Item 1. Business
Introduction
We are one of the largest private homebuilders in the United States based on number of home closings and revenues. We design, build and market high-quality single-family detached homes, townhomes and stacked-flat condominiums under the Ashton Woods Homes brand name. We operate in Atlanta, Dallas, Houston, Orlando, Phoenix, Denver and Tampa. These cities represent seven of the 20 largest new residential housing markets in the United States according to the U.S. Census Bureau. We have been in operation for over 15 years and serve a broad customer base including first-time buyers and first- and second-time move-up buyers. We focus on achieving the highest standards in design, quality and customer satisfaction. We have received numerous awards, including the 2005 and 2004 J.D. Power Award for Highest in Customer Satisfaction with New Homebuilders in Atlanta, and we were ranked in the top 13% of all homebuilders nationally in customer satisfaction in 2006 and 2005 by an independent nationally recognized survey company not affiliated with us.
BUSINESS STRATEGY
Provide Our Customers with Superior Value, Quality and Customer Service. Based on the awards we have received, we believe we are recognized for building homes that offer superior design, excellent quality and outstanding value. We believe that our rigorous focus on value, quality and customer service provides us with an important competitive advantage which can enable us to increase our sales and enhance our profitability. We perform comprehensive research of homebuyer preferences and utilize the services of award-winning outside architectural firms to provide our customers with attractive, well designed homes, consistent with the tastes and trends in each of our markets. We offer our homebuyers the opportunity to personalize their new homes in our state-of-the-art Ashton Woods Homes Design Centers in Atlanta, Dallas, Houston, Tampa and Orlando, or in our fully decorated model homes in each of our communities. We instill in all our employees the importance of high quality and superior customer service through extensive in-house training, as well as through a compensation structure directly tied to our J.D. Power customer satisfaction results.
Our reputation for outstanding quality, superior designs and excellent customer service is evidenced by the numerous awards and accolades we have received over the past several years. These awards include:
The entities sponsoring these awards are trade organizations. Although we, along with other homebuilders, are members in the organizations sponsoring these awards, we do not have an ownership interest in and are not otherwise affiliated with the award sponsors. Additionally, we were the only homebuilder to receive a five-star rating for home design in Atlanta from J.D. Power, where we were also awarded Highest in Customer Satisfaction
with New Homebuilders by J.D. Power in 2005 and 2004. Our commitment to customer service has been further recognized in a nationwide survey, where we ranked in the top 13% of homebuilders nationally in 2006 and 2005. We intend to continue to increase sales and profitability by continuing to provide superior values, quality and customer service.
Information regarding the J.D. Power and Associates 2005 New Home Builder Customer Satisfaction Studysm was based on responses from 73,353 buyers of newly constructed homes in 30 of the largest U.S. markets, who were surveyed between March and July 2005. With respect to the 2005 survey, the Atlanta market covers Barrow, Cherokee, Clayton, Cobb, Coweta, Dawson, Dekalb, Douglas, Fayette, Forsyth, Fulton, Gwinnett, Hall, Henry, Newton, Paulding, Rockdale, Spalding and Walton counties. Information regarding the J.D. Power 2004 New Home Builder Customer Satisfaction Studysm was based on responses from 64,502 buyers of newly constructed homes, respectively, in 25 of the largest U.S. markets. With respect to the 2004 survey, the Atlanta market covers Barrow, Bartow, Carroll, Cherokee, Clayton, Cobb, Coweta, Dawson, DeKalb, Douglas, Fayette, Forsyth, Fulton, Gwinnett, Hall, Henry, Newton, Paulding, Rockdale, Spalding and Walton counties.
Leverage Our Product, Customer and Geographic Diversification. We offer a broad portfolio of products including single-family detached homes, townhomes and stacked-flat condominiums, designed for and marketed to first-time buyers and first- and second-time move-up buyers. We operate or are initiating operations in seven geographically diverse markets. Our product, customer and geographic diversification enables us to balance dynamic market conditions, enhance financial stability and reduce our exposure to any specific market or homebuyer segment. Single-family detached homes, townhomes, stacked-flat condominiums and active adult communities accounted for 80%, 13%, 6% and 1%, respectively, of our net new home orders for the fiscal year ended May 31, 2007, and 72%, 14%, 13% and 1%, respectively, of our net new home orders for the fiscal year ended May 31, 2006. We capitalize on our broad product portfolio by targeting a diversified customer base. We estimate that first-time buyers, and first- and second-time move-up buyers accounted for 31%, 42% and 27%, respectively, of our net new home orders during the fiscal year ended May 31, 2007 and 37%, 41% and 22%, respectively, of our net new home orders during the fiscal year ended May 31, 2006.
We believe we are able to successfully leverage our market presence in our existing markets and enhance our product offerings. We believe we are able to appeal to a broader group of homebuyers and enhance our growth without a significant increase of overhead costs. This strategy has proven successful as we build mult-family product lines, such as townhomes and stacked-flat condominiums, in many of our markets along with an active adult line targeted to buyers over 55 years of age in Atlanta. We intend to continue to leverage our product, customer and geographic diversification to enhance our growth prospects and profitability while maintaining a conservative financial profile.
Pursue Disciplined Expansion in Large, High Growth Markets. We currently operate in Atlanta, Dallas, Houston, Orlando, Phoenix, Denver and Tampa, seven of the 21 largest new residential housing markets in the United States by single-family housing starts. Enhancing our product and price point portfolio in each of our existing markets is central to our growth strategy. We perform extensive research, including customer focus groups, to determine demand for additional product offerings in each of our markets. We target the homebuyer segments with the most attractive demand and supply characteristics, which we identify with the help of proprietary market studies analyzing economic and demographic trends and the competitive environment. We believe our existing markets offer attractive long-term growth opportunities. We further believe we have demonstrated our ability to effectively compete and succeed in our markets through our expansion into townhomes, stacked-flat condominiums and an active adult line in certain of our markets.
We will also continue to evaluate prudent expansion opportunities into select new markets. Our strategy for growth in new markets is driven by identifying large homebuilding markets with attractive long-term growth prospects and favorable supply and demand characteristics. We typically hire experienced local managers to manage each new market and initially focus on providing homes for the first- and second-time move-up buyer segments. While we consider acquisitions where attractive opportunities are identified, we have historically pursued a strategy of developing start-up operations to drive our expansion in select new markets.
Acquire and Develop Strong Land Positions. We maintain a rigorous focus on only acquiring land in premier locations, which we believe provides us with superior competitive positioning and enhanced operational
performance. We target land opportunities in each of our markets largely through the use of an in-depth analysis of supply and demand fundamentals, combined with site-specific financial feasibility studies, which we prepare with the help of our local operational managers. We utilize strict financial hurdles to evaluate each land acquisition opportunity. This process enables us to optimize our financial returns while minimizing our land and inventory risk.
Additionally, we develop a significant portion of the land we use in our homebuilding operations. We believe that our considerable expertise in land development enables us to maintain attractive land positions, create desirable communities and optimize our financial returns. We intend to continue to utilize our disciplined land selection process and land development expertise to maintain and enhance our strong land positions.
Manage Inventory Risk and Maintain Conservative Financial Profile. We operate with a conservative approach to financial and inventory management, maintaining prudent leverage and substantial liquidity. We have a disciplined land acquisition process with strict financial hurdles. All land purchases must be approved by our Chief Executive Officer and our Chief Financial Officer. We target a four-year supply of land, achieving a balance of land owned and developed for our own use, and additional lots controlled through option contracts. As of May 31, 2007, our supply of land controlled for use in our homebuilding operations was 3.3 years, consisting of a 2.4-year supply of owned land and a 0.9-year supply of land controlled through option contracts. Additionally, we actively manage our housing inventory by pre-selling substantially all of our homes prior to starting construction, limiting our inventory risk and minimizing our construction cycles. Limitations on the number of speculative units are approved at the corporate level. As of May 31, 2007, we had only 93 completed but unsold homes among our 44 active communities. Our disciplined strategy enables us to maintain a conservative leverage and liquidity profile. As of May 31, 2007, our total debt to total capitalization was 52.1%, and we had $193.5 million available for borrowing under our senior unsecured credit facility. We intend to continue to deploy our capital prudently and efficiently and to maintain a conservative inventory and financial profile.
Leverage Our Highly Experienced Management Team. We benefit from a strong and experienced senior management team, with our executive officers averaging more than 15 years of experience in the homebuilding industry. Thomas Krobot, our Chief Executive Officer, has over 35 years of industry experience and has been with our company since 1995. Robert Salomon, our Chief Financial Officer, has approximately 15 years of industry experience and has been with us since 1998. Mark Thomas, our Senior Vice President, has approximately 11 years of industry experience and joined us in 2006. In addition to our seasoned senior management team, we have an outstanding group of division presidents who manage our individual markets. Each division president brings substantial industry knowledge and deep market expertise, with an average of approximately 16 years of experience in new residential construction.
HISTORY
We are headquartered in Atlanta, Georgia. We were founded in 1989 in Dallas and have expanded into several growing housing markets primarily in the South and Southwest United States. Since our inception, we have grown organically by forming homebuilding and land development operations in select strategic markets with strong housing and employment growth characteristics.
Our initial homebuilding operations were established in Dallas in 1989, followed by Houston in 1990 and Atlanta in 1992. We formed land development operations in Denver in 1994 and Orlando in 1998. We focused on growing our core markets until 2001 when we entered a second expansion phase through the formation of homebuilding operations in Orlando in 2001 and Phoenix in 2002. We most recently entered Tampa with homebuilding operations and expanded our presence in Denver with homebuilding operations in fiscal year 2005.
OWNERSHIP
We are owned by six families or family trusts related to the following individuals: Elly Reisman, Norman Reisman, Bruce Freeman, Seymour Joffe, Larry Robbins and Harry Rosenbaum. The owners control us through individual Nevada-based holding companies in which each family or family trust owns all of the equity interests.
The same families and family trusts or related parties also control the Great Gulf Group of Companies (“Great Gulf Group”), which was formed in Toronto in 1983. Great Gulf Group’s operations, in addition to
Ashton Woods, consist of one of Toronto’s largest homebuilders of single-family attached and detached homes and high rise condominiums, a commercial, retail and industrial properties construction and management company, and other operations focused in land and resort development, as well as diversified financial investments.
MARKETS AND PRODUCTS
We operate in Atlanta, Dallas, Houston, Orlando, Phoenix, Denver and Tampa. We evaluate a number of factors in determining which geographic markets to enter. We analyze economic and real estate conditions by evaluating such statistical information as the historical and projected population growth, the number of new jobs created and projected to be created, the number of housing starts in previous periods, building lot availability and price, housing inventory, competitive environment, and home sale absorption rates.
We generally seek to maintain the flexibility to alter our product mix within a given market depending on market conditions. In determining our product mix in each market we consider demographic trends, demand for a particular type of product, margins, timing and the economic strength of the market. While remaining responsive to market opportunities within the industry, we have focused, and intend to continue to focus, our business primarily on first-time and first- and second-time move-up buyers offering single-family detached homes, townhomes and stacked-flat condominiums, which are developments with four or fewer stories of condominium units.
While we develop single-family detached homes in all of our markets, townhomes are currently only offered in Atlanta, Orlando, Denver and Dallas. In addition, in 2005, we began developing stacked-flat condominiums in the Atlanta and Orlando markets, which we believe will further diversify our product portfolio and appeal to a broader base of customers. For the fiscal year ended May 31, 2007, our homebuilding revenue was comprised of single-family detached homes (76% of revenues), townhomes (10% of revenues) and condominiums (14% of revenues).
Our single-family detached homes range in price from $130,000 to over $650,000, and our townhomes range in price from $180,000 to over $400,000. Stacked-flat condominiums have prices ranging from $200,000 to over $230,000.
As of May 31, 2007, we had 44 active communities in our existing markets, comprised of 33 single-family detached home communities, seven townhome communities, three stacked-flat condominium communities and one active adult single-family detached home community.
HOME DESIGN AND DESIGN CENTERS
We are dedicated to providing high-quality, well-designed homes in desirable communities meeting the demands of today’s homebuyers. The product line offered in a particular community depends upon many factors, including the supply of existing housing and the demand for new housing in the general area. In order to ensure we meet the demand in the marketplace, we conduct in-depth qualitative and quantitative market research including consumer focus groups. This research enables us to improve the linkage between the design of our homes and the community development and meet the specific lifestyle demands of our targeted homebuyer.
Our in-house architectural team manages outside architects to ensure our home designs provide maximum utilization of space for the wide variety of product offerings ranging from single-family detached homes and townhomes for both first-time homebuyers and move-up homebuyers to our stacked-flat condominiums for first-time homebuyers.
We maintain fully decorated model homes in each of our communities merchandised to provide the homebuyers with the ability to view the completed product as part of their buying decision. In addition, we utilize our Ashton Woods Homes Design Centers to provide homebuyers the ability to personalize their homes. The design centers are staffed with expert in-house designers who can help make selections from an extensive array of products, including carpets, tiles, cabinets, light fixtures and countertops, among others. Our home design centers are organized to fully facilitate the home buying experience for both first-time homebuyers and move-up homebuyers.
LAND ACQUISITION AND DEVELOPMENT
Our land strategy is to maintain a four-year land supply, based on homes closed during the last twelve months, which may fluctuate based on improving or declining market conditions. We believe that our attractive land positions in our markets will enable us to continue to maintain market share in the current homebuilding environment and to increase our residential production when the homebuilding market improves. As of May 31, 2007, we had a land supply for use in our homebuilding operations of approximately 3.3 years, consisting of a 2.4-year supply of owned land and a 0.9-year supply of land controlled through option contracts.
We typically purchase land only after necessary entitlements have been obtained so that development or construction may begin as market conditions dictate. The term “entitlements’’ refers to development agreements, tentative maps or recorded plats, depending on the jurisdiction within which the land is located. Entitlements generally give the developer the right to obtain building permits upon compliance with conditions that are ordinarily within the developer’s control. Even though entitlements are usually obtained before land is purchased, we are still required to secure a variety of other governmental approvals and permits during development. The process of obtaining such approvals and permits can substantially delay the development process. For this reason, we may consider, on a limited basis, purchasing unentitled property in the future when we can do so in a manner consistent with our business strategy.
We select land for control based upon a variety of factors, including:
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internal and external demographic and marketing studies;
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project suitability;
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suitability for development generally within a one to four-year time period from the beginning of the development process to the delivery of the last home;
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financial review as to the feasibility of the proposed project, including projected profit margins, return on capital employed and the capital payback period;
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results of environmental and legal due diligence;
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proximity to local traffic corridors and amenities; and
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management’s judgment as to the real estate market and economic trends, and our experience in a particular market.
In addition to the land purchased specifically for our homebuilding operations, we have in the past pursued land development opportunities in which we acquired and developed lots for sale to third party builders in addition to use in our own homebuilding operations. We still hold some of this land for our use and for sale to third party builders in Denver and Orlando, among other markets.
Our land development activities in Denver consist of the development of custom lots for sale to third party custom builders in Parker, Colorado, which is southeast of Denver. As of May 31, 2007, we had 239 lots held for development during the coming fiscal years for sale to third parties.
We believe that we have significant land development expertise which we will continue to leverage in developing land for our own use. However, we do not plan to engage in land development for sale to third parties as a significant aspect of our business in the future.
We acquire land through purchases, rolling option contracts and joint ventures with other builders or developers. We acquire approximately one-fourth to one-third of our land through rolling option contracts, which allow us to control lots and land without incurring the risks of land ownership or financial commitments other than relatively small non-refundable deposits. We enter into option contracts with third parties to purchase finished lots generally as home construction begins. These contracts are generally non-recourse and require non-refundable deposits of 2% to 15% of the sales price. As of May 31, 2007, we had $4.4 million in non-refundable deposits on real estate under option or contract. As of May 31, 2007, we had 6,419 lots under control for use in our homebuilding operations, 4,580 of which are owned by us and 1,839 or 28.6%, of which are available to us through
rolling options. As of May 31, 2007, we had no commitments under option contracts with specific performance obligations. Once we acquire land, we generally initiate development through contractual agreements with local subcontractors. These activities include site planning, engineering and home construction, as well as constructing road, sewer, water, utilities, drainage, recreation facilities and other refinements.
The following table presents information regarding land owned and land under option by market as of May 31, 2007:
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Includes (i) options under agreements with unrelated third parties and related parties, (ii) options under agreements with joint ventures with unrelated third parties and related parties, and (iii) 198 lots in Houston held by a joint venture with an unrelated third party that is managed by us and as to which option agreements do not yet exist. All of the controlled lots held by joint ventures described below under “Joint Ventures” are included in “Lots under option”. Additionally, we own 239 lots of raw land and land under development in Denver that are not anticipated to be used in our homebuilding operations.
JOINT VENTURES
Occasionally, we use partnerships or joint ventures to purchase and develop land where these arrangements are economically advantageous. As of May 31, 2007, we controlled 518 lots for future use by our homebuilding operations through joint ventures with unrelated third parties. We anticipate continuing to form new partnerships or joint ventures in the future where economically advantageous.
LETTERS OF CREDIT AND SURETY BONDS
We are frequently required, in connection with the development of our projects, to obtain letters of credit and surety bonds in support of our related obligations with respect to such developments. The amount of such obligations outstanding at any time varies in accordance with our pending development activities. In the event any letters of credit or surety bonds are drawn upon, we would be obligated to reimburse the issuer of such letters of credit or surety bond. As May 31, 2007, we had outstanding $21.3 million of letters of credit and surety bonds related to our obligations to local governments to construct roads and other improvements in various developments. We do not believe that any such letters of credit or surety bonds will be drawn upon.
MARKETING AND SALES
We believe that we have established a reputation for developing high quality homes, which helps generate interest in each new project. We market our products through a variety of means ranging from fully decorated model homes at each of our communities to newspaper and magazine advertising as well as internet exposure via our website. We focus on continually improving upon our brand awareness and maintaining consistency across our various markets. To this end, we have implemented a standardized sales office design and have increased national advertising to further these initiatives.
We normally build, decorate, furnish and landscape between one and four model homes for each project and maintain on-site sales offices. As of May 31, 2007, we maintained 129 model homes, all of which were owned.
We believe that model homes play a particularly important role in our marketing efforts. Consequently, we expend a significant effort in creating an attractive atmosphere at our model homes. Interior decorations are undertaken by local third-party design specialists, and vary within our models based upon the lifestyles of targeted homebuyers. Structural changes in design from the model homes are generally permitted within specific guidelines, and homebuyers may select various optional amenities through the Ashton Woods Homes Design Centers which allow our homebuyers to personalize their new home. The design centers are staffed with expert in-house designers that can help make selections from an extensive array of resources. Homebuyers can choose from among hundreds of carpets, tiles, floors, cabinets, light fixtures, countertops and more.
