PULTEGROUP INC 10-K 2011
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2010
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number 1-9804
(Exact name of registrant as specified in its charter)
100 Bloomfield Hills Parkway, Suite 300
Bloomfield Hills, Michigan 48304
(Address of principal executive offices) (Zip Code)
Registrants telephone number, including area code: (248) 647-2750
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES x NO ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES ¨ NO x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Act. YES x NO ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES ¨ NO x
The aggregate market value of the registrants voting stock held by nonaffiliates of the registrant as of June 30, 2010, based on the closing sale price per share as reported by the New York Stock Exchange on such date, was $3,135,385,021.
As of February 1, 2011, the registrant had 382,005,253 shares of common stock outstanding.
Documents Incorporated by Reference
Applicable portions of the Proxy Statement for the 2011 Annual Meeting of Shareholders are incorporated by reference in Part III of this Form.
TABLE OF CONTENTS
ITEM I. BUSINESS
On March 18, 2010, we changed our name from Pulte Homes, Inc. to PulteGroup, Inc. (PulteGroup or the Company). PulteGroup is a publicly-held holding company traded on the New York Stock Exchange under the ticker symbol PHM. We are one of the largest homebuilders in the United States. PulteGroup is a Michigan corporation organized in 1956, though our founder began our homebuilding operations in 1950. While our subsidiaries engage primarily in the homebuilding business, we also have mortgage banking operations, conducted principally through Pulte Mortgage LLC (Pulte Mortgage), and title operations.
On August 18, 2009, we completed the acquisition of Centex Corporation (Centex) through the merger of PulteGroups merger subsidiary with and into Centex pursuant to the Agreement and Plan of Merger dated as of April 7, 2009 among PulteGroup, Pi Nevada Building Company, and Centex. As a result of the merger, Centex became a wholly-owned subsidiary of PulteGroup. Accordingly, the results of Centex are included in our consolidated financial statements from the date of the merger.
Since early 2006, the U.S. housing market has been unfavorably impacted by weak consumer confidence, tightened mortgage standards, and large supplies of resale and new home inventories and related pricing pressures, among other factors. When combined with significant foreclosure activity, a more challenging appraisal environment, higher than normal unemployment levels, and uncertainty in the United States economy in recent periods, these conditions have contributed to sharply weakened demand for new homes, slower sales, and heightened pricing pressures to attract homebuyers. As a result, we have experienced a pre-tax loss in each quarter since the fourth quarter of 2006. Such losses resulted from a combination of reduced operational profitability and significant asset impairments.
Homebuilding, our core business, is engaged in the acquisition and development of land primarily for residential purposes within the continental United States and the construction of housing on such land targeted for first-time, first and second move-up, and active adult home buyers. In the fourth quarter of 2010, we realigned the organizational structure for certain of our Areas. As a result, our reportable Homebuilding segments are as follows:
We also have one reportable segment for our financial services operations, which consists principally of mortgage banking and title operations. Our Financial Services segment operates generally in the same geographic markets as our Homebuilding segments.
Financial information for each of our reportable business segments is included in Note 6 to our Consolidated Financial Statements.
Our internet website address is www.pultegroupinc.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available free of charge through our website as soon as reasonably practicable after we electronically file them with or furnish them to the Securities and Exchange Commission. Our code of ethics for principal officers, our business practices policy, our corporate governance guidelines, and the charters of the Audit, Compensation and Management Development, and Nominating and Governance committees of our Board of Directors are also posted on our website and are available in print, free of charge, upon request.
Through our brands, which include Pulte Homes, Del Webb, Centex, and DiVosta, we offer a wide variety of home designs including single-family detached, townhouses, condominiums, and duplexes at different prices and with varying levels of options and amenities to all of our major customer segments: first-time, first and second move-up, and active adult. Over our 61-year history, we have delivered over 575,000 homes.
As of December 31, 2010, our Homebuilding operations offered homes for sale in nearly 800 communities. Sales prices of unit settlements during 2010 ranged from less than $100,000 to greater than $1.0 million, with 89% falling within the range of $100,000 to $400,000. The average unit selling price in 2010 was $259,000, compared with $258,000 in 2009, $284,000 in 2008, $322,000 in 2007, and $337,000 in 2006. The significant decrease in the average selling price of our homes since 2006 resulted from a combination of pricing pressures due to challenging industry conditions and a shift in product mix toward more first-time buyers.
Sales of single-family detached homes, as a percentage of total unit sales, were 79% in 2010, compared with 77% in 2009, 75% in 2008, and 74% in both 2007 and 2006. The increase in the percentage of single-family detached homes can be attributed to a weakened demand for townhouses, condominiums, and other attached housing, as prices for detached new homes have become more affordable for first-time and active adult homebuyers. Our Homebuilding operations are geographically diverse and, as a result, help to insulate us from demand changes in individual markets. Since 2006, however, such diversification has not insulated us from demand changes due to the nationwide downturn in the homebuilding industry that has had a significant adverse impact on operations in each of our markets. As of December 31, 2010, our Homebuilding business operated in 67 markets spanning 29 states and the District of Columbia.
Ending backlog, which represents orders for homes that have not yet closed, was $1.1 billion (3,984 units) at December 31, 2010 and $1.6 billion (5,931 units) at December 31, 2009. For each order in backlog, we have received a signed customer contract and the required customer deposit, which is refundable in certain instances. Of the orders in backlog at December 31, 2010, substantially all are scheduled to be closed during 2011, though all orders are subject to potential cancellation by or final negotiations with the customer. In the event of cancellation, the majority of our sales contracts stipulate that we have the right to retain the customers deposit, though we may choose to refund the deposit in certain instances.
Land acquisition and development
We acquire land primarily for the construction of our homes for sale to homebuyers, though we periodically sell select parcels of land to third parties for commercial or other development. Additionally, we may determine that certain land assets no longer fit into our strategic operating plans. We select locations for development of homebuilding communities after completing a feasibility study, which includes, among other things, soil tests, independent environmental studies and other engineering work, an evaluation of the necessary zoning and other governmental entitlements, and extensive market research that enables us to match the location and product offering with our targeted consumer group. We consider factors such as proximity to developed areas, population and job growth patterns and, if applicable, estimated development costs. We frequently manage a portion of the risk of controlling our land positions through the use of option contracts. We typically acquire land with the intent to complete sales of housing units within 24 to 36 months from the date of opening a community, except in the case of certain Del Webb active adult developments and other large projects for which the completion of community build-out requires a longer time period. As a result of the downturn in the homebuilding industry that began in 2006, however, our supply of controlled land is in excess of our short-term needs in many of our markets.
Land is generally purchased after it is properly zoned and developed or is ready for development. In the normal course of business, we dispose of owned land not required by our homebuilding operations through sales to appropriate end users. Where we develop land, we engage directly in many phases of the development process, including land and
Homebuilding Operations (continued)
Land acquisition and development (continued)
site planning, and obtaining environmental and other regulatory approvals, as well as constructing roads, sewers, water and drainage facilities, and other amenities. We use our staff and the services of independent engineers and consultants for land development activities. Land development work is performed primarily by independent contractors and local government authorities who construct sewer and water systems in some areas. At December 31, 2010, we controlled 147,194 lots, of which 131,964 were owned and 15,230 were under option agreements.
Sales and marketing
We are dedicated to improving the quality and value of our homes through innovative architectural and community designs and state-of-the-art customer marketing techniques. Analyzing various qualitative and quantitative data obtained through extensive market research, we segment our potential customers into well-defined buyer groups. Segmentation analysis provides a method for understanding the business opportunities and risks across the full spectrum of consumer groups in each market. Once the demands of potential buyers are understood, we link our home design and community development efforts to the specific lifestyle of each targeted consumer group.
To meet the demands of our various customers, we have established a solid design expertise for a wide array of product lines. We believe that we are an innovator in home design, and we view design capacity as an integral aspect of our marketing strategy. Our in-house architectural services teams and management, supplemented by outside consultants, are successful in creating distinctive design features, both in exterior facades and interior options and features. We typically offer a variety of potential options and upgrades, such as different flooring, countertop, and appliance choices and design our base house and option packages to meet the needs of our customers as defined through rigorous market research.
Typically, our sales teams, together with outside sales brokers, are responsible for guiding the customer through the sales process. We are committed to industry-leading customer service through a variety of quality initiatives, including our customer care program, which ensures that homeowners are comfortable at every stage of the building process. Using a seven-step, interactive process, homeowners are kept informed during their homebuilding and home owning experience. The steps include (1) a pre-construction meeting with the construction field manager; (2) pre-dry wall frame walk; (3) quality assurance inspection; (4) first homeowner orientation; (5) 30-day follow-up after the close of the home; (6) three-month follow-up after the close of the home; and (7) an 11-month quality list after the close of the home. Fully furnished and landscaped model homes are used to showcase our homes and their distinctive design features. Financing under United States government-insured and guaranteed programs is often used and is facilitated through our financial services operations.
Through our Del Webb brand, we are better able to address the needs of active adults, which is among the fastest growing homebuying segments. We offer both destination communities and in place communities, for those buyers who prefer to remain in their current geographic area. These highly amenitized communities offer a variety of features, including golf courses, recreational centers, and educational classes, to the over age fifty-five buyer to maintain an active lifestyle.
Through our portfolio of brands, each serving unique customer segments, we are able to provide a distinct experience to potential customers. We introduce our homes to prospective buyers through a variety of media advertising, illustrated brochures, Internet listings and link placements, mobile applications, and other advertising displays. In addition, our websites, www.pulte.com, www.delwebb.com, www.centex.com, and www.divosta.com provide tools to help users find a home that meets their needs, investigate financing alternatives, communicate moving plans, maintain a home, learn more about us, and communicate directly with us. Approximately 6.5 million potential customers visited our websites during 2010.
The construction process for our homes begins with the in-house design of the homes we sell. The building phase is conducted under the supervision of our on-site construction field managers. Substantially all of our construction work is performed by independent subcontractors under contracts that, in many instances, cover both labor and materials on a fixed-price basis. We believe that our subcontractors and material suppliers are an extension of our
Homebuilding Operations (continued)
production system and jointly focus on lean construction techniques to bring the highest value possible to our customers while maintaining strong trade relations. Using a selective process, we have teamed up with what we believe are premier subcontractors and suppliers to improve all aspects of the house construction process.
We maintain efficient construction operations by using standard materials and components from a variety of sources and utilizing standard construction practices. We continue to shift toward component off-site manufacturing methods for certain portions of the construction process to provide high efficiency, high quality, and lower cost products to our customers. To minimize the effects of changes in construction costs, the contracting and purchasing of building supplies and materials generally is negotiated at or near the time when related sales contracts are signed. In addition, we leverage our size by actively negotiating certain materials on a national or regional basis to minimize production component cost. We are also working to establish a more integrated system that can effectively link suppliers, contractors, and the production schedule through various strategic business partnerships and e-business initiatives.
We cannot determine the extent to which necessary building materials will be available at reasonable prices in the future. While the availability of materials and labor is not a significant concern under current market conditions, we have, on occasion, experienced shortages of skilled labor in certain trades and of building materials in some markets in previous years.
Competition, regulation, and other factors
Our dedication to customer satisfaction is evidenced by our consumer and value-based brand approach to product development and is something that we believe distinguishes us in the homebuilding industry and contributes to our long-term competitive advantage. The housing industry in the United States, however, is fragmented and highly competitive. In each of our local markets, there are numerous homebuilders with which we compete. We also compete with sales of existing house inventory. Any provider of housing units, for sale or to rent, including apartment operators, may be considered a competitor. Conversion of apartments to condominiums further provides certain segments of the population an alternative to traditional housing, as does manufactured housing. We compete primarily on the basis of location, price, reputation, design, community amenities, and the quality of our homes. The housing industry is affected by a number of economic and other factors including: (1) significant national and world events, which impact consumer confidence; (2) changes in the costs of building materials and labor; (3) changes in interest rates; (4) changes in other costs associated with home ownership, such as property taxes and energy costs; (5) the supply of new and existing housing, including foreclosures; (6) various demographic factors; (7) changes in federal income tax laws; (8) changes in government mortgage financing programs; and (9) availability of sufficient mortgage capacity. In addition to these factors, our business and operations could be affected by shifts in the overall demand for new homes.
