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Case 13: Lennar Corporation’s Joint Venture Investments Graeme Rankine Amid our negative sector stance, we are upgrading our relative rating on LEN to Overweight from Neutral, as our new price target represents lower downside potential on the stock vs. its peers. Importantly, in addition to LEN’s relative underperformance and below-average valuation, our outlook for below-average book value contraction by 2009-end is a key factor behind our relative ratings change. Specifically, over the last 12 months, LEN has underperformed, down 33% vs. the group’s 23% decline (S&P: -36%), we believe largely driven by concerns regarding its above-average JV exposure. This performance, in turn, has in part led to a 35% valuation discount to its peers on a P/B basis, currently at 0.50x vs. its larger-cap peers’ 0.77x average. However, while we believe this valuation discount could narrow, given LEN’s continued reduction in JV exposure, our outlook for below-average book value contraction is the key driver for LEN’s lower downside risk, in our view. —JP Morgan, Lennar, January 8, 2009. • • 1 On January 8, 2009, Anna Amphlett reflected on JP Morgan’s report that Lennar Corporation’s stock price had been negatively impacted by the recent U.S. housing crisis more than other firms in the housing industry, and, therefore, the investment risk was less than that of its peers (see Exhibit 1 for the company’s recent stock price performance). Amphlett, a newly recruited financial analyst at Southern Cross Investments LLC, had been asked to prepare a report on Lennar’s joint ventures and how the company accounted for these investments. She knew that she would be questioned by her boss about JP Morgan’s concern over Lennar’s “above-average JV exposure,” since she had learned in her MBA program that joint ventures were a practical way for a company to diversify risk and gain access to the expertise of joint venture partners. But she knew as well that joint ventures were also a method some companies used to finance investments “off-balance sheet.” She wondered if the stock might even stage a comeback in the near future. JP Morgan set a price target for Lennar’s stock of $8.50 per share, less than the share’s trading range of around $11. Lennar had grown considerably through 2006, but in the last two years, revenues had suffered a sizeable reversal (see Exhibit 2 for historical financial information). 2 On returning from a two-week vacation, Amphlett was shocked to learn that on January 9, Barry Minkow’s Fraud Discovery Institute (FDI) had raised questions on a Web site about Lennar’s off-balance-sheet debt and a large personal loan taken out by a top company executive (see Exhibit 3 for details of the allegations).1 On the day of the announcement, the company’s stock price plunged and trading volume increased dramatically (see Exhibit 4 for information about the stock price reaction to the Minkow claims). Amphlett’s completed research report recommended that Southern Cross acquire Lennar’s shares, but she now realized it was imperative that she understand the nature and purpose of Lennar’s joint ventures before submitting the report. COMPANY BACKGROUND • • 3 By early 2009, Lennar Corporation was one of the nation’s largest homebuilders and a provider of financial services. The company’s homebuilding operations included the construction and sale of single-family attached and detached homes, and multilevel residential buildings, in communities targeted to first-time, move-up, and active adult homebuyers. The company was also involved in the purchase, development, and sale of residential land, and in all phases of planning and building in residential communities, including land acquisition, site planning, preparation and improvement of land, and design, construction, and marketing of homes. The company operated in Florida, Maryland, New Jersey, Virginia, Arizona, Colorado, Texas, California, Nevada, Illinois, Minnesota, New York, and both North and South Carolina. The company’s financial services business provided mortgage financing, title insurance, closing services, and other ancillary services (including high-speed Internet and cable television) for both buyers and sellers. Substantially all of the loans that the company originated were sold in the secondary mortgage market on a servicing released, non-recourse basis. The average sales price of a Lennar home was $270,000 in fiscal 2008, compared to $297,000 in fiscal 2007. 