Lennar Earnings Call - No Bottom Yet

I just got off the Lennar call and wanted to share these highlights regarding the housing markets. Management has not yet seen the bottom in the markets they build in.

During the call, Lennar said that they would need to see three things before there is a recovery or stabilization in the market:

1) Inventories of both new and existing homes will have to stabilize first and be absorbed.

2) Mortgage markets will need to settle.

3) Consumer confidence is going to have to be restored.

Lennar said that there was no sign during the quarter that any of these occurred, and that in fact they had deteriorated further during the quarter.

General Market Conditions

“These continue to be very difficult times for the homebuilding industry”

“Current market conditions are primarily defined by the overhang of inventory in those markets which is comprised of completed homes on the ground, spec homes that are back on the market and owned homes that are up for sale. The overriding sentiment in our reviews is that the market has continued to become more and more competitive as inventories are managed and there continues to be a great deal of downward pricing pressure through the use of incentives, price reductions and incentivized brokerage fees."

On Signs of the Bottom

“Overall the supply of homes to sell continues to climb in many of our markets and we are not able to get a good reading how quickly this inventory will be absorbed or whether it will continue to increase as foreclosures increase and add to inventory.”

Mortgage Markets

“Adding to the sluggishness on the demand side is the continuing deterioration of the mortgage market as an additional component of demand has been sidelined.”

“We have not yet seen stability in the mortgage market either.”

On the Arrival of Helicopter Ben

“While the recent cut in interest rates by the federal reserve will began a process of rebuilding confidence it will most certainly not be a panacea for conditions as they exist.”

Wilbur Ross Speaks and You Damn Well Better Listen

I just listened to a great interview with Wilbur Ross on Bloomberg which was brought to my attention by the people at Vinvesting


Wilbur Ross Bloomberg Interview

The interview is 25 minutes long and goes into good detail on the issues of the day, including the sub prime lending fall out, brokerage earnings, the growth of the hedge fund industry and the inherent weakness of quantitative "black box" investing.

Jackass of the Day - August 31, 2007

"The program could play a very important role in saving from foreclosure American homeowners who have been taken advantage of by unscrupulous subprime lenders and brokers,"

Senate Banking Committee Chairman Christopher Dodd, D-Conn

And how will you tell them apart? Can you distinguish between greed and stupidity?

The Conundrum

The Conundrum is simple and is this - the market continues to climb based on a "buy on the dips" mentality fed, at least in part, on continued takeover speculation that is embedded in the value of equities. Every time the market declines significantly, it bounces right back as investors jump into names they have been stalking. I think that at every buy side shop there is an investment thesis template that reads "potential buyout candidate" and all the analyst has to do is fill in the name and symbol, and give it to his Portfolio Manager.

However, the financing that supports that takeover activity is starting to undergo a repricing by investors based on a reevaluation of the perceived risk. Many investors have stopped investing at all here or have paused, while other investors are rejecting covenant lite and toggle or pay in kind bonds while demanding higher yields. Higher yields mean less of a return on these deals which will shrink the universe of potential buyout candidates.

There are at least 6 "hung up" bridge loans held by investment banks where Wall Street firms provided interim financing to buyout shops, in anticipation of replacing the bridge loan with permanent financing. Until this pipeline clears or the investment banks feel that conditions in the credit market are returning to normal (I hate to even use the word normal) this type of stop gap financing will be harder to come by.

The latest deal financing to fall through was reported today by The Wall Street Journal - the buyout of Allison Transmission, a unit of General Motors. Investment banks postponed an offering of $3.1 billion in loans.

We have a conundrum here. The stock market cannot continue to be propped up by the private equity buyout frenzy if the financing that supports that frenzy is no longer viable. There are a number of possibilities here:

1) The market is seeing through the current turmoil in the credit markets and expects the financing to return. If true, this would be extraordinary considering the market usually has a one-week time horizon.

2) The market believes that even if risk reprices at a higher level - the internal rate of return (IRR) on private equity deals will still be sufficient enough that the buyouts will continue.

3) There are other things that are pushing the market higher besides the buyout frenzy. This could be a number of things, perhaps even the dreaded "liquidity" excuse that I hate so much as OPEC and the Chinese have so much money they have to put it somewhere.

4) I am completely wrong and have no idea what I am talking about and shouldn't be writing an investment blog much less running a hedge fund. If this is true please send me an e-mail privately and tell me.

5) The investors who are propping the market up don't fully understand the reasons supporting valuation that I described earlier in this post so therefore they cannot stop investing when these reasons end.

6) There is a lag time before the financing problems impact the stock market.

7) Investors believe that private equity shops have so much money that they will spend it no matter what. If they make bad deals it will be years before the limited partners who invest in these funds feel it.

If I had to make a bet, it would be on reasons 2 and 7 (I hope it's not #4). Interest rates are still low historically, some marginal deals may fall through, but many would still work at least on paper based on a spreadsheet with optimistic projections of future cash flow growth and EBITDA exit multiples.

Homebuilder Debt to Capital Ratio - Be Careful Out There

Lennar Inc. (LNR) just released its quarterly earnings report and highlighted what it considers its low debt to total capitalization of 31.6%. Investors should note, however, that the numerator of this calculation only includes the on balance sheet debt and Equity of Lennar. Lennar has not filed its 10-Q for the May quarter as of the day I wrote this, but the company has the following debt according to its 10-Q from the previous quarter (ended 2/28/07).

$ 278,232 - 7 5/8% senior notes due 2009
$ 299,766 - 5.125% senior notes due 2010
$ 249,461 - 5.95% senior notes due 2011
$ 345,719 - 5.95% senior notes due 2013
$ 247,559 - 5.50% senior notes due 2014
$ 501,851 - 5.60% senior notes due 2015
$ 249,694 - 6.50% senior notes due 2016
$ 300,000 - senior floating-rate notes due 2009
$ 109,212 - Mortgage notes on land and other debt

$ 2,581,494

This total debt number is close to the number in Lennar's press release of $2,585,286,000 for the May quarter, which when divided by total debt and equity of $8,168,841,000 gives us the 31.6% number. However, if you dig into the 10-Q for February you will see that Lennar calculates the debt to total capital of its unconsolidated entities as follows:

Debt of Unconsolidated Entities $5,619,394,000
Total Equity of Unconsolidated Entities $3,299,991,000
Total Capital $8,919,385,000

Debt to total capital of Unconsolidated Entities 63%

To be fair to Lennar, there is a footnote that says the Equity is carried at book value and the market value is $1.3 billion higher than book.

If you do a weighted average of the on balance sheet debt to capital and then the unconsolidated entities, then you get

Debt $8,200,888,000
Equity $9,074,972,000

Total Capital $17,275,860,000

Debt to Capital 47.47%

I believe that Lennar has a reputation as one of the more open and transparent Homebuilders so it may not be possible to calculate this for the other publicly traded Homebuilders, but investors should look twice at the official number that come out in press releases.

Now when I contacted investor relations to get the company opinion on this matter they said that:

"it would not be accurate to add the equity and debt from our JVs. Most of this debt is non-recourse to Lennar or has recourse via maintenance guaranties."

Well, now I am even more confused and need to do a little more work on the entire concept of these structures. I will come back to this at a later time. If anyone has encountered these structures before and has a more complete understanding of them, please comment.