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January 03, 2008

Lennar Insolvent: Enron Redux???
by Reggie Middleton

Required reading for this blog post is the fully consolidated Lennar 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 dowload 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 thier 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 redcue 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 (eventhought 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, Beazer, Hovnanian, 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 put's 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 insovent. Included in the calculations is:

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 obviouslydon't feel this woud be either one time or extraordinary, hence probably belongs in FAS 144 category.
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.
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 covenenats, 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' 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 thier customers. The problem is that Lennar funds acquisistions 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 specfic phenomenon) with a extremely sensitive and leveraged connection with landvalues 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 sensitivty 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 thier insolvency.

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

Now, knowing that thier 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 oppurtunity, 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!" Unfortunatey, they don't see what's 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!

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

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