Our homebuilding operating cycle historically reflected increased revenues and cash flow from operations during the fourth quarter based on the timing of home settlements. However, the challenging market conditions experienced since early 2006 have lessened the seasonal variations of our results. Given the current significant uncertainty in the homebuilding industry, we can make no assurances as to when and whether our historical seasonality will recur.
Our operations are subject to building, environmental, and other regulations of various federal, state, and local governing authorities. For our homes to qualify for Federal Housing Administration (FHA) or Veterans Administration (VA) mortgages, we must satisfy valuation standards and site, material, and construction requirements of those agencies. Our compliance with federal, state, and local laws relating to protection of the environment has had, to date, no material effect upon our capital expenditures, earnings, or competitive position. More stringent requirements could be imposed in the future on homebuilders and developers, thereby increasing the cost of compliance.
On December 1, 2009, the Environmental Protection Agency (EPA) promulgated new regulations regarding effluent limitation guidelines (ELG) for discharges from construction and development sites. The new rule requires all construction sites subject to National Pollutant Discharge Elimination System construction storm water permits issued by the EPA or an authorized state to implement certain sediment and erosion controls and pollution prevention measures. These rules also require sampling of storm water discharges and compliance with a numeric effluent
Homebuilding Operations (continued)
Competition, regulation, and other factors (continued)
limitation of 280 nephelometric turbidity units (NTUs) beginning August 1, 2011 for sites disturbing 20 or more acres at once and beginning February 2, 2014 for sites disturbing 10 or more acres at once. Effective January 4, 2011, the effluent limitation standard of 280 NTUs has been stayed by the EPA until it can complete a new rulemaking to correct the numeric limitation. The EPA currently plans to prepare a revision to the current numeric limit of 280 NTUs in early 2011 and to take final action in May 2011. The numeric limit is the only portion of the new rule that has been stayed by the EPA.
In addition to the new ELG rules, the EPA also announced that it is committed to and has begun a rulemaking to address post-construction storm water discharges from newly developed and redeveloped sites. This rulemaking is expected to be completed by November 2012. There can be no assurance whether the EPA will adopt final rules regarding post-construction storm water discharges, or, if it does, the form the final rules will take.
We are currently assessing the impact that the new ELG rules and potential post-construction rules will have on its business and results of operations.
Financial Services Operations
We conduct our financial services business, which includes mortgage and title operations, through Pulte Mortgage and other subsidiaries. Pulte Mortgage arranges financing through the origination of mortgage loans primarily for the benefit of our homebuyers. We also engage in the sale of such loans and the related servicing rights. We are a lender approved by the FHA and VA and are a seller/servicer approved by Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA), Federal Home Loan Mortgage Corporation (FHLMC), and other investors. In our conventional mortgage lending activities, we follow underwriting guidelines established by FNMA, FHLMC, and private investors. We believe that our customers use of our in-house mortgage and title operations provides us with a competitive advantage by enabling more control over the quality of the overall home buying process for our customers while also helping us align the timing of the house construction process with our customers financing needs.
We utilize a centralized fulfillment center to perform our mortgage underwriting, processing and closing functions and also use centralized loan consultants. We believe centralizing both the fulfillment and origination of our loans improves the speed, efficiency, consistency, and quality of our mortgage operations, improving our profitability and allowing us to focus on providing attractive mortgage financing opportunities for our customers. The majority of our customers now send us their data online to start the mortgage process. Once the completed online questionnaire is received, an interview is scheduled and the combination of the interview with the data sent online represents our mortgage application.
In originating mortgage loans, we initially use our own funds and borrowings made available to us through various credit arrangements. We subsequently sell such mortgage loans to outside investors. Substantially all of the loans we originate are sold in the secondary market within a short period of time after origination.
During 2010, 2009, and 2008, we originated mortgage loans for 63%, 70%, and 72%, respectively, of the homes we sold. Such originations represented substantially all of our total originations in each of those years as the primary purpose for our mortgage operations is to support our homebuilding business. Our capture rate, which we define as loan originations from our homebuilding business as a percentage of total loan opportunities from our homebuilding business excluding cash settlements, was 78% in 2010, while the capture rate was 85% in 2009 and 92% in 2008.
We sell our servicing rights monthly on a flow basis through fixed price servicing sales contracts to reduce the risks inherent in servicing loans. This strategy results in owning the servicing rights for only a short period of time. The servicing sales contracts provide for the reimbursement of payments made when loans prepay within specified periods of time, usually 90 to 120 days after sale.
The mortgage industry in the United States is highly competitive. We compete with other mortgage companies and financial institutions to provide attractive mortgage financing to our homebuyers. The Internet is also an important resource for homebuyers in obtaining financing as a number of competitors provide online approval for their customers.
Financial Services Operations (continued)
In originating and servicing mortgage loans, we are subject to rules and regulations of the FHA, VA, GNMA, FNMA, and FHLMC. In addition to being affected by changes in these programs, our mortgage banking business is also affected by many of the same factors that impact our homebuilding business.
Our mortgage operations are also subject to potential losses associated with mortgage loans originated and sold to investors that may result from borrower fraud, borrower early payment defaults, or loans that have not been underwritten in accordance with the investor guidelines. In the normal course of business, our mortgage operations also provide limited indemnities for certain loans sold to investors. Historically, losses related to these indemnities were not significant. Beginning in 2009, we experienced a significant increase in anticipated losses as a result of the high level of loan defaults and related losses in the mortgage industry and increasing aggressiveness by investors in presenting such claims to us. The vast majority of these losses relate to loans originated in 2006 and 2007 when industry lending standards were less stringent and borrower fraud is believed to have peaked.
Our subsidiary title insurance companies serve as title insurance agents in select markets by providing title insurance policies and examination and closing services to buyers of homes we sell. We have only limited risk associated with our title operations due to the low incidence of claims related to underwriting risk associated with issued title insurance policies and fiduciary risk resulting from closing services.
Financial Information About Geographic Areas
Substantially all of our operations are located within the United States. However, we have some non-operating foreign subsidiaries and affiliates, which are insignificant to our consolidated financial results.
Other Non-Operating Expenses
Other non-operating expenses consist of income and expenses related to corporate services provided to our subsidiaries. These expenses are incurred for financing, developing, and implementing strategic initiatives centered on new business development and operating efficiencies, and providing the necessary administrative support associated with being a publicly traded entity listed on the New York Stock Exchange. Accordingly, these results will vary from year to year as these strategic initiatives evolve.
All subsidiaries and operating units operate independently with respect to daily operations. Homebuilding real estate purchases and other significant homebuilding, mortgage banking, financing activities, and similar operating decisions must be approved by the business units management and/or corporate senior management.
At December 31, 2010, we employed 4,363 people, of which 630 people were employed in our Financial Services operations. Except for a small group of employees in our St. Louis homebuilding division, our employees are not represented by any union. Contracted work, however, may be performed by union contractors. Our local and corporate management personnel are paid incentive compensation based on a combination of individual performance and the performance of the applicable business unit or the Company. Each business unit is given a level of autonomy regarding employment of personnel, although our senior corporate management acts in an advisory capacity in the employment of subsidiary officers. We consider our employee and contractor relations to be satisfactory.
ITEM 1A. RISK FACTORS
Discussion of our business and operations included in this annual report on Form 10-K should be read together with the risk factors set forth below. They describe various risks and uncertainties to which we are, or may become, subject. These risks and uncertainties, together with other factors described elsewhere in this report, have the potential to affect our business, financial condition, results of operations, cash flows, strategies, or prospects in a material and adverse manner.
Downward changes in general economic, real estate construction, or other business conditions could adversely affect our business or our financial results.
The residential homebuilding industry is sensitive to changes in economic conditions and other factors, such as the level of employment, consumer confidence, consumer income, availability of financing, and interest rate levels. Adverse changes in any of these conditions generally, or in the markets where we operate, could decrease demand and pricing for new homes in these areas or result in customer cancellations of pending contracts, which could adversely affect the number of home deliveries we make or reduce the prices we can charge for homes, either of which could result in a decrease in our revenues and earnings and would adversely affect our financial condition.
The homebuilding industry is currently experiencing an economic down cycle, which has had an adverse effect on our business and results of operations.
Prior to 2006, land and home prices rose significantly in many of our markets. However, since early 2006, the homebuilding industry has been impacted by weak consumer confidence, tightened mortgage standards, a significant increase in the number of foreclosed homes, and large supplies of resale and new home inventories which have contributed to an industry-wide softening of demand for new homes. As a result of these factors, we have experienced significant decreases in our revenues and profitability. We have also incurred substantial impairments of our land and certain other assets. We cannot predict the duration or the severity of the current market conditions, nor provide any assurances that the adjustments we have made in our operating strategy to address these conditions will be successful.
If the market value of our land and homes drops significantly, our profits could decrease.
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. We acquire land for expansion into new markets and for replacement of land inventory and expansion within our current markets. If housing demand decreases below what we anticipated when we acquired our inventory, we may not be able to make profits similar to what we have made in the past, we may experience less than anticipated profits, and/or we may not be able to recover our costs when we sell and build homes. When market conditions are such that land values are not appreciating, option arrangements previously entered into may become less desirable, at which time we may elect to forego deposits and pre-acquisition costs and terminate the agreement. In the face of adverse market conditions, we may have substantial inventory carrying costs, we may have to write down our inventory to its fair value, and/or we may have to sell land or homes at a loss.
As a result of the changing market conditions in the homebuilding industry that have occurred since early 2006, we incurred significant land-related charges in each of the respective periods resulting from the write-off of deposits and pre-acquisition costs related to land transactions we no longer plan to pursue, net realizable valuation adjustments related to land positions sold or held for sale, impairments on land assets related to communities under development or to be developed in the future, and impairments of our investments in unconsolidated joint ventures. It is possible that the estimated cash flows from these projects may change and could result in a future need to record additional valuation adjustments. Additionally, if conditions in the homebuilding industry worsen in the future or if our strategy related to certain communities changes, we may be required to evaluate our assets, including additional projects, for additional impairments or write-downs, which could result in additional charges that might be significant.
Our success depends on our ability to acquire land suitable for residential homebuilding at reasonable prices, in accordance with our land investment criteria.
The homebuilding industry is highly competitive for suitable land. The availability of finished and partially finished developed lots and undeveloped land for purchase that meet our internal criteria depends on a number of factors outside our control, including land availability in general, competition with other homebuilders and land buyers
Our success depends on our ability to acquire land suitable for residential homebuilding at reasonable prices, in accordance with our land investment criteria. (continued)
for desirable property, inflation in land prices, zoning, allowable housing density, and other regulatory requirements. Should suitable lots or land become less available, the number of homes we may be able to build and sell could be reduced, and the cost of land could be increased, perhaps substantially, which could adversely impact our results of operations.
Our long-term ability to build homes depends on our acquiring land suitable for residential building at reasonable prices in locations where we want to build. In the past, we experienced significant competition for suitable land as a result of land constraints in many of our markets. As competition for suitable land increases, and as available land is developed, the cost of acquiring suitable remaining land could rise, and the availability of suitable land at acceptable prices may decline. Any land shortages or any decrease in the supply of suitable land at reasonable prices could limit our ability to develop new communities or result in increased land costs. We may not be able to pass through to our customers any increased land costs, which could adversely impact our revenues, earnings, and margins.
Future increases in interest rates, reductions in mortgage availability, or increases in the effective costs of owning a home could prevent potential customers from buying our homes and adversely affect our business and financial results.