We generally sell our homes through commissioned employees. Our personnel are available to assist prospective homebuyers by providing them with floor plans, price information and tours of model homes and to assist them with the selection of options. The selection of interior features is a principal component of our marketing and sales efforts. Sales personnel are trained by us and attend periodic meetings to be updated on sales techniques, competitive products in the area, the availability of financing, construction schedules and marketing and advertising plans, which management believes result in a sales force with extensive knowledge of our operating policies and housing products. Our policy also provides that sales personnel be licensed real estate agents where required by law.
We sometimes use various sales incentives in order to attract homebuyers. The sales incentives come in several forms, including sales price reductions, reductions in the prices of options or upgrades for their homes and the payment of certain closing costs and other mortgage financing programs. These sales incentives are included in the contract price and do not require our continuing involvement after the home is closed and title passes to the homebuyer. The decision to offer incentives and the type of incentives offered at any point in time are driven by market forces, including the marketing strategies of our competitors and will vary by market depending on the interests of target homebuyers, the features of the relevant communities and the competitive environment.
Sales of our homes are made pursuant to home sale contracts the terms of which vary according to market practices and to the legal requirements of the markets in which they are used. Typically, each contract requires a deposit from the homebuyer, which may vary from one to 30 percent of the purchase price, according to product type and market practice. In addition, the home sale contract typically contains a financing contingency. The financing contingency provides homebuyers with the right to cancel in the event they are unable to obtain financing at a prevailing interest rate within a specified time period from the execution of the home sale contract.
CUSTOMER FINANCING
As part of our objective to make the home buying process more convenient and to increase the efficiency of our building cycle, we originate mortgages for our customers through Ashton Woods Mortgage, LLC, which is a joint venture with Wells Fargo Home Mortgage. It has a mortgage capture rate (representing the percentage of our homes closed with mortgages originated by Ashton Woods Mortgage, LLC) of more than 80.0% and does not retain or service the mortgages that it originates. Ashton Woods Mortgage, LLC provides mortgage origination services only, and it originates mortgage financing for qualified homebuyers for the ultimate purchase of our homes. Upon origination, the mortgages are sold concurrently to Wells Fargo Home Mortgage or other third party mortgage companies as deemed necessary by Wells Fargo Home Mortgage. We record Ashton Woods Mortgage, LLC’s earnings using the equity method of accounting, and its earnings are a component of the line item of “Earnings in unconsolidated entities’’ on our income statement.
TITLE SERVICES
We also offer title services to our homebuyers in Dallas and Houston through 49.0% ownership interests in two title companies and in Florida through a 49.0% ownership interest in a joint venture with a third party title company. The title service companies are managed by, and all underwriting risks associated with the title are transferred to, the majority owners of these companies. The earnings from these title companies are recorded using the equity method of accounting, and the earnings are a component of the line item “Earnings in unconsolidated entities’’ on our income statement.
CONSTRUCTION
We act as the general contractor for the construction of our projects. Subcontractors are typically retained on a project-by-project basis to complete construction at a fixed price. Agreements with our subcontractors and material suppliers are generally entered into after competitive bidding. Our divisional project operators supervise the construction of each project, coordinate the activities of subcontractors and suppliers, subject their work to quality and cost controls and assure compliance with zoning and building codes.
We specify that quality, durable materials be used in the construction of our homes. We have numerous suppliers of raw materials and services used in our business, and such materials and services have been and continue to be available. From time to time we enter into regional and national supply contracts with certain of our vendors to leverage our purchasing power and size to control costs. However, we do not have any material long-term contractual commitments with any of our subcontractors or suppliers. We do not maintain inventories of construction materials except for materials being utilized for homes under construction. Material prices may fluctuate due to various factors, including demand or supply shortages, which may be beyond the control of our vendors. We believe that our relationships with our suppliers and subcontractors are good.
Construction time for our homes depends on the availability of labor, materials and supplies, the type and size of the home, location and weather conditions. Our homes are designed to promote efficient use of space and materials, and to minimize construction costs and time. In all of our markets, construction of a home is typically completed within four to five months following commencement of construction.
WARRANTY PROGRAM
We offer a standard one, two, ten-year warranty program. The one-year limited warranty covers workmanship and materials and includes home inspection visits with the customer. We subcontract our homebuilding work to subcontractors who provide us with an indemnity and a certificate of insurance prior to receiving payments for their work and, therefore, claims relating to workmanship and materials are generally the primary responsibility of our subcontractors. In addition, the first year of our warranty covers defects in plumbing, electrical, heating, cooling and ventilation systems, and construction defects. The second year of the warranty covers construction defects and certain defects in plumbing, electrical, heating, cooling and ventilation systems of the home (exclusive of defects in appliances, fixtures and equipment). The remaining years of protection cover only construction defects.
We record a liability of approximately 1.0% to 1.3% of the sales price of a home to cover warranty expenses, although this allowance is subject to adjustment in special circumstances. Our historical experience is that warranty expenses generally fall within the amount established for such allowance.
In addition, we maintain insurance coverage with Residential Warranty Corporation for construction defects. We believe that our accruals and third party insurance are adequate to cover the ultimate resolution of our potential liabilities associated with known and anticipated warranty and construction defect related claims and litigation.
CORPORATE OPERATIONS
We perform the following functions at a centralized level:
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evaluate and select geographic markets;
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allocate capital resources to particular markets, including final approval of all land acquisitions;
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regulate the flow of financial resources and maintain relationships with our lenders;
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maintain centralized information systems; and
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monitor the decentralized operations of our subsidiaries and divisions.
We allocate capital resources necessary for new projects in a manner consistent with our overall operating strategy. We utilize return on assets, gross margins, net income margin and inventory turnover as the primary criteria for our allocation of capital resources. We will vary the capital allocation based on market conditions, results of operations and other factors. Capital commitments are determined through consultation among selected executive and operational personnel, who play an important role in ensuring that new projects are consistent with our strategy. Centralized financial controls are also maintained through the standardization of accounting and financial policies and procedures.
Structurally, we operate through separate divisions, which are located within the market in which they operate. Each division is managed by executives with substantial experience in the division’s market. In addition, each division is equipped with the skills to complete the functions of land acquisition, land development, construction, marketing, sales, product service and accounting.
COMPETITION AND MARKET FACTORS
The development and sale of residential properties is highly competitive and fragmented. We compete with numerous small and large residential builders for sales on the basis of a number of interrelated factors, including location, reputation, amenities, design, quality and price. We also compete for sales with individual resales of existing homes, available rental housing and resales of stacked-flat condominiums. We believe that we compare favorably to other builders in the markets in which we operate, due primarily to our experience within our geographic markets and breadth of product line, which allows us to vary our product offerings to reflect changing conditions within a market; our responsiveness to market conditions, enabling us to capitalize on the opportunities for advantageous land acquisitions in desirable locations; and our reputation for quality design, construction and service. Notwithstanding our perceived advantages with respect to other builders, some of our competitors have significantly greater financial resources or lower costs than we do. Because some of our competitors are larger than us, they may possess certain advantages over us, such as the ability to raise money at lower cost and the ability to negotiate significantly better prices on supplies and with subcontractors. Certain of our smaller competitors may have an advantage over us because they tend to have closer ties to the communities in which they build and, based on length of operation in the market, better name recognition than us. Furthermore, many custom homebuilders may have an advantage over us because purchasers of custom homes tend to want a level of flexibility in the design and construction of their homes that we do not offer.
The demand for new housing is affected by consumer confidence levels and prevailing economic conditions generally, including employment and interest rate levels. A variety of other factors affect the housing industry and demand for new homes, including the availability of labor and materials and increases in the costs thereof, changes in costs associated with home ownership such as increases in property taxes and energy costs, changes in consumer preferences, demographic trends, the amount of resale housing inventory available in the market and the availability of and changes in mortgage financing programs.
GOVERNMENT REGULATION AND ENVIRONMENTAL MATTERS
Substantially all of our land is purchased with entitlements, giving us the right to obtain building permits upon compliance with specified conditions, which generally are within our control. Upon compliance with such conditions, we must obtain building permits. The length of time necessary to obtain such permits and approvals affects the carrying costs of unimproved property acquired for the purpose of development and construction. In addition, the continued effectiveness of permits already granted is subject to factors such as changes in policies, rules and regulations and their interpretation and application. Several governmental authorities have imposed impact fees as a means of defraying the cost of providing certain governmental services to developing areas. To date, the governmental approval processes discussed above have not had a material adverse effect on our development activities and have not had a material effect on our capital expenditures, earnings and competitive position, and indeed all homebuilders in a given market face the same fees and restrictions. There can be no assurance, however, that these and other restrictions will not adversely affect us in the future.
We may also be subject to periodic delays or may be precluded entirely from developing communities due to building moratoriums or “slow-growth’’ or “no-growth’’ initiatives or building permit allocation ordinances which could be implemented in the future in the states and markets in which we operate. Substantially all of our land is entitled and, therefore, the moratoriums generally would only adversely affect us if they arose from health, safety and welfare issues such as insufficient water or sewage facilities. Local and state governments also have broad discretion regarding the imposition of development fees for projects in their jurisdiction. These fees are normally established, however, when we receive recorded final maps and building permits. We are also subject to a variety of local, state and federal statutes, ordinances, rules and regulations concerning the protection of health and the environment. Although in the future these laws may result in delays, cause us to incur substantial compliance and other costs, and prohibit or severely restrict development in certain environmentally sensitive regions or areas, these laws have not had a material effect on our capital expenditures, earnings and competitive position to date.
EMPLOYEES
As of May 31, 2007, we employed 416 people, of whom 132 were sales and marketing personnel, 182 were executive, management and administrative personnel and 102 were involved in construction. Although none of the our employees are covered by collective bargaining agreements, certain of the subcontractors engaged by us are represented by labor unions or are subject to collective bargaining arrangements. We believe that our relations with our employees and subcontractors are good.
Item 1A.
Item 1A. Risk Factors
Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements include, but are not limited to, the following:
The homebuilding industry historically has been cyclical and is now experiencing the first downturn in a number of years. Continuation of this downturn may result in continuing reduction in our operating revenues and lower net income.
The housing industry historically has been cyclical and has been affected significantly by adverse changes in consumer confidence levels and prevailing general and local economic conditions, including interest rate levels. These changes in economic conditions have in the past resulted in more caution on the part of potential purchasers of our homes and consequently resulted in a decline in our home sales. Beginning in 2006 and continuing in 2007, the homebuilding industry has experienced the first downturn in a number of years resulting in a significant decline in demand for newly built homes in many of our markets. Significant drivers of these economic conditions in this cycle have involved, among other things, a decline in demand in our markets due to changes in consumer confidence in the real estate market, increased inventory of new and used homes for sale and resulting increases in cancellation rates in most of our markets, pricing pressures resulting from the imbalance between supply and demand and the recent collapse of the sub-prime lending industry that financed a significant number of home sales over the last four years. These factors have had an impact on our operating performance, and have caused our operating revenues to decline. We have no basis for predicting how long demand and supply will remain out of balance in our markets and whether, once the market stabilizes, sales volumes or pricing will return to prior levels. While the factors discussed above may have an impact on the homebuilding industry generally, if they continue to put pressure on the homebuilding industry they may have a more significant impact on us compared to certain of our competitors because our operations are concentrated in fewer geographic markets.
If the market value of our inventory drops significantly, we could be required to further write down the carrying value of our inventory to its estimated fair value, which would negatively impact our results of operations and financial condition.
We acquire land for expansion into new markets and for replacement of land inventory and expansion within our current markets. The market value of land, building lots and housing inventories can fluctuate significantly as a result of changing market conditions, and the measures we employ to manage inventory risk may not be adequate to insulate our operations from a severe drop in inventory values. Because of deteriorating conditions in the homebuilding industry, we recognized asset impairment charges with respect to our inventories during fiscal years 2006 and 2007. If the market value of our inventory drops again in the future, we could be required to further write down the carrying value of our inventory to its estimated fair value, which would negatively impact our results of operations and financial condition.
Our home sales and operating revenues could decline due to macroeconomic and other factors outside of our control, such as changes in consumer confidence, declines in employment levels and terrorist attacks.
The housing industry historically has been cyclical and has been affected significantly by adverse changes in consumer confidence levels and prevailing general and local economic conditions, including interest rate levels. These changes in economic conditions may result in more caution on the part of potential purchasers of our homes and consequently result in a decline in our home sales. Significant drivers of these economic conditions involve,
among other things, conditions of supply and demand in our markets as well as changes in consumer confidence and income, employment levels, interest rate levels, government regulations, terrorist attacks and domestic and international instability. These risks and uncertainties could periodically have an adverse effect on consumer demand for and the pricing of our homes, which could impact our operating performance, make it more difficult for us to compete with larger home builders who have more resources to address pricing pressure and cause our operating revenues to decline. While the factors discussed above may have an impact on the homebuilding industry generally, they may have a more significant impact on us compared to certain of our competitors because our operations are concentrated in fewer geographic markets and because we may not have as significant reserves of resources to help us adjust to a decline in demand for our homes.
Our operating results are variable, and as a result, our historical performance may not be a meaningful indicator of future results.
We have historically experienced, and in the future expect to continue to experience, variability in our operating results on a quarterly and an annual basis. Factors expected to contribute to this variability include, among other things:
•
the timing of land acquisitions and zoning and other regulatory approvals;
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the timing of home closings, land sales and level of home sales;
•
our product mix;
•
our ability to continue to acquire additional land or options thereon on acceptable terms;
•
the condition of the real estate market and the general economy;
•
delays in construction due to acts of God, adverse weather, reduced subcontractor availability and strikes; and
•
employment levels.
For example, the timing of land acquisitions, zoning and other regulatory approvals impacts our ability to pursue the development of new housing projects in accordance with our business plan. If the timing of land acquisitions or zoning or regulatory approvals is delayed, we will be delayed in our ability to develop housing projects, which would likely decrease our backlog. Furthermore, these delays could result in a decrease in our revenues and earnings for the periods in which the delays occur and possibly subsequent periods until the planned housing projects can be completed. A delay in a significant number of home closings or land sales due to acts of God, adverse weather, subcontractor availability or strikes would have a similar impact on revenues and earnings for the period in which the delays occur. Further, revenues may increase in subsequent periods over what would normally be expected as a result of increased home closings as the delays described above are resolved.
Changes in employment levels could affect the number of people seeking new housing in one or more of our markets. Consequently, if there was an adverse change in employment levels in our markets, we may not reach our projected level of home sales, and we may have planned the construction of more homes than necessary resulting in a slowdown in the closing of our developments. Conversely, favorable changes in employment levels could result in unexpected increases in our revenues and earnings.
An increase in mortgage interest rates or unavailability of mortgage financing may reduce consumer demand for our homes.
Virtually all purchasers of our homes finance their acquisitions through lenders providing mortgage financing. A substantial increase in mortgage interest rates or unavailability of mortgage financing would adversely affect the ability of prospective homebuyers to obtain the financing they would need in order to purchase our homes, as well as adversely affect the ability of prospective move-up homebuyers to sell their current homes. For example, if mortgage financing became less available, demand for our homes could decline. A reduction in demand could also have an adverse effect on the pricing of our homes because we and our competitors may reduce prices in an effort to better compete for home buyers. A reduction in pricing could result in a decline in revenues and in our margins.
We intend to continue to consider growth or expansion of our operations which could have a material adverse effect on our cash flows or profitability.
We intend to continue to consider growth or expansion of our operations in our current markets or in other areas which will require substantial capital expenditures. The magnitude, timing and nature of any future expansion will depend on a number of factors, including the identification of suitable markets, our financial capabilities, the availability of qualified personnel in the target market and general economic and business conditions. Our expansion into new or existing markets could have a material adverse effect on our cash flows or profitability.
Historically, our strategy has been to enter new markets through the start-up of company-developed divisions, rather than the acquisition of existing homebuilding companies. Because we typically do not acquire existing homebuilders when entering a new market, we do not have the advantage of the experience and goodwill of an established homebuilding company. As a result, we incur substantial start-up costs in establishing our operations in new markets, and we may not be successful in taking operations in new markets from the start-up phase to profitability. If we are not successful in making operations in new markets profitable, we may not be able to recover our investment, and our financial results could suffer.
Furthermore, in the future we may choose to enter new markets or expand operations in existing markets through acquisitions, and these acquisitions may result in the incurrence of additional debt. Acquisitions also involve numerous risks, including difficulties in the assimilation of the acquired company’s operations, the incurrence of unanticipated liabilities or expenses, the diversion of management’s attention from other business concerns, risks of entering markets in which we have limited or no direct experience, and the potential loss of key employees of the acquired company.
Lack of greater geographic diversification could expose our business to increased risks if there are economic downturns in our markets.
We have homebuilding operations in Atlanta, Dallas, Houston, Orlando, Phoenix, Tampa and Denver. We also have land operations in Denver and Orlando. Our operations in Atlanta, Orlando and Phoenix together provided 64.0% and 65.8% of our home building revenues for the fiscal years ended May 31, 2007 and 2006, respectively. Failure to be more geographically diversified could adversely impact us if the homebuilding business in our current markets, especially Atlanta, Orlando, and Phoenix should decline.
We could experience a reduction in home sales and revenues or reduced cash flows if we are unable to obtain reasonably priced financing to support our homebuilding and land development activities.
The homebuilding industry is capital intensive, and homebuilding requires significant up-front expenditures to acquire land and begin development. Accordingly, we incur substantial indebtedness to finance our homebuilding and land development activities. Although we believe that internally generated funds and borrowing capacity under our senior unsecured credit facility will be sufficient to fund our capital and other expenditures (including land acquisition, development and construction activities), the amounts available from such sources may not be adequate to meet our needs. If such sources are not sufficient, we would seek additional capital in the form of debt or equity financing from a variety of potential sources, including additional bank financing and/or securities offerings. The amount and types of indebtedness which we may incur are limited by the terms of the agreements governing our existing debt. In addition, the availability of borrowed funds, to be utilized for land acquisition, development and construction, may be greatly reduced, and the lending community may require increased amounts of equity to be invested in a project by borrowers in connection with both new loans and the extension of existing loans. The failure to obtain sufficient capital to fund our planned capital and other expenditures could have a material adverse effect on our business.
Changes in the government regulations applicable to homebuilders could restrict our business activities, increase our operating expenses and cause our revenues to decline.
Regulatory requirements applicable to homebuilders could cause us to incur significant liabilities and operating expenses and could restrict our business activities. We are subject to local, state and federal statutes and rules regulating, among other things certain developmental matters, building and site design, and matters concerning the protection of health and the environment. Our operating expenses may be increased by governmental regulations, such as building permit allocation ordinances, impact and other fees and taxes, which may be imposed to defray the cost of providing certain governmental services and improvements. Other governmental regulations, such as building moratoriums and “no growth’’ or “slow growth’’ initiatives, which may be adopted in communities which have developed rapidly, may cause delays in our home projects or otherwise restrict our business activities resulting in reductions in our revenues. Any delay or refusal to grant us necessary licenses, permits or approvals from government agencies could have an adverse effect on our operations. Because we currently operate in only seven markets, any increase in costs or delays due to regulatory changes in one or more of our markets may have a proportionately greater impact on us than some other homebuilding companies that operate in more markets or more regions of the country.
