Lennar reversed $403 million of its deferred asset reserve in Q2. This is not a significant financial event, but is a symbolic one is that it shows Lennar has reached a stable financial condition and consistent profitability. It also shows the housing market has stabilized, likely bottomed and is possibly beginning to recover.
For the past few quarters, Lennar has seen more traffic in its Welcome Home Centers. It has seen an increase in its monthly sales per community.
Lennar's strategy is to focus on high margins in well-positioned communities. It expects that strategy to drive SG&A operating leverage that will continue to produce strong and sustainable bottom line earnings. In Q1, it purchased 4,561 homesites for $206 million, and spent $81 million on land development. Its land acquisition and land development spending increased 74% over the prior-year period. Lennar also signed option contracts to acquire 1,597 homesites. Over the last several quarters, Lennar put under contract or letter of intent over 24,000 homesites that have yet to close. The land deals have been underwritten to exceed a 20% gross margin and a 20% IRR with no inflation. Because Lennar raises prices in smaller increments, such as $1000 or $2500, the appraisal process has not been causing as many problems as it is easier to get an appraisal for the modest increase. Lennar expects its community count to be 5 to 10 percent higher at the end of the year from where it started at the beginning of the year. Lennar is starting to demothball some communities.
During Q2, approximately 48% of Lennar's deliveries came from communities purchased or put under contract during the last 3 years. Its gross margins on closings in those communities was approximately 200 basis points higher than the gross margin for the entire company in Q2.
Approximately 29% of Lennar's land purchases in Q2 were in the mid-Atlantic, 23% in the West, 22% in Texas, 14% in Florida, 7% in the Pacific Northwest, with the remaining 5% spread throughout other markets. Most of the purchases were relationships deals outside of the competitive bidding market. The geographic mix will differ every quarter depending on the values the company finds.
Lennar Financial Services had an excellent quarter and added incremental volume by participating in the refinance market.
In Q2, Rialto's earnings fell short of expectations, but the contribution that Rialto's connections and relationships have made to the core Homebuilding business has exceeded expectations. Rialto acquires, resolves and adds value to distressed and advantageously priced real estate assets. It has added expertise in terms of finding new deals. It's PPIP and private equity fund are performing well. However, Rialto fell short of expectations mainly due to the timing of recoveries and higher expenses resulting from a number of borrowers and guarantors in its earlier distressed debt portfolios, taking obstinate positions about repaying their loans. Further, there has been an increased effort by a number of investor and developer obligors to alter existing laws to frustrate the original contractual terms of the underlying loan agreements or personal guarantees, which would limit Rialto's ability to collect what is due. Ultimately, the legislative attempts to modify the contracts and the attempts by borrowers to not honor the contract have been unsuccessful, but there is increased costs associated with use of the judicial process and revenue recognition is delayed.
There has been a lot of recent press coverage on a financing deal with a Chinese bank on the Hunters Point and Treasure Island partnerships. Lennar does not comment on deals that are in negotiation or not closed, but it has a great number of very exciting dealings around various strategic assets that will reveal themselves over time.
Lennar explained why it believes it will continue to be successful and why it is different from its competition: (1) it has relationships that create a lot of deals that are not available on the open market; (2) it can move quickly to close a deal when it finds a good opportunity; (3) it has the expertise and flexibility to handle complex deals, (4) it has credibility in that when it signs a contract it rarely has to renegotiate because it did its due diligence ahead of time; (5) it will persistently pursue a deal it wants until there is absolutely no chance it will get it, (6) its consistent operating performance in opening communities and driving traffic tends to give it a first look at deals and often makes it the perfect builder in a multi-builder community, (7) Rialto gives it the expertise to buy assets that will turn into land such as CDD bonds and bank notes and mortgages, which gives Lennar a constant stream of high-margin opportunities.
Lennar also believes it is more competitive due to its Everything Included platform, which simplifies home purchases. It introduced in the West a new product called Next Gen, Home Within A Home, which targets baby boomers who are caring for aging parents or boomerang kids. It expects to offer this product in 25 percent of its communities by the end of the year. The product is without competition from resales and is producing strong gross margins and incremental sales.
Evaluation of markets.
Lennar has seen consistent improvement in traffic and demand, which confirms that the housing market and the economy is stabilizing and starting to trend. However, the housing market is not in full recovery and the data is still negative in some instances. The stabilization is uneven across the country and even within markets, and it is not broad-based. However, the demand is stronger than in prior years. There are pockets of areas that are improving and those pockets are growing. Demand is constrained, however, by mortgage qualification standards and a difficult appraisal environment. The appraisals have recently gotten in line with the market and are no longer driving prices lower. Some in the government are pushing for the loosening of credit standards, realizing that the paperwork is too cumbersome and the required credit scores were too high.