Most of our customers finance their home purchases through our mortgage bank. Interest rates have been at historical lows for several years. As a result, new homes have been more affordable. Increases in interest rates or decreases in availability of mortgage financing, however, could reduce the market for new homes. Potential homebuyers may be less willing or able to pay the increased monthly costs or to obtain mortgage financing that exposes them to interest rate changes. Lenders may increase the qualifications needed for mortgages or adjust their terms to address any increased credit risk. Even if potential customers do not need financing, changes in interest rates and mortgage availability could make it harder for them to sell their current homes to potential buyers who need financing. These factors could adversely affect the sales or pricing of our homes and could also reduce the volume or margins in our financial services business. Beginning in early 2007, the availability of certain mortgage financing products became more constrained as the mortgage industry began to more closely scrutinize sub-prime, Alt-A, and other non-conforming mortgage products. Our financial services business could also be impacted to the extent we are unable to match interest rates and amounts on loans we have committed to originate through the various hedging strategies we employ. Additionally, these developments have had, and may continue to have, a material adverse effect on the overall demand for new housing and thereby on the results of operations for our homebuilding business.
In addition, the Federal Reserve has purchased a sizeable amount of mortgage-backed securities in part to stabilize mortgage interest rates and to support the market for mortgage-backed securities. As the Federal Reserve reduces its holdings of mortgage-backed securities over time, the availability and affordability of mortgage loans, including the consumer interest rates for such loans, could be adversely affected.
We also believe that the availability of FHA and VA mortgage financing is an important factor in marketing some of our homes. The FHA has and may continue to impose stricter loan qualification standards, raise minimum down payment requirements, impose higher mortgage insurance premiums and other costs and/or limit the number of mortgages it insures. The liquidity provided by Fannie Mae and Freddie Mac to the mortgage industry is also critical to the housing market. The impact of the federal governments conservatorship of Fannie Mae and Freddie Mac on the short-term and long-term demand for new housing remains unclear. Any limitations or restrictions on the availability of financing by these agencies could adversely affect interest rates, mortgage financing, and our sales of new homes and mortgage loans.
Significant costs of homeownership include mortgage interest expense and real estate taxes, both of which are generally deductible for an individuals federal and, in some cases, state income taxes. Any changes to income tax laws by the federal government or a state government to eliminate or substantially reduce these income tax deductions, as has been considered from time to time, would increase the after-tax cost of owning a home. Increases in real estate taxes by local governmental authorities also increase the cost of homeownership. Any such increases to the cost of homeownership could adversely impact the demand for and sales prices of new homes.
Adverse capital and credit market conditions may significantly affect our access to capital and cost of capital.
The capital and credit markets have experienced significant volatility in recent years. In many cases, the markets have exerted downward pressure on the availability of liquidity and credit capacity for issuers. We need liquidity for future growth and development of our business. Without sufficient liquidity, we may not be able to purchase additional land or develop land, which could adversely affect our financial results. One source of liquidity is our unsecured revolving credit facility. In the event the current challenging market conditions persist or we incur additional land-related charges or other asset impairments, we may violate certain financial covenants in the credit facility. These violations, if not waived by the lenders or cured, could result in an optional maturity date acceleration by the lenders, which might require repayment of any borrowings and replacement or cash collateralization of any letters of credit outstanding under the credit facility, and could also result in a default under our $3.4 billion of senior notes.
The ability to reach an agreement with our lenders or to seek alternative sources of financing, if necessary, would depend on a variety of factors such as market conditions, the general availability of credit, the overall availability of credit to the homebuilding industry, our credit ratings and credit capacity, as well as the possibility that lenders could develop a negative perception of our long- or short-term financial prospects if the level of our business activity decreases further due to the market downturn. At December 31, 2010, we had cash and equivalents of $1.5 billion and no borrowings outstanding under our unsecured revolving credit facility. However, our internal sources of liquidity may prove to be insufficient, and in such case, we may not be able to successfully obtain additional financing on terms acceptable to us, or at all.
Another source of liquidity includes our ability to use letters of credit and surety bonds pursuant to certain performance-related obligations and as security for certain land option agreements and under various insurance programs. The majority of these letters of credit and surety bonds are in support of our land development and construction obligations to various municipalities, other government agencies, and utility companies related to the construction of roads, sewers, and other infrastructure. If we are unable to obtain letters of credit or performance bonds when required, or the conditions imposed by issuers increase significantly, our financial condition and results of operations could be adversely affected.
Competition for homebuyers could reduce our deliveries or decrease our profitability.
The housing industry in the United States is highly competitive. We compete primarily on the basis of location, price, reputation, design, community amenities, and the quality of our homes. We compete in each of our markets with numerous national, regional, and local homebuilders. This competition with other homebuilders could reduce the number of homes we deliver or cause us to accept reduced margins in order to maintain sales volume.
We also compete with resales of existing or foreclosed homes, housing speculators, and available rental housing. Increased competitive conditions in the residential resale or rental market in the regions where we operate could decrease demand for new homes and increase cancellations of sales contracts in backlog.
Supply shortages and other risks related to the demand for skilled labor and building materials could increase costs and delay deliveries.
The homebuilding industry is highly competitive for skilled labor and materials. Additionally, the cost of certain building materials, especially lumber, steel, and concrete, is influenced by changes in global commodity prices. Increased costs or shortages of skilled labor and/or materials could cause increases in construction costs and construction delays. We generally are unable to pass on increases in construction costs to those customers who have already entered into sale contracts as those sales contracts generally fix the price of the home at the time the contract is signed, which may be well in advance of the construction of the home. Sustained increases in construction costs may, over time, erode our margins, and pricing competition for materials and labor may restrict our ability to pass on any additional costs, thereby decreasing our margins.
Our income tax provision and tax reserves may be insufficient if a taxing authority is successful in asserting positions that are contrary to our interpretations and related reserves, if any.
Significant judgment is required in determining our provision for income taxes and our reserves for federal, state, and local taxes. In the ordinary course of business, there may be matters for which the ultimate outcome is uncertain. Our evaluation is based on a number of factors, including changes in facts or circumstances, changes in tax law,
Our income tax provision and tax reserves may be insufficient if a taxing authority is successful in asserting positions that are contrary to our interpretations and related reserves, if any. (continued)
correspondence with tax authorities during the course of audits, and effective settlement of audit issues. Although we believe our approach to determining the tax treatment is appropriate, no assurance can be given that the final tax authority review will not be materially different than that which is reflected in our income tax provision and related tax reserves. Such differences could have a material adverse effect on our income tax provision in the period in which such determination is made and, consequently, on our net income for such period.
We are periodically audited by various federal, state, and local authorities regarding tax matters. Our current audits are in various stages of completion; however, no outcome for a particular audit can be determined with certainty prior to the conclusion of the audit, appeal and, in some cases, litigation process. As each audit is concluded, adjustments, if any, are appropriately recorded in our financial statements in the period determined. To provide for potential tax exposures, we maintain tax reserves based on reasonable estimates of potential audit results. However, if the reserves are insufficient upon completion of an audit, there could be an adverse impact on our financial position and results of operations.
We may not realize our deferred income tax assets.
The ultimate realization of our deferred income tax assets is dependent upon generating future taxable income, executing tax planning strategies, and reversals of existing taxable temporary differences. We have recorded valuation allowances against our deferred income tax assets. The valuation allowance will fluctuate as conditions change.
Our ability to utilize net operating losses (NOLs), built-in losses (BILs), and tax credit carryforwards to offset our future taxable income and/or to recover previously paid taxes would be limited if we were to undergo an ownership change within the meaning of Section 382 of the Internal Revenue Code (the IRC). In general, an ownership change occurs whenever the percentage of the stock of a corporation owned by 5-percent shareholders (within the meaning of Section 382 of the IRC) increases by more than 50 percentage points over the lowest percentage of the stock of such corporation owned by such 5-percent shareholders at any time over the testing period.
An ownership change under Section 382 of the IRC would establish an annual limitation to the amount of NOLs, BILs, and tax credit carryforwards we could utilize to offset our taxable income in any single year. The application of these limitations might prevent full utilization of the deferred tax assets attributable to our NOLs, BILs, and tax credit carryforwards. We have not experienced an ownership change as defined by Section 382. To preserve our ability to utilize NOLs, BILs, and other tax benefits in the future without a Section 382 limitation, we adopted a shareholder rights plan, which is triggered upon certain transfers of our securities, and amended our by-laws to prohibit certain transfers of our securities. Notwithstanding the foregoing measures, there can be no assurance that we will not undergo an ownership change within the meaning of Section 382.
As a result of the merger with Centex, our ability to use certain of Centexs pre-ownership change NOLs, BILs, or deductions is limited under Section 382 of the Internal Revenue Code. The applicable Section 382 limitation is approximately $68 million per year for NOLs, losses realized on built-in loss assets that are sold within 60 months of the ownership change, and certain deductions. The limitation may result in a significant portion of Centexs pre-ownership change NOLs, BILs, and tax credit carryforwards or deductions not being available for our use.
We have significant goodwill and intangible assets. If the goodwill becomes impaired, then our profits may be significantly reduced or eliminated and shareholders equity may be reduced.
We have recorded significant goodwill and intangible assets related to prior business combinations. We evaluate the recoverability of goodwill and intangible assets whenever facts and circumstances indicate the carrying amount may not be recoverable. We also perform our annual impairment testing of goodwill in the fourth quarter of each year. If the carrying value of goodwill or intangible assets is deemed impaired, the carrying value is written down to fair value. This would result in a charge to our operating earnings. We recorded goodwill impairments of $656.3 million, $563.0 million, and $5.7 million in 2010, 2009, and 2008, respectively, and have $240.5 million and $175.4 million of goodwill and intangible assets, respectively, remaining at December 31, 2010. If managements expectations of future results and cash flows decrease significantly, additional impairments of either goodwill or intangible assets may occur.
Government regulations could increase the cost and limit the availability of our development and homebuilding projects or affect our related financial services operations and adversely affect our business or financial results.
Our operations are subject to building, environmental, and other regulations of various federal, state, and local governing authorities. For our homes to qualify for FHA or VA mortgages, we must satisfy valuation standards and site, material, and construction requirements of those agencies. Our compliance with federal, state, and local laws relating to protection of the environment has had, to date, no material effect upon capital expenditures, earnings, or competitive position. More stringent requirements could be imposed in the future on homebuilders and developers, thereby increasing the cost of compliance.
New housing developments may be subject to various assessments for schools, parks, streets, and other public improvements. These can cause an increase in the effective prices for our homes. In addition, increases in property tax rates by local governmental authorities, as recently experienced in response to reduced federal and state funding, can adversely affect the ability of potential customers to obtain financing or their desire to purchase new homes.
We also are subject to a variety of local, state, and federal laws and regulations concerning protection of health, safety, and the environment. The impact of environmental laws varies depending upon the prior uses of the building site or adjoining properties and may be greater in areas with less supply where undeveloped land or desirable alternatives are less available. These matters may result in delays, may cause us to incur substantial compliance, remediation and other costs, and can prohibit or severely restrict development and homebuilding activity in environmentally sensitive regions or areas.
Our financial services operations are also subject to numerous federal, state, and local laws and regulations. These include eligibility requirements for participation in federal loan programs and compliance with consumer lending and similar requirements such as disclosure requirements, prohibitions against discrimination, and real estate settlement procedures. They may also subject our operations to examination by applicable agencies. These may limit our ability to provide mortgage financing or title services to potential purchasers of our homes.
We are subject to claims related to mortgage loans we sold in the secondary mortgage market that may be significant.