We may incur additional operating expenses due to compliance requirements or fines, penalties and remediation costs pertaining to environmental regulations within our markets.
We are subject to a variety of local, state and federal statutes, ordinances, rules and regulations concerning the protection of health and the environment. The particular environmental laws which apply to any given community vary greatly according to the community site, the site’s environmental conditions and the present and former use of the site. We expect that increasingly stringent requirements will be imposed on homebuilders in the future. Environmental laws may result in delays, cause us to implement time consuming and expensive compliance programs, and prohibit or severely restrict development in certain environmentally sensitive regions or areas. Environmental regulations can also have an adverse impact on the availability and price of certain raw materials, such as lumber. Furthermore, our failure to comply with all applicable environmental laws and regulations may result in the imposition of fines and penalties or remediation obligations that may require us to pay substantial amounts of money. The occurrence of any of the foregoing could result in an increase in our expenses and a reduction in our net income.
We are subject to warranty claims arising in the ordinary course of our business that could adversely affect our results of operations.
We are subject in the ordinary course of our business to home warranty claims. We provide our homebuyers with a one year warranty covering workmanship and materials, a two year warranty covering construction defects and certain defects in plumbing, electrical, heating, cooling and ventilation systems and a ten year warranty covering construction defects. Warranty claims are common in the homebuilding industry and can be costly, and the terms and limitations of the limited warranties provided to homebuyers may not be effective against claims made by the homebuyers. We maintain homebuilder protective policy insurance coverage with Residential Warranty Corporation for construction defects. However, we may not be able to renew our insurance coverage or renew it at reasonable rates. As a result, we may be liable for damages, the cost of repairs and/or the expense of litigation surrounding possible construction defects, soil subsidence or building-related claims. Furthermore, claims may arise out of uninsurable events or circumstances not covered by insurance and not subject to effective indemnification agreements with our subcontractors. Increases in the cost to insure against warranty claims may result in an increase in our self-insured retentions and claims reserves. Further, the loss of insurance or liability for uninsured claims could result in an increase in our expenses reducing our margins and adversely affecting our results of operations and our ability to implement our business plan.
Our operating expenses could increase if we are required to pay higher insurance premiums or incur substantial litigation costs for claims involving construction and product defect liability claims, including claims related to mold, which could cause our net income to decline.
The costs of insuring against construction defect and product liability claims are high, and the amount and
scope of coverage offered by insurance companies is currently limited. The scope of coverage may continue to be limited or be further restricted and may become more costly which could require us to divert money away from implementing our business plan in order to pay insurance premiums.
Increasingly in recent years, lawsuits (including class action lawsuits) have been filed against builders asserting claims of personal injury and property damage caused by the presence of mold in residential dwellings. Our insurance may not cover all of the claims, including personal injury claims, arising from the presence of mold, or such coverage may become prohibitively expensive. If we are not able to obtain adequate insurance against these claims, we may experience litigation costs and losses that could reduce our net income.
Historically, builders have recovered from subcontractors and their insurance carriers a significant portion of the construction and product defect liabilities and costs of defense that the builders have incurred. Insurance coverage available to subcontractors for construction and product defects is becoming increasingly expensive and the scope of coverage is restricted. If we cannot effectively recover from our subcontractors or their carriers, we may suffer greater losses which could decrease our net income.
A builder’s ability to recover against any available insurance policy depends upon the continued solvency and financial strength of the insurance carrier that issued the policy. Many of the states in which we build homes have lengthy statutes of limitations applicable to claims for construction defects. To the extent that any carrier providing insurance coverage to us or our subcontractors becomes insolvent or experiences financial difficulty in the future, we may be unable to recover on those policies and our net income may decline. Our inability to recover under those policies or to recover the losses from our subcontractors could have a more severe impact on us than on our larger competitors that have more financial resources.
We are dependent on the services of certain key employees, and the loss of their services could hurt our business.
We currently operate with a management team comprised of five executive officers and a single president overseeing each geographic market. Therefore, we rely heavily on each of these individuals for their expertise and understanding of our business operations and strategy. Our decision making process is generally concentrated among these individuals and is based on their skill and depth of knowledge of us and the homebuilding industry. If we are unable to retain any of these key employees, particularly Tom Krobot, Robert Salomon and Mark Thomas, or attract, train, assimilate or retain other skilled personnel in the future, it could hinder the execution of our business strategy. Further, the loss of one or more of these key employees would put additional strain on the existing management team to fill the vacancy until a replacement can be identified. Competition for qualified personnel in all of our operating markets is intense, and it could be difficult for us to find experienced personnel to replace our current employees, particularly our management team. Furthermore, a significant increase in the number of our active communities would place additional strain on the members of our management team and would necessitate the hiring of a significant number of additional personnel, including senior officers, who are in short supply in our markets, particularly with respect to individuals with significant homebuilding experience.
We are dependent on the continued availability and satisfactory performance of our subcontractors, which, if unavailable, could have a material adverse effect on our business.
We conduct our construction operations only as a general contractor. Virtually all construction work is performed by unaffiliated third party subcontractors. As a consequence, we depend on the continued availability of and satisfactory performance by these subcontractors for the construction of our homes. There may not be sufficient availability of and satisfactory performance by these unaffiliated third party subcontractors. If there are not sufficient quality subcontractors available to assist us in home construction, our ability to construct homes on the schedule we have committed to with our homebuyers would be affected. This could result in an increase in the number of homebuyers that cancel their contracts with us, resulting in less of our backlog being closed in a year than is projected, or could result in an increase in our costs to construct homes in a timely manner, which could result in an increase in our overall costs and thus a decline in our margins and in our net income.
Supply risks and shortages relating to labor and materials can harm our business by delaying construction and increasing costs.
The homebuilding industry from time to time has experienced significant difficulties with respect to:
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shortages of qualified trades people and other labor;
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shortages of materials; and
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volatile increases in the cost of certain materials, including lumber, framing and cement, which are significant components of home construction costs.
These difficulties can, and often do, cause unexpected short-term increases in construction costs and cause construction delays. We are generally unable to pass on any unexpected increases in construction costs to those customers who have already entered into sales contracts, as those contracts generally fix the price of the house at the time the contract is signed, which may be up to one year in advance of the delivery of the home. Furthermore, sustained increases in construction costs may, over time, erode our profit margins. In the future, pricing competition may restrict our ability to pass on any additional costs, and we may not be able to achieve sufficient operating efficiencies and economics of scale to maintain our current profit margins.
Our financial condition and results of operations may be adversely affected by any decrease in the value of our land inventory, as well as by the associated carrying costs.
We must continuously acquire land for replacement and expansion of land inventory within our existing and new markets. The risks inherent in purchasing and developing land increase as consumer demand for housing decreases. Thus, we may have bought and developed land which we cannot profitably sell or on which we cannot profitably build and sell homes. The market value of land, building lots and housing inventories can fluctuate significantly as a result of changing market conditions. It is possible that the measures we employ to manage inventory risks will not be successful and as a result our operations may suffer.
In addition, inventory carrying costs can be significant and can result in losses in a poorly performing project or market. In the event of significant changes in economic or market conditions, we may have to sell homes at significantly lower margins or at a loss.
Our business and operating results could be adversely affected by adverse weather conditions and natural disasters.
Adverse weather conditions, such as extended periods of rain, snow or cold temperatures, and natural disasters, such as hurricanes, tornadoes, floods and fires, can delay completion and sale of homes, damage partially complete or other unsold homes in our inventory and/or decrease the demand for homes or increase the cost of building homes. To the extent that natural disasters or adverse weather events occur, our business and results may be adversely affected. To the extent our insurance is not adequate to cover business interruption losses or repair costs resulting from these events, our revenues and earnings may be adversely affected.
If we are unsuccessful in competing against other homebuilders, our market share could decline or our growth could be impaired and, as a result, our financial results could suffer.
The homebuilding industry is highly competitive. Homebuilders compete for, among other things, desirable land, financing, raw materials, skilled labor and purchasers. We compete for residential sales on the basis of a number of interrelated factors, including location, reputation, amenities, design, quality and price, with numerous large and small homebuilders, including some homebuilders with nationwide operations and greater financial resources and/or lower costs than us. The consolidation of some homebuilding companies may create competitors that have greater financial, marketing and sales resources than we do and thus are able to compete more effectively against us. In addition, there may be new entrants in the markets in which we currently conduct business. We also compete for sales with the resale market for existing homes and with available rental housing. Increased competition could cause us to increase our selling incentives and reduce our home prices. Increased competition
could also reduce the number of homes we deliver, reducing our revenues, or cause us to accept reduced margins to maintain sales volumes. A reduction in our revenue or margins due to competitive factors could affect our ability to service our debt, including the notes.
Reduced numbers of home sales may force us to absorb additional costs which could have an adverse impact on our operating results and financial condition.
We incur many costs even before we begin to build homes in a community. These include costs of preparing land and installing roads, sewage and other utilities, as well as taxes and other costs related to ownership of the land on which we plan to build homes. Reducing the rate at which we build homes extends the length of time it takes us to recover these costs, which could have an adverse impact on our operating results and financial condition.
Increases in our cancellation rate could have a significant negative impact on our operating results.
Our cancellation rate, which is the percentage of gross new home orders cancelled during a reporting period, increased significantly during fiscal years 2006 and 2007, compared with cancellation rates during fiscal years 2004 and 2005, which has negatively impacted the number of closed homes, net home orders, and home sales revenue and net income during fiscal year 2007. Continued high cancellation rates resulting from a number of factors, including, slower home price appreciation, increases in the supply of homes available to be purchased, higher mortgage interest rates, increased competition and adverse changes in economic conditions, could have a significant negative impact on our home sales revenue and result in lower net income or higher net loss in future reporting periods.
Item 1B.
Item 1B. Unresolved Staff Comments
Not applicable
Item 2.
Item 2. Properties
We lease 6,284 square feet of office space in Atlanta, Georgia for our corporate offices. This lease expires in 2008. In addition, we lease 90,999 square feet of space for our operating divisions under leases expiring between 2007 and 2009. The leases have terms ranging from 12 months to 60 months, with various renewal options.
Item 3.
Item 3. Legal Proceedings
From time to time we are involved in various routine legal proceedings incidental to our business. We believe that none of these matters, some of which are covered by insurance, will have a material adverse impact upon our consolidated financial statements as a whole if decided against us.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Repurchases of Equity Securities
We are a limited liability company, and all of our membership interests are owned by six families or family trusts related to the following individuals: Elly Reisman, Norman Reisman, Bruce Freeman, Seymour Joffe, Larry Robbins and Harry Rosenbaum. The owners control us through individual Nevada-based holding companies in which each family or family trust owns all of the equity interests. See Item 12 “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” for additional information about the ownership of our membership interests. There is no established public trading market for our membership interests.
Although we do not pay dividends to our members, we periodically make distributions to them for the payment of federal and state income taxes and as general distributions of our income. During the fiscal years ended May 31, 2007 and 2006, we distributed a total of $30.4 million and $37.3 million, respectively, to our members. In 2007 and 2006, $22.9 million and $25.1 million respectively, were related to the payment of income taxes and $7.5 million and $12.2 million respectively were general distributions. We are restricted in our ability to pay distributions under various covenants of our debt agreements.
Item 6.
Item 6. Selected Financial Data
The following table sets forth selected consolidated financial information for Ashton Woods USA L.L.C. for and as of each of the five fiscal years in the period ended May 31, 2007.
(1)
Because we are structured as a limited liability company, income tax obligations are paid by our members and are not borne by us. Therefore, our net income is higher than it would be if we were structured as a subchapter C corporation. However, historically we have made distributions to our members that include amounts necessary for them to pay income taxes attributable to them.
(2)
EBITDA (earnings before interest, taxes, depreciation and amortization) is calculated by adding previously capitalized interest amortized to costs of sales, franchise taxes, depreciation and amortization to net income. EBITDA is not a financial measure under generally accepted accounting principles in the United States, or GAAP. EBITDA should not be considered an alternative to net income determined in accordance with GAAP as an indicator of operating performance, nor an alternative to cash flows from operating activities determined in accordance with GAAP as a measure of liquidity. Because some analysts and companies may not calculate EBITDA in the same manner as us, the EBITDA information in this report may not be comparable to similar presentations by others.
EBITDA is a measure commonly used in the homebuilding industry and is presented as a useful adjunct to net income and other measurements under GAAP because it is a meaningful measure of a company’s performance, as interest, taxes, depreciation and amortization can vary significantly between companies due in part to differences in structure, accounting policies, tax strategies, levels of indebtedness, capital purchasing practices and interest rates. EBITDA also assists management in evaluating operating performance, and we believe that it is a useful measure for investors to compare us with our competitors.
The following is a reconciliation of EBITDA to net income, the most directly comparable GAAP measure:
In fiscal years 2007 and 2006, we recognized non-cash impairment charges of $18.8 million and $4.5 million respectively. Consequently, EBITDA during each of those years was reduced by these non-cash charges.
EBITDA does have certain limitations as a tool for measuring Company performance from period to period, because that performance is affected by the use of cash to purchase capital assets and to pay interest and taxes. These amounts, as well as depreciation and amortization associated with capital assets, can fluctuate significantly over time due to fluctuations in our debt levels used to finance our inventory, purchases of capital assets and operations, income levels and other performance issues, which is not apparent if EBITDA is used as an evaluation tool. Because we borrow money to finance our inventory purchases and operations, interest expense is a necessary element of our costs and affects our ability to generate revenue. Further, because we use capital assets, depreciation and amortization are necessary elements of our costs and also affect our ability to generate revenue. Any performance measure that excludes interest expense, depreciation and amortization has material limitations. To compensate for these limitations, our management uses both EBITDA and net income, the most directly comparable GAAP measurement, to evaluate our performance.
(3)
EBITDA margin is calculated by dividing EBITDA by total revenues.
(4)
Interest incurred for any period is the aggregate amount of interest which is capitalized during such period.
(5)
A home is included in “homes closed” when title is transferred to the buyer. Revenues and cost of sales for a home are recognized at the date of closing.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
We are one of the largest private homebuilders in the United States. We design, build and market high-quality single-family detached homes, townhomes and stacked-flat condominiums under the Ashton Woods Homes brand name. We currently operate in Atlanta, Dallas, Houston, Orlando, Phoenix, Denver and Tampa. These cities represent seven of the 21 largest new residential housing markets in the United States. We have been in operation for over 15 years and serve a broad customer base including first-time buyers and first- and second-time move-up buyers. We focus on achieving the highest standards in design, quality and customer satisfaction. We have received numerous awards, including the 2005 and 2004 J.D. Power Award for Highest in Customer Satisfaction with New Homebuilders in Atlanta, and are ranked in the top 13% of all homebuilders nationally in customer satisfaction in 2006 and 2005 by a nationally recognized survey company not affiliated with us.
Our revenues are primarily generated from designing, building and marketing single-family detached homes, townhomes, and stacked-flat condominiums in the five states and seven markets we currently serve. We also acquire and develop land for use in our homebuilding operations and for sale to others. From time to time, we elect to sell parcels of land or finished lots that do not fit with our home development program. Parcels of land or finished lots may be deemed not to fit within our home development program for a variety of reasons, including, when a specific parcel contains a greater supply of lots than deemed appropriate for the particular development or specific lots are designed for a housing product that is not within our business plan for that area, such as custom built homes or homes that are not within the size specifications for the particular development. These land sales are incidental to our business of selling and building homes and have fluctuated significantly in the past. We anticipate continuing to sell parcels of land and finished lots in the future when circumstances warrant; however, we do not anticipate future sales of land being as significant a part of our revenues as they have been in the past. We expect that the significance of land sales revenue will fluctuate from quarter to quarter.
We also conduct mortgage origination and title services for the benefit of our homebuilding operation. These ancillary services do not provide us with significant revenues and are carried out through separate jointly-owned entities, which are operated by our partners in these entities. The earnings from these jointly-owned entities are recorded using the equity method of accounting, and the earnings are a component of the line item “Earnings in unconsolidated entities” on our income statement. We have a 49.9% interest in an entity that offers mortgage financing to all of our buyers and in the past has offered refinancing services to others. The mortgage operation’s revenues consist primarily of origination and premium fee income, interest income and the gain on sale of the mortgages. We also offer title services to our homebuyers in Dallas and Houston through 49.0% ownership interests in two title companies, and in Florida through a 49.0% ownership interest in a joint venture with a third party title company. The companies are managed by, and all underwriting risks associated with the title are transferred to, the majority owners.
The continued downturn in the homebuilding industry has resulted in decreases in home closings, net new home orders, revenues and net income for the fiscal year ended May 31, 2007, from the record levels achieved during the prior fiscal year.
The decline in net new home orders resulted from, among other things, the continued general reduction in the demand for new homes and the oversupply of new and used homes available for sale in the marketplace. The recent problems in the sub-prime mortgage lending market exacerbated the oversupply of new and used homes available for sale. Fewer potential homebuyers have been able to qualify for a mortgage loan as
compared to a year ago resulting in a smaller pool of homebuyers and impacting the sale of existing homes by our move-up buyers.
Throughout fiscal year 2007, we increased the sales incentives offered to homebuyers and increased marketing efforts to stimulate net new home orders and to maintain homes in backlog. The sales incentives offered to our homebuyers vary depending upon the particular market and include sales price reductions, reductions in the prices of options for their homes, discounted upgrades, the payment of certain closing costs and other mortgage financing programs. We believe that these incentives contributed to an improvement in our cancellation rate from 34% for the first six months of fiscal year 2007 to 29% for the final six months of fiscal year 2007. For the entire fiscal year our average cancellation rate was 31%.
Management has been and continues to be committed to maintaining our conservative balance sheet practices through the strict control of speculative inventory and curtailment of land acquisition activities. We have focused our efforts on generating net new home sales through the continued use of sales incentives and an increase in our advertising efforts. As of May 31, 2007, we had 138 homes at various stages of completion (of which 93 homes were completed) for which we did not have a sales contract (“spec homes”) as compared to 129 total spec homes at the end of the prior year, of which 73 were completed. In addition, our desire to maintain a conservative balance sheet has resulted in a land supply under our historical four-year supply target as we have tightened our underwriting guidelines for new land acquisitions. As of May 31, 2007, our supply of land controlled for use in our homebuilding operations was 3.3 years, consisting of a 2.4 year supply of owned land and a 0.9 year supply of land controlled through option contracts. Management will continue to evaluate our land supply in relation to the overall health of the homebuilding environment and will adjust our land supply accordingly in the future.
The homebuilding market continued to deteriorate throughout fiscal year 2007 and is in a significant downturn due in large part to the over supply of new and used homes for sale as compared to the demand for housing by potential homebuyers. We believe the continued high level of new and resale inventory available for sale in the market, the reduced level of consumer confidence and higher mortgage interest rates coupled with tightened mortgage lending standards will continue to negatively impact demand for new homes for the foreseeable future. We have made significant adjustments in our operations including, among other things, reductions in sales and marketing and general and administrative expenses, reduced construction costs, reduced land acquisitions and increased sales incentives, in an effort to mitigate the effects of a prolonged decrease in the demand for new homes, although there can be no assurances that these efforts will be successful. Further deterioration in the homebuilding market may cause additional pressures on sales incentives that may lead to reduced gross margins and potentially additional inventory impairments in the future.