4 Lennar was founded as a local Miami homebuilder in 1954. The company completed an initial public offering in 1971, and listed its common stock on the New York Stock Exchange in 1972. During the 1980s and 1990s, the company entered and expanded operations in 13-213-3 13-313-4some of its current major homebuilding markets including California, Florida, and Texas through both organic growth and acquisitions such as Pacific Greystone Corporation in 1997, among others. In 1997, the company completed the spin-off of its commercial real estate business to LNR Property Corporation. In 2000, Lennar acquired U.S. Home Corporation, which expanded the company’s operations into New Jersey, Maryland, Virginia, 13-413-5Minnesota, and Colorado, and strengthened its position in other states. During 2002 and 2003, the company acquired several regional homebuilders, which brought the company into new markets and strengthened its position in several existing markets. EXHIBIT 3: Fraud Discovery Institute Press Release Fraud Discovery Institute, Inc. Launches Top 10 Red Flags for Fraud at Lennar Corporation (NYSE:LEN) Subtitle: Consumer group launches new Web site,; Alleges Lennar Corporation (NYSE:LEN) operates a “Ponzi Scheme” through their multiple joint ventures For Immediate Release, San Diego, California, Friday, January 9, 2009 The Fraud Discovery Institute, Inc. released today the Top 10 Red Flags for Fraud at Lennar Corporation, the country’s second largest homebuilder. Through the release of a 30-page report, a YouTube video, and a Web site with a catchy URL (, the consumer advocate group is drawing attention to multiple alleged fraudulent activities that have become a pattern of behavior. According to cofounder Barry Minkow, “You can sum up just how outrageous the fraud and abuse are at Lennar Corporation by simply listening to company President and CEO Stuart Miller who, on a recent conference call, said that Lennar Corporation had improved their cash reserves to $1.1 billion, up from $642 million a year before. What Mr. Miller conveniently left out was how the company obtained the $1.1 billion cash. It came from the June 2008 NewHall/LandSource bankruptcy that has created 5,000 victims. Although Lennar Corporation ended up with hundreds of millions of cash through the debacle, the public must ask how many people, companies, and communities were destroyed in the process of improving Lennar’s balance sheet.” A preview of some of the red flags includes: o o o o o • How Lennar Corporation tried to “bury” the Forest Lawn Mortuary. • How Lennar Corporation treats their joint ventures exactly like a Ponzi scheme—pledging their older joint venture interests to leverage themselves into newer joint venture relationships (despite operating agreements that prohibit this unauthorized movement of money). • How Lennar Chief Operating Officer Jon Jaffe received a $5,000,000 third trust deed loan in late 2007 that literally overencumbers his home. This loan came from a lender who appears to be an undisclosed related party to Lennar Corporation and their joint venture partner in Kern County, California. • How Lennar Corporation continues to provide vague and less-than-transparent responses to the SEC inquiries about off-balance sheet, joint venture debt. • How Lennar has exhibited a pattern of behavior over a sustained period of time of deceptive business practices, ranging from building homes using Chinese drywall to cut costs, to causing CALPERS (the California Public Retirement Fund) to lose approximately $1 billion. The Fraud Discovery Institute, Inc. also refers to multiple lawsuits filed against Lennar Corporation for claims of breach of contract and fraud. FDI became involved with Lennar on behalf of one of their joint venture partners who was involved in the construction of “The Bridges” in Rancho Santa Fe, one of San Diego’s most successful residential communities. The joint venture partner is alleging in a lawsuit that Lennar violated the operating agreement. “We began this case with sincere doubts that a public company listed on the New York Stock Exchange, with internal controls that include an audit committee, would allow the exploitation of not just our client, but hundreds and thousands of others as evidenced by the public record. We were shocked and felt compelled to further investigate and educate law enforcement to the ‘below the surface’ happenings at this company.” • 5 The company balanced a local operating structure with centralized corporate level management. Decisions related to the overall strategy, acquisitions of land and businesses, risk management, financing, cash management, and information systems were centralized at the corporate level. The local operating structure consisted of divisions, which were managed by individuals who had significant experience in the homebuilding industry and, in most instances, in their particular markets. They were responsible for operating decisions regarding land identification, entitlement and development, the management of inventory levels for the current volume levels, community development, home design, construction, and marketing homes. 