Before we get started with my dark missive, let's clarify the title with a few definitions and a brief history lesson:

Voodoo Accounting - Any form of accounting that does not follow principles of conservatism. While there are many methods by which financial statements can be fudged, it always comes down to inflating revenue or hiding expenses. Any method that boosts profitability through accounting tricks eventually catches up with the company. As soon as it does "poof", past profits disappear like magic. (Hence the name "voodoo accounting"). My calculation of Lennar's fully consolidated financial statements show that about 40% of its full recourse debt lies off balance sheet.

Insolvency - a financial condition experienced by a person or business entity when their assets no longer exceed their liabilities.

Lennar Corporation - a company that I am short that is:

1. borderline insolvent;
2. makes use of voodoo accounting to book profits from assets held off balance (to boost performance metrics) and conceals significant debt off balance sheet as well (to health metrics);
3. is operating at negative margins;
4. significantly discounting an exorbitant amount of inventory that is extremely overvalued in a highly unfavorable macro environment that is getting worse, not better.

Enron - The Enron scandal was a financial scandal that was revealed in late 2001. After a series of revelations involving irregular accounting procedures bordering on fraud, perpetrated throughout the 1990s, involving Enron and its accounting firm Arthur Andersen, it stood at the verge of undergoing the largest bankruptcy in history by mid-November 2001. Enron filed for bankruptcy on December 2, 2001.

As the scandal was revealed, Enron shares dropped from over US$90.00 to just pennies. Enron's plunge occurred after it was revealed that much of its profits and revenue were the result of deals with special purpose entities (limited partnerships which it controlled). The result was that many of Enron's debts and the losses that it suffered were not reported in its financial statements. In addition, the scandal caused the dissolution of Arthur Andersen, which at the time was one of the world's top five accounting firms.

Historical dictionary ends here, Dark Missive restarts...

Unfortunately, it appears that I have reached formatting limits of the blogging mechanism that I am leasing, so the charts may be a little difficult to read. Here is a .pdf verstheion of the analysis portion of this blog post (the part without my smart ass opinions) which should be more legible for those who have a problem reading the html blog version below. Feel free to distribute it at will.

Now, to the point - Lennar is leveraged to the hilt. They have a significant amount of debt, a murderous macro environment, a dead business model, and cut throat competition. They also have a lot of secrets hidden off balance sheet. I will leave the research report below untouched, and simply add some highlights here (due to my inability to post the edits).

Now, after that brief history and vocabulary lesson, I need someone like Stephen Kim from Citibank to issue another fundamentally silly, yet overly bullish report on the homebuilders again so I can strengthen my short position on Lennar. Before the pundits and legal eagles come after me, let it be known that I am not accusing Lennar of fraud or wrongdoing, but I am accusing them of underperformance and the use of off balance sheet vehicles to conceal assets, debt, and risk from investors. What's the difference, you ask? Well, there is reality in the accounting sense, and economic reality. Lennar has $5.5 billion of off balance sheet debt, more than a billion of that fully recourse or otherwise holding the company directly liable. They have not violated GAAP rules, to my knowledge. But, the economic reality is that debt is debt, liabilities are liabilities and ROI and ROA are real measures of performance. Despite the fact that LEN's books are kosher from an accounting perspective belies the fact that they are highly misleading from an economic perspective, which is the perspective that rewards the investor.

To put this into perspective, notice that a proper forensic consolidation of Lennar's full recourse debt (and debt that can attach to the parent company assets through contractual means) shows that Lennar carries about half of its debt, and probably even more of its total liabilities off balance sheet and does not report on it. That is scary for a company that is writing down assets by the billions and is facing sequential quarterly losses in a negative macro environment amongst intense competition. As mentioned in the parenthetical, I have been very, very conservative in this forensic examination. Absolutely no non-recourse debt is involved (I had $3.5 billion of non-recourse to choose from, and it still draws debt service and encumbers assets). My models are flexible enough to granularly segregate the various tranches of debt and include them at will.

Properly including contractually enforceable and full recourse debt shows an extremely high probability of bankruptcy in 8 quarters. The currently published probability is in the high 80% range, though to be conservative the graph states 72%.