On January 10, 2007, we amended our senior unsecured credit facility to amend the definition of “EBITDA” contained therein to exclude certain non-cash gains and include certain non-cash losses or charges and to extend the maturity date to January 19, 2011, for 88.3%, or $265.0 million of the facility. On February 21, 2007, we obtained consent from an additional lender representing 5.0% or $15 million of the facility, to the extension of the senior unsecured credit facility to January 19, 2011. In June 2007, we entered into another amendment to the revolving credit facility. The June 2007 amendment provides for a reduction in the interest coverage ratio and for adjustments to the leverage ratio and the interest rate in the event that our interest coverage ratio falls below a certain level. See Note 14 to the consolidated financial statements for additional information.
RECENT ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently evaluating the impact of adopting SFAS 157 on our results of operations or financial position.
RECENTLY ADOPTED ACCOUNTING POLICIES
In December 2004, the FASB issued SFAS 123 (Revised), Share-Based Payment (“SFAS 123 (R)”), which was a revision of SFAS No. 123. “Accounting for Stock-Based Compensation” (FAS 123). FAS 123(R) supersedes APB
Opinion 25, “Accounting for Stock Issued to Employees” and amends SFAS No. 95, “Statement of Cash Flows”, and requires instead that compensation expense be recognized based on the fair value on the date of the grant. SFAS 123(R) was effective beginning in the first quarter of fiscal 2007. The adoption of SFAS 123(R) did not have a material impact on our consolidated results of operations or financial position.
In September 2006, the Securities and Exchange Commission (“SEC”) Staff issued Staff Accounting Bulletin 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 addresses how the effects of prior year uncorrected financial statement misstatements should be considered in current year financial statements. SAB 108 requires registrants to quantify misstatements using both balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relative quantitative and qualitative factors. SAB 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006. The adoption of SAB 108 did not have an effect on our consolidated financial statements.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
General. A more comprehensive enumeration of our significant accounting policies is presented in the notes to the accompanying financial statements as of May 31, 2007 and 2006, and for the years ended May 31, 2007, 2006 and 2005. Each of our accounting policies has been chosen based upon current authoritative literature that collectively comprises generally accepted accounting principles (“GAAP”) for companies operating in the United States of America. In instances where alternative methods of accounting are permissible under GAAP, we have chosen the method that most appropriately reflects the nature of our business, the results of our operations and our financial condition, and have consistently applied those methods over each of the periods presented in the financial statements.
Some of our critical accounting policies require the use of judgment in their application or require estimates of inherently uncertain matters. Although our accounting policies are in compliance with GAAP, a change in the facts and circumstances of the underlying transactions could significantly change the application of the accounting policies and the resulting financial statement impact. Listed below are those policies that we believe are critical and require the use of complex judgment in their application.
Basis of Presentation. Our financial statements include the accounts of Ashton Woods USA L.L.C. and all of its wholly-owned, majority-owned and controlled subsidiaries. All significant intercompany accounts, transactions and balances have been eliminated in consolidation. We have also consolidated certain variable interest entities from which we are purchasing lots under option purchase contracts, under the requirements of FASB Interpretation No. 46R issued by the FASB.
Revenue Recognition. We recognize homebuilding revenues when a home closes and title to and possession of the property are transferred to the buyer. Substantially all of our revenues are received in cash within a day or two of closing. We include amounts in transit from title companies at the end of each reporting period in accounts receivable. When we execute sales contracts with our homebuyers, or when we require advance payment from homebuyers for custom changes, upgrades or options related to their homes, we record the cash deposits received as liabilities until the homes are closed or the contracts are canceled. We either retain or refund to the homebuyer deposits on canceled sales contracts, depending upon the applicable provisions of the contract.
Inventories and Cost of Sales. Finished inventories and land held for sale are stated at the lower of accumulated cost or fair value less cost to sell. Homebuilding projects and land held for development and construction are stated at cost unless facts and circumstances indicate that such cost would not be recovered from the undiscounted cash flows generated by future dispositions, after considering estimated cash flows associated with all future expenditures to develop the assets, including interest payments that will be capitalized as part of the cost of the asset. In this instance, such inventories are written down to estimated fair value, which is determined based on management’s estimate of future revenues and costs that would be considered by an unrelated buyer in determining the fair value of the asset. Due to uncertainties in the estimation process, it is possible that actual results could differ.
In addition to the costs of direct land acquisition, land development and home construction, inventory costs include interest, real estate taxes and indirect overhead costs incurred during development and home construction. We use the specific identification method for the purpose of accumulating home construction costs. Cost of sales for homes closed includes the specific construction costs of each home and all applicable land acquisition, land development and related costs (both incurred and estimated to be incurred) based upon the total number of homes expected to be closed in each project. Any changes to the estimated total development costs subsequent to the initial home closings in a project are generally allocated on a pro-rata basis to the remaining homes in the project.
When a home is closed, we generally have not yet paid and recorded all incurred costs necessary to complete the home. Each month we record as a liability and a charge to cost of sales the amount we estimate will ultimately be paid related to completed homes that have been closed as of the end of that month.
We compare our home construction budgets to actual recorded costs to estimate the additional costs remaining to be paid on each closed home. We monitor the accuracy of each month’s accrual by comparing actual costs paid on closed homes in subsequent months to the amount we accrued. Although actual costs to be paid on closed homes in the future could differ from our current estimate, our method has historically produced consistently accurate estimates of actual costs to complete closed homes.
Each reporting period, we review all components of inventory in accordance with SFAS No. 144, which requires that if the sum of the undiscounted future cash flows expected to result from a community is less than the carrying value of the community, an asset impairment must be recognized in the consolidated financial statements as a component of cost of sales. The amount of the impairment is calculated by subtracting the fair value of the community from the carrying value of the community.
In order for management to assess the fair value of a community, certain assumptions must be made which are highly subjective and susceptible to change. We evaluate, among other things, the actual gross margins for homes closed and the gross margins for homes sold in backlog. This evaluation also includes critical assumptions with respect to future home sales prices, cost of sales, including levels of sales incentives and the monthly rate of sale, which are critical in determining the fair value of a community. If events and circumstances indicate that the carrying value of a community are not expected to be recoverable, then the community is written down to its estimated fair value. Given the historical cyclicality of the homebuilding industry, the valuation of homebuilding inventories are sensitive to changes in economic conditions, such as interest rates and unemployment levels. Changes in these economic conditions could materially affect the projected home sales price, the level of sales incentives, the costs to develop land and construct the homes and the monthly rate of sale. Because of these potential changes in economic and market conditions in conjunction with the assumptions and estimates required of management in valuing homebuilding inventory, actual results could differ materially from management’s assumptions and may require material inventory impairments to be recorded in the future.
In accordance with SFAS No. 144, valuation adjustments are recorded on finished homes and land held for sale when events or circumstances indicate that the fair value, less costs to sell, is less than the carrying value.
We recorded $18.8 million of impairment losses during the fiscal year ended May 31, 2007 - $4.3 million in Atlanta, $2.1 million in Dallas, $7.1 million in Phoenix, $0.1 million in Orlando and $5.2 million in Tampa as compared to $4.5 million of impairment losses in fiscal year 2006 - $2.0 million for Phoenix, $1.8 million for Tampa, $0.4 million for Dallas, $0.2 million for Atlanta and $0.1 million for Houston.
Consolidation of Variable Interest Entities. In January 2003, FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46”). On December 24, 2003, FIN 46 was replaced by FIN 46R. FIN 46R requires the consolidation of variable interest entities in which an enterprise absorbs a majority of the entity’s expected losses, receives a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity.
In the ordinary course of business, we enter into land and lot option purchase contracts in order to procure land or lots for the construction of homes. Under such option purchase contracts, we will fund a stated deposit in consideration for the right, but not the obligation, to purchase land or lots at a future point in time with
predetermined terms. Under the terms of the option purchase contracts, many of our option deposits are non-refundable. Certain non-refundable deposits are deemed to create a variable interest in a variable interest entity under the requirements of FIN 46R. As such, certain of our option purchase contracts result in the acquisition of a variable interest in the entity holding the land parcel under option.
In applying the provisions of FIN 46R, we evaluate those land and lot option purchase contracts with variable interest entities to determine whether we are the primary beneficiary based upon analysis of the variability of the expected gains and losses of the entity. Based on this evaluation, if we are the primary beneficiary of an entity with which we have entered into a land or lot option purchase contract, the variable interest entity is consolidated.
Since we own no equity interest in any of the unaffiliated variable interest entities that we must consolidate pursuant to FIN 46R, we generally have little or no control or influence over the operations of these entities or their owners. When our requests for financial information are denied by the land sellers, certain assumptions about the assets and liabilities of such entities are required. In most cases, the fair value of the assets of the consolidated entities have been estimated to be the remaining contractual purchase price of the land or lots we are purchasing. In these cases, it is assumed that the entities have no significant debt obligations and the only asset recorded is the land or lots we have the option to buy with a related offset to minority interest for the assumed third party investment in the variable interest entity. Creditors, if any, of these variable interest entities have no recourse against us.
Warranty Liabilities. We establish warranty liabilities by charging cost of sales and crediting a warranty liability for each home closed. Unlike our two- and ten-year warranties which we insure through a third-party insurance company, we self-insure for our obligations under our one-year warranties. Consequently, we estimate the amounts charged to be adequate to cover expected warranty-related costs for materials and labor required under the one-year warranty obligation period. The one-year warranty is comprehensive for all parts and labor. Our warranty cost accruals are based upon our historical warranty cost experience in each market in which we operate and are adjusted as appropriate to reflect qualitative risks associated with the type of homes we build and the geographic areas in which we build them. Actual future warranty costs could differ significantly from our currently estimated amounts.
Insurance Claim Costs. We have, and require the majority of our subcontractors to have, general liability and workers compensation insurance. These insurance policies protect us against a portion of our risk of loss from claims, subject to certain deductibles and other coverage limits. We accrue an estimated liability for costs to cover our deductible amounts under those policies and for any estimated costs of claims and lawsuits in excess of our coverage limits or not covered by our policies, based on an analysis of our historical claims, which includes an estimate of construction defect claims incurred but not yet reported. Projection of losses related to these liabilities is subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products we build, claim settlement patterns, insurance industry practices, and legal interpretations, among others. Because of the high degree of judgment required in determining these estimates, actual future costs could differ significantly from our currently estimated amounts.
RESULTS OF OPERATIONS
Overview
The following tables set forth the key operating and financial data for our operations as of and for the fiscal years ended May 31, 2007, 2006 and 2005.
(1)
Home gross margins is defined as home sales revenues less cost of home sales, which includes land, house construction costs, indirect costs of construction, capitalized interest, a reserve for warranty expense, land impairments and closing costs, as a percent of home sales revenue.
Fiscal year 2007 compared to fiscal year 2006
Revenues. Revenues decreased 17.4% or $122.0 million for fiscal year 2007 to $581.0 million as compared to $703.0 million for fiscal year 2006. We experienced a 17.4% decrease in homes closed to 1,992 in fiscal year 2007 from 2,413 in the prior year. Homes closed decreased in all of our markets, except Orlando, where homes closed remained flat year over year, and Tampa, where homes closed increased by 46 closings, in fiscal year 2007 due to the overall decline in the housing industry. The impact of this decline was intensified by an increase in cancellations experienced during fiscal year 2007. Despite this decline in homes closed, the average sales price per home closed increased slightly by $9,000 per home or 3.2% to $287,000 as compared to $278,000 in fiscal year 2006 due to the mix of homes closed during fiscal year 2007 being more heavily weighted towards single-family detached move up
housing as compared to fiscal year 2006. This was offset somewhat by the 3.6% and the 14.7% declines in sale prices in Tampa and Phoenix, respectively, due to an increase in sales incentives during fiscal year 2007 as compared to fiscal year 2006.
Our revenues from land sales decreased to $7.6 million for fiscal year 2007 as compared to $31.3 million in the prior fiscal year, primarily as a result of identifying fewer parcels of land or finished lots that no longer fit within our home development program. Land sales are incidental to the business of building and selling homes.
Gross Margins. Home gross margins were 17.1% for fiscal year 2007 compared to 22.5% in the prior fiscal year. The decrease in our home gross margins was primarily due to $18.8 million in impairment expense related to our real estate inventory recognized in fiscal year 2007 compared to $4.5 million in impairment expense related to our real estate inventory recognized in fiscal year 2006 and an increase in sales incentives offered in fiscal year 2007 as compared to the prior year.
Sales and Marketing Expenses. Sales and marketing expenses, which include sales commissions, advertising, model expenses and other costs, totaled $34.8 million for fiscal year 2007 or 6.0% of revenues, compared to $35.4 million in fiscal year 2006 or 5.0% of revenues. The dollar decrease of $0.6 million, or 1.7%, was primarily due to a decrease in the number of homes sold and closed during the current fiscal year and reflects the decrease in sales commissions due to the 17.4% decrease in homes closed, offset in part by an increase in marketing costs experienced by all divisions.
General and Administrative and Related Party Expenses. General and administrative and related party expenses totaled $40.8 million in fiscal year 2007 or 7.0% of revenues, compared to $42.1 million in the prior year or 6.0% of revenues. The dollar decrease of $1.3 million resulted primarily from decreased compensation costs attributable to the decrease in net earnings as all bonuses earned by corporate and division management are partially based on our profitability.
Net Income. Net income decreased $61.8 million or 71.5% in the fiscal year ended May 31, 2007 as compared to the fiscal year ended May 31, 2006. The decrease resulted primarily from the 17.4% decrease in homes closed, 24.0% decrease in home gross margins and the impairment expense, as well as an increase in sales and marketing and general and administrative expenses as a percentage of total revenues.
Net New Home Orders and Backlog. Net new home orders decreased 32.8% or by 764 orders, during the fiscal year ended May 31, 2007 as compared to the fiscal year ended May 31, 2006. The decrease was the result of a decrease in our active communities, the decrease in the number of homes available for sale, the continued increase in cancellations and the continued decline in consumer demand for new homes.
Net new home orders in Atlanta decreased in fiscal year 2007 to 321 as compared to 533 in the prior fiscal year, representing a decrease of 212 orders, or 39.8%. The decrease was due to the decrease in active communities from nine to eight and the continued decline in consumer demand for new homes.
Net new home orders in Orlando decreased to 183 in fiscal year 2007 compared to 371 in fiscal year 2006. This decrease of 188 orders, or 50.7%, reflects an increase in cancellations and a general decline in consumer demand for new homes.
Net new home orders in Tampa increased slightly in fiscal year 2007 to 54 as compared to 46 in the prior fiscal year, representing an increase of eight orders, or 17.4%. Although a slight increase, the division had its first closings during the fourth quarter of fiscal year 2006.
Net new home orders in Dallas decreased to 356 in fiscal year 2007 compared to 622 in the fiscal year ended May 31, 2006. This decrease of 266 orders, or 42.8%, reflects the continued decline in overall market conditions.
Net new home orders in Houston decreased in fiscal year 2007 to 353 as compared to 435 in the prior fiscal year, representing an decrease of 82 orders, or 18.9%. The decrease was primarily due to the decrease in active communities from twelve to eight.
Net new home orders in Phoenix decreased to 275 in the fiscal year ended May 31, 2007 as compared to 321 net new home orders in the prior year, representing 46 units, or 14.3%. This reduction was due to a higher level of cancellations coupled with a decline in consumer demand for new homes.
Backlog as of May 31, 2007 was 821 homes representing a sales value of $236.2 million and a decrease in the sales value of backlog of $143.7 million or 37.8% at the end of the fiscal year as compared to the sales value of backlog of $379.9 million at the end of fiscal year 2006. Backlog represents the number and value of new sales orders net of any cancellations that may have occurred during the reporting period. Historically, we have experienced a cancellation rate between 15% - 20% of the gross new orders recorded in any reporting period, which resulted in 80% - 85% of the number of units in our backlog closing under existing sales contracts. However, during the latter part of fiscal year 2006 and for fiscal year 2007, we experienced cancellations of gross new home orders of approximately 30%. We attribute the increase in cancellations and the slowdown in demand for new homes to increases in housing inventories as a result of a change in consumer confidence and the increase in interest rates during the fiscal year. Continued deterioration of these and other homebuilding economic factors resulted in continued and prolonged decreases in demand for new homes. We expect, assuming no significant change in market conditions or mortgage interest rates, approximately 70% of the number of units in our backlog will close under existing sales contracts during fiscal year 2008.
Fiscal year 2006 compared to fiscal year 2005
Revenues. Revenues increased 40.7% or $203.4 million for fiscal year 2006 to $703.0 million as compared to $499.6 million for fiscal year 2005. We experienced a 27.4% increase in homes closed to 2,413 in fiscal year 2006 from 1,894 in fiscal year 2005. Homes closed increased in all of our markets in fiscal year 2006 with the exception of Phoenix, which experienced a decrease of 32 closings due to delays created by subcontractor shortages in the market and an increase in cancellations experienced during the fourth quarter. In addition, the average sales price per home closed increased $34,000 per home or 13.9% to $278,000 as compared to $244,000 in fiscal year 2005 due to pricing power experienced in Orlando and Phoenix with our single-family detached product offset somewhat by the continued product diversification into lower priced townhomes and condominiums in Atlanta, Orlando and Dallas.
Our revenues from land sales decreased to $31.3 million for fiscal year 2006 as compared to $37.0 million in fiscal year 2005, primarily as a result of identifying fewer parcels of land or finished lots that no longer fit within our home development program. Land sales are incidental to the business of building and selling homes.
Gross Margins. Home gross margins were 22.5% for fiscal year 2006 compared to 21.0% in fiscal year 2005. The increase in our home gross margins year over year was due to the pricing power we experienced in Orlando and Phoenix from net new home orders received during the favorable market conditions of fiscal year 2005 and the first half of fiscal year 2006. Our diversification into townhomes and stacked-flat condominiums in Atlanta and Orlando also favorably impacted our margins as we experienced pricing power as a result of strong net new orders in these products.
Sales and Marketing Expenses. Sales and marketing expenses, which include sales commissions, advertising, model expenses and other costs, totaled $35.4 million for fiscal year 2006 or 5.0% of revenues, compared to $26.5 million in fiscal year 2005 or 5.3% of revenues. The increase of $8.9 million, or 33.6%, was primarily due to an increase in the number of homes available for sale and closed during the current fiscal year. The increase reflects the increase in sales commissions due to the 27.4% increase in homes closed and the increase in marketing costs experienced by the Orlando, Phoenix and Tampa divisions as their operations continue to grow and establish brand recognition in their respective markets.