Our mortgage operations have made certain representations and warranties related to mortgage loans sold in the secondary mortgage market that the loans sold meet certain requirements, including representations as to underwriting standards, the type of collateral, the existence of primary mortgage insurance and the validity of certain borrower representations in connection with the loan. Our mortgage operations may be, and have been, required to repurchase loans and/or indemnify the investors that purchased the loans for losses due to material breaches of these representations and warranties. In addition, we entered into an agreement in conjunction with the wind down of Centexs mortgage operations, which originated its last loan in December 2009, that provides a guaranty for one major investor in loans originated by Centexs mortgage operations. This guaranty provides that we will honor the potential repurchase obligations of Centexs mortgage operations related to breaches of similar representations in the origination of a certain pool of loans.
The repurchase liability we recorded is estimated based on several factors, including the level of current and estimated probable future repurchase demands made by investors, our ability to cure the defects identified in the repurchase demands, and the severity of loss upon repurchase. While we believe that our current repurchase liability reserves are adequate, the factors referred to above, upon which we estimate our repurchase liability, are subject to change in light of market developments, the economic environment and other circumstances, some of which are beyond our control. Accordingly, there can be no assurance that such reserves will not need to be increased in the future.
Homebuilding is subject to warranty and other claims in the ordinary course of business that can be significant.
As a homebuilder, we are subject to home warranty, construction defect, and other claims arising in the ordinary course of business. We record warranty and other reserves for the homes we sell based on historical experience in our markets and our judgment of the qualitative risks associated with the types of homes built. We have, and require the majority of our subcontractors to have, general liability, property, errors and omissions, workers compensation, and other business insurance. These insurance policies protect us against a portion of our risk of loss from claims, subject to certain self-insured per occurrence and aggregate retentions, deductibles, and available policy limits. Through our
Homebuilding is subject to warranty and other claims in the ordinary course of business that can be
captive insurance subsidiaries, we reserve for costs to cover our self-insured and deductible amounts under these policies and for any costs of claims and lawsuits, based on an analysis of our historical claims, which includes an estimate of claims incurred but not yet reported. Because of the uncertainties inherent in these matters, we cannot provide assurance that our insurance coverage, our subcontractor arrangements, and our reserves will be adequate to address all our warranty and construction defect claims in the future. Contractual indemnities can be difficult to enforce, we may be responsible for applicable self-insured retentions, and some types of claims may not be covered by insurance or may exceed applicable coverage limits. Additionally, the coverage offered by and the availability of general liability insurance for construction defects are currently costly and limited. We have responded to the recent increases in insurance costs and coverage limitations by increasing our self-insured retentions and claim reserves. There can be no assurance that coverage will not be further restricted and become more costly. Additionally, we are exposed to counterparty default risk related to our and our subcontractors insurance carriers. We seek to manage such risk by maintaining our policies with highly-rated carriers.
Natural disasters and severe weather conditions could delay deliveries, increase costs, and decrease demand for new homes in affected areas.
Our homebuilding operations are located in many areas that are subject to natural disasters and severe weather. The occurrence of natural disasters or severe weather conditions can delay new home deliveries, increase costs by damaging inventories, reduce the availability of materials, and negatively impact the demand for new homes in affected areas. Furthermore, if our insurance does not fully cover business interruptions or losses resulting from these events, our earnings, liquidity, or capital resources could be adversely affected.
Inflation may result in increased costs that we may not be able to recoup if demand declines.
Inflation can have a long-term impact on us because increasing costs of land, materials, and labor may require us to increase the sales prices of homes in order to maintain satisfactory margins. In addition, inflation is often accompanied by higher interest rates, which have a negative impact on housing demand, in which case we may not be able to raise home prices sufficiently to keep up with the rate of inflation and our margins could decrease.
Future terrorist attacks against the United States or increased domestic and international instability could have an adverse effect on our operations.
A future terrorist attack against the United States could cause a sharp decrease in the number of new contracts signed for homes and an increase in the cancellation of existing contracts. Accordingly, adverse developments in the war on terrorism, future terrorist attacks against the United States, or increased domestic and international instability could adversely affect our business.
This Item is not applicable.
ITEM 2. PROPERTIES
Our homebuilding and corporate headquarters are located in leased office facilities at 100 Bloomfield Hills Parkway, Bloomfield Hills, Michigan 48304. Pulte Mortgage leases its primary office facilities in Englewood, Colorado, and we also maintain various support functions in leased facilities near Phoenix, Arizona. Our homebuilding divisions and financial services branches lease office space in the geographic locations in which they conduct their day-to-day operations.
Because of the nature of our homebuilding operations, significant amounts of property are held as inventory in the ordinary course. Such properties are not included in response to this Item.
ITEM 3. LEGAL PROCEEDINGS
We are involved in various legal and governmental proceedings incidental to our continuing business operations, many involving claims related to certain construction defects. The consequences of these matters are not presently determinable but, in our opinion, after consulting with legal counsel and taking into account insurance and reserves, the ultimate liability is not expected to have a material adverse impact on our results of operations, financial position, or cash flows. However, to the extent the liability arising from the ultimate resolution of any matter exceeds our estimates reflected in the recorded reserves relating to such matter, we could incur additional charges that could be significant.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
Set forth below is certain information with respect to our executive officers.
The following is a brief account of the business experience of each officer during the past five years:
Mr. Dugas was appointed Chairman in August 2009 and President and Chief Executive Officer in July 2003. Prior to that time, he served as Executive Vice President and Chief Operating Officer. He was appointed Chief Operating Officer in May 2002 and Executive Vice President in December 2002. Since joining our company in 1994, he has served in a variety of management positions.
Mr. Cregg was appointed Executive Vice President in May 2003 and was named Chief Financial Officer effective January 1998.
Mr. Ellinghausen was appointed Executive Vice President, Human Resources in December 2006 and previously held the position of Senior Vice President, Human Resources since April 2005.
Ms. Meyer was appointed Senior Vice President and Chief Marketing Officer in September 2009. Prior to joining our company, Ms. Meyer held various senior marketing positions, most recently serving as Vice President and Chief Marketing Officer for Chrysler, LLC. Prior to joining Chrysler, LLC, Ms. Meyer held various marketing positions at Toyota Motor Sales from 2001 to 2007, most recently as Vice President of Marketing for Lexus.
Mr. Cook was appointed Senior Vice President, General Counsel and Secretary in December 2008 and previously held the position of Vice President, General Counsel and Secretary since February 2006. Prior to joining our company, Mr. Cook most recently held the position of Vice President and Deputy General Counsel, Corporate, at Sears Holdings Corporation and was employed by Sears, Roebuck and Co. since 1996.
Mr. Schweninger was appointed Vice President and Controller effective March 2009. Since joining our company in 2005, he held the positions of Director Finance & Accounting Process Improvement and Director of Corporate Audit.
There is no family relationship between any of the officers. Each officer serves at the pleasure of the Board of Directors.
Our common shares are listed on the New York Stock Exchange (Symbol: PHM).
Related Stockholder Matters
The table below sets forth, for the quarterly periods indicated, the range of high and low closing prices and cash dividends declared per share.
At February 1, 2011, there were 3,195 shareholders of record.
On November 24, 2008, our Board of Directors discontinued the regular quarterly dividend on the Companys common stock effective in the first quarter of 2009.
Issuer Purchases of Equity Securities (1)
The information required by this item with respect to equity compensation plans is set forth under Item 12 of this annual report on Form 10-K and is incorporated herein by reference.
The following line graph compares for the fiscal years ended December 31, 2006, 2007, 2008, 2009 and 2010 (a) the yearly cumulative total shareholder return (i.e., the change in share price plus the cumulative amount of dividends, assuming dividend reinvestment, divided by the initial share price, expressed as a percentage) on PulteGroups common shares, with (b) the cumulative total return of the Standard & Poors 500 Stock Index, with (c) the cumulative total return on the common stock of publicly traded peer issuers we deem to be our principal competitors in the homebuilding line of business (assuming dividend reinvestment and weighted based on market capitalization at the beginning of each year), and with (d) the Dow Jones U.S. Select Home Construction Index. Beginning in 2010, we have included the Dow Jones U.S. Select Home Construction Index, which will replace our PEER Only comparison effective in 2011. The Dow Jones U.S. Select Home Construction Index is a widely-recognized index comprised primarily of large national homebuilders. We believe comparison of our shareholder return to this index represents a more meaningful analysis for investors.
COMPARISON OF FIVE YEAR CUMULATIVE TOTAL RETURN*
AMONG PULTEGROUP, INC., S&P 500 INDEX, AND PEER INDEX
Fiscal Year Ended December 31, 2010
Assumes Initial Investment of $100
ITEM 6. SELECTED FINANCIAL DATA
Set forth below is selected consolidated financial data for each of the past five fiscal years. The selected financial data should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations and our Consolidated Financial Statements and Notes thereto included elsewhere in this report.
ITEM 6. SELECTED FINANCIAL DATA (continued)
On August 18, 2009, we completed the acquisition of Centex through the merger of PulteGroups merger subsidiary with and into Centex pursuant to the Agreement and Plan of Merger dated as of April 7, 2009 among PulteGroup, Pi Nevada Building Company, and Centex. As a result of the merger, Centex became a wholly-owned subsidiary of PulteGroup. Accordingly, the results of Centex are included in our consolidated financial statements from the date of the merger.
Since early 2006, the U.S. housing market has been unfavorably impacted by weak consumer confidence, tightened mortgage standards, and large supplies of resale and new home inventories and related pricing pressures, among other factors. When combined with the significant foreclosure activity, a more challenging appraisal environment, higher than normal unemployment levels, and uncertainty in the U.S. economy in recent periods, these conditions have contributed to sharply weakened demand for new homes, slower sales, and heightened pricing pressures to attract homebuyers. As a result, we have experienced a pre-tax loss in each quarter since the fourth quarter of 2006. Such losses resulted from a combination of reduced operational profitability and significant asset impairments. Since the beginning of 2006, we have incurred total land-related charges of $5.5 billion and goodwill impairments of $1.6 billion.
The U.S. housing market and broader economy remain in a period of uncertainty; however, we are beginning to see signs of stabilization in certain of our local markets, though at near historically low levels. This more stable environment resulted in a significant reduction in the level of land-related charges recorded during 2010 compared with recent years. We believe our strategic merger with Centex positions us well for a recovery in the homebuilding industry. However, significant short-term uncertainty remains. The expiration of the federal homebuyer tax credit associated with the Worker, Homeownership, and Business Assistance Act of 2009 (the Act), which was applicable to orders under contract by April 30 and closed by September 30, 2010, favorably impacted our revenues for the first half of 2010 but also contributed to industry-wide softness in new orders in the latter half of 2010.
Entering 2011, there are indications that certain of the aforementioned negative trends may be slowing or improving. However, there are also a number of factors that may further worsen market conditions or delay a recovery in the homebuilding industry. Such factors include:
Accordingly, we continue to operate our business with the expectation that difficult market conditions will continue to impact us for at least the near term. While we are purchasing select land positions where it makes strategic and economic sense to do so, our targeted profile for such investments consists of developed lots, frequently under rolling lot option contracts, that are cash flow positive early in the project cycle and accretive to earnings. We also continue to evaluate each existing land parcel to determine whether the strategy and economics support holding the
parcel or disposing of it. We have closely evaluated and made significant reductions in employee headcount and overhead expenses since the beginning of the industry downturn and in conjunction with the Centex merger. Due to the persistence of these difficult market conditions, improving the efficiency of our overhead costs will continue to be a significant area of focus. We are also adjusting the content in our homes to provide our customers more affordable alternatives, including building homes with smaller floor plans in certain of our communities.
As a result of the Centex merger, we have achieved significant savings in corporate and divisional overhead costs and interest costs for the combined entity. We have also achieved synergies in our purchasing leverage and integrating the combined organizations operational best practices. The Centex merger has contributed to growth through expanded geographic and customer segment diversity and the ability to leverage additional brands. We believe that the combination of our operational improvement activities with the benefits of the Centex merger will help strengthen our market position and allow us to take advantage of opportunities that may develop in the future.