Including JV's
Debt Rating (Including JV's)	2005	2006	2007E	2008E	2009E	2010E	2011E	2012E
Working Capital / Total Assets	0.55	0.55	0.50	0.47	0.39	0.35	0.27	0.22
Retained Earnings / Total Assets	0.32	0.37	0.32	0.28	0.22	0.13	0.05	(0.02)
EBIT (trailing 12 months) / Total Assets	0.16	0.07	(0.14)	(0.12)	(0.14)	(0.17)	(0.16)	(0.13)
MV of Equity / BV of Total Liabilities	1.26	0.50	0.86	0.91	0.91	0.88	0.88	0.81
Sales (trailing 12 months) / Total Assets	1.11	1.31	0.91	0.68	0.67	0.73	0.82	0.88
Z-score ( Including JV's )	3.50	3.03	2.02	1.77	1.52	1.30	1.23	1.18
Debt rating	CCC+	CCC	CCC-	CCC-	D	D	D	D

In my opinion, and according to some extremely thorough research, Lennar should have been rated as deep junk as far back as 2005. It's debt to enterprise value, debt to equity, debt to capitalization, and practically any other metric that measures debt or earnings quality looks dismal, indeed.

I am sure many of you are saying that they just have to last a few quarter to grow out of this...

This graph of gross margins looks more like a Stephen King animated horror graphic than a financial projection, but it is highly justified (see the report below). Lennar will probably not see positive numbers until after 2012.

Now, on to the formal analysis:

Before we go on, here's a snapshot of Reggie Middleton's Boom, Bust & Bling Blog Real Estate Analysis that you may find of interest. If you are a regular to the blog, feel free to skip ahead to the analysis:

Home Building Industry: Myths, Markets & Manipulators: The Real Deal on the Homebuilders | Bubbles, Banks and Builders|Bubbles, Banks, and Builders, Pt. Deux |Bubbles, Banks & Builders: Pt.III - "Do or Die, Bed Stuy"|Bubbles, Bank, & Builders - Pt IV: I can't believe this guy |Straight Talk From the Homebuilder CFO: The Coming Land Recession, Pt I | Straight Talk From the Homebuilder CFO: The Coming Land Recession, Pt II |Straight Talk From the Homebuilder CFO: The tricks builders use to disguise the true losses on their book value| Straight Talk From the ex-Homebuilder CFO: Yes.. straight from the Lennar CEOs mouth... land has zero value... | What does Reggie Middleton and Ryland's upper management have in common? They are both selling shares faster than no doc loans get approved! |Thoughts on the US Publicly Traded Homebuilders | Correction, and further thoughts on the topic |Who else is in trouble? | As was predicted in the homebuilders annual reports, and this blog...| The Performance of Centex's Mortgage Originations, or CountryWide Redux, pt III |It's approaching "Do or Die" time for the homebuilders - Will desperation tank the US real estate market? |Hovnanian Announces Successful Preliminary "Deal of the Century", OR Hey, Our Marketing/PR Team Pulled it Off, and We Finally Got Some Positive Press!!! | Credibility is the Key to Success for a CEO - Hovnanian has Lost that Key: A letter to Mr. Hovnanian | KB Home's Numbers are Horrible, and that's putting it mildly! | Apply "COMMON SENSE" when evaluating the home builders!| Home builders are up over 20%, housing prices to drop 28% over 4 yrs, inventory > 8%, listings >1.2% - Shorts, Anybody??? | Potential Home Builder Bankruptcy

Global Macro: Okay, I have just recharged the batteries in my crystal ball: Back tested Home Price Trends - Historical and Forecasted | Quick note on increase in construction spending: not necessarily good economic news | There is no recession, the economy is in fine shape, and business is strong!!! | More than lower interest rates fueled the recent real estate boom | NY Housing Trends: Where is NYC Headed? | Manhattan Real Estate is Falling. That's Right, I said it!!! And Beware Those with Short Term Memory. | Beware, even the strong rental market! | The Case-Shiller Index for the Month of July | Prospects for the Stock Market: What Are the Fundamentals? | The Unusual Behavior of the Federal Funds and 10-Year Treasury Rates: A Conundrum or Goodhart's Law? | Whaaat!! How much did you cut? | Rates are still going up, Mr. Bernanke | Dangerous Times: Where are the Experts? | What can the Fed really do to help adjustable rate mortgage holders? Close to nothing... | The "Real" Trend in US Housing Prices... | For those who feel the world has decoupled from the US economically - and in the financial markets, I bring you "The Great Global Macro Experiment" | How Far Will US Home Prices Drop?