General and Administrative and Related Party Expenses. General and administrative and related party expenses totaled $42.1 million in fiscal year 2006 or 6.0% of revenues, compared to $28.9 million in fiscal year 2005 or 5.8% of revenues. The increase of $13.2 million resulted from the continued significant growth in Orlando and Phoenix, the investment in the start-up divisional operations in Tampa and Denver, the commensurate increases in our corporate staff to support these operations and, to a lesser extent, increased compensation costs attributable to the increase in net earnings as all bonuses earned by corporate and division management are partially based on our profitability.
Net Income. Net income increased $27.0 million or 45.4% in the fiscal year ended May 31, 2006 as compared to the fiscal year ended May 31, 2005. The increase resulted primarily from the 27.4% increase in homes closed and an increase in average sales price per home closed of 13.9%. Total sales and marketing expenses increased $8.9 million due primarily to the increase in homes closed and the related commissions attributable to those homes. General and administrative expenses also increased $13.2 million during the fiscal year due to significant growth in our Orlando and Phoenix operations, the establishment of two new operations in Denver and Tampa, and, to a lesser extent, to an increase in our corporate staffing. Total sales and marketing and general and administrative expenses decreased as a percentage of total revenues by 0.1%. Earnings from unconsolidated entities, which represents earnings primarily from our mortgage and title joint ventures in which we have a 49% ownership interest, increased $1.6 million or 104.0% as a result of increased home closing volume, as compared to the prior fiscal year.
Net New Home Orders and Backlog. Net new home orders increased 4.4% or by 98 orders, during the fiscal year ended May 31, 2006 as compared to the prior fiscal year. The increase was the result of an increase in our active communities and the number of homes available for sale primarily in Atlanta, Houston and Dallas offset by a decline in net new home orders in Orlando and Phoenix. In addition, we recorded our initial net new orders in Tampa during fiscal year 2006 of 46 orders in two active communities.
Net new home orders in Atlanta increased in fiscal year 2006 to 533 as compared to 503 in the prior fiscal year, representing an increase of 30 orders, or 6.0%. The increase reflects the increase in active communities from eight to nine and the continued expansion in our product line to stacked-flat condominiums and active adult single-family detached homes.
Net new home orders in Orlando decreased to 371 in fiscal year 2006 compared to 450 in the fiscal year ended May 31, 2005. This decrease of 79 orders, or 17.6%, reflects a weakening in market conditions experienced during primarily the third and fourth quarters of fiscal year 2006 as we experienced an increase in cancellations and a general moderation in consumer demand for new homes.
Net new home orders in Dallas increased to 622 in fiscal year 2006 compared to 519 in the fiscal year ended May 31, 2005. This increase of 103 orders, or 19.8%, reflects the expansion of our product line to include townhome communities and an improvement in overall market conditions.
Net new home orders in Houston increased in fiscal year 2006 to 435 as compared to 409 in the prior fiscal year, representing an increase of 26 orders, or 6.4%. The increase reflects an overall improvement in market conditions.
Net new home orders in Phoenix declined to 321 in the fiscal year ended May 31, 2006 as compared to 349 net new home orders in the prior year, representing 28 units, or 8.0%. This reduction was due to a combination of limits placed on the number of new home orders that we accepted during the first half of our fiscal year due to our significant backlog and our desire to focus our production capacity on completing the homes in our backlog and a higher level of cancellations experienced during our fiscal fourth quarter coupled with a moderation in consumer demand for new homes.
Backlog as of May 31, 2006 was 1,249 homes representing a sales value of $379.9 million and an increase in the sales value of backlog of $10.0 million or 2.7% at the end of the fiscal year as compared to the sales value of backlog of $369.9 million at the end of fiscal year 2005. Historically, we have experienced a cancellation rate between 15% - 20% of the gross new orders recorded in any reporting period, which resulted in 80% - 85% of the number of units in our backlog closing under existing sales contracts. However, during the third and fourth quarters of fiscal year 2006, we experienced an increase in cancellations of gross new home orders to approximately 30%. We attribute the increase in cancellations and the slowdown in demand for new homes to increases in housing inventories as a result of speculative investors becoming net sellers of homes rather than net buyers, a change in consumer confidence and urgency to buy homes and the increase in interest rates during the second half of our fiscal year.
Homebuilding Segments
We have grouped our homebuilding activities into two reportable segments, which we refer to as Homebuilding East and Homebuilding West. At May 31, 2007, our reportable homebuilding segments consisted of homebuilding divisions located in the following areas:
East: Atlanta, Orlando and Tampa
West: Dallas, Houston, Phoenix and Denver
Selected Financial and Operational Data
Fiscal year 2007 compared to fiscal year 2006
Homebuilding East: Revenues decreased to $272.8 million for the fiscal year ended May 31, 2007 from $302.7 million for the fiscal year ended May 31, 2006. The decrease in revenues was primarily due to a lack of any land sales during fiscal year 2007 compared to $30.5 million in land sales during fiscal year 2006 and a 10.2% decrease in the number of homes closed, which was partially offset by an 11.4% increase in the average sales price of homes closed. Homes closed in Atlanta decreased 25.1% due to continued weakening in the demand for new homes in the market. Homes closed in Orlando were flat year over year, due to the significant level of backlog at the start of fiscal year 2007. Homes closed in Tampa increased slightly because the division had its first closings during the fourth quarter of fiscal year 2006. Since land sales are incidental to our business of building and selling homes, we generally sell only parcels of land and finished lots that do not fit with our home development program. The absence of land sales revenue was a result of not having identified any parcels of land and finished lots that did not fit with our home development program during the fiscal year ended May 31, 2007.
Gross profit decreased $33.6 million, or 39.8%, for the fiscal year ended May 31, 2007, compared to the fiscal year ended May 31, 2006, primarily as a result of increased sales incentives offered to homebuyers, $9.6 million of inventory valuation adjustments and a decrease in gross profit from land sales of $16.2 million. Gross margins were 18.6% for the fiscal year ended May 31, 2007, compared to 27.9% for the fiscal year ended May 31, 2006.
Homebuilding West: Revenues decreased 23% for the fiscal year ended May 31, 2007 to $308.0 million from $400.0 million in the fiscal year ended May 31, 2006. The decrease in revenues was primarily due to the 22.9% decrease in homes closed in Dallas, the 22.6% decrease in the number of homes closed in Houston and the 22.1% decrease in the number of homes closed in Phoenix. The average sales price of homes delivered decreased 2.8% in the region primarily due to a 14.7% decrease in the average sales price in Phoenix and a decrease in the number of homes closed in higher priced communities. These decreases were offset somewhat by the slight increases in average sales prices experienced in both Dallas and Houston as both markets delivered a greater percentage of move-up single-family homes in fiscal year 2007 as compared to the prior fiscal year.
Gross profit decreased $30.8 million, or 37.0%, for the fiscal year ended May 31, 2007, compared to the fiscal year ended May 31, 2006 primarily as a result of increased sales incentives offered to homebuyers and an decrease in gross profit from land sales of $0.6 million. Gross margins were 17.0% for the fiscal year ended May 31, 2007, compared to 20.8% for the fiscal year ended May 31, 2006.
Fiscal year 2006 compared to fiscal year 2005
Homebuilding East: Revenues increased for the fiscal year ended May 31, 2006 to $302.7 million from $191.9 million in the fiscal year ended May 31, 2005 primarily due to a 53.8% increase in the number of homes closed. Homes closed in Atlanta increased 28.0% due to the continued demand for new homes in the market. Homes closed in Orlando increased 110.5% over the prior year due primarily to the significant backlog existing in Orlando at the beginning of the fiscal year. Homes closed in Tampa increased because the division had its first closings during the fourth quarter of fiscal year 2006.
Gross profit increased $30.6 million, or 56.9%, for the fiscal year ended May 31, 2006, compared to the fiscal year ended May 31, 2005 primarily as a result of an increase in the number of homes closed. Gross margins were flat year over year - 27.9% for the fiscal year ended May 31, 2006, compared to 28.0% for the fiscal year ended May 31, 2005.
Homebuilding West: Revenues increased 30.0% for the fiscal year ended May 31, 2006 to $400.0 million from $307.7 million in the fiscal year ended May 31, 2005 primarily due to the 14.0% increase in the number of homes closed in Dallas, the 38.6% increase in the number of homes closed in Houston, offset by the 7.9% decrease in homes closed in Phoenix. The average sales price of homes delivered increased 21.0% due to an increase in the number of homes closed in higher priced communities.
Gross profit increased $18.8 million, or 29.3%, for the fiscal year ended May 31, 2006, compared to the fiscal year ended May 31, 2005, primarily as a result of an increase in the number of homes closed. Gross margins were flat year over year - 20.8% for the fiscal year ended May 31, 2006, compared to 20.9% for the fiscal year ended May 31, 2005.
Liquidity and Capital Resources
Our principal uses of cash are land purchases, lot development and home construction. We fund our operations with cash flows from operating activities and/or borrowings under our senior unsecured credit facility. As we utilize our capital resources and liquidity to fund the growth of our operations, we focus on maintaining conservative balance sheet leverage ratios. We believe that we will be able to continue to fund our operations and our future cash needs (including debt maturities) through a combination of cash flows from operating activities and our existing senior unsecured credit facility.
As of May 31, 2007, our ratio of total debt to total capitalization was 52.1%, compared to 51.5% as of May 31, 2006. Total debt to total capitalization consists of notes payable divided by total capitalization (notes payable plus members’ equity).
Operating Cash Flow. During the fiscal year ended May 31, 2007, we provided approximately $35.3 million from our operating activities. We had net income of $24.7 million, impairment loss of $18.8 million and a decrease in accounts receivable of $12.3 million, which was partially offset by a decrease in accounts payable and accruals of $20.9 million.
During the fiscal year ended May 31, 2006, we used approximately $24.7 million in our operating activities. We increased our investment in inventory by $134.0 million during fiscal year 2006, which was partially offset by net income of $86.5 million earned during the period on homes closed and increases in accounts payable and accruals of $21.1 million.
Investing Cash Flow. Cash used in investing activities totaled $2.9 million for the fiscal year ended May 31, 2007 for additions to capital assets of $5.3 million offset by a return of investment in unconsolidated entities of $2.3 million.
For the fiscal year ended May 31, 2006, cash used in investing activities totaled $11.3 million. We increased our investment in unconsolidated entities by $2.6 million and used $8.6 million of cash for additions to capital assets.
Financing Cash Flow. During the fiscal year ended May 31, 2007, cash used by financing activities totaled $32.5 million, which included borrowings under our senior unsecured credit facility of $154.5 million, repayments of amounts outstanding under our senior unsecured credit facility of $156.2 million and distributions of $30.4 million to our members for the payment of federal and state income taxes and as general distributions of our income.
During fiscal year 2006, cash provided by financing activities totaled $36.1 million, which included the issuance of $125.0 million of senior subordinated notes, borrowings under our senior unsecured credit facility of $240.0 million, repayments of amounts outstanding under our senior unsecured credit facility of $272.0 million, a reduction in related party debt of $13.7 million and distributions of $37.3 million to our members for the payment of federal and state income taxes and as general distributions of our income.
Senior Unsecured Credit Facility. In December 2005, we entered into an amended senior unsecured credit facility. The senior unsecured credit facility provides for up to $300.0 million of unsecured borrowings, subject to a borrowing base, and includes an accordion feature by which we may request, subject to certain conditions, an increase of the senior unsecured credit facility up to a maximum of $400.0 million. The senior unsecured credit facility provides for the issuance of up to $50.0 million in letters of credit. At May 31, 2007, we had available borrowing capacity under this facility of $193.5 million as determined by borrowing base limitations defined in the agreement. Our obligations under the amended senior unsecured credit facility are guaranteed by all of our subsidiaries and all of the holders of our membership interests.
Once during each fiscal year (i.e., June 1-May 31), we may request that the lenders extend the maturity date by an additional year. On January 10, 2007, we amended the senior unsecured credit facility to extend the maturity date to January 19, 2011, for 88.3%, or $265.0 million of the facility and to amend the definition of “EBITDA” contained therein to exclude certain non-cash gains and include certain non-cash losses or charges and. On February 21, 2007, we obtained consent from an additional lender representing 5.0% or $15 million of the facility, to the extension of the senior unsecured credit facility to January 19, 2011.
The senior unsecured credit facility contains a number of customary financial and operating covenants, including covenants requiring us to maintain a minimum consolidated tangible net worth; limiting the principal amount of our secured debt to $50 million at any given time; limiting the net book value of our unimproved entitled land, land under development and finished lots to 150.0% of our adjusted tangible net worth; limiting the aggregate distributions by us and our subsidiaries in any fiscal year; restricting our ability to incur additional indebtedness; and restricting our ability to engage in mergers and consolidations and our ability to sell all or substantially all of our assets. The senior unsecured credit facility also contains covenants requiring us to maintain a certain ratio of consolidated total liabilities to adjusted net worth and to maintain a certain interest coverage ratio. In June 2007, we entered into another amendment to the senior unsecured credit facility which provides for a permanent reduction in the interest coverage ratio to 2.0x, from 2.50x, and includes a provision allowing such ratio to fall to no less than 1.75x for up to three consecutive fiscal quarters in any rolling four fiscal quarter period ending on or before May 31, 2009. The June 2007 amendment also provides that in the event our interest coverage ratio for any fiscal quarter is less than 2.0x, (1) the ratio of consolidated total liabilities to adjusted net worth decreases to 2.0x, from 2.25x, for such fiscal quarter and (2) the interest rates for borrowings under the senior unsecured credit facility will increase to the levels set forth in the amendment.
The borrowings under the facility bear daily interest at rates based upon the London Interbank Offered Rate (LIBOR) plus a spread based upon our interest coverage ratio and ratio of consolidated total liabilities to adjusted net worth. In addition to the stated interest rates, the revolving credit facility requires us to pay certain fees. The effective interest rate of the unsecured bank debt at May 31, 2007, was approximately 6.57%. As of and for the year ended May 31, 2007, we were in compliance with the covenants under the senior unsecured credit facility.
Borrowings under the senior unsecured credit facility are limited by the availability of sufficient real estate borrowing base, which is determined regularly throughout the life of the senior unsecured credit facility. At May 31, 2007, we had $61.3 million in outstanding borrowings, and $193.5 million in available borrowings under the senior unsecured credit facility.
9.5% Senior Subordinated Notes. In September 2005, we and Ashton Woods Finance Co., our 100% owned finance subsidiary, co-issued $125 million aggregate principal amount of 9.5% Senior Subordinated Notes due 2015 in a private placement pursuant to Rule 144A promulgated under the Securities Act of 1933, as amended. The net proceeds were used to repay amounts outstanding under our senior unsecured revolving credit facility and to repay certain related party debt. In April 2006, we completed an offer to exchange all of the notes issued in September 2005 for an equal amount of 9.5% Senior Subordinated Notes due 2015, which were registered under the Securities Act of 1933. Interest on the notes is payable semiannually. We may redeem the notes, in whole or part, at any time on or after October 1, 2010, at a redemption price equal to 100% of the principal amount, plus a premium declining ratably to par, plus accrued and unpaid interest. In addition, at any time prior to October 1, 2008, we may redeem up to 35% of the aggregate principal amount of the notes with the proceeds of qualified equity offerings at a redemption price equal to 109.5% of the principal amount, plus accrued and unpaid interest. The notes are unsecured and subordinated in right of payment to all of our existing and future senior debt, including borrowings under our senior unsecured credit facility. All of our existing subsidiaries, other than the co-issuer, fully and unconditionally guaranteed, jointly and severally, the notes on a senior subordinated basis. Each of the subsidiary guarantors is 100% owned by us. Future direct and indirect U.S. subsidiaries, excluding subsidiaries that are designated unrestricted subsidiaries in accordance with the indenture, will be required to guarantee the notes on a full and unconditional basis, jointly and severally with the other subsidiary guarantors. The guarantees are general unsecured obligations of the guarantors and are subordinated in right of payment to all existing and future senior debt of the guarantors, which includes their guarantees of our senior unsecured credit facility. We do not have any independent operations or assets apart from its investments in our subsidiaries. As of May 31, 2007, the outstanding notes with a
face value of $125.0 million had a fair value of approximately $118.2 million, based on quoted market prices by independent dealers.
The indenture governing the notes contains covenants that limit our ability and the ability of our subsidiaries to, among other things, incur additional indebtedness; pay dividends or make other distributions; make investments; sell assets; incur liens; enter into agreements restricting our subsidiaries’ ability to pay dividends; enter into transactions with affiliates; and consolidate, merge or sell all or substantially all of our assets. Unlike the senior unsecured credit facility, the financial covenants in the indenture governing the notes primarily limit our ability to incur additional debt, make distributions or engage in other actions rather than require us to maintain certain financial ratios or levels. Consequently, the covenants in the indenture have not had a significant impact on our operations, financial condition and results of operations. However, in the future our ability to secure financing for our operations could be limited by these covenants, and if we are limited in our ability to obtain financing, our operations, financial condition and results of operations could be adversely affected. As of and for the year ended May 31, 2007, we were in compliance with the covenants under the senior subordinated notes.
OFF-BALANCE SHEET ARRANGEMENTS AND AGGREGATE AND CONTRACTUAL COMMITMENTS
Our primary contractual cash obligations for our operations are payments under our debt agreements, lease payments under operating leases and purchase obligations with specific performance requirements under lot option purchase agreements. These lot option purchase agreements may require us to purchase land contingent upon the land seller meeting certain obligations. We expect to fund our contractual obligations in the ordinary course of business through our operating cash flows and our senior unsecured credit facility.
Our future cash requirements for contractual obligations as of May 31, 2007 are presented below:
(1)
Excludes interest obligations under the senior unsecured credit facility as these amounts are not currently determinable
(2)
Excludes interest obligations under the secured note as these amounts are not currently determinable
In the ordinary course of our business, we enter into land and lot option purchase contracts with unaffiliated entities in order to procure land or lots for the construction of homes. Certain of such land and lot option purchase contracts contain specific performance provisions which require us to purchase the land or lots subject to the contract upon satisfaction of certain conditions by us and the sellers. Under option purchase contracts without specific performance provisions, we will fund a stated deposit in consideration for the right, but not the obligation, to purchase land or lots at a future point in time with predetermined terms.
Under option contracts without specific performance provisions, our liability is generally limited to the forfeiture of deposits, any letters of credit posted and any other nonrefundable amounts specified in the contracts. As of May 31, 2007, we had fulfilled our obligations under all specific performance agreements and we expect to exercise, subject to market conditions, substantially all of our option contracts without specific performance provisions. Various factors, some which are beyond our control, such as market conditions, weather conditions and the timing of the completion of development activities, can have a significant impact on the timing of option exercises. Under the terms, and assuming no significant changes in market conditions or other factors, we expect to exercise our land options as shown in the table below. Amounts (in thousands) shown in the following table, include
cash deposits totaling an aggregate of approximately $4.4 million.