13-513-6 • • • 6 During 2008, Lennar significantly reduced its property acquisitions. The company acquired land for development and for the construction of homes that were sold to homebuyers. At November 30, 2008, Lennar owned 74,681 home sites and had access through option contracts to an additional 38,589 home sites, of which 12,718 were through option contracts with third parties, and 25,871 were through option contracts with unconsolidated entities in which Lennar had investments. At November 30, 2007, the company owned 62,801 home sites and had access through option contracts to an additional 85,870 home sites, of which 22,877 were through option contracts with third parties, and 62,993 were through option contracts with unconsolidated entities. 7 Lennar supervised and controlled the development of land and the design and building of its residential communities with a relatively small labor force. The company hired subcontractors for site improvements and virtually all of the work involved in the construction of homes. Generally, arrangements with subcontractors provided that the company’s subcontractors completed specified work in accordance with price schedules and applicable building codes and laws. The price schedules were subject to change to meet changes in labor and material costs or for other reasons. Lennar did not own heavy construction equipment. The company financed construction and land development activities, primarily with cash generated from operations and public debt issuances, as well as cash borrowed under its revolving credit facility. 8 The company employed sales associates who were paid salaries, commissions, or both, to complete on-site sales of homes. Lennar also sold homes through independent brokers. Lennar worked continuously to improve homeowner customer satisfaction throughout the presale, sale, construction, closing, and post-closing periods. Through the participation of sales associates, on-site construction supervisors, and customer care associates, Lennar created a quality home buying experience for its customers, which led to enhanced customer retention and referrals. The company delivered 15,735, 33,283, and 49,568 homes during 2008, 2007, and 2006, respectively. LENNAR’S JOINT VENTURES • 9 At November 30, 2008, Lennar had equity investments in 116 unconsolidated entities, compared to 214 un-consolidated entities at November 30, 2007. Due to market conditions at the time, the company focused on reducing the number of unconsolidated entities in which it had investments. The company’s investments in unconsolidated entities by type of venture were as follows: • • 10 Lennar invested in unconsolidated entities that acquired and developed land (1) for its homebuilding operations or for sale to third parties; or, (2) for the construction of homes for sale to third-party homebuyers. Through these entities, Lennar primarily sought to reduce and share risk by limiting the amount of its capital invested in land, while obtaining access to potential future home sites and allowing the company to participate in strategic ventures. The 13-613-7use of these entities also, in some instances, enabled the company to acquire land to which it could not otherwise obtain access, or could not obtain access on as-favorable terms, without the participation of a strategic partner. Participants in these joint ventures were landowners/developers, other homebuilders, and financial or strategic partners. Joint ventures with landowners/developers gave the company access to home sites owned or controlled by a partner. Joint ventures with other homebuilders provided the company with the ability to bid jointly with the partner for large land parcels. Joint ventures with financial partners allowed Len-nar to combine its homebuilding expertise with access to its partners’ capital. Joint ventures with strategic partners allowed the company to combine its homebuilding expertise with the specific expertise (e.g., commercial or infill experience) of its partner. 11 Although the strategic purposes of its joint ventures and the nature of its joint venture partners varied, the joint ventures were generally designed to acquire, develop, and/or sell specific assets during a limited lifetime. The joint ventures were typically structured through noncorporate entities in which control was shared with its venture partners. Each joint venture was unique in terms of its funding requirements and liquidity needs. Lennar and the other joint venture participants typically made pro-rata cash contributions to the joint venture. In many cases, Lennar’s risk was limited to its equity contribution and potential future capital contributions. The capital contributions usually coincided in time with the acquisition of properties by the joint venture. Additionally, most joint ventures obtained third-party debt to fund a portion of the acquisition, development, and construction costs of their communities. The joint venture agreements usually permitted, but did not require, the joint ventures to make additional capital calls in the future. However, capital calls relating to the repayment of