While signs of improvement for the overall U.S. economy, employment, and consumer confidence provide reasons for some level of optimism, our outlook is tempered for 2011 as the timing of a sustainable recovery in the homebuilding industry remains uncertain. If the negative trends in economic conditions or financial market volatility experienced in recent years return either nationally or to any of our local markets, it could adversely affect our business and results of operations in future periods, including a further reduction in the demand for housing as well as difficulties in accessing financing on acceptable terms. Given these conditions and the continued weakness in new home sales, visibility as to future earnings performance is limited. Our evaluation for land-related charges recorded to date assumed our best estimates of cash flows for the communities tested. If conditions in the homebuilding industry or our local markets worsen in the future, or if our strategy related to certain communities changes, we may be required to evaluate our assets, including additional projects, for further impairments or write-downs, which could result in future charges that might be significant.
The following is a summary of our operating results for 2010, 2009 and 2008 ($000s omitted, except per share data):
For additional information on each of the above, see the applicable Notes to the Consolidated Financial Statements. Merger-related costs relates to transaction and integration costs directly related to the Centex merger. In total, Homebuilding incurred $123.7 million of such costs in 2009. These costs consisted of $57.0 million of restructuring costs (primarily severance and lease exit costs) included in the above table within restructuring costs plus $66.6 million of investment banking and other professional fees, amortization of certain fair value adjustments, and certain other integration costs.
In addition to the above charges, Homebuilding continued to experience declining revenues (after adjusting for the incremental revenue resulting from the Centex merger) and challenged gross margins.
The above operating results for Centexs Homebuilding operations included the aforementioned goodwill impairment charges of $563.0 million and the majority of the merger-related transaction and integration costs.
The following is a summary of loss before income taxes for our Homebuilding operations ($000s omitted):
As indicated above, the Centex merger had a significant impact on the operating results for 2010 and 2009. Excluding the impact of the Centex merger, our revenues, unit settlements, and net new orders in both 2010 and 2009 would have experienced significant decreases from the respective prior year periods. Our reported home sale revenues, unit settlements, and net new orders for 2010 as reflected in the above tables represent decreases of 19%, 22%, and 28%, respectively, from the combined operating results of the two companies from 2009. However, these lower volumes were offset by lower land-related charges, improved gross margins and operating leverage, and removal of the substantial majority of duplicative overhead costs from the combined companies. Excluding the impact of the goodwill impairments and insurance-related losses recorded in 2010 and 2009, our Homebuilding loss before income taxes in 2010 was significantly improved from the losses reported by either company or the combined companies in the prior year periods. This illustrates the impact of the various actions we have taken to restructure our combined homebuilding operations into a more efficient organization as well as the more stable environment that we believe the homebuilding industry has entered.
Homebuilding Operations (continued)
Home sale revenues for 2010, which include $1.9 billion related to Centex, were higher than 2009 by $550.5 million, or 14%. In 2009, home sale revenues, which included $1.1 billion related to Centex, were lower than those for 2008 by $2.2 billion, or 35%. The increase in home sale revenues in 2010 over 2009 was mainly attributable to increased unit settlements of 14% as average selling price remained stable from 2009 to 2010. The decrease in home sale revenues in 2009 from 2008 was attributable to a decrease in unit settlements of 29% combined with a decrease in the average selling price of 9%. The lower average selling price in 2010 and 2009 compared with 2008 resulted from a combination of pricing pressures due to challenging industry conditions and a shift in the product and geographic mix of homes closed during the periods, including an increased concentration in the first-time buyer segment resulting from the Centex merger along with adjusting the product offering in certain communities to better align with current market conditions.
Homebuilding gross profit margins from home sales in 2010 were 9.4%, compared with negative 10.5% in 2009 and negative 10.1% in 2008. The improvement in our gross margin is largely due to the significant decrease in land and community valuation adjustments to $169.7 million in 2010, compared with $751.2 million in 2009 and $1.2 billion in 2008. Gross profit margins were also adversely impacted in 2009 by the fair value adjustment related to homes under construction inventory acquired with the Centex merger. We recognized this fair value adjustment as an increase of $31.1 million to home cost of revenues as the related homes closed. Home sale gross profit margins, excluding land and community valuation adjustments, amortization of capitalized interest, and merger-related costs, were 16.7% in 2010 compared to 12.3% in 2009 and 12.2% in 2008. The increase in gross margin reflects a combination of factors, including shifts in the product and geographic mix of homes closed during the year, better alignment of our product offering with current market conditions, and our various initiatives to reduce the construction cost of our homes. (See the Non-GAAP Financial Measure section for reconciliation of home sale gross profit margins, excluding land and community valuation adjustments, amortization of capitalized interest, and merger-related costs, to home sale gross profit margins).
We continue to evaluate our existing land positions to ensure the most effective use of capital. Land sale revenues and their related gains or losses may vary significantly between periods, depending on the timing of land sales. Land sales had a negative margin contribution of $25.7 million for 2010 and negative margin contributions of $113.9 million and $262.2 million for 2009 and 2008, respectively. These margin contributions in 2010, 2009, and 2008 included net realizable value adjustments totaling $39.1 million, $113.7 million, and $271.1 million, respectively, related to land held for sale.
Selling, general, and administrative expenses, as a percentage of home sale revenues, were 19.4% in 2010 compared with 16.3% in 2009 and 13.0% in 2008. This increase was largely the result of $280.4 million in insurance-related charges taken during 2010, substantially all of which related to general liability construction defect claims. Inclusive of this charge, insurance-related expenses totaled $313.6 million, $34.9 million, and $103.5 million in 2010, 2009, and 2008, respectively. Excluding the charge recorded in 2010, insurance-related expenses decreased in 2010 and 2009 from 2008 primarily as the result of lower revenues. We also experienced some adverse development in our projected general liability claims during 2008 that contributed to that years expense. Excluding such charges, our selling, general, and administrative expense both in dollars and as a percentage of home sale revenues decreased significantly from 2009. Homebuilding selling, general, and administrative expense also included severance costs of $22.3 million in 2010. During 2009, Homebuilding selling, general, and administrative expense included transaction and integration costs related to the Centex merger, including employee severance costs, totaling $65.0 million, as well as certain duplicative corporate and divisional overhead costs during the transition period following the merger. Employee severance costs recorded to Homebuilding selling, general, and administrative expense during 2008 totaled $28.1 million. Overall, we have achieved significant reductions in overhead costs since the Centex merger. However, our overhead leverage remains high relative to our sales volumes, so achieving a more efficient overhead structure remains an area of focus. In order to further reduce overhead cost and drive greater leverage, we reconfigured our organization during the fourth quarter of 2010, reducing the number of operating areas from six to four and consolidating certain divisions. Along with these changes in our field operations, we also further reduced corporate and support staffing across a number of functions to further consolidate and streamline our operating processes. We expect that these changes in our operating structure along with the completion of our integration activities related to the Centex merger will significantly reduce our selling, general, and administrative costs in 2011.
Equity in earnings (loss) of unconsolidated entities was $2.8 million, $(49.7) million, and $(12.9) million for 2010, 2009, and 2008, respectively. The primary cause for this change in results is the lower levels of impairments related to these entities in 2010 and 2008 compared with 2009. The majority of our unconsolidated entities represent land development joint ventures, so the timing of income and losses can vary significantly between periods depending on the timing of transactions and circumstances specific to each entity.
Homebuilding Operations (continued)
Other income (expense), net includes the write-off of deposits and pre-acquisition costs resulting from decisions not to pursue certain land acquisitions which totaled $5.6 million, $54.3 million, and $33.3 million in 2010, 2009, and 2008, respectively. These write-offs vary in amount from year to year as we continue to evaluate potential land acquisitions for the most effective use of capital. Other income (expense), net also includes lease exit costs and asset impairments related to overhead reduction efforts totaling $28.4 million in 2010 and $13.3 million in 2008. In 2009, other income (expense) included certain integration costs, including lease exit costs, directly related to the Centex merger totaling $27.5 million.
Other income (expense), net also includes goodwill impairment charges of $656.3 million, $563.0 million, and $5.0 million in 2010, 2009, and 2008, respectively. See Note 3 to the Consolidated Financial Statements for additional discussion of these impairments.
For 2010, net new orders increased 7% to 15,148 units compared with 14,185 units in 2009. The increase in net new order units was primarily attributable to the positive impact of the federal homebuyer tax credit in the first half of 2010 and incremental orders resulting from the Centex merger partially offset in the latter half of 2010 by a lower average sales pace per community. For 2009, net new order units decreased 7% to 14,185 units compared with 15,306 units in 2008. Excluding Centex, net new order units decreased moderately during 2010 and significantly during 2009 due to the uncertainty in the overall U.S. housing industry. Most markets continue to have significant resale and new home inventory on the market, and this, combined with low consumer confidence, difficulties experienced by customers in selling their existing homes, the high rate of foreclosures, and the tighter mortgage financing market, has resulted in reduced net new orders. Cancellation rates were 19% in 2010, 23% in 2009, and 33% in 2008 as the cancellation rate for 2010 reverted back to our more typical historical range compared with the heightened cancellation rates experienced during 2006 through 2008.
The dollar value of net new orders increased $190.8 million in 2010 compared to 2009 and decreased $393.0 million in 2009 compared to 2008. At December 31, 2010, we had 786 active selling communities, a decrease of 11% from December 31, 2009. At December 31, 2009, we had 882 active selling communities, an increase of 54% from December 31, 2008. Centex contributed 435 active communities at December 31, 2009. Ending backlog, which represents orders for homes that have not yet closed, was 3,964 units at December 31, 2010 with a dollar value of $1.1 billion compared with ending backlog of 5,931 units at December 31, 2009 with a dollar value of $1.6 billion.
We had 6,284 and 6,653 homes in production at December 31, 2010 and 2009, respectively, excluding 1,452 and 1,657 model homes, respectively. Included in our total homes in production were 3,494 and 2,793 homes that were unsold to customers at December 31, 2010 and 2009, respectively, of which 1,856 and 1,309 homes, respectively, were completed.
At December 31, 2010 and 2009, our Homebuilding operations controlled 147,194 and 154,694 lots, respectively. Of these controlled lots, 131,964 and 138,273 lots were owned and 10,082 and 14,208 lots were under option agreements approved for purchase at December 31, 2010 and 2009, respectively. In addition, there were 5,148 and 2,213 lots under option agreements pending approval at December 31, 2010 and 2009, respectively. While we are purchasing select land positions where it makes strategic and economic sense to do so, the reduction in lots resulting from unit settlements, land disposition activity, and withdrawals from land option contracts exceeded the number of lots added by new transactions during the year ended December 31, 2010.
The total purchase price related to land under option for use by our Homebuilding operations at future dates approximated $709.5 million at December 31, 2010. These land option agreements, which may be cancelled at our discretion, and may extend over several years, are secured by deposits and pre-acquisition costs totaling $95.1 million, of which only $3.1 million is refundable. This balance excludes contingent payment obligations which may or may not become actual obligations to us.
Non-GAAP Financial Measures
This report contains information about our home sale gross profit margins, excluding land and community valuation adjustments, amortization of capitalized interest, and merger-related costs, which is considered a non-GAAP financial measure under the SECs rules and should be considered in addition to, rather than as a substitute for, home sale gross margin (which we define as home sale revenues less home cost of revenues) as a measure of our operating performance. Management and our local divisions use this measure in evaluating the operating performance of each
Non-GAAP Financial Measures (continued)
community and in making strategic decisions regarding sales pricing, construction and development pace, product mix, and other daily operating decisions. We believe it is a relevant and useful measure to investors for evaluating our performance through gross profit generated on homes delivered during a given period and for comparing our operating performance to other companies in the homebuilding industry. Although other companies in the homebuilding industry report similar information, the methods used may differ. We urge investors to understand the methods used by other companies in the homebuilding industry to calculate gross margins and any adjustments thereto before comparing our measures to that of such other companies.