Under FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” as amended by FIN 46-R issued in December 2003 (collectively referred to as “FIN 46”), if the entity holding the land under option is a variable interest entity, our deposit represents a variable interest in that entity. Creditors of the variable interest entities have no recourse against us. In applying the provisions of FIN 46, we evaluated all land option agreements and determined that we have three lot purchase contracts with certain related parties to acquire 659 finished lots at an aggregate price of approximately $33.0 million, which have created variable interests and of which 163 finished lots remain to be acquired for an aggregate price of $7.1 million. While we own no equity interest in the entities, we must consolidate these entities pursuant to FIN 46R. The consolidation of these variable interest entities added $5.9 million, $4.8 million and $0.7 million in real estate not owned, liabilities related to real estate not owned and minority interests in real estate not owned, respectively, to our balance sheet at May 31, 2007 and added $14.3 million, $12.2 million and $1.8 million in real estate not owned, liabilities related to real estate not owned and minority interests in real estate not owned, respectively, to our balance sheet at May 31, 2006.
We participate in a number of land development entities with equity investments of 50% or less and do not have a controlling interest. These land development entities are typically entered into with developers, other homebuilders and related parties to develop finished lots for sale to the members of the entities and other third parties. We account for our interest in these entities under the equity method. Our share of profits from these entities are deferred and treated as a reduction of the cost basis of land purchased from the entity. The land development entities with unrelated parties typically obtain secured acquisition and development financing. In some instances, the entity partners have provided varying levels of guarantees of debt of the unconsolidated entities. These repayment guarantees require us to repay our share of the debt of unconsolidated entities in the event the entity defaults on its obligations under the borrowings. We had repayment guarantees of $1.5 million and $3.6 million at May 31, 2007 and 2006, respectively.
Forward-Looking Statements
Certain statements included in this report on Form 10-K contain forward-looking statements, which represent our expectations or beliefs concerning future events, and no assurance can be given that the results described in this report will be achieved. These forward-looking statements can generally be identified by the use of statements that include words such as “estimate,’’ “project,’’ “believe,’’ “expect,’’ “anticipate,’’ “intend,’’ “plan,’’ “foresee,’’ “likely,’’ “will,’’ “goal,’’ “target’’ or other similar words or phrases. All forward-looking statements are based upon information available to us on the date of this report.
These forward-looking statements are subject to risks, uncertainties and other factors, many of which are outside of our control that could cause actual results to differ materially from the results discussed in the forward-looking statements. Item 1A - “Risk Factors” contains information about factors that could cause actual results to differ materially from the results discussed in our forward-looking statements. Other factors, risks and uncertainties that could cause actual results to differ materially from the results discussed in the forward-looking statements include but are not limited to:
•
economic changes nationally or in our local markets;
•
volatility of mortgage interest rates, inflation and underwriting standards;
•
increased competition;
•
shortages of skilled labor or raw materials used in the production of houses;
•
increased prices for labor, land and raw materials used in the production of houses;
•
increased land development costs on projects under development;
•
the cost and availability of insurance, including the availability of insurance for the presence of mold;
•
the impact of construction defect and home warranty claims;
•
any delays in reacting to changing consumer preferences in home design;
•
changes in consumer confidence;
•
delays in land development or home construction resulting from adverse weather conditions;
•
increases in resale inventory;
•
potential delays or increased costs in obtaining necessary permits as a result of changes to, or complying with, laws, regulations or governmental policies, including environmental laws, regulations and policies; or
•
terrorist acts and other acts of war.
Any forward-looking statement speaks only as of the date on which such statement is made, and, except as required by law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time and it is not possible for management to predict all such factors.
The Company disclaims any responsibility to update any forward-looking statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to a number of market risks in the ordinary course of business. Our primary market risk exposure for financial instruments relates to fluctuations in interest rates. We do not believe our exposure in this area is material to cash flows or earnings. From time to time, we have entered into interest rate swap agreements to manage interest costs and hedge against risks associated with fluctuating interest rates with respect to floating rate debt, however, as of May 31, 2007 we have not entered into any interest rate swap agreements. We do not enter into or hold derivatives for trading or speculative purposes. As of May 31, 2007, we had a total of $61.3 million of floating rate debt outstanding under our senior unsecured credit facility, and borrowings under that facility generally bear interest based on an applicable margin plus LIBOR or an alternate base rate. As of May 31, 2007, we were not a party to any interest rate swap agreements.
Item 8.
Item 8. Financial Statements and Supplementary Data
The Company’s Consolidated Financial Statements appear beginning at page.
Item 9.
Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A. Controls and Procedures
The Company’s Chief Executive Officer and Chief Financial Officer, with the assistance of management, have evaluated the Company’s disclosure controls and procedures as of May 31, 2007, and based upon that evaluation have concluded that the Company’s disclosure controls and procedures were effective, as of May 31, 2007, to provide reasonable assurance that information the Company is required to disclose in reports that the Company files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported as and when required.
Further, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective for purposes of ensuring that information required to be disclosed in reports filed by us under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, in a manner to allow timely decisions regarding the required disclosure.
It should be noted, however, that a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within the Company have been detected. Furthermore, the design of any control system is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how unlikely. Because of these inherent limitations in a cost-effective control system, misstatements or omissions due to error or fraud may occur and not be detected.
There has been no change in our internal control over financial reporting that occurred during the fourth fiscal quarter of 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
None
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The following table presents information with respect to our executive officers and directors:
Mr. Krobot has served as our President and Chief Executive Officer since 1995 and as a member of our Board since September 2005. Before joining the Company, Mr. Krobot worked for Ryland Homes as a Senior Vice President responsible for seven cities, one lumber yard and over 2,000 units per year in the Southeast Region (Georgia, North Carolina, South Carolina, Florida) and as a Regional Manager of its Midwest Region (Columbus and Cincinnati, Ohio and Indianapolis, Indiana). Mr. Krobot is a graduate of the University of Dayton.
Mr. Salomon has served as our Chief Financial Officer since 1998. Before joining the Company, Mr. Salomon worked for MDC Holdings, Inc., most recently as the Senior Vice President of Finance of its homebuilding division in California, Richmond American Homes. Mr. Salomon is a graduate of The University of Iowa and a member of the American Institute of Certified Public Accountants.
Mr. Thomas joined the Company in March 2006 as Senior Vice President. Prior to joining the Company, he was Area President for Pulte Homes’ Texas organization from October 2004 to February 2006. From 2002 to 2004, Mr. Thomas was the President of Pulte Homes’ Indiana division. Mr. Thomas holds a Masters of Business Administration from Northwestern University and a Bachelors of Business Administration from the University of Memphis.
Mr. Serbin joined the Company in 2002 as Vice President of Sales and Marketing. Prior to joining the Company, he was Vice President of Sales and Marketing for Pulte Homes in Orlando, Florida. Mr. Serbin is a graduate of the California State College in Hayward, California where he received a degree in Business Administration.
Mr. Farrell joined the Company in December 2004 as the Vice President of Construction. From July 2000 to November 2004, Mr. Farrell was employed with Centex Homes as the Vice President of Construction in Atlanta, Georgia. From 1989 to 2000, Mr. Farrell was a Construction Manager for Pulte Homes in Atlanta, Georgia and the Washington Metro Area in Maryland.
Mr. Joffe, a member of our Board or our prior management committee since 1997, is a founder of the Great Gulf Group and is its Chief Financial Officer. Prior to 1983, Mr. Joffe worked in real estate and public accounting. Mr. Joffe qualified as a Chartered Accountant in South Africa and in Canada.
Mr. Freeman, a member of our Board or our prior management committee since 1997, is a founder of the Great Gulf Group and is its Executive Vice President. Prior to 1983, Mr. Freeman was the Vice President of Sales for Great Gulf Homes. Mr. Freeman has worked in residential real estate marketing since 1969.
Mr. Rosenbaum, a member of our Board or our prior management committee since 1997, is a founder of the Great Gulf Group and is its Chief Operating Officer. Prior to 1983, Mr. Rosenbaum was a partner in a law practice. Mr. Rosenbaum graduated as a lawyer from Osgoode Hall Law School and was called to the bar in 1976.
Audit Committee Financial Expert
The Company does not have an audit committee. Since our securities are not currently listed on or with a national securities exchange or national securities association, we are not required to have an independent audit committee. Further, given the small size of the Board, the Board believes it appropriate for all members of the Board to be involved in the discussions and decisions typically delegated to an audit committee. Our Board has determined that Mr. Joffe meets the qualifications of an “audit committee financial expert” as defined in the rules and regulations of the SEC, but does not meet the definition of an “independent director” under the rules promulgated by Nasdaq or the New York Stock Exchange as a result of his affiliation with our ownership group. However, because our securities are not listed on a national securities exchange or national securities association, we are not required to have an audit committee financial expert who is an “independent director.”
Although the Company has not yet adopted a code of ethics, the Company is in the process of preparing a Code of Business Conduct and Ethics, which will meet the definition of a “code of ethics” under Item 406 of the Securities and Exchange Commission’s Regulation S-K. Once adopted, the Code of Business Conduct and Ethics will apply to and be binding upon all of the Company’s employees (including the principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions).
Item 11.
Item 11. Executive Compensation
COMPENSATION DISCUSSION AND ANALYSIS
Overview
The purpose of this compensation discussion and analysis is to provide information about each material element of compensation awarded to, earned by, or paid to each of our named executive officers during fiscal year 2007. Our compensation policies are designed to reward superior performance, recognize individual initiative and achievement and encourage actions to meet our short-term and long-term goals.
Compensation Governance and Philosophy
The entire Board of Directors undertakes the duties of the Compensation Committee with respect to the compensation of Mr. Krobot and Mr. Salomon. Mr. Krobot, with the input from Mr. Salomon, determines the compensation of the other executive officers. Mr. Krobot, our President and Chief Executive Officer, is a member of our Board of Directors. As a member of the Board of Directors, he participates in discharging the duties of the Compensation Committee, other than with respect to his own compensation.
Our executive compensation programs have been aligned with the Board of Directors’ beliefs that total cash compensation should be comparable to the median compensation for similar positions in the homebuilding industry and that annual incentive opportunities should represent a significant portion of total cash compensation for executives. The Board of Directors believes that annual incentive compensation should provide a meaningful upside opportunity which depends on our business and financial results and be at risk when performance or results do not meet expectations. We communicate our general performance expectations and goals to executives, but bonus payments are at the discretion of the Board of Directors taking into account actual performance. It is the Board of Directors’ further belief that managing a compensation program around these principles will place executives’ and owners’ interests together and enhance the financial returns to our owners. The Board of Directors utilizes publicly available information about compensation levels in the homebuilding industry in establishing the compensation levels of our executives. Each component of compensation is described more fully below.
Base Salary
The base salaries for our executive officers provide the foundation for a fair and competitive compensation opportunity. Base salary levels are generally targeted at or slightly below the average of our industry. Base salary, which is a fixed element of total pay, is only one element, and not the most significant element, of our total compensation program because of our performance-based compensation philosophy. Base salaries are a necessary part of our compensation program and provide executives with a fixed portion of pay that is not performance-based. Our goal is to provide modest, yet competitive, base pay levels in comparison to other homebuilders.
Base salaries for Mr. Krobot and Mr. Salomon, in fiscal year 2007, were determined by the Board of Directors in part after reviewing publicly available industry information. Mr. Krobot, with input from Mr. Salomon, determined the compensation of the other executive officers based on comparisons of industry salary practices for positions of similar responsibilities, additional elements of the executives’ total compensation, and on individual performance.
Annual Bonus Incentives
We pay annual bonus incentives to Mr. Krobot and Mr. Salomon based on the parameters outlined in their employment agreements.
•
Mr. Krobot’s annual bonus is equal to 4.0% of the first $10,000,000 and 3.0% of any amount in excess of $10,000,000 of our annual net income, reflected in our annual audited financial statements, as adjusted to exclude imputed interest on equity, bonuses paid at the operational level and specific projects as agreed from time to time.
•
Mr. Salomon’s annual bonus is equal to 0.75% of our annual net income, reflected in our annual audited financial statements, as adjusted to exclude initial start-up losses of any new division during the first two
years of operation, imputed interest on equity, bonuses paid at the operational level and specific projects as agreed from time to time.
We periodically pay bonuses to our other senior executives, which are entirely discretionary and are based on individual performance and our performance. For fiscal year 2007, discretionary bonuses were paid to various executives, including two named executive officers, Tad Serbin and Ralph Farrell. We chose to pay these amounts to reward each individual’s accomplishments in light of the results achieved by us, and as a continuing cash incentive for their performance. We hired Mr. Thomas during fiscal year 2006, and in order to induce him to join us, we agreed to pay him a guaranteed annual bonus of $800,000 for fiscal year 2007.
Deferred Compensation Plan
Effective June 1, 2005, we adopted the Ashton Woods USA L.L.C. Deferred Compensation Plan (the “Plan”) for the purpose of providing deferred compensation to a select group of management and highly compensated employees, including the named executive officers. Annually, we make contributions, in the amounts determined by the Board of Directors, to each participant’s Plan account. These contributions are in addition to the salary and bonuses received by the participants. For a more detailed description of the Plan please refer to the section “Nonqualified Deferred Compensation”.
Severance Benefits
Severance benefits are provided from time to time to executive officers as a result of negotiations of their employment agreements. The Board of Directors does not have a standard program applicable to all executives, but has negotiated severance or other enhanced benefits for named executive officers upon termination of their employment or upon a change of control. Such arrangements are negotiated from time to time in an effort to provide appropriate incentives to executives and are negotiated based on the Board of Director’s understanding of standard market practice among private companies in the homebuilding industry. Currently, Messrs Krobot and Salomon are the only named executive officers with employment agreements. For a discussion of the severance benefits available to them refer to the section “Employment Agreements”.
Compensation Committee Report
The Board of Directors has reviewed and discussed the Compensation Discussion and Analysis with management and has recommended that it be included in this Form 10-K.
THE BOARD OF DIRECTORS
Seymour Joffe
Bruce Freeman
Harry Rosenbaum
Thomas Krobot
SUMMARY COMPENSATION TABLE
The following table sets forth certain summary information concerning the total compensation for the fiscal year ended May 31, 2007, earned by our Chief Executive Officer, Chief Financial Officer and our three most highly compensated executive officers, which are referred to as the named executive officers.
SUMMARY COMPENSATION TABLE
Nonqualified Deferred Compensation
The Plan is a non-qualified deferred compensation plan which is administered by a committee appointed by the Board of Directors. Under the Plan, we may make contributions to the participants’ accounts, and amounts in the participants’ accounts earn an annual interest rate which is periodically determined by the Board of Directors. Currently, the annual interest rate is 9.0%.
Contributions vest ratably over a five year period. However, a participant’s account will become fully vested if the participant remains employed with us until the participants’ death, total disability or the participant turns 65. Furthermore, a participant’s account will become fully vested if the participant is terminated without cause within two years of a change of control.
Once a contribution is fully vested, a participant, who is still employed by us, may receive a cash distribution of such vested contribution and any earnings thereon. Otherwise, a participant will receive a cash payment of the participant’s vested contributions upon termination of the participant’s employment with us or upon the participant’s death or disability. In the event that the committee administering the Plan determines that a participant’s employment was terminated by us for good cause, the participant will forfeit his or her interest in the Plan.
[a]
Consists of amounts credited to each executive officer’s account under the Ashton Woods USA L.L.C. Nonqualified Deferred Compensation Plan for the fiscal year ended May 31, 2007. Each of these amounts is included in the Summary Compensation Table in the “All Other Compensation” column.
[b]
Aggregate earnings equal 9% of the accumulated benefit balance as of May 31, 2007. The “Change in Pension Value and Deferred Compensation Earnings” column in the Summary Compensation Table reflects the portion of these earnings that are deemed to be above market.
[c]
Aggregate balance at last fiscal year end equals the amounts credited to each executive officers account since inception of the Asthon Woods USA L.L.C. Nonqualified Compensation Plan on June 1, 2005.
Employment Agreements
On January 30, 2006, we entered into an employment agreement with our President and Chief Executive Officer, Tom Krobot. The agreement, which is effective as of June 1, 2005, is for a term of approximately five years ending May 31, 2010. The employment agreement provides for an annual base salary of $225,000 and an annual bonus in an amount equal to 4.0% of the first $10,000,000 and 3.0% of any amount in excess of $10,000,000 of our annual net income, calculated in accordance with generally accepted accounting principles and reflected in our annual audited financial statements, as adjusted to exclude imputed interest on equity, bonuses paid at the operational level and specific projects as agreed from time to time. The agreement also provides for certain incentive payments upon a sale of the Company, irrespective of form, or the consummation by the Company of an initial public offering of equity securities. Such payments are due upon the sale of the Company or initial public offering irrespective of the executive’s continued employment with us. The incentive payment owed upon the sale of the Company will be equal to an amount determined by multiplying the excess of the aggregate purchase price paid by the buyer or buyers in such transaction over the book value of the Company, as determined in good faith by our board of directors, at the time of such sale by 3.0%, provided such payment is subject to a floor of $3,000,000.
Upon an initial public offering, Mr. Krobot is entitled to a payment equal to 3.0% of the excess of the aggregate market value of the Company at such time, determined based on the excess of valuation applied in the offering, over the then book value of the Company, as determined in good faith by our board of directors, subject to a minimum of $3,000,000. The payment upon an initial public offering shall be paid through the issuance of stock with an aggregate value equal to the payment owed, if possible, otherwise, such payment shall be made in cash or some other mutually agreed upon method.
Following the payments of amounts owed to Mr. Krobot upon a sale of initial public offering of the Company, the agreement will terminate, and Mr. Krobot will continue as an at will employee. The agreement also provides Mr. Krobot with certain severance payments upon termination of his employment as follows:
•
Upon termination of employment upon death or disability, in addition to base salary accrued through the date of termination, Mr. Krobot or his estate, will be entitled to a payment in an amount equal to the greater of (a) $3,000,000 or (b) a prorated portion (based on the number of years of the term of the agreement that has expired divided by five), of 3.0% of the excess of the then-determined public market value of the Company over the book value of the Company, in each case as determined in good faith by the board of directors.
•
Upon termination without cause, in addition to base salary accrued through the date of termination, Mr. Krobot will be entitled to a payment equal to the greater of: (a) the sum of one year’s base salary at the rate then in effect plus a bonus payable pursuant to the annual bonus provisions of the agreement based on projections of our net income for the following 12 months, plus an amount equal to a bonus calculated in such manner based on a pro rata share of net income for the then-current fiscal year; or (b) the sum of a bonus calculated in accordance with the annual bonus provisions of the agreement pro rated based on net income for the then-current fiscal year plus 3.0% of the excess of the then-determined public market value of the Company over the then-book value of the Company, in each case as determined in good faith by the board of directors, subject to a minimum of $3,000,000.
•
If Mr. Krobot’s employment terminates upon expiration of the term of the agreement, Mr. Krobot will be entitled to a payment equal to 3.0% of the excess of then-public market value of the Company as compared to the book value of the Company, in each case as determined in good faith by the board of directors, subject to a minimum payment of $3,000,000.