Lennar discussed a number of
trends it is currently seeing in the housing market. First,
homebuyers today are not looking at housing as a way to make money on
increases in prices. Instead, they believe housing has real value
since affordability is at extremely high levels. Second,
homebuyers are starting to feel pressure to make the purchase so they
don't miss out and there is more urgency in the market, with rising
prices creating this sense of urgency. Third,
consumers are realizing the value of mortgage payments versus rental
payments. Rental prices are high and are increasing. Fourth,
consumers understand the mortgage process is much more conservative
now and it is difficult to get approved. They are getting their
credit in order and making the required down payment to purchase
property. Fifth,
inventories are declining in many markets and in some areas, houses
for sale are becoming more scarce. Sixth,
there are fewer strategic defaults as a result of the government's
recasting of HARP 2.0, the home refinance program for performing but
underwater loans. Seventh,
the trend of children moving back home and elderly parents moving in
is slowing and starting to reverse as a result of the improvement in
employment and consumer confidence.
In short, Lennar is growing more confident that housing has bottomed and a new cycle for housing has begun. It expects mixed signals on national housing statistics in the next year.
Financials.
Homebuilding segment
In Q2, closings were up 20%.
New orders increased 40% from Q2/2011 and 48 % from Q1/2012. For the prior 4 quarters, sales were 2.4 sales per community per month. In Q2, sales increased 3.5 sales per month. Incentives decreased to 10.7%, a 140-basis-point improvement from Q2/2011. The reduction in incentives primarily due to the improved rate of sales and a higher percentage of homes sold prior to starting construction. In the West, 85 percent of the communities have improved on incentives, and the Central region is a little better, while the East is a little worse.
Backlog improved by 61%. Due to the rapid increase in backlog, sold homes represent 48% of total homes under construction. Lennar's backlog conversion ratio has been running above 110% for the past few years. A lot of homes will close in Q4, not Q3, and therefore, Lennar expects its backlog conversion ratio for Q3 deliveries to be between 85% and 90%.
Revenues from home sales increased 23%. There was a 20% increase in wholly owned deliveries and a 2% increase in average sales price to $250,000. The average sales price by region are as follows: East, $231,000, up 4%; Southeast Florida, $266,000, up 1%; Central Florida, $229,000, up 9%; Houston, $229,000, down 1%; West, $304,000, down 1%; and the other category, $321,000, down 17% due to product mix.
Gross margins were 22.5%. One factor in improving margins in Q2 was developing strategies to improve the performance of communities where the rates of sales was below the company average. Gross margins were strong in all regions, but strongest in the East and South Florida. Lennar expects its gross margin to be between 21% and 22.5% for the remainder of the year.
Operating margins were 9.2%. There are some cost pressures materializing, though Lennar believes the increases will be offset by sales price improvements and its focus on managing direct costs. For the last 6 quarters, Lennar's average direct costs have stayed in a range of $40 to $42 per square foot.
SG&A declined to 13.2%, an improvement of 170 basis points.
On a year-over-year basis, Q2 inventory increased about $557 million to approximately $4.4 billion. From Q1, inventory increased about $145 million. At May 31, 2012, Lennar owned and controlled 121,517 homesites and had 440 active communities.
Lennar completed a $525 million 3-year unsecured revolving credit facility, of which $410 million was initially committed. Its liquidity increased to $1.1 billion when adding its cash balance to the fully undrawn revolver.
Financial Services segment
Lennar's Financial Services business segment generated operating earnings of $18 million versus $2.5 million in Q2/2011 and generated its strongest quarterly operating earnings for Financial Services since 2006. Mortgage pretax income increased to $17.2 million from $5.3 million in the prior year.
Mortgage originations in Q2 increased by 50%. Lennar's in-house mortgage capture rate of Lennar homebuyers was 77% this quarter. Originations with non-Lennar homebuyers increased 89% in Q2 primarily due to an increase in the number of refinanced transactions. There was a significant volume of refinance activity in Q2.
Title company.
Lennar's title company had a $1.4 million profit in Q2 versus a loss of $2.2 million in the prior year. The volume of transactions increased by 39%.
Rialto
The Rialto business segment generated operating earnings of $4.3 million. This number is net of $3.2 million of net earnings attributable to noncontrolling interest, and that compares to $9.8 million in the prior year. The FDIC portfolios had a $3.2 million gain; non-FDIC portfolios had a $1.3 million gain; PPIP contributed $2.7 million; and the Rialto Real Estate Fund contributed $3 million of earnings.
The full transcript of the earnings conference call can be found on Seeking Alpha at the following link:
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