Corporate Earnings and Finance: A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton | Washington Mutual get hits hard - you were warned here about this in September! | COUNTRYWIDE POSTED its first quarterly loss in 25 years on $2.27 billion in mortgage losses and write-downs and soaring credit-loss reserves. But... | Washington Mutuals Mortgage Division Posts 5th Straight Quarterly Loss | Yeah, Countrywide is pretty bad, but it ain't the only one at the subprime party... Comparing Countrywide to its peers | Are the Mortgage Insurers in Serious Trouble? | Rampant share buybacks bold ill for future growth

Investment Summary

Lennar's financial performance continues to be thwarted by the continuing slowdown in the US residential housing sector. The company's EPS continued its downward momentum in the sixth consecutive quarter, falling to a loss per share of $3.25 in 3Q2007 from $3.57 in 2Q2006. As declining consumer confidence and tightening credit conditions continue to hamper the housing demand and pricing, the prospects of near-term recovery in the homebuilding sector are currently bleak. Going forward, investor confidence in the sector can only be expected to worsen as disclosures are made of the hitherto concealed off-balance sheet liabilities of homebuilding companies. Lennar's is a case in point with the company's recent 8K filing highlighting the company's exposure to around $1.0 billion of its unconsolidated joint ventures (JV) debt with potential exposure to almost 100% of the latter's additional $4.5 billion liabilities.

Key Points

• $5.5 billion of hidden debt - As of August 31, 2007, Lennar's hidden debt through JV's stood at a staggering $5.5 billion. Including reimbursement agreement with partners, Lennar's maximum recourse exposure stands at a $1.0 billion. Additionally, Lennar has approximately $0.25 billion of debt in form of recourse through reimbursement agreements and $0.68 billion as joint and several recourse debts. Besides these, the JVs also have $3.7 billion of non-recourse debt. Aptly in response to this mounting debt in November 2007, S&P had lowered Lennar's debt rating as junk to BB+ from BBB- earlier. Earlier in October 2007, Moody's had downgraded Lennar's debt ratings to junk status.
• Falling backlogs and rising inventory - With declining consumer confidence in the residential housing market and tight credit supply triggering waves of home booking cancellations, homebuilders including Lennar, are facing declining backlogs and rising inventory levels. We expect Lennar's order backlog to decline as new order volumes continue to fall. Lennar's operating days backlog fell to 91 days as on August 31, 2007, from 104 as on August 31, 2006 and we expect this to further decline to 85 days as on February 28, 2008. To lower its inventory levels, the company is offering price incentives on home sales while also doing away with land options in hand. For nine months ended August 31, 2007, the company incurred $343.3 million expense relating to option deposits and pre-acquisition costs on land options it does not intend to purchase, reflecting company's reluctance to build up further inventory. In 3Q2007, Lennar's controlled home-sites and total home-sites declined 42.3% and 32.8%, respectively, over 3Q2006.
• Pressure on margins - In order to reduce standing inventory, homebuilders across the industry are re-pricing existing home prices to reduce their order backlog. Heavy discounting coupled with use of incentives and incentivized brokerage fees is driving Lennar's realized prices downward. The company's gross margin excluding FAS144 adjustments has declined from 26.0% in 2006 to 18.4% in 2006 and further declined to 14.4% for nine months ending August 2007, while its net margin declined from 14.0% in 2005 to 6% in 2006. For nine months ending August 31, 2007, net margins declined to a negative of 12.3%.As Lennar continues to adjust its pricing to meet current market conditions, we expect a further deterioration of the company's net margins. We expect Lennar's operating margin to decline to turn negative of 16% and 18% in 2007 and 2008, respectively.
• Higher levels of inventory impairments - To reflect the deteriorating market conditions, Lennar is on land impairment and write-off spree. In 3Q2007, the company reported total valuation adjustments of $856 million related to the valuation adjustments, write-offs of option deposits and pre-acquisition costs, goodwill and notes receivable. As the company adjusts its balance sheet to reflect current market conditions, we expect inventory impairments to continue till 2010 to reflect expected downward trend in prices.
• High exposure to overheated markets - In 2006 Lennar derived 36.8% of its revenues from Western markets including California and Nevada, and 31.3% from Eastern markets including Florida, Maryland, New Jersey and Virginia. Lennar's high exposure to over-heated markets including Florida and California prove to be a drag on the earnings of the company in the near-to-medium term, in our view.
• Muted 3QFY2007 results - Lennar reported a net loss of $513.9 million, or $3.25 per diluted share in 3Q2007, compared with net earnings of $206.7 million, or $1.30 per diluted share, in 3Q2006. Revenues from homebuilding declined 44.2% to $2.2 billion in 3Q2007 from $4.0 billion in 3Q2006, primarily off a 41.4% decline in home deliveries and a 5.1% decline in average sales price. As a result of declining consumer confidence and stringent lending standards, Lennar's new home orders declined 47.5% to 5,084 million in 3Q2007 from 11,056 million in 2Q2007 with an order backlog of 6,367 million as of August 31, 2007.