•
Upon the sale of the Company, if Mr. Krobot’s employment is terminated, in addition to the incentive payment described above and his base salary accrued through the date of termination, Mr. Krobot will receive an amount equal to a bonus calculated in accordance with the annual bonus provisions described above based on a pro rated share of net income for the current fiscal year to the date of termination.
Finally, the Agreement provides that we will provide health insurance for Mr. Krobot and his spouse, whether or not Mr. Krobot is an employee of ours, until he reaches the age of 65, upon the same terms then available to executive officers of the Company.
By memorandum dated April 30, 2006, our Board of Directors confirmed to Robert Salomon, our Chief Financial Officer, his annual salary, bonus calculation and certain severance payments if Mr. Salomon is terminated following a sale of the Company resulting in a change of control of our equity. On August 9, 2006, we entered into an employment agreement with Mr. Salomon, which addresses the provisions set forth in the memorandum in more detail. The agreement is for a term of five years ending August 2011, subject to automatic renewal for additional one-year terms absent notice of termination from either party. The initial employment agreement provided for an annual base salary of $200,000. On March 26, 2007, the Board of Directors of the Company approved a salary increase for Mr. Salomon. Effective April 1, 2007, Mr. Salomon’s salary increased from $200,000 per year to $260,000 per year. The agreement also includes an annual bonus in an amount equal to 0.75% of our annual net income, calculated in accordance with generally accepted accounting principles and reflected in our annual audited financial statements, as adjusted to exclude initial start-up losses of any new division during the first two years of operation, imputed interest on equity, bonuses paid at the operational level and specific projects as agreed from time to time.
The Agreement also provides for the following payments to Mr. Salomon upon termination of his employment:
•
Upon termination without cause, including upon expiration of the agreement, Mr. Salomon will be entitled to a severance payment equal to (a) one year of base salary and (b) a prorated amount of the bonus payable for the then current year through the date of termination.
•
Upon termination for any reason following the sale of the Company, irrespective of form, Mr. Salomon will be entitled to a severance payment equal to the greater of (a) the bonus paid pursuant to the employment agreement for the most recently completed fiscal year and (b) $500,000.
The agreement also provides for termination with cause and upon death or disability, in which case Mr. Salomon will receive any accrued salary to the date of termination and any other benefits to which he is entitled under then existing benefit plans.
POTENTIAL PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL
The following table provides the estimated value of the benefits that each of the named executive officers would have received had his employment been terminated on the last business day of fiscal year 2007 under the scenarios described below or had a change of control or initial public offering of the Company’s equity occurred on the last business day of fiscal year 2007. The table does not include benefits that are generally available to all salaried employees.
(1)
Lump sum payment in cash. The incentive payment is equal to the greater of $3 million or 3% of the excess of the purchase price paid by a buyer of us over our book value. We assumed that a buyer would pay the average of (i) a multiple our book value as of May 31, 2007 and (ii) (a) a multiple our EBITDA for fiscal year 2007 adjusted to exclude the effect of the inventory impairment charge taken during fiscal year 2007 less (b) our total debt as of May 31, 2007. Based on our estimate of what a buyer would pay and our book value as of May 31, 2007, Mr. Krobot would have received the minimum payment of $3 million. See the description of the Mr. Krobot’s employment agreement above for an explanation of the payment due to him upon a change of control.
(2)
Lump sum payment in stock, cash or some other mutually agreed upon method. The incentive payment is equal to the greater of $3 million or 3% of the excess of our aggregate market value, based on the valuation applied in an IPO, over our book value. We assumed that our aggregate market value in an IPO would be equal to the average of (i) a multiple of our book value as of May 31, 2007 and (ii) (a) a multiple our EBITDA for fiscal year 2007 adjusted to exclude the effect of the inventory impairment charge taken during fiscal year 2007 less (b) our total debt as of May 31, 2007. Based on our estimate of our aggregate market value in an IPO and our book value as of May 31, 2007, Mr. Krobot would have received the minimum payment of $3 million. See the description of the Mr. Krobot’s employment agreement above for an explanation of the payment due to him upon an IPO.
(3)
Lump sum payment in cash. Amounts in a Plan participant’s account becomes fully vested (i.e., accelerated vesting) upon the participant’s death or disability or upon the participant’s termination without cause within two years of a change of control.
(4)
Lump sum payment in cash. This is vested portion of the participant’s account as of May 31, 2007.
(5)
This is an estimate based on the premiums paid during fiscal 2007 to provide coverage for Mr. Krobot and his wife.
(6)
Lump sum payment in cash. See the description of the Mr. Salomon’s employment agreement above for an explanation of the payments due to him.
Director Compensation
The members of our Board of Directors do not receive compensation for services as our directors.
Compensation Committee Interlocks and Insider Participation
The entire Board of Directors undertakes the duties of the Compensation Committee with respect to the compensation of Messrs. Krobot and Salomon. Mr. Krobot, with input from Mr. Salomon, determines the compensation of the other executive officers. Mr. Krobot, our President and Chief Executive Officer, is a member of our Board of Directors. As a member of the Board of Directors, he will participate in discharging the duties of the Compensation Committee.
For a discussion of transactions between us and certain affiliates of members of our Board of Directors, see Item 13 “Certain relationships and related transactions, and director independence.”
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The following table sets forth certain information as of May 31, 2007 regarding the beneficial ownership of the membership interests in the Company. In addition, the footnotes below explain that certain of the persons or entities listed in the table have special membership interests entitling them to allocations of profits and cash distributions in the land development activities in Denver, Colorado and Orlando, Florida of certain of the Company’s subsidiaries. Ashton Woods Finance co. is a wholly-owned subsidiary of the Company.
(1)
Beneficial ownership is determined in accordance with Section 13 of the Exchange Act and the rules promulgated thereunder. Accordingly, if an individual or entity is a member of a “group” which has agreed to act together for the purpose of acquiring, holding, voting or disposing of membership interests, such individual or entity is deemed to be the beneficial owner of the membership interests held by all members of the group. Further, if an individual or entity has or shares the power to vote or dispose of membership interests held by another entity, beneficial ownership of the interests held by such entity may be attributed to such other individuals or entities.
(2)
The address of this beneficial owner is 3751 Victoria Park Ave, Toronto, Ontario M1W 3Z4 Canada.
(3)
Entities and/or family trusts associated with these individuals hold interests (including the special membership interests referred to in footnote 7 below) in the Company through Little Shots Nevada L.L.C. For beneficial ownership purposes, the membership and special membership interests held by Little Shots Nevada L.L.C. are attributable to each such individual. The entities associated with each such individual have, respectively, a 33.3% ownership interest in Little Shots Nevada L.L.C. and are entitled to receive an allocation of 33.3% of any proceeds received by Little Shots Nevada L.L.C. as a result of its 21.0% special membership interest in the Denver, Colorado land development activities and its 21.0% special membership interest in the Orlando, Florida land development activities.
(4)
This entity is owned by entities and/or family trusts associated with Elly Reisman.
(5)
This entity is owned by entities and/or family trusts associated with Norman Reisman.
(6)
This entity is owned by entities and/or family trusts associated with Larry Robbins.
(7)
These and other related entities also hold special membership interests in allocations of profits and cash distributions in the land development activities in Denver, Colorado and Orlando, Florida of certain of the Company’s subsidiaries as follows:
As noted in footnote 3 above, entities and/or family trusts associated with Seymour Joffe, Bruce Freeman and Harry Rosenbaum are entitled to receive a portion of the proceeds received by Little Shots Nevada L.L.C. through allocations on such special membership interests based on their respective percentage ownership interests in Little Shots Nevada L.L.C. as set forth in footnote 3.
Special membership interests do not entitle the holders thereof to vote or otherwise participate in the management or operation of the Company or any of its subsidiaries.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
In August 2005, we entered into a Services and Software License Agreement (the “Services and License Agreement”) with Paramount Development Corporation Limited (“Paramount”), which is an affiliate of the Great Gulf Group. Under the Services and License Agreement, which was effective as of June 1, 2005, Paramount licenses to us and our affiliates certain software which we use in performing the following functions: accounting, job costing, work order, home warranty, home design, scheduling, and purchase orders. Furthermore, pursuant to the Services and License Agreement, Paramount provides us and our affiliates with the services of its employees to assist us with land development matters relating to our land operations in Orlando and Denver. In return for the software license and the land development services, we pay Paramount a fee of $600 for each home closed. The initial term of the Services and License Agreement is two years and will automatically renew for successive one-year terms unless either party gives notice that the agreement will not be renewed.
Although we did not have a written agreement with Paramount covering the software license and land development services prior to entering into the Services and License Agreement, Paramount provided us with such software and services in return for a payment of $600 for each home closed. During the fiscal year 2007, we paid Paramount $1.2 million for the software license and land development services.
We, in the ordinary course of our business, from time to time enter into lot option purchase agreements to facilitate the development of land for our use with entities that are owned directly or indirectly by the seven families that indirectly own our membership interests or that are otherwise affiliates of the Great Gulf Group. These entities generally obtain secured acquisition and development financing which is supported by specific performance requirements under our lot option purchase agreements.
As of May 31, 2007, we had three lot purchase contracts with such related parties to acquire 659 finished lots at an aggregate price of approximately $33.0 million which have created variable interests and of which 163 finished lots remain to be purchased for an aggregate price of $7.1 million. While we do not own any equity interests in these entities, we must consolidate the entities pursuant to FIN46R.
We believe that the transactions described above between us and the various related parties have been and will continue to be on terms no less favorable to us than those available from unaffiliated third-parties in transactions negotiated at arms-length. We do not intend to enter into any transactions in the future with or involving any of our
officers or directors or any members of their immediate family on terms that would be less favorable to us than those that would be available from unaffiliated third-parties in arms-length transactions.
None of the members of our Board of Directors meet the definition of an “independent director” under the rules promulgated by Nasdaq or the New York Stock Exchange as a result of their affiliation with our ownership group or their employment with the Company. However, because our securities are not listed on a national securities exchange or national securities association, none of our directors are required to qualify as an “independent director.”
Item 14.
Item 14. Principal Accountant Fees and Services
For the fiscal years ended May 31, 2007 and 2006, professional services were performed by KPMG LLP.
Audit and audit-related fees aggregated $612,213 and $555,670 for the fiscal years ended May 31, 2007 and 2006, respectively, and were composed of the following:
Audit Fees: The aggregate fees billed for the audit of our annual financial statements for the fiscal years ended May 31, 2007 and 2006 and for reviews of our quarterly financial statements were $546,000 and $375,000, respectively.
Audit-Related Fees: The aggregate fees billed for audit-related services for the fiscal years ended May 31, 2007 and 2006 were $66,213 and $155,670, respectively. These fees relate to assurance and related services performed by KPMG that are reasonably related to the performance of the audit or review of our financial statements.
Tax Fees: The aggregate fees billed for tax services for the fiscal years ended May 31, 2007 and 2006 were $116,700 and $119,000, respectively. These fees relate to professional services performed by KPMG with respect to tax compliance, tax advice and tax planning.
All Other Fees: None
The Board of Directors annually approves each year’s engagement for audit services in advance. The Board of Directors has also established complementary procedures to require pre-approval of all permitted non-audit services provided by the Company’s independent auditors. All non-audit services described above were pre-approved by the Board of Directors in fiscal year 2007.
PART IV
Item 15.
Item 15. Exhibits and Financial Statements Schedules
(a) 1. Financial Statements
Report of Independent Registered Public Accounting Firm;
Consolidated Balance Sheets - as of May 31, 2007, and 2006;
Consolidated Statements of Earnings - years ended May 31, 2007, 2006 and 2005;
Consolidated Statements of Members’ Equity - years ended May 31, 2007, 2006 and 2005; and
Consolidated Statements of Cash Flows - years ended May 31, 2007, 2006 and 2006;
Notes to Consolidated Financial Statements.
2. Financial Statement Schedules
None required
3. Exhibit
The following list of exhibits includes both exhibits submitted with this Form 10-K as filed with the Commission and those incorporated by reference to other filings:
The exhibits, which are referenced in the above documents, are hereby incorporated by reference. Such exhibits have been omitted for purposes of this filing but will be furnished supplementary to the Commission upon request.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: July 19, 2007
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
July 19, 2007
/s/ THOMAS KROBOT
Thomas Krobot
President, Chief Executive Officer
and Director
(Principal Executive Officer)
July 19, 2007
/s/ ROBERT SALOMON
Robert Salomon
Chief Financial Officer
(Principal Financial Officer and Principal Accounting
Officer)
July 19, 2007
/s/ SEYMOUR JOFFE
Seymour Joffe
Director
July 19, 2007
/s/ BRUCE FREEMAN
Bruce Freeman
Director
July 19, 2007
/s/ HARRY ROSENBAUM
Harry Rosenbaum
Director
Report of Independent Registered Public Accounting Firm
The Members
Ashton Woods USA L.L.C.:
We have audited the accompanying consolidated balance sheets of Ashton Woods USA L.L.C. and subsidiaries as of May 31, 2007 and 2006, and the related consolidated statements of earnings, members’ equity, and cash flows for each of the years in the three-year period ended May 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ashton Woods USA L.L.C., and subsidiaries as of May 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended May 31, 2007, in conformity with U.S. generally accepted accounting principles.
KPMG LLP
Atlanta, Georgia
July 19, 2007
ASHTON WOODS USA L.L.C.
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements
ASHTON WOODS USA L.L.C.
CONSOLIDATED STATEMENTS OF EARNINGS
See accompanying notes to consolidated financial statements
ASTHON WOODS USA L.L.C.
CONSOLIDATED STATEMENTS OF MEMBERS’ EQUITY
See accompanying notes to consolidated financial statements.
ASHTON WOODS USA L.L.C.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements
Ashton Woods USA L.L.C.
Notes to Consolidated Financial Statements
Note 1 - Summary of Significant Accounting Policies
Organization
Ashton Woods USA L.L.C. (the “Company’’), operating as Ashton Woods Homes, is a limited liability company formed on February 6, 1997 for a period of duration ending no later than February 1, 2037. The Company acquires and develops land for residential purposes and designs, sells and builds residential homes on such land in seven markets located in Georgia, Texas, Florida, Arizona, and Colorado. The Company also holds an investment in an unconsolidated entity that provides mortgage origination for homebuyers through Ashton Woods Mortgage, LLC (“Ashton Woods Mortgage’’). In addition, the Company provides title services to its buyers in Texas and Florida through three unconsolidated entities.
Presentation
The consolidated financial statements include the accounts of the Company, and its wholly-owned, majority-owned and controlled subsidiaries, as well as certain variable interest entities required to be consolidated pursuant to Financial Interpretation No. 46R (“FIN 46R’’) issued by the Financial Accounting Standards Board (FASB). All intercompany balances and transactions have been eliminated in consolidation.
The Company’s balance sheet presentation is unclassified due to the fact that certain assets and liabilities have both short and long-term characteristics.
Cash and Cash Equivalents
The Company considers all highly liquid investments with an initial maturity of three months or less when purchased to be cash equivalents.
Inventory
Finished inventories and land held for sale are stated at the lower of accumulated cost or fair value less cost to sell. Homebuilding projects and land held for development and construction are stated at cost unless facts and circumstances indicate that such cost would not be recovered from the undiscounted cash flows generated by future dispositions, after considering estimated cash flows associated with all future expenditures to develop the assets, including interest payments that will be capitalized as part of the cost of the asset. In this instance, such inventories are written down to estimated fair value, which is determined based on management’s estimate of future revenues and costs that would be considered by an unrelated buyer in determining the fair value of the asset. Due to uncertainties in the estimation process, it is possible that actual results could differ.
In addition to the costs of direct land acquisition, land development and home construction, inventory costs include interest, real estate taxes and indirect overhead costs incurred during development and home construction. The Company uses the specific identification method for the purpose of accumulating home construction costs. Cost of sales for homes closed includes the specific construction costs of each home and all applicable land acquisition, land development and related costs (both incurred and estimated to be incurred) based upon the total number of homes expected to be closed in each project. Any changes to the estimated total development costs subsequent to the initial home closings in a project are generally allocated on a pro-rata basis to the remaining homes in the project.
When a home is closed, the Company generally has not yet paid and recorded all incurred costs necessary to complete the home. Each month the Company records as a liability and a charge to cost of sales the amount it estimates will ultimately be paid related to completed homes that have been closed as of the end of that month.
The Company compares home construction budgets to actual recorded costs to estimate the additional costs remaining to be paid on each closed home. The Company monitors the accuracy of each month’s accrual by comparing actual costs paid on closed homes in subsequent months to the amount accrued. Although actual costs to
be paid on closed homes in the future could differ from the current estimate, this method has historically produced consistently accurate estimates of actual costs to complete closed homes.
Each reporting period, the Company reviews all components of inventory in accordance with SFAS No. 144, which requires that if the sum of the undiscounted future cash flows expected to result from a community is less than the carrying value of the community, an asset impairment must be recognized in the consolidated financial statements as a component of cost of sales. The amount of the impairment is calculated by subtracting the fair value of the community from the carrying value of the community.
In order for management to assess the fair value of a community, certain assumptions must be made which are highly subjective and susceptible to change. The Company evaluates, among other things, the actual gross margins for homes closed and the gross margins for homes sold in backlog. This evaluation also includes critical assumptions with respect to future home sales prices, cost of sales, including levels of sales incentives and the monthly rate of sale, which are critical in determining the fair value of a community. If events and circumstances indicate that the carrying value of a community are not expected to be recoverable, then the community is written down to its estimated fair value. Given the historical cyclicality of the homebuilding industry, the valuation of homebuilding inventories are sensitive to changes in economic conditions, such as interest rates and unemployment levels. Changes in these economic conditions could materially affect the projected home sales price, the level of sales incentives, the costs to develop land and construct the homes and the monthly rate of sale. Because of these potential changes in economic and market conditions in conjunction with the assumptions and estimates required of management in valuing homebuilding inventory, actual results could differ materially from management’s assumptions and may require material inventory impairments to be recorded in the future.
In accordance with SFAS No. 144, valuation adjustments are recorded on finished homes and land held for sale when events or circumstances indicate that the fair value, less costs to sell, is less than the carrying value.
The impairments recorded during the twelve months ended May 31, 2007 and 2006 by reportable segment are as follows (in thousands):
Deposits paid related to land option purchase agreements and contracts to purchase land are capitalized when paid and classified as other assets until the related land is acquired. The deposits are then transferred to inventory at the time the land is acquired. Deposits are charged to expense if the land acquisition is no longer considered probable.
Real Estate Not Owned
Consolidated real estate not owned represents the fair value of land under option purchase agreements when consolidated pursuant to FIN 46R.
Investments in Unconsolidated Entities
The Company participates in a number of land development entities in which it has less than a controlling interest. These land development entities are typically entered into with developers, other homebuilders and related parties to develop finished lots for sale to the members of the entities and other third parties. The Company accounts for its interest in these entities under the equity method. The Company’s share of profits from these entities are deferred and treated as a reduction of the cost basis of land purchased from the entity.