The following table sets forth a reconciliation of this non-GAAP financial measure to home sale gross margin, a GAAP financial measure, which management believes to be the GAAP financial measure most directly comparable to this non-GAAP financial measure ($000s omitted):
Homebuilding Segment Operations
Homebuilding, our core business, is engaged in the acquisition and development of land primarily for residential purposes within the continental United States and the construction of housing on such land targeted for first-time, first and second move-up, and active adult home buyers. In the fourth quarter of 2010, we realigned the organizational structure for certain of our Areas. Accordingly, the operating data by segment have been reclassified to conform to the current presentation. We conduct our operations in 67 markets, located throughout 29 states and the District of Columbia, and have presented our reportable Homebuilding segments as follows:
Homebuilding Segment Operations (continued)
We also have one reportable segment for our financial services operations which consists principally of mortgage banking and title operations conducted through Pulte Mortgage and other subsidiaries. Our Financial Services segment operates generally in the same markets as our Homebuilding segments.
The following table presents selected financial information for our homebuilding reporting segments ($000s omitted):
Homebuilding Segment Operations (continued)
* Represents lots related to certain wind down operations acquired with the Centex merger.
For 2010, East home sale revenues increased 25% compared with 2009 due to a 28% increase in unit settlements offset slightly by a 2% decrease in average selling price. Excluding Centex, home sale revenues and settlements decreased slightly while average selling price increased slightly compared with 2009. The income before income taxes was primarily attributable to higher revenues, increased gross margins (both including and excluding land-related charges), and improved overhead leverage compared with 2009, and a decrease in land-related charges to $18.4 million in 2010, compared with land-related charges of $224.9 million and impairments related to unconsolidated joint ventures totaling $31.1 million in 2009. Net new orders increased 9% compared with 2009. Excluding Centex, net new orders decreased moderately compared with 2009. The cancellation rate decreased to 16% in 2010 compared with 19% in 2009.
East home sale revenues in 2009 decreased 33% compared with 2008 due to a 25% decrease in unit settlements combined with a 10% decrease in the average selling price, including significant home sale revenue reductions in our Northeast, Georgia, and Charlotte markets. Excluding Centex, home sale revenues and settlements decreased significantly compared with 2008 while average selling price was flat. The increased loss before income taxes was primarily attributable to the reduction in revenues combined with higher land-related charges. East recorded land-related charges of $224.9 million and impairments totaling $31.1 million related to unconsolidated joint ventures during 2009, compared with land-related charges of $220.6 million in 2008. Gross margins, excluding land-related charges, decreased slightly during 2009. Net new orders for 2009 increased 3% compared with 2008 primarily due to the merger with Centex. The cancellation rate for 2009 was 19% compared with 29% in 2008.
For 2010, Gulf Coast home sale revenues increased 28% compared with 2009 due to a 26% increase in unit settlements combined with a 1% increase in the average selling price, though our North Florida market experienced a significant decrease in revenues. Excluding Centex, home sale revenues and settlements decreased slightly and average selling price increased slightly compared with 2009. The significant decrease in loss before income taxes in 2010 was attributable to higher revenues and lower land-related charges, which totaled $63.6 million and $261.3 million in 2010 and 2009, respectively. Gross margins including and excluding land-related charges increased moderately compared with 2009. Net new orders increased by 24% compared with 2009 primarily due to the Centex merger. Excluding Centex, net new orders for 2010 decreased moderately from 2009. The cancellation rate in 2010 was 23% compared with 25% in 2009.
For 2009, Gulf Coast home sale revenues decreased 23% compared with 2008 due to a 15% decrease in unit settlements combined with a 9% decrease in the average selling price, including a significant decrease in home sale revenues in our North and Central Florida markets. Excluding Centex, home sale revenues and settlements decreased significantly compared with 2008 and average selling price decreased slightly. The Gulf Coast area experienced an increased loss before income taxes in 2009 compared with 2008 due to decreased home sale revenues and higher land-related charges, which totaled $261.3 million and $247.7 million in 2009 and 2008, respectively. Excluding land-related charges, gross margins increased moderately compared with 2008. Net new orders increased by 5% compared with 2008, primarily due to the Centex merger. The cancellation rate in 2009 was 25% compared with 33% in 2008.
Homebuilding Segment Operations (continued)
For 2010, Central home sale revenues decreased less than 1% compared with 2009 due to a 6% decrease in unit settlements offset by a 6% increase in the average selling price. Excluding Centex, home sale revenues and settlements decreased moderately while average selling price increased moderately compared with 2009. Our Arizona market continued to experience significant declines in volumes due to the challenging market conditions in the Phoenix area. Central experienced a decreased loss before income taxes in 2010 compared with 2009 due to significantly higher gross margins (including and excluding land-related charges) and improved overhead leverage during 2010. In 2010, Central recorded land-related charges totaling $40.8 million, compared to land-related charges of $174.8 million and impairments of investments in unconsolidated joint ventures of $19.3 million in 2009. Net new orders decreased by 8% compared with 2009 primarily due to decreased demand in Arizona. Excluding Centex, net new orders for 2010 decreased significantly compared to 2009. The cancellation rate in 2010 was 14% compared with 23% in 2009.
Our Central segment faced difficult local economic conditions in the majority of its markets during 2009. Central home sale revenues decreased 46% compared with 2008 due to a 41% decrease in unit settlements combined with a 10% decrease in average selling price, including a significant decrease in the Illinois markets home sale revenues. Excluding Centex, home sale revenues settlements decreased significantly compared with 2008 and average selling price decreased slightly. For 2009 and 2008, Central operating results were negatively impacted by land-related charges of $174.8 million and $493.9 million, respectively. During 2009 the Central market also incurred charges of $19.3 million related to investments in unconsolidated joint ventures. Excluding land-related charges, gross margins decreased slightly compared with 2008. Net new orders in 2009 decreased 24% compared with 2008. For 2009, cancellation rates were 23% compared with 32% for 2008.
For 2010, West home sale revenues decreased 1% compared with 2009 due to a less than 1% decrease in both unit settlements and average selling price, though our Las Vegas and Bay Area markets experienced significant declines in volumes. Excluding Centex, home sale revenues and settlements decreased moderately while average sales price increased less than 1% compared with 2009. The decreased loss before income taxes in 2010 compared with 2009 is attributable to significantly higher gross margins (both including and excluding land-related charges), and lower land-related charges of $63.5 million in 2010 compared with $190.0 million in 2009. The loss before taxes in 2010 and 2009 also included impairment charges of $1.9 million and $1.2 million, respectively, related to unconsolidated joint ventures. Net new orders decreased by 4% in 2010 compared with 2009 primarily due to declines in Las Vegas and Bay Area. Cancellation rates were 23% in 2010 compared with 25% in 2009.
West home sale revenues decreased 35% in 2009 compared with 2008 due primarily to a 32% decrease in unit settlements and a 5% decrease in average selling price as the majority of our West markets experienced lower home sale revenues. Excluding Centex, home sale revenues and settlements decreased significantly and average selling price decreased moderately compared with 2008. During 2009, the reduction in revenues was partially offset by higher gross margins in several of our markets, which also included $190.0 million in land-related charges and a $1.2 million valuation adjustment related to unconsolidated joint ventures. The decreased loss before income taxes in 2009 was primarily due to significantly lower land-related charges and lower impairments in unconsolidated joint ventures, which totaled $464.2 million and $15.4 million, respectively, in 2008. Excluding land-related charges, we experienced increased gross margins in each of our West markets, with the exception of the Bay Area. Net new orders decreased by 11% in 2009 compared with 2008. Cancellation rates were 25% in 2009 compared with 41% in 2008.
Financial Services Operations
We conduct our Financial Services operations, which include mortgage and title operations, through Pulte Mortgage and other subsidiaries. We originate mortgage loans using our own funds or borrowings made available through various credit arrangements, and then sell such mortgage loans monthly to outside investors. Also, we sell our servicing rights on a flow basis through fixed price servicing sales contracts. The following table presents selected financial information for our Financial Services operations ($000s omitted):
Operating as a captive business model primarily targeted to supporting our Homebuilding operations, the operating results of our Financial Services operations are directly linked to Homebuilding. Since 2007, the mortgage industry experienced a significant shift away from subprime, Alt-A, and high loan-to-value loans brought about by investors reluctance to purchase these loans due to their perceived risk. This, among other things, has resulted in an overall tightening of lending standards and a shift toward agency production and fixed rate loans versus adjustable rate mortgages (ARMs).
Our Homebuilding customers continue to account for substantially all loan production, representing 98% of loan originations for 2010, 98% for 2009, and 99% for 2008. Total Financial Services revenues during 2010 increased 3% compared with 2009 primarily as a result of increased home settlement volumes in 2010 compared to 2009. Financial Services revenues for 2009 decreased 22% compared with 2008 primarily as a result of lower loan origination volume due to lower home settlements within our Homebuilding operations. Interest income, which is included in mortgage operations revenues, was moderately lower in 2010 than in 2009 due to the combination of lower interest rates and selling loans faster in 2010; and significantly lower in 2009 than in 2008, due to the decrease in loan origination volume. Revenues from our title operations increased 9% in 2010 compared with 2009 due to increased home settlement volume, and increased 59% in 2009 compared with 2008 due to the Centex merger.
Agency production for funded origination principal was 99%, 99%, and 98% in 2010, 2009, and 2008, respectively. Within the funded agency origination principal, FHA loans were approximately 38%, 40%, and 25% in 2010, 2009, and 2008, respectively. Our capture rate for 2010 was 78% compared with 85% for 2009 and 92% for 2008. Our capture rate represents loan originations from our Homebuilding operations as a percentage of total loan opportunities from our Homebuilding operations, excluding cash settlements. Our customers average FICO scores for 2010, 2009, and 2008 were 749, 743, and 739, respectively. At December 31, 2010, our loan application backlog was $558.8 million, compared with $877.9 million at December 31, 2009.
Substantially all loan production in 2010, 2009, and 2008 consisted of fixed rate loans, the majority of which are prime, conforming loans. We define prime loans as full documentation first mortgages with FICO scores of 621 or higher, Alt-A loans as non-full documentation first mortgages with FICO scores of 621 or higher, and sub-prime loans as first mortgages with FICO scores of 620 or lower. The shift toward agency fixed-rate loans from ARMs and interest-only mortgages, a component of ARMs, has contributed to profitability as fixed rate loans generally result in higher profitability due to higher servicing values, less competition, and structured guidelines that allow for expense efficiencies when processing the loan.
Income before income taxes increased significantly in 2010 compared with 2009 primarily due to lower expenses related to loan repurchase liabilities combined with improved operating efficiencies. Income before income taxes decreased significantly in 2009 compared with 2008 primarily due to increased loan loss reserves, decreased loan
Financial Services Operations (continued)
origination volumes, and lower values of servicing rights. The 2009 loss before income taxes also includes certain integration costs directly related to the Centex merger totaling $8.4 million, which consist primarily of severance benefits and lease exit and related asset impairment costs. Financial Services also incurred goodwill impairment charges of $0.7 million in 2008 but none in either 2009 or 2010.