Lennar's homebuilding volumes:

For new orders' estimates, we have used data pertaining to building permits from State of the Cities Data Systems (SOCDS), new housing starts and new home sales from US Census Bureau, and have identified key representative states/ cities in which Lennar operates.

The above sources have been assigned weights; higher weights assigned to SOCDS building permits data since it tracks the trend state-wise and reflects the expected new construction activity, in turn indicating the new orders received.

We expect Lennar's Western regions to experience the steepest decline in new orders followed by Eastern and Central regions. Overall we expect Lennar to post a decline in new orders by approximately 35% and 19% for 2007 and 2008, respectively. However from 2009 onwards, we expect new orders growth to pickup in all the regions except west which would continue to be a drag on overall volume growth till 2010.

Lennar's homebuilding price:

To forecast average price for building, we have used key US home prices indices - Home Price Index (HPI) sourced from Office of Federal Housing Enterprise Oversight (OFHEO), S&P/Case-Shiller Home Price Index reported by Standard and Poor's (S&P), Home Asking Prices from Housing Tracker and Condor Prices from Radar Logic. For each region, we have identified states/ cities, whose price indices are available, as follows -

The above sources have been assigned weights to forecast pricing growth at each of Lennar's operating regions. For S&P/Case-Shiller Home Price Index we have used forecasted values from S&P. We have computed historical spread for Housing tracker and Radar Logic with Case-Shiller Home Price Index to computed forecasted values for Housing tracker and Radar Logic. Currently we have assigned higher weights to S&P/Case-Shiller Home Price Index since they represent forecasted values.

Housing price in US continues to deteriorate owing to excess supply as there is a very big push to reduce standing inventory across the industry. Existing home builders are re-pricing their existing inventory in order to sell their order backlog. Excess supply situation further fuelled by flat to down housing demand coupled with use of incentives, price reductions, and incentivized brokerage fees is putting downward pricing pressure. Overall we expect average home price to decline 5.1% and 5.2% in 2007 and 2008, respectively. We expect Lennar's home price to continue to decline till 2010.

Lennar's Homebuilding revenues:

We expect Lennar's homebuilding revenues to witness a decline of 39.3% and 32.9% in 2007 and 2008, respectively, to reach $9.49 billion and $6.37 billion in 2007 and 2008. We expect revenues to continue to decline till 2009 (8.6%). For 2010 we expect revenues to remain nearly flat. For 2011 and 2012, we expect Lennar's homebuilding revenues to increase by 3.3% and 6.3%, respectively.

Lennar's Homebuilding cost of sales:

We expect Lennar's per cost of sales excluding impairment to grow at a modest pace of 1.9% and 2.3%, in 2007 and 2008, respectively. To reflect the deteriorating market conditions, Lennar is on land impairment and write-off spree. For nine-months ending August 31, 2007, Lennar reported valuation adjustment of $1.2 billion. We expect Lennar to write-down its inventory till 2010 as we expect home prices to continue to fall till 2010. However, we believe Lennar to write-down most of its inventory in 2007. Resultantly, we expect Lennar's unit cost of sales including impairment to increase by 8.1% in 2007. However owing to significant decline in deliveries, Lennar's total cost of sales are expected to decline by 28.8% and 30.3% in 2007 and 2008, respectively.

