I have updated my analysis on Ryland to include a full consolidation of off balance sheet vehicles and a more complete run down of their cash situation. They are one of the cleanest builders once it comes to JVs, with off balance sheet debt having a minimal impact on their financial situation. Unfortunately, that financial situation still has a very negative outlook with the company struggling for cash, and coming closing to tripping covenants, renegotiating said covenants, then coming right back to the point where they will trip them again -while attempting to manage debt by paying down cheaper long term debt with more expensive short term debt. This is all a result of the horrendous macro environment they are working in, and the management's selling of shares into a corporate buyback program doesn't exactly invoke confidence in the alignment of management and shareholder's interests. I calculate they will trip existing covenants this upcoming fiscal year and run out of cash shortly thereafter, prompting a need to borrow even more. Download the research report update on the Ryland Group here, in pdf and/or continue on for the highlights in html.
Key Highlights
Declining homebuilding margins: Ryland's homebuilding gross margins are expected to be under continued downward pressure amid declining home prices and sales volumes off deteriorating homebuilding sector in the United States. This coupled with rising inventory impairment charges and increased price concessions and sales incentives to foster sales has resulted in even a more difficult operating environment for Ryland. The company reported negative gross margins of 1.2% and 0.3% in 2Q2007 and 3Q2007, respectively, with the margins not expected to turn positive in the next couple of years. We expect full year 2007 gross margins to be 1.9%, and believe the downward trend would continue with the expected negative gross margins of 3.5% and 2.8% in 2008 and 2009, respectively.
Inventory impairment: As a result of declining home values, Ryland recorded an inventory valuation adjustment (downwards) of $128.1 million in 3Q2007, representing a negative earnings impact of $3.05 per share. In midst of declining home prices, the company is expected to book an inventory impairment charge of $438.5 million and $317.4 million for 2007 and 2008, respectively. However, we believe Ryland is strategically better placed vis-à-vis its peers with regard to inventory holdings in the worst hit markets in the United States. Owing to its strategy of geographical diversification as evident by the fact that not more than 10% of the company's capital is allocated to any single of the 28 markets it operates in, Ryland had limited exposure to the most disturbed housing markets. In the most overheated US markets, including California, Phoenix and Fort Meyers, Ryland had only 12.0%, 2.6% and 1.6% of its total assets as on June 30, 2007, respectively. As a result, Ryland's inventory impairment charge as a percentage of inventories for the 3QFY2007 was 5.4% against an average of 8.0% for its peer group. For the purpose of our analysis we have taken Ryland's peer group to include Lennar Corp, KB Home, Dr. Horton Inc, Pulte Homes Inc, Hovnanian Enterprises Inc, Beazer Home, MDC Holdings Inc and Sparkassen Immobilien.
Mounting troubles in Financial Services: Increasing interest costs on warehouse lines of credit off rising spreads resulting from tightening of lending standards, and growing difficulties in resale of mortgages in the secondary market pose a challenge for most US homebuilders offering mortgage financing to home buyers. Ryland's mortgage financing business has been impacted by the currently prevailing tough credit conditions with the company's mortgage origination capture rate falling to 77.7% in 3Q2007 from 82.2% in 3Q2006. The company's ability to sell majority of its mortgages under a no-recourse agreement to a third-party financing company has also been affected with its principal buyer, Countrywide Financing, running into financial troubles. Apart from compressed margins, this may translate into Ryland having to hold a larger proportion of its mortgages on its balance sheet, with all associated risks of defaults.
Limited exposure to JV liabilities: Ryland's total exposure towards debt through unconsolidated entities is among the lowest in the industry. As of September 30, 2007, Ryland participated in 11 joint ventures with about $30.4 million investments in unconsolidated entities and $41.7 million representing the company's share in the total joint venture debt. With relatively lower concern over hidden liabilities associated with the company, investors and creditors could place higher confidence under the present difficult housing scenario in the United States.
Higher cancellation rates: The recent quarters have witnessed cancellation rates of the homebuilding companies increased to a significant level, driven by tightening lending standards and persisting negative consumer sentiments. Ryland's 3Q2007 cancellation rate was 43.0%, up from 34.3% in 2Q2007. We expect this to increase further to average at 47.5% for 2007 and 39.9% for 2008. Faced with higher cancellation rates, Ryland faces the pressure of offering price discounts and incentives to dispose for cancelled housing units which could further strain the company's margins. The company has initiated efforts to reduce its inventory levels and is cutting down on its land holdings with its total land lots under control as of September 30, 2007 standing at 45,254, a 32.4% decline over the previous year. The company's owned lots (63% of the total lots) declined 14.2% y-o-y while its option lots (37% of the total lots) fell 50.4%.
Disappointing 3Q2007 results: Ryland's 3Q2007 revenues declined 35.2% to $732.3 million against $1,130.9 million in 3Q2006 off a 32.3% decline in deliveries to 2,495 units and a 2.7% decline in average sales price to $284,000. Including inventory valuation adjustments and write-offs of $128.1 million, Ryland reported negative gross margin of 0.3% versus gross margin of 22.5% in 3Q2006. Ryland net loss was $54.7 million or $1.30 per share against net earnings of $87.9 million or $1.97 per share in 3Q2006.
Possibility of downgraded credit ratings: Responding to concerns about the company's ability to reduce its inventory levels and generate positive cash flow, S&P changed its outlook for Ryland in November 2007 from stable to negative, rating the company at BBB-minus. Moody's has also announced it may downgrade its rating for Ryland's senior unsecured debt rating to junk from Baa currently.
Refinancing long-term debt with short-term debt: During 3Q2007, Ryland pre-paid $75 million of senior debt financing partly by drawing $42 million from its revolving credit facility. Of late Ryland has been aggressively utilizing its borrowings under revolving credit facility and has drawn down $63 million, $11 million and $42 million in 1Q2007, 2Q2007 and 3Q2007, respectively, bringing its aggregate borrowing under the revolving credit facility to $117 million (of its total borrowing limit of $750 million). As the company is scheduled to repay another long-term debt installment of $75 million in 2Q2008, we expect company's utilization under its revolving credit facility to increase to $217 million by the end of 2008. This refinancing would entail increased interest costs for Ryland as the company finds itself hard tied to repay its short-term credit line borrowings which carry higher costs vis-à-vis long-term finance. Further, as Ryland faces negative operating cash flow of $505.2 million in 2009, we expect the company to drawdown additionally under its credit line raising its total drawdown to $717 million by the end of 2009.
Increased cost of financing: In view of deteriorating financial condition of the company, we believe Ryland would not be able to uphold conditions set forth in its debt covenants starting 4Q2008 with a leverage ratio of 47.9% (against prescribed leverage ratio of 47.5%). As the company undertakes further borrowing under its revolving credit facility, Ryland's leverage ratio is expected to increase to 66.3% in 2009 (against prescribed limit of 37.5%), and to 85.0% and 93.3%, in 2011 and 2012, respectively. With increased use of short-term borrowing and widening gap between Ryland's leverage ratio and prescribed limits, we envisage increase in financing cost for Ryland. We expect Ryland's effective interest rate to increase from 4.4% in 2007 to 5.6% in 2008. For 2009, 2010 and 2011, we expect Ryland's effective interest rate to increase to 6.4%, 6.6% and 6.8%, respectively.
Negative management outlook: Since August 2007, insiders have been net sellers, selling approximately 0.49 million shares or 1.2% of outstanding shares worth $15.5 million, reflecting the management's reduced confidence on the company's prospects in the near term.
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