At the home building industry investors' conference in San Francisco last June 2nd, the topic du jour was one Credit Suisse First Boston sector analyst Ivy Zelman had zeroed in on relentlessly among public firms for months: Their accounting for land and joint ventures versus their core home building operations. Prepared for a showdown, Lennar Corp.'s chief financial officer Bruce Gross landed at SFO armed with Powerpoint slides.
The best defense in this case would be an offense; one Zelman would buy into. It amounted to opening the books on deals and financial structures that Lennar—and all of its publicly traded counterparts—by all rights would hardly breathe a word about, as they occur off-balance sheet and require negligible disclosure.
“Ivy's been a driver on this issue of transparency, suggesting that if there are questions around our handling of joint venture and land option deals, the tendency for investors would be to shy away,” says Gross. “Our response, and the increased amount of disclosure we've chosen to divulge, was a direct result of her crusade on this issue.”
NEW REALITIES Factors that differentiate home builders today from real estate cycle-prone operations of yesteryear include their product and geographical diversification, their professional management, and their handling of land and money. Two of public home builders' trendy land position management practices, land banking and joint ventures, have been getting the third degree among ratings agencies and analysts lately, so for Zelman, the Lennar choice to open up in detail its joint ventures was a triumph.
Importantly, more ratings and equity analysts who cover residential construction companies have intensified their clamor these days for public home builders to make more information available to lenders and investors about off-balance sheet financial structures and deals that give builders access to a future supply of building lots without all the risk and expense. They're going so far as to suggest, not nefarious nor illegal behavior about that many options deals, which legally and financially allow builders to walk away from them if they want to or need to, are hardly different than ownership in the real world, putting much of the risk and exposure to weakening market conditions squarely on the shoulders of the builder.
“According to the disclosure [in the 10-K], LEN deferred $107 million of joint venture income associated with land purchased from its joint ventures in 2005, and $58 million in 2004,” Zelman and CSFB analyst Dennis McGill note in a recent industry report, A Level Playing Field. “As Lennar would be purchasing these lots shortly before constructing the home, this disclosure is a good proxy for the benefit that ultimately flows through cost of goods sold.”
The operative term is that there is “a good proxy.” A good proxy is what allows analysts and investors to filter through tomes of data and filings and gauge how healthfully companies are performing their bread and butter work. As boom times in new home building morph into the enigmatic limbo many call “normal” business levels, casualties are fully expected. Nobody wants to be the one who missed a telltale metric, particularly if there's an opportunity to forecast doom.
“We simply believe that the home building operations should be analyzed and valued in isolation of the joint ventures,” says Zelman. “This is because joint venture income is not a good proxy for cash flow and is not directly comparable to an operating profit measure such as EBIT or EBITDA. Also as a dissolving asset, it's much more difficult to accurately or confidently forecast joint venture profits, particularly without much knowledge behind the revenue drivers.”
DARE TO COMPARE More transparency, analysts say, will allow for a fairer, clearer way to compare and contrast the home building business fundamentals of one company with another, evaluate whose core operations are stronger, and assess whose debt represents a greater risk, both to lenders and investors.