DHI

Business Context and Reporting Period

Company: D.R. Horton, Inc. (DHI)
Filing Type: Form 10-K (Annual Report)
Period Ended: September 30, 2008
Industry: Residential Homebuilding and Financial Services

D.R. Horton is the largest homebuilder in the United States by homes closed, operating in 27 states and 77 metropolitan markets. The company's operations are divided into six homebuilding reporting segments and one financial services segment (DHI Mortgage and title services). Fiscal 2008 was characterized by a severe industry downturn, marked by high inventory levels, elevated cancellation rates, credit tightening, and a significant decline in consumer confidence. Consequently, the company shifted its strategy from growth to strengthening its balance sheet, reducing inventory, and controlling costs.

Key Financial Metrics

Operational Highlights:

• Homes Closed: 26,396 (down 36% from 41,370 in 2007).
• Average Selling Price: $233,500 (down 10% from $259,200 in 2007).
• Net Sales Orders: 21,251 (down 37% from 33,687 in 2007).
• Backlog: $1.21 billion (5,297 homes), down 55% from the prior year.
• Cancellation Rate: 40% (up from 38% in 2007).

Material Changes Versus Prior Period

The company reported a significant deterioration in financial performance compared to fiscal 2007, driven by the deepening housing recession.

• Revenue Decline: Total revenues fell 41% to $6.65 billion. Homebuilding revenues dropped 41% due to a 36% decrease in homes closed and a 10% decrease in average selling prices.
• Loss Expansion: The net loss widened to $2.63 billion from $0.71 billion. This was primarily driven by a $2.48 billion charge for inventory impairments and land option cost write-offs (compared to $1.33 billion in 2007) and a $79.4 million goodwill impairment charge.
• Margin Compression: Home sales gross margins decreased 600 basis points to 11.2%. Total homebuilding gross profit turned negative at $(1.76) billion due to impairment charges.
• Balance Sheet Strengthening: Despite the losses, the company generated $1.88 billion in operating cash flow, allowing it to reduce total debt by $628 million and increase cash balances by over $1.1 billion. Inventory levels were reduced by approximately 50% through sales and impairments.
• Segment Performance: All six homebuilding regions reported losses before income taxes in 2008, compared to mixed results in 2007. The West and Southeast regions reported the largest losses, driven by significant impairments in California, Las Vegas, and Florida markets.

Guidance, Outlook, Risks, and Unusual Items

Management Outlook: Management maintains a cautious outlook, stating that housing market conditions may continue to deteriorate and the timing of a recovery is unclear. The company expects to close fewer homes in fiscal 2009 than in 2008. The primary focus remains on reducing inventory, controlling costs, and maintaining liquidity.

Unusual Items:

• Impairment Charges: Recorded $2.37 billion in inventory impairments and $111.9 million in land option write-offs. Additionally, a $79.4 million goodwill impairment was recorded for the Southwest region.
• Tax Valuation Allowance: Recorded a $961.3 million valuation allowance against deferred tax assets due to cumulative losses, though a $676.2 million federal income tax receivable was recorded based on a net operating loss carryback to 2006.

Key Risks and Contingencies:

• Credit Market Disruption: The company's senior debt ratings were downgraded below investment grade by all three major agencies, triggering borrowing base limitations on its revolving credit facility. Availability under the facility was reduced to $52.8 million.
• Liquidity Constraints: While the company has sufficient cash to meet near-term obligations, access to public capital markets is limited, and refinancing debt at maturity may be difficult or expensive.
• Regulatory Changes: The elimination of seller-funded down payment assistance on FHA loans (effective October 1, 2008) is expected to negatively impact future sales.
• Legal Proceedings: The company is involved in class action lawsuits alleging violations of the Real Estate Settlement Procedures Act and antitrust laws regarding its affiliated mortgage company. Management believes these claims are without merit.

Important Facts for Investor Verification

• Debt Covenants: Verify compliance with the tangible net worth covenant of the revolving credit facility, as management noted the margin of compliance has declined and an amendment may be sought in fiscal 2009.
• Inventory Valuation: Assess the remaining $4.68 billion inventory balance, noting that $2.19 billion of communities had impairment indicators as of September 30, 2008, and further write-downs may be necessary if market conditions worsen.
• Cancellation Rates: Monitor the 40% cancellation rate, which is significantly higher than historical norms, as this directly impacts future revenue recognition and backlog reliability.
• Debt Maturities: Confirm the company's ability to refinance or repay $549.7 million of senior notes maturing in early 2009, given the current credit market environment.
• Tax Refund Realization: Verify the receipt of the $676.2 million federal income tax refund, which is a critical component of the company's projected cash flow for fiscal 2009.