Since we sell the majority of our loans monthly and retain only limited risk related to the loans we originate, our overall loan losses have historically not been significant. In 2010 and 2009, however, we experienced higher than historical losses on our loans held for investment, repurchased or re-insured loans, and foreclosed properties. The largest source of these losses has been a significant increase in anticipated losses for loans previously originated and sold to investors. Such losses may result from certain representations and warranties that the loans sold meet certain requirements, including representations as to underwriting standards, the type of collateral, the existence of primary mortgage insurance and the validity of certain borrower representations in connection with the loan. If determined to be at fault, we either repurchase the loans from the investors or reimburse the investors losses. We establish liabilities for such anticipated losses based upon, among other things, the level of current and estimated probable future repurchase demands made by investors, our ability to cure the defects identified in the repurchase demands, and the severity of loss upon repurchase. Beginning in 2009, we have experienced a significant increase in anticipated losses as a result of the high level of loan defaults and related losses in the mortgage industry and increasing aggressiveness by investors in presenting such claims to us. Additionally, Centexs mortgage operations were historically broader than those of Pulte Mortgage, so our exposure to losses related to loans previously originated increased significantly as a result of the Centex merger. While not increasing our exposure to Centexs contingent loan origination liabilities, we entered into an agreement in conjunction with the wind down of Centexs mortgage operations, which originated its last loan in December 2009, that provides a guaranty for one major investor in loans originated by Centexs mortgage operations. This guaranty provides that we will honor the potential repurchase obligations of Centexs mortgage operations related to breaches of representations and warranties in the origination of a certain pool of loans. Other than with respect to this pool of loans, our contractual repurchase obligations are limited to our non-guarantor subsidiaries (see Note 17 for a discussion of non-guarantor subsidiaries).
The vast majority of losses related to our overall exposure for loans previously originated and sold to investors relate to loans originated in 2006 and 2007 when industry lending standards were less stringent and borrower fraud is believed to have peaked. Given the volatility in the mortgage industry and the uncertainty regarding the ultimate resolution of these claims, it is reasonably possible that future losses may exceed our current estimates. Changes in these liabilities are as follows ($000s omitted):
In addition to the above, loan loss provisions related to our portfolio loans, real estate owned, and mortgage reinsurance reserves totaled $1.2 million, $9.8 million, and $17.0 million in 2010, 2009, and 2008, respectively.
We are exposed to market risks from commitments to lend, movements in interest rates, and cancelled or modified commitments to lend. A commitment to lend at a specific interest rate (an interest rate lock commitment) is a derivative financial instrument (interest rate is locked to the borrower). In order to reduce these risks, we use other derivative financial instruments to economically hedge the interest rate lock commitment. These financial instruments can include cash forward placement contracts on mortgage-backed securities, whole loan investor commitments, options on treasury futures contracts, and options on cash forward placement contracts on mortgage-backed securities. We enter into one of the aforementioned derivative financial instruments upon accepting interest rate lock commitments. The changes in the fair value of the interest rate lock commitment and the other derivative financial instruments are included in Financial Services revenues. We do not use any derivative financial instruments for trading purposes.
Other non-operating expenses consist of income and expenses related to corporate services provided to our subsidiaries. These expenses are incurred for financing, developing, and implementing strategic initiatives centered on new business development and operating efficiencies, and providing the necessary administrative support associated with being a publicly traded entity listed on the New York Stock Exchange. Accordingly, these results will vary from year to year as these strategic initiatives evolve. The following table presents a summary of other non-operating expenses ($000s omitted):
The slight decrease in net interest income in 2010 compared with 2009 resulted from higher invested cash balances and a corporate note receivable offset by lower interest rates. The decrease in net interest income in 2009 compared with 2008 resulted from significantly lower interest rates on our invested cash balances. The decrease in selling, general, and administrative expenses for 2010 compared with 2009 is due primarily to the prior year period containing certain integration costs directly related to the Centex merger totaling $5.4 million. Other income (expense), net consists of gains (losses) on debt retirements (see Note 8 to the Consolidated Financial Statements).
We capitalize interest cost into inventory during the active development and construction of our communities. Each layer of capitalized interest is amortized over a period that approximates the average life of communities under development. Interest expense is allocated over the period based on the cyclical timing of unit settlements. Interest expensed to Homebuilding cost of revenues for 2010, 2009, and 2008 includes $27.6 million, $68.2 million, and $84.8 million, respectively, of capitalized interest related to inventory impairments. During the second and third quarters of 2010, the level of our active inventory was lower than our debt level. Accordingly, $1.5 million of Homebuilding interest costs were expensed directly to interest expense in 2010. During 2009 and 2008, we capitalized all of our Homebuilding interest costs into inventory because the level of our active inventory exceeded our debt levels. Given the substantial reduction in debt that occurred in the fourth quarter of 2010, our active inventory exceeded our debt levels at December 31, 2010. While the amount of interest incurred and capitalized into homebuilding inventory will decline as the result of these debt retirements, the amount of interest expensed will actually increase in the near term due to the amortization of previously capitalized amounts.
Information related to interest capitalized into inventory is as follows ($000s omitted):
* Homebuilding interest incurred includes interest on our senior debt, short-term borrowings, and other financing arrangements and excludes interest incurred by our Financial Services segment and certain other interest costs.
Our income tax assets and liabilities and related effective tax rate are affected by a number of factors, the most significant of which is the valuation allowance recorded against our deferred tax assets and changes in our unrecognized tax benefits. Due to the effect of our valuation allowance and changes in our unrecognized tax benefits, our effective tax rates for 2008 through 2010 are not meaningful as our income tax benefit is not correlated to the amount of our pretax loss. Our effective tax rates were a benefit of 11.2% for 2010 compared with a benefit of 40.1% and 12.4% for 2009 and 2008, respectively.
Income Taxes (continued)
The income tax benefit for 2010 was primarily due to the favorable resolution of certain federal and state income tax matters. Our 2009 income tax benefit of $792.6 million was primarily due to the impact of the Worker, Homeownership, and Business Assistance Act of 2009 (the Act), which was enacted into law on November 6, 2009. The Act amended Section 172 of the Internal Revenue Code to allow net operating losses realized in either tax year 2008 or 2009 to be carried back up to five years (previously limited to two years). The Act allowed us to carry back 2009 taxable losses to prior years and receive refunds of previously paid federal income taxes. We recorded income taxes receivable of $867.3 million at December 31, 2009, related to the carryback of net operating losses pursuant to the Act.
Liquidity and Capital Resources
We finance our land acquisitions, development, and construction activities by using internally-generated funds and existing credit arrangements. We routinely monitor current and expected operational requirements and financial market conditions to evaluate the use of available financing sources, including securities offerings. Based on our current financial condition and credit relationships, we believe that our operations and borrowing resources are sufficient to provide for our current and foreseeable capital requirements. However, we continue to evaluate the impact of market conditions on our liquidity and may determine that modifications are appropriate if the current difficult market conditions extend beyond our expectations or if we incur additional land-related charges.
At December 31, 2010, we had cash and equivalents of $1.5 billion and no borrowings outstanding under our unsecured revolving credit facility (the Credit Facility). We also had $3.4 billion of senior notes outstanding. Other financing included limited recourse land-collateralized financing totaling $0.6 million. Sources of our working capital include our cash and equivalents, our Credit Facility, and our unsecured letter of credit facility (the LOC Agreement). An additional source of liquidity during 2010 was the receipt of federal tax refunds aggregating $934.7 million. Such refunds resulted primarily from the carryback of taxable losses provided by the Worker, Homeownership, and Business Assistance Act of 2009.
We follow a diversified investment approach for our cash and equivalents by maintaining such funds with a diversified portfolio of banks within our group of relationship banks in high quality, highly liquid, short-term investments, generally money market funds and federal government or agency securities. We monitor our investments with each bank on a daily basis and do not believe our cash and equivalents are exposed to any material risk of loss. However, given the volatility in the global financial markets, there can be no assurances that losses of principal balance on our cash and equivalents will not occur.
Our ratio of debt to total capitalization, excluding our land-collateralized debt, was 61.4% at December 31, 2010, and 47.4% net of cash and equivalents.
In June 2009, we entered into the LOC Agreement, a five-year, unsecured letter of credit facility that permits the issuance of up to $200.0 million of letters of credit. The LOC Agreement supplements our existing letter of credit capacity included in our Credit Facility (described below). At December 31, 2010, $167.2 million of letters of credit were outstanding under the LOC Agreement.
Given the difficult conditions in the homebuilding industry in recent years, we have reduced the borrowing capacity under the Credit Facility as the result of a combination of reduced working capital needs and challenges in meeting the Credit Facilitys financial covenants. On December 23, 2010, we entered into the Fifth Amendment to Third Amended and Restated Credit Agreement (the Fifth Amendment), which decreased the borrowing capacity under the Credit Facility from $750.0 million to $250.0 million and also reduced the required level of cash and equivalents to be maintained in certain liquidity reserve accounts. Previously, on December 11, 2009, we entered into the Fourth Amendment and Waiver to Third Amended and Restated Credit Agreement, which reduced the borrowing capacity under the Credit Facility from $1.2 billion to $750.0 million, replaced the maximum debt to capitalization ratio with a maximum debt to tangible capital limit, reduced the tangible net worth minimum, and waived any default under the previous Credit Facility resulting from failure to comply with the tangible net worth financial covenant.
Under the terms of the Credit Facility, we have the capacity to issue letters of credit totaling up to $250.0 million. Borrowing availability is reduced by the amount of letters of credit outstanding. The Credit Facility includes a borrowing base limitation when we do not have an investment grade senior unsecured debt rating from at least two of
Liquidity and Capital Resources (continued)
Fitch Ratings, Moodys Investor Service, and Standard and Poors Corporation (the Rating Agencies). We currently do not have investment grade ratings from any of the Rating Agencies and are therefore subject to the borrowing base limitation. Given the uncertainty of current market conditions, we anticipate operating under the borrowing base limitation for the remainder of the Credit Facilitys term. Under the borrowing base limitation, the sum of our senior debt and the amount drawn on the Credit Facility may not exceed an amount based on certain percentages of various categories of our unencumbered inventory and other assets. At December 31, 2010, we had no borrowings outstanding and full availability of the remaining $28.4 million under the Credit Facility after consideration of $221.6 million of outstanding letters of credit. As a result, the borrowing base limitation did not restrict our borrowing availability at December 31, 2010.
We are also required to maintain certain liquidity reserve accounts in the event we fail to satisfy an interest coverage test. Specifically, if the interest coverage ratio (as defined in the Credit Facility) is less than 2.0 to 1.0, we are required to maintain cash and equivalents in designated accounts with certain banks. While our access to and utilization of cash and equivalents maintained in liquidity reserve accounts is not restricted, failure to maintain sufficient balances within the liquidity reserve accounts restricts our ability to utilize the Credit Facility. We maintained the required cash and equivalents of $250.0 million within the liquidity reserve accounts at December 31, 2010, calculated under the Credit Facility as two times the amount by which the interest incurred over the last four quarters exceeds interest income over the last four quarters, excluding Financial Services, with a maximum amount of $250.0 million to be maintained in the liquidity reserve accounts effective with the Fifth Amendment. Additionally, failure to satisfy the interest coverage test can also result in an increase to LIBOR margin and letter of credit pricing. Our interest coverage ratio for the quarter ended December 31, 2010 was negative 0.66. For the period ending March 31, 2011, we will be required to maintain cash and equivalents of $250.0 million within the liquidity reserve accounts.
The Credit Facility contains certain financial covenants. We are required to not exceed a debt to tangible capital ratio as well as to meet a tangible net worth covenant each quarter. At December 31, 2010, our debt to tangible capital ratio (as defined in the Credit Facility) was 57.5% (compared with the requirement not to exceed 60.0%) while our tangible net worth (as defined in the Credit Facility) cushion was $436.2 million. Accordingly, we were in compliance with all of the covenants under the Credit Facility as of December 31, 2010. However, the required debt to tangible capital ratio adjusts to 57.5% as of both March 31 and June 30, 2011 and 55.0% as of the end of each quarter thereafter. In the event we are not able to reduce our debt to tangible capital ratio below our current level, our compliance with the required covenant levels may be adversely impacted. Violations of the financial covenants in the Credit Facility, if not waived by the lenders or cured, could result in an optional maturity date acceleration by the lenders, which might require repayment of any borrowings and replacement or cash collateralization of any letters of credit outstanding under the Credit Facility. In the event these violations were not waived by the lenders or cured, the violations could also result in a default under our $3.4 billion of senior notes. Based on current market conditions, we believe that we may need to take action in order to avoid violating the debt to tangible capital ratio, potentially as early as March 31, 2011. Possible actions could include: negotiating changes to the Credit Facilitys financial covenants with our group of lenders or arranging a new credit facility; terminating the Credit Facility, which would release the funds currently maintained in the liquidity reserve accounts ($250.0 million) and using our available cash to collateralize required letters of credit ($221.6 million at December 31, 2010); or replacing the Credit Facility with a separate letter of credit facility, similar to our existing LOC Agreement. While there can be no assurances that we could complete any of these actions given the uncertainties in the homebuilding industry and the financial markets, we believe that the combination of these potential actions will allow us to avoid any violations of covenants under either the Credit Facility or senior notes for the near term.
