should be, I would think, some reduction in overhead carry and that sort of gets to my next question which is your SG&A rate. Now you talked about a divisional SG&A rate of about 10% as your goal. I just hadn’t heard you talk about that in prior years. I just want to make sure I’m understanding. So the 10% divisional SG&A rate pretty much aggregates up to a 10% SG&A rate as a percentage of home sale revenues that we would see on your income statement? Or is there some adjustment factor you can give us?

Stuart Miller

Number one the answer to the last part of the question is yes it should reflect on the income statement at that level. You are right, we haven’t really talked about it much. This has been a primary focus over the last year or year and a half and I just haven’t wanted to talk about it until I see real progress in the field. This last round of Ops reviews gave me a level of optimism about where we are actually going to land here. Now might it move around because volumes aren’t where divisions expect them to be or something? It is possible but we have made a lot of progress in this arena.

Stephen Kim – Alpine Woods

Does that suggest your break even point in terms of absorptions per community to break even profit wise is reduced from where it was 2-3 years ago?

Stuart Miller

It is reduced materially. It has come down materially.

Operator

The final question comes from the line of Alex Barron – Agency Trading Group.

Alex Barron – Agency Trading Group

I don’t know if I missed it but did you mention what the cash flow from operations was for the quarter?

Bruce Gross

We didn’t mention it yet because the cash flow statement isn’t completed Alex. Essentially cash quarter-over-quarter was reduced about $200 million in total.

Alex Barron – Agency Trading Group

My other question was I know you guys have already sold some land but of the communities you currently own I was wondering what percentage of those have been impaired at least once.

Bruce Gross

Currently of our total communities we have impaired 5% this quarter. We don’t really track a cumulative percentage count but we have impaired about 5% of our communities that is in our second quarter impairment number.

Stuart Miller

The other way for me to say that would be we have impaired 100% of the ones that should be impaired. I’m sorry we are not really directly answering your question.

Alex Barron – Agency Trading Group

In terms of how…I know you guys have been doing these financing incentives with rate buy downs and paying closing costs and down payment assistance, how is that accounted for? Is that in the cost of goods sold? Is that part of SG&A? How does that flow through the income statement?

Bruce Gross

That is included in sales incentives which is a reduction to revenue. So it factors into the gross margin calculation. 100% of it.

Alex Barron – Agency Trading Group

So it is basically the revenue is what is adjusted?

Bruce Gross

Yes. Sales incentives are a reduction of revenue and 100% of any cost relating to a buy down program is included in sales incentives which is a reduction in revenue.

Stuart Miller

That will be the last question for this morning. We appreciate everybody’s attention as we report our second quarter. We are optimistic about our progress and where we are in this tough market condition and look forward to reporting our third quarter.

Operator

That does conclude today’s conference call. You may now disconnect.

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Source: Lennar Corp. F2Q08 (Qtr End 05/31/08) Earnings Call Transcript
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