Lennar Financial service revenues:

In addition to increasing interest liabilities on warehouse lines of credit increase, growing disability to re-sell their mortgages in the secondary market is posing a challenge for most homebuilders in the US who offer mortgage financing to its buyers. This should have an adverse effect on Lennar's financial services segment as well as on its loan originations.

During 2006, Lennar originated approximately 41,800 mortgage loans of approximately $10.5 billion. Substantially all of the loans the Financial Services segment originates are sold in the secondary mortgage market on a servicing released, non-recourse basis; however, the Company remains liable for certain limited representations and warranties related to loan sales.

We believe that difficult conditions in the credit market will impact the spreads for Lennar. Consequentially, we expect Lennar's margins in the financial segment to further deteriorate from the existing levels. We expect Lennar's gross margin in the financial segment to decline from 4.4% in 2007 to a negative of 10.6% in 2009. However with pick-up in new orders starting 2009 and a consequential increase in mortgage origination, we expect margins to stabilize. Going forward for 2011 and 2012, we expect Lennar's margins for Financial services at 3.9% and 7.3%, respectively.

Lennar's share price vis-à-vis U.S housing index

Lennar's share price has shown a high degree of correlation with the US housing prices. Lennar's share price has immensely benefited during the boom in the US housing market driven by significant growth in housing prices. Between January 2000-2007 Lennar's share price has yielded 598% returns to its shareholders. During the corresponding period housing prices increased 807%. However with decline in land prices starting mid-2006,and expected to continue into next few years, we envisage Lennar's share price to remain under pressure.

Owing to declining trend in US home price, Lennar's operating margin has declined from a peak of 10% in 2005 to 4% in 2006 and is expected to turn to a negative of 13% and 12% in 2007 and 2008, respectively. Lennar's Z-score has declined from 3.73 in 2004 to 3.03 in 2006 and we expect it to decline further to 2.24 in 2007 and 2.02 in 2008, indicating warning signals towards bankruptcy. However, 2009 onwards we expect Lennar to be in serious financial trouble with high probability of bankruptcy with its Z-score falling to 1.76.

Impact of housing price on Lennar's solvency

Deterioration of Lennar's revenues and gross margins:

Lennar's homebuilding revenues witnessed an increase of 33.0% and 17.4%, in 2005 and 2006. However for nine-months ended August 31, 2007, Lennar's revenues declined 33.7% owing to deterioration in U.S housing markets. Consequentially for 2007, we expect Lennar's homebuilding revenues to decline 39.3% to $9.5 billion owing to 34.1% decline in deliveries and 5.1% decline in average home price. We expect revenues to continue to decline in 2008 (32.9%) and 2009 (8.6%). However post 2009, we expect slowdown in US housing markets to ease off and resultantly we expect a nominal 0.1%, 3.3% and 6.3% increase in homebuilding revenues for 2010, 2011 and 2012, respectively. Lennar's west and east markets which include operations in California and Florida, respectively, are expected to be the worst effected regions and hence we expect Lennar's homebuilding revenues in west and east markets to fall 41.6% and 43.5%, respectively in 2007. Further in 2008 we expect revenues from these two regions to fall further by 37.4% and 31.6%, respectively.

To accurately reflect the current market conditions, Lennar wrote-off significant impairments in its inventory. For 2Q2007 and 3Q2007, Lennar reported a total valuation adjustment of $857 million including $303 million valuation adjustment relating to finished homes, CIP and land on which the Company intends to build homes, and $242 million pertaining to option write-offs and pre-acquisition costs on land options. Lennar's homebuilding gross margin including impairment charges declined from 15.7% in 2005 to 6.1% in 2006 and is expected to decline further to a negative 14.6% in 2007 and a negative 16.3% in 2008.