The Company’s investments in Ashton Woods Mortgage and the title services entities are also accounted for under the equity method, as the Company does not have a controlling interest. Under the equity method, the Company’s share of the unconsolidated entities’ earnings or loss is recognized as earned.
Property and Equipment
Property, plant and equipment is recorded at cost. Depreciation and amortization generally is recorded using the straight-line method over the estimated useful lives of the assets, which range from 2 years to 5 years, and depreciable lives for leasehold improvements typically reflect the life of the lease. Repairs and maintenance costs are expensed as incurred.
The Company’s property and equipment at May 31, 2007 and 2006 consist of the following (in thousands):
Revenue Recognition
Homebuilding and lot sale revenue are recognized at the time of the closing of a sale, when title to and possession of the property are transferred to the buyer. Sales commissions are included in sales and marketing expenses. Virtually all homebuilding, land and lot sales revenues are received in cash within two days of closing.
Warranty Costs
The Company provides its homebuyers with limited warranties that generally provide for ten years of structural coverage, two years of coverage for plumbing, electrical and heating, ventilation and air conditioning systems and one year of coverage for workmanship and materials. Warranty liabilities are initially established on a per home basis by charging cost of sales and establishing a warranty liability for each home delivered to cover expected costs of materials and labor during the warranty period. The amounts accrued are based on management’s estimate of expected warranty-related costs under all unexpired warranty obligation periods. The Company’s warranty liability is based upon historical warranty cost experience in each market in which it operates and is adjusted as appropriate to reflect qualitative risks associated with the types of homes built and the geographic areas in which they are built. The following table sets forth the Company’s warranty liability, which is included in accounts payable and accruals on the consolidated balance sheets:
For the three years ended of May 31, 2007, 2006 and 2005 (in thousands):
Advertising Costs
The Company expenses advertising costs as they are incurred. Advertising expense was approximately $6.0 million, $4.4 million and $2.8 million in fiscal 2007, 2006 and 2005, respectively.
Minority Interest
During the fiscal year 2004 and a portion of fiscal year 2005 the Company had a controlling interest in a limited partnership for land acquisition and development in Orlando, Florida. Accordingly, the financial position of this partnership and results of operations were consolidated in the Company’s consolidated financial statements and the other partner’s share of earnings of the limited partnership was recorded as minority interest during such periods. During fiscal year 2005, the Company acquired the minority share in this limited partnership.
Provision for Income Taxes
The Company operates as a limited liability company. Accordingly, the Company incurs no liability for federal or state income taxes, other than franchise taxes, as these taxes are passed through to the members.
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Reclassifications
Certain prior year balances have been reclassified to conform to the current year presentation.
Segments
The Company’s operating segments are aggregated into reportable segments in accordance with SFAS No. 131 Disclosures About Segments of an Enterprise and Related Information (“SFAS 131”), based primarily upon similar economic characteristics, geography and product type. The Company’s homebuilding reportable segments are as follows:
1) East (Atlanta, Orlando and Tampa markets) and
2) West (Dallas, Houston, Phoenix and Denver markets)
See Note 13 for further discussion of the Company’s segments.
Note 2 - Inventory
Inventory consists of the following as of May 31, (in thousands):
The Company capitalizes interest costs to inventory during development and construction. Capitalized interest is charged to cost of sales as the related inventory is delivered to the buyer. The following table summarizes the
Company’s interest costs incurred, capitalized and charged to cost of sales during the years ended May 31, (in thousands):
Note 3 - Consolidated Land Inventory Not Owned
In the ordinary course of business, the Company enters into land option agreements in order to procure land for the construction of homes in the future. Pursuant to these land option agreements, the Company will provide a deposit to the seller as consideration for the right to purchase land at different times in the future, usually at predetermined prices. Under FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” as amended by FIN 46-R issued in December 2003 (collectively referred to as “FIN 46”), if the entity holding the land under option is a variable interest entity, the Company’s deposit represents a variable interest in that entity. Creditors of the variable interest entities have no recourse against the Company.
In applying the provisions of FIN 46, the Company evaluated all land option agreements and determined that the Company has three lot purchase contracts with certain related parties to acquire 659 finished lots at an aggregate price of approximately $33.0 million, which have created variable interests and of which 163 finished lots remain to be acquired for an aggregate price of $7.1 million. In addition, the Company has provided various specific performance guarantees under one of the option purchase contracts, which has been deemed as providing subordinated financial support to the entity. While the Company owns no equity interest in the entities, it must consolidate pursuant to FIN 46R. The consolidation of these variable interest entities added $5.9 million, $4.8 million and $0.7 million in real estate not owned, liabilities related to real estate not owned and minority interests in real estate not owned, respectively, to the Company’s balance sheet at May 31, 2007 and added $14.3 million, $12.2 million, and $1.8 million in real estate not owned, liabilities related to real estate not owned and minority interests in real estate not owned, respectively, to the Company’s balance sheet at May 31, 2006.
Land option agreements that did not require consolidation under FIN 46 at May 31, 2007 and 2006, had a total purchase price of $56.2 million and $35.6 million, respectively. In connection with these agreements, the Company had deposits of $3.9 million and $2.5 million, included in other assets at May 31, 2007 and 2006, respectively.
Note 4 - Investments in Unconsolidated Entities
The Company enters into land development joint ventures from time to time as a means of accessing larger parcels of land and lot positions, managing its risk profile and leveraging its capital base. At May 31, 2007 and 2006, the Company had equity investments of 50% or less and did not have a controlling interest in these unconsolidated entities. The Company’s partners are generally unrelated homebuilders, land developers or other real estate entities. These unconsolidated entities follow accounting principles generally accepted in the United States of America and the partners share in their profits and losses generally in accordance with their ownership interests.
The Company and/or its entity partners enter into option purchase agreements under which they can purchase finished lots held by the unconsolidated entity. Option prices are generally negotiated prices that approximate fair value when the option contract is signed. The Company’s share of the entity’s earnings is deferred until homes related to the lots purchased are delivered and title passes to a homebuyer.
The land development entities with unrelated parties typically obtain secured acquisition and development financing. As of May 31, 2007, the Company has entered into lot option purchase agreements with three
unconsolidated entities for the purchase of 887 lots, of which 518 remain to be purchased with an aggregate remaining purchase price of $18.9 million. These unconsolidated entities had borrowings outstanding totaling $8.1 million and $9.2 million at May 31, 2007 and 2006, respectively. In some instances, the entity partners have provided varying levels of guarantees of debt of the unconsolidated entities. These repayment guarantees require the Company to repay its share of the debt of unconsolidated entities in the event the entity defaults on its obligations under the borrowings. The Company had repayment guarantees of $1.5 million and $3.6 million at May 31, 2007 and 2006, respectively.
Summarized condensed financial information related to unconsolidated entities that are accounted for using the equity method at May 31, 2007 and 2006 was as follows (in thousands):
Note 5 - Notes Payable
The Company’s notes payable at May 31, 2007 and 2006 consist of the following (in thousands):
In September 2005, the Company and Ashton Woods Finance Co., the Company’s 100% owned finance subsidiary, co-issued $125 million aggregate principal amount of 9.5% Senior Subordinated Notes due 2015 in a private placement pursuant to Rule 144A promulgated under the Securities Act of 1933, as amended. The net proceeds were used to repay amounts outstanding under the Company’s senior unsecured revolving credit facility and to repay certain related party debt. In April 2006, the Company completed an offer to exchange all of the notes issued in September 2005 for an equal amount of 9.5% Senior Subordinated Notes due 2015, which were registered under the Securities Act of 1933. Interest on the notes is payable semiannually. The Company may redeem the notes, in whole or part, at any time on or after October 1, 2010, at a redemption price equal to 100% of the principal amount, plus a premium declining ratably to par, plus accrued and unpaid interest. In addition, at any time prior to October 1, 2008, the Company may redeem up to 35% of the aggregate principal amount of the notes
with the proceeds of qualified equity offerings at a redemption price equal to 109.5% of the principal amount, plus accrued and unpaid interest. The notes are unsecured and subordinated in right of payment to all of the Company’s existing and future senior debt, including borrowings under the Company’s senior unsecured credit facility. All of the Company’s existing subsidiaries, other than the co-issuer, fully and unconditionally guaranteed, jointly and severally, the notes on a senior subordinated basis. Each of the subsidiary guarantors is 100% owned by the Company. Future direct and indirect U.S. subsidiaries, excluding subsidiaries that are designated unrestricted subsidiaries in accordance with the indenture, will be required to guarantee the notes on a full and unconditional basis, jointly and severally with the other subsidiary guarantors. The guarantees are general unsecured obligations of the guarantors and are subordinated in right of payment to all existing and future senior debt of the guarantors, which includes their guarantees of the Company’s senior unsecured credit facility. The Company does not have any independent operations or assets apart from its investments in its subsidiaries. As of and for the year ended May 31, 2007, the Company was in compliance with the covenants under the senior subordinated notes. As of May 31, 2007, the outstanding notes with a face value of $125.0 million had a fair value of approximately $118.2 million, based on quoted market prices by independent dealers.
In December 2005, the Company entered into an amended senior unsecured credit facility. The senior unsecured credit facility provides for up to $300.0 million of unsecured borrowings, subject to a borrowing base, and includes an accordion feature by which the Company may request, subject to certain conditions, an increase of the senior unsecured credit facility up to a maximum of $400.0 million. The senior unsecured credit facility provides for the issuance of up to $50.0 million in letters of credit. At May 31, 2007, the Company had available borrowing capacity under this facility of $193.5 million as determined by borrowing base limitations defined in the agreement. The Company’s obligations under the amended senior unsecured credit facility are guaranteed by all of its subsidiaries and all of the holders of its membership interests.
Once during each fiscal year (i.e., June 1-May 31), the Company may request that the lenders extend the maturity date by an additional year. On January 10, 2007, the Company amended the senior unsecured credit facility to extend the maturity date to January 19, 2011, for 88.3%, or $265.0 million of the facility and to amend the definition of “EBITDA” contained therein to exclude certain non-cash gains and include certain non-cash losses or charges. On February 21, 2007, the Company obtained consent from an additional lender representing 5.0% or $15 million of the facility, to the extension of the senior unsecured credit facility to January 19, 2011.
The senior unsecured credit facility contains a number of customary financial and operating covenants, including covenants requiring the Company to maintain a minimum consolidated tangible net worth; limiting the principal amount of our secured debt to $50 million at any given time; limiting the net book value of our unimproved entitled land, land under development and finished lots to 150.0% of its adjusted tangible net worth; limiting the aggregate distributions by the Company and its subsidiaries in any fiscal year; restricting the Company’s ability to incur additional indebtedness; and restricting the Company’s ability to engage in mergers and consolidations and its ability to sell all or substantially all of its assets. The senior unsecured credit facility also contains covenants requiring the Company to maintain a certain ratio of consolidated total liabilities to adjusted net worth and to maintain a certain interest coverage ratio. In June 2007, the Company entered into another amendment to the senior unsecured credit facility which provides for a permanent reduction in the interest coverage ratio to 2.0x, from 2.50x, and includes a provision allowing such ratio to fall to no less than 1.75x for up to three consecutive fiscal quarters in any rolling four fiscal quarter period ending on or before May 31, 2009. The June 2007 amendment also provides that in the event our interest coverage ratio for any fiscal quarter is less than 2.0x, (1) the ratio of consolidated total liabilities to adjusted net worth decreases to 2.0x, from 2.25x, for such fiscal quarter and (2) the interest rates for borrowings under the senior unsecured credit facility will increase to the levels set forth in the amendment.
The borrowings under the facility bear daily interest at rates based upon the London Interbank Offered Rate (LIBOR) plus a spread based upon the Company’s interest coverage ratio and ratio of consolidated total liabilities to adjusted net worth. In addition to the stated interest rates, the revolving credit facility requires the Company to pay certain fees. The effective interest rate of the unsecured bank debt at May 31, 2007, was approximately 6.57%. As of and for the year ended May 31, 2007, the Company was in compliance with the covenants under the senior unsecured credit facility.
Borrowings under the senior unsecured credit facility are limited by the availability of sufficient real estate borrowing base, which is determined regularly throughout the life of the senior unsecured credit facility. At May 31, 2007, we had $61.3 million in outstanding borrowings, and $193.5 million in available borrowings under the senior unsecured credit facility.
Note 6 - Transactions With Related Parties
A services agreement with a related party provides the Company with the license, development and support for the Company’s computer systems and the provision of certain administrative services. The Company pays $600 per home closing quarterly, in arrears for these services, and in 2005, the Company made payments of $1,500 per lot closed for certain services rendered by the related party to one of the Company’s subsidiaries. During the fiscal years ended May 31, 2007, 2006 and 2005, $1.2 million, $1.5 million and $1.2 million was incurred related to these services, respectively.
The Company had entered into option purchase agreements for the purchase of finished lots for use in its homebuilding operations for the acquisition and development of land and lots for use in its homebuilding operations with certain related parties. These entities were considered variable interest entities pursuant to FIN 46R and consolidated by the Company. As of May 31, 2007, the Company has 140 finished lots under contract to be purchased, representing $5.8 million in purchase price.
The Company had an unsecured note with a related party in the principal amount of $13.7 million at May 31, 2005, which was repaid during the fiscal year ended May 31, 2006.
Note 7 - Employee Benefit Plans
The Company has a 401(k) plan for all Company employees who have been with the Company for a period of three months or more. The Company matches portions of employee’s voluntary contributions up to 4% of an employee’s compensation up to the maximum allowed under federal guidelines. Expenses for the plan were $1.1 million, $0.9 million and $0.7 million in fiscal 2007, 2006 and 2005, respectively.
Note 8 - Financial Instruments
The fair values of the Company’s financial instruments are based on quoted market prices, where available, or are estimated. Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates are subjective in nature, involve matters of judgment and therefore, cannot be determined with precision. Estimated fair values are significantly affected by the assumptions used.
The carrying amounts of cash and cash equivalents and the unsecured revolving credit facility, as reported in the Company’s balance sheets approximate their fair values due to their short maturity or floating interest rate terms, as applicable.
Note 9 - Employment Agreements
On January 30, 2006, the Company entered into an employment agreement with its President and Chief Executive Officer, Tom Krobot. The agreement, which is effective as of June 1, 2005, is for a term of approximately five years ending May 31, 2010. The employment agreement includes base salary and annual bonus provisions that are calculated based on annual net income. The agreement also provides for certain incentive payments upon a sale of the Company, irrespective of form, the consummation by the Company of an initial public offering of equity securities, upon his termination under certain circumstances or upon expiration of the agreement. The incentive payment will be equal to the amount determined by multiplying the excess of the aggregate fair value of the Company over the book value of the Company by 3%, provided such payment is subject to a floor of $3.0 million. The Company has accrued approximately $1.2 million related to this employment agreement since the effective date of June 1, 2005. The liability under this employment agreement has been measured using the intrinsic value method.
On August 9, 2006, the Company entered into an employment agreement with its Chief Financial Officer, Robert Salomon. The agreement is for a term of five years ending August 9, 2011, subject to automatic renewal for additional one-year terms absent notice of termination from either party. The employment agreement includes base salary and an annual bonus provision that is calculated based on annual net income. The Agreement also provides for payments to Mr. Salomon upon termination of his employment with cause or any reason following the sale of the Company.
Note 10 - Commitments and Contingencies
The Company is involved in lawsuits and other contingencies in the ordinary course of business. Management believes that, while the ultimate outcome of the contingencies cannot be predicted with certainty, the ultimate liability, if any, will not have a material adverse effect on the Company’s consolidated financial statements.
In the normal course of business, the Company provides standby letters of credit and surety bonds issued to third parties to secure performance under various contracts. As of May 31, 2007, 2006 and 2005, the Company had letters of credit and surety bonds outstanding of $21.3 million, $25.4 million and $11.0 million, respectively.
The Company leases office space and equipment under various operating leases. Minimum annual lease payments under these leases at May 31, 2007 were (in thousands):
Rent expense approximated $1.7 million, $1.8 million and $1.0 million for fiscal 2007, 2006 and 2005, respectively and is included within general and administrative expense on the consolidated statements of earnings.
Note 11 - Cash Flow Information
Supplemental disclosures of cash flow information and non-cash activities are follows (in thousands):
Note 12 - Quarterly Financial Information (Unaudited)
Note 13 - Information on business segments
SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information” (“SFAS 131”), defines operating segments as a component of an enterprise for which discrete financial information is available and is reviewed regularly by the chief operating decision-maker, or decision-making group, to evaluate performance and make operating decisions. The Company has identified its chief operating decision-makers (“CODMs”) as three key executives-the Chief Executive Officer, Senior Vice President and Chief Financial Officer.
The Company has identified each homebuilding market as an operating segment in accordance with SFAS 131. Operations of the Company’s homebuilding segments primarily include the sale and construction of single-family attached and detached homes, and to a lesser extent, condominiums, as well as the purchase, development and sale of residential land directly and through the Company’s unconsolidated entities. The Company’s operating segments have been aggregated into the reportable segments noted below because they have similar: (1) economic characteristics; (2) housing products; (3) class of homebuyer; (4) regulatory environments; and (5) methods used to construct and sell homes. Prior to fiscal year 2007, we only had one reportable segment, therefore, we have restated the corresponding items of segment information for earlier periods.
The Company’s homebuilding reportable segments are as follows:
(1) East (Atlanta, Orlando and Tampa markets)
(2) West (Dallas, Houston, Phoenix and Denver markets)
Each reportable segment follows the same accounting policies described in Note 1 - “Summary of Significant Accounting Policies” to the consolidated financial statements. Operational results of each segment are not necessarily indicative of the results that would have occurred had the segment been an independent, stand-alone entity during the periods presented.
The following table summarizes revenue, gross profit and net income for each of the Company’s reportable segments (in thousands):
The following table summarizes assets for each of the Company’s reportable segments (in thousands):
(1)
Balance consists of cash from the housing divisions, deferred debt issuance costs and other corporate assets not allocated to the segments
The following table summarizes total expenditures for additions to property and equipment for each of the company’s reportable segments (in thousands):
The following table sets forth information relating to home sales revenues by product for the years ended May 31, 2007, 2006 and 2005:
Note 14 - Subsequent events
On June 15, 2007, the Company amended certain terms of its unsecured revolving credit facility. The amendment provides for a permanent reduction in the interest coverage ratio to 2.00 to 1.00, from 2.50 to 1.00, and includes a provision allowing such ratio to fall to no less than 1.75 to 1.00 for up to three consecutive fiscal quarters in any rolling four fiscal quarter period ending on or before May 31, 2009. The amendment also provides that in the event the interest coverage ratio for any fiscal quarter is less than 2.00 to 1.00, (1) the ratio of consolidated total liabilities to adjusted net worth decreases to 2.00 to 1.00, from 2.25 to 1.00, for such fiscal quarter and (2) the interest rates will increase to the levels set forth in the amendment.