joint venture debt, under payment or maintenance guarantees, generally were required. See Exhibits 5 and 6 for selected financial statement information about Lennar Corporation. SHARING ARRANGEMENTS • 12 Alliances, partnering, mergers and acquisitions, and joint ventures are sharing arrangements that enable parties to collaborate for mutual gain that would not otherwise be available from working alone. Each party may enter the relationship to obtain access to physical resources, financing, risk-sharing opportunities, specific skills and technologies, and new products and markets. Joint ventures usually involve creating a separate organization established through equity participation by the joint venture partners, and under their mutual shared control. Mergers and acquisitions involve the acquisition and control of one entity by another, or the creation of a third entity owned by each of the merger parties. Alliances usually involve contractual agreements to work • • • • • • • • • together in specific ways and for specific periods, and share any resulting revenues, or profits, but do not involve equity participation by the parties. 13 One study found that joint venture announcements in the period 1972-1979 resulted in a statistically significant two-day increase in shareholder wealth of 0.74%, suggesting that investors perceive joint ventures as enhancing shareholder wealth.3 Another study reported that the NUMMI joint venture established in 1983 between General Motors (GM) and Toyota in an idle GM plant was a major factor in the improvement in manufacturing quality and productivity at GM. At the outset, the cooperation provided an opportunity for each party to gain more from working together than working alone— Toyota wanted to learn about managing an American workforce, while GM wanted to learn about building small 13-713-8 13-813-9 13-913-10 13-1013-11 13-1113-12 131213-13 13-1313-14 13-1413-15cars using lean manufacturing methods, and to utilize an idle plant.4 A third study noted that joint venture formations reached a peak in 1995, but have declined in popularity because executives have been concerned about three key issues: lack of control, lack of trust, and uncertainty about exiting from the arrangement.5 EXHIBIT 6: Selected Footnotes from Lennar’s 2008 Financial Statements 1. Summary of Significant Accounting Policies Basis of Consolidation The accompanying consolidated financial statements include the accounts of Lennar Corporation and all subsidiaries, partnerships, and other entities in which Lennar Corporation has a controlling interest and variable interest entities (see Note 16) in which Lennar Corporation is deemed the primary beneficiary (the “Company”). The Company’s investments in both unconsolidated entities in which a significant, but less than controlling, interest is held and in variable interest entities in which the Company is not deemed to be the primary beneficiary are accounted for by the equity method. All intercompany transactions and balances have been eliminated in consolidation. Revenue Recognition Revenues from sales of homes are recognized when the sales are closed and title passes to the new homeowner, the new homeowner’s initial and continuing investment is adequate to demonstrate a commitment to pay for the home, the new homeowner’s receivable is not subject to future subordination and the Company does not have a substantial continuing involvement with the new home in accordance with SFAS 66. Revenues from sales of land are recognized when a significant down payment is received, the earnings process is complete, title passes, and collectability of the receivable is reasonably assured. Investments in Unconsolidated Entities The Company evaluates its investments in unconsolidated entities for impairment during each reporting period in accordance with APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (“APB 18”). A series of operating losses of an investee or other factors may indicate that a decrease in value of the Company’s investment in the unconsolidated entity has occurred which is other-than-temporary. The amount of impairment recognized is the excess of the investment’s carrying amount over its estimated fair value. • • • • • Additionally, the Company considers various qualitative factors to determine if a decrease in the value of the investment is other than temporary. These factors include age of the venture, intent, and ability for the Company to retain its investment in the entity, financial condition, and long-term prospects of the entity and relationships with the other partners and banks. If the Company believes that the decline in the fair value of the investment is temporary, then no impairment is recorded. The evaluation of the Company’s investment in unconsolidated entities includes two critical assumptions made by management: (1) projected future dis ...
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