Historical trends in revenues and gross margin:

During the US housing boom, Lennar's revenues increased more than three folds to $16.3 billion in 2006 from $4.7 billion in 2000. However following the recent slowdown in US housing markets, revenues for nine months ended August 31, 2007 declined 33.3% to $8.0 billion from $12.0 billion over corresponding period last year. We expect the decline in Lennar's revenues to persist in 2008 and 2009 with 2007 and 2008 revenues falling significantly by an expected 38.8% and 32.7%, respectively, to $10.0 billion and $6.7 billion. This represents a realistic 4.5% long-term CAGR 2000-2008, against the growth trajectory witnessed during 2000-2006 at a CAGR of 23.0%, which is highly unsustainable.

Hidden liabilities via consolidated JV's:

According to recent 8-K filed by Lennar on November 6, 2007, total debt of unconsolidated JV's stood at $5.5 billion. Out of this $1.2 billion is in the Lennar's maximum recourse exposure. Including a $0.26 billion reimbursement agreements with partners, Lennar's net recourse exposure is approximately $1.0 billion. We believe that since this debt is recourse in nature, the Company is directly accountable in case of default. As a result, we have consolidated the entire debt of $1.0 billion including effect of interest payments on financial statements of Lennar.

In addition to this, Lennar also has $0.67 billion in form of partner's several recourse and $3.7 billion of non-recourse debt. Since this debt is non-recourse in nature, we have currently excluded the impact of non-recourse debt on Lennar's financial statement.

Lennar's balance sheet including JV's debt (including recourse debt and 0% of non-recourse debt):

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Even with the most conservative approach after considering only the recourse debt of $1 billion (to which the company remains liable by way of recourse debt) out of total debt from JV's worth about $5.5 billion, Lennar's 2007 debt to capitalization jumps to 83.7%. For 2010, Lennar's debt to capitalization would be 152.2% which is further expected to worsen to 199.1% by 2011.

Drop in credit ratings:

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On standalone basis excluding the impact of JV's debt, Lennar's Z-score is expected to worsen with further deterioration in the housing sector. While the company's Z-score (excluding the impact of debt from unconsolidated JVs) declined from 3.73 in 2004 to 3.03 in 2006, we expect this to further fall to 2.24 in 2007 indicating warning signals about potential financial problems. The company's Z-score may worsen to 1.76 in 2009 with industry conditions remaining unfavorable and in the absence of any committed initiatives by the company to recover from its current problems.

Considering the full impact of recourse debt with 0% non-recourse debt, Lennar's Z-score further falls to 2.02 for 2007 and to 1.77 in 2008, Indicates serious financial trouble and a high probability of bankruptcy.

In November 2007, S&P had lowered Lennar's debt rating as junk to BB+ with a negative outlook from BBB- earlier. As per S&P, the prime reason for the rate cut was "weakened credit measures, Lennar's concentration in highly competitive and oversupplied housing markets, and the company's considerable investment in off-balance-sheet joint ventures." In October 2007, Moody's had downgraded Lennar's debt ratings to junk status.

Valuation:

Relative:

Earnings approach:

We believe that owing to volatility of earnings, earnings based valuation, including DCF and EP, is not appropriate for the housing sector. Based on relative valuation using P/B multiple we expect Lennar's share price is at $20.43 against current share price of $16.02. This is a valuation based solely upon the comparable adjusted book value. It, unfortunately, has its flaws. The primary flaw being the inability to factor in earnings quality (like DCF and economic profit which can't be used here, or more accurately stated, produce valuations in the deep negatives - as in less than zero without some fancy financial tinkering) and more importantly the risk associated with the massive debt carried by the subject company. Factor in the risk, earnings volatility, and the macro environment, and one will be hard pressed to value Lennar above the single digits.

Key Metrics:

Lennar's order backlog is expected to decline from 11,608 million at the end of 2006 to 6,415 million by 2007-end from continued decline in new orders. Lennar's new orders are expected to decline by 35.0% and 18.9%, in 2007 and 2008, respectively. We expect volumes to stabilize 2009 onwards with new orders growth of 0.8%, 2.6% and 3.0% in 2009, 2010 and 2011, respectively.

At the 4Q2007 delivery rate, Lennar's operating backlog days stood at 95 against 104 as on 3Q2006-end indicating declining cash flows.

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