Pulte Mortgage provides mortgage financing for many of our home sales and uses its own funds and borrowings made available pursuant to certain third party and intercompany borrowings. Pulte Mortgage uses these resources to finance its lending activities until the mortgage loans are sold to third party investors, generally within 30 days. At December 31, 2009, Pulte Mortgage had a combination of repurchase lending agreements in place with various banks that provided borrowing capacity totaling $175.0 million. Given our strong liquidity and the cost of third party financing relative to existing mortgage rates, Pulte Mortgage allowed each of its third party borrowing arrangements to expire during 2010 and began funding its operations using internal Company resources. At December 31, 2010, we elected to fund $74.5 million of Pulte Mortgages financing needs via a repurchase agreement with the Company. In order to satisfy regulatory requirements in certain states, Pulte Mortgage also maintains a $2.5 million repurchase lending agreement with a bank that expires in October 2011. There were no borrowings outstanding under this facility as of December 31, 2010.
Liquidity and Capital Resources (continued)
Pursuant to the two $100 million stock repurchase programs authorized by our Board of Directors in October 2002 and 2005, and the $200 million stock repurchase authorization in February 2006 (for a total stock repurchase authorization of $400 million), we have repurchased a total of 9,688,900 shares for a total of $297.7 million. There have been no repurchases under these programs since 2006. We had remaining authorization to purchase common stock aggregating $102.3 million at December 31, 2010.
For the last three years, we have generated significant positive cash flow primarily through the liquidation of land inventory without a corresponding level of reinvestment combined with refunds of income taxes paid in prior years. We have used this positive cash flow to, among other things, increase our cash reserves as well as retire outstanding debt. Over the last three years, we have retired $3.1 billion of debt, including debt assumed with the Centex merger (see Note 8 to the Consolidated Financial Statements for additional details regarding these retirements). The majority of this debt was retired prior to its stated maturity. In the fourth quarter of 2010, we retired $898.5 million of senior notes. Additionally, we voluntarily used $111.2 million to repurchase at a discount prior to their maturity certain community development district obligations with an aggregate principal balance of $124.1 million in order to improve the future financial performance of the related communities (see Note 16 to the Consolidated Financial Statements) and also voluntarily used $74.5 million of Company funds to finance Pulte Mortgages lending operations rather than continue to use third party financing arrangements. However, we do not anticipate that we will be able to continue to generate positive cash flow at these same levels in the near future. Additionally, should growth conditions return to the homebuilding industry, we will need to invest significant capital into our operations to support such growth.
Our net cash provided by operating activities amounted to $580.3 million in 2010, $738.9 million in 2009 and $1.2 billion in 2008. During 2010, we received federal income tax refunds of $934.7 million compared with $362.0 million and $212.1 million in 2009 and 2008, respectively. After adjusting for these tax refunds, operating cash flow was negative for 2010. Generally, the primary drivers of cash flow from operations are inventory levels and profitability. For the years ended 2008 through 2010, our net losses were largely attributable to non-cash asset impairments, including land-related charges and goodwill impairments. Cash flows from operations in 2010 were negatively impacted by the voluntary repurchase of certain community development district obligations for $111.2 million (see above) and using $74.5 million to internally finance Pulte Mortgages lending operations. During 2010, inventory levels and residential mortgage loans available-for-sale decreased slightly while operating cash flows in 2009 and 2008 benefited from a significant net decrease in inventory and residential mortgage loans available-for-sale.
Net cash used by investing activities was $19.5 million at December 31, 2010, compared to net cash provided by investing activities of $1.7 billion in 2009 and net cash used in investing activities of $55.9 million in 2008. The net cash used in 2010 was primarily the result of investments in unconsolidated entities and capital expenditures, partially offset by distributions from unconsolidated entities and a reduction in residential mortgage loans held for investment. Our contributions to unconsolidated entities and investments in capital expenditures have declined in recent years as the result of the reduction in our overall land investments. Substantially all of the cash provided by investing activities in 2009 was the result of cash acquired through the Centex merger. For 2008, the majority of the cash used by investing activities related to contributions to our unconsolidated entities.
Net cash used in financing activities totaled $948.4 million, $2.2 billion, and $567.7 million in 2010, 2009, and 2008, respectively. Net cash used in 2010 was primarily the result of the repurchase of senior notes as mentioned above as well as repayments made under Financial Services credit arrangements. The large increase in net cash used in financing activities in 2009 was largely attributable to $2.0 billion used to retire outstanding debt combined with reductions in amounts outstanding under our Financial Services credit arrangements. Net cash used in 2008 was largely attributable to the repurchase of outstanding senior notes combined with reductions in amounts outstanding under our Financial Services credit arrangements.
On November 24, 2008, our Board of Directors discontinued the regular quarterly dividend on our common stock effective in the first quarter of 2009.
We, and the homebuilding industry in general, may be adversely affected during periods of high inflation because of higher land and construction costs. Inflation may also increase our financing, labor, and material costs. In addition, higher mortgage interest rates significantly affect the affordability of permanent mortgage financing to prospective
Liquidity and Capital Resources (continued)
homebuyers. While we attempt to pass to our customers increases in our costs through increased sales prices, the current industry conditions have resulted in lower sales prices in substantially all of our markets. If we are unable to raise sales prices enough to compensate for higher costs, or if mortgage interest rates increase significantly, affecting our prospective homebuyers willingness or ability to adequately finance home purchases, our revenues, gross margins, and net income would be adversely affected.
We experience variability in our quarterly results from operations due to the seasonal nature of the homebuilding industry. Historically, we have experienced significant increases in revenues and cash flow from operations during the fourth quarter based on the timing of home settlements. However, the challenging market conditions experienced since early 2006 have lessened the seasonal variations of our results. Given the current significant uncertainty in the homebuilding industry, we can make no assurances as to when and whether our historical seasonality will recur.
Contractual Obligations and Commercial Commitments
The following table summarizes our payments under contractual obligations as of December 31, 2010:
We are subject to the usual obligations associated with entering into contracts (including land option contracts) for the purchase, development, and sale of real estate in the routine conduct of our business. Option contracts for the purchase of land enable us to defer acquiring portions of properties owned by third parties and unconsolidated entities until we are ready to build homes on them. This reduces our financial risks associated with long-term land holdings. At December 31, 2010, we had agreements to acquire 15,230 homesites through option contracts. At December 31, 2010, we had $92.0 million of non-refundable option deposits and pre-acquisition costs related to these agreements.
At December 31, 2010, we had $258.0 million of gross unrecognized tax benefits and $48.4 million of related accrued interest and penalties. We are currently under examination by various taxing jurisdictions and anticipate finalizing the examinations with certain jurisdictions within the next twelve months. However, the final outcome of these examinations is not yet determinable. The statute of limitations for our major tax jurisdictions remains open for examination for tax years 1998-2010.
The following table summarizes our other commercial commitments as of December 31, 2010:
Off-Balance Sheet Arrangements
We use letters of credit and performance and surety bonds to guarantee our performance under various contracts, principally in connection with the development of our projects. The expiration dates of the letter of credit contracts coincide with the expected completion date of the related homebuilding projects. If the obligations related to a project are ongoing, annual extensions of the letters of credit are typically granted on a year-to-year basis. At December 31, 2010, we had outstanding letters of credit of $388.9 million. Performance bonds and surety bonds generally do not have stated expiration dates; rather, we are released from the bonds as the contractual performance is completed. These bonds, which approximated $1.3 billion at December 31, 2010, are typically outstanding over a period of approximately three to five years. We do not believe that there will be draws upon any such letters of credit or performance or surety bonds.
In the ordinary course of business, we enter into land option or option type agreements in order to procure land for the construction of houses in the future. At December 31, 2010, these agreements totaled approximately $709.5 million. Pursuant to these land option agreements, we provide a deposit to the seller as consideration for the right to purchase land at different times in the future, usually at predetermined prices. In certain instances, we are required to record the land under option as if we own it. At December 31, 2010, we consolidated certain land option agreements and recorded assets of $50.8 million as land, not owned, under option agreements.
At December 31, 2010, aggregate outstanding debt of unconsolidated joint ventures was $15.5 million, of which our proportionate share of such joint venture debt was $5.1 million. Of our proportionate share of joint venture debt, we provided limited recourse guaranties for $1.4 million of such joint venture debt at December 31, 2010. See Note 7 to the Consolidated Financial Statements for additional information.
For 2010, 2009, and 2008, we recognized equity in earnings (loss) of unconsolidated entities of $2.9 million, $(49.7) million, and $(12.8), respectively. The earnings (losses) in 2010, 2009, and 2008 included impairments related to investments in unconsolidated joint ventures totaling $1.9 million, $54.1 million, and $18.5 million, respectively.
Critical Accounting Policies and Estimates
The accompanying consolidated financial statements were prepared in conformity with United States generally accepted accounting principles. When more than one accounting principle, or the method of its application, is generally accepted, we select the principle or method that is appropriate in our specific circumstances (see Note 1 of our Consolidated Financial Statements). Application of these accounting principles requires us to make estimates about the future resolution of existing uncertainties; as a result, actual results could differ from these estimates. In preparing these consolidated financial statements, we have made our best estimates and judgments of the amounts and disclosures included in the consolidated financial statements, giving due regard to materiality.
Homebuilding Homebuilding revenue and related profit are generally recognized at the time of the closing of the sale, when title to and possession of the property are transferred to the buyer. In situations where the buyers financing is originated by Pulte Mortgage, our wholly-owned mortgage subsidiary, and the buyer has not made an adequate initial or continuing investment as required by ASC 360-20, Property, Plant, and Equipment - Real Estate Sales, the profit on such sales is deferred until the sale of the related mortgage loan to a third-party investor has been completed unless there is a loss on the sale in which case the loss on such sale is recognized at the time of closing.
Financial Services Mortgage servicing fees represent fees earned for servicing loans for various investors. Servicing fees are based on a contractual percentage of the outstanding principal balance, or a contracted set fee in the case of certain sub-servicing arrangements, and are credited to income when related mortgage payments are received or the sub-servicing fees are earned. Loan origination fees, commitment fees, and certain direct loan origination costs are recognized as incurred. Expected gains and losses from the sale of residential mortgage loans and their related servicing rights are included in the measurement of written loan commitments that are accounted for at fair value through Financial Services at the time of commitment. Subsequent changes in the fair value of these loans are reflected in Financial Services revenues as they occur. Interest income is accrued from the date a mortgage loan is originated until the loan is sold. Loans are placed on non-accrual status once they become greater than 90 days past due their contractual terms. Subsequent payments received are applied according to the contractual terms of the loan.
Inventory is stated at the lower of accumulated cost or fair value, as determined in accordance with ASC 360-10, Property, Plant, and Equipment Impairment or Disposal of Long-Lived Assets (ASC 360-10). Accumulated cost
Critical Accounting Policies and Estimates (continued)
Inventory valuation (continued)
includes costs associated with land acquisition, land development, and home construction costs, including interest, real estate taxes, and certain direct and indirect overhead costs related to development and construction. For those communities for which construction and development activities have been idled, applicable interest and real estate taxes are expensed as incurred. Land acquisition and development costs are allocated to individual lots using an average lot cost determined based on the total expected land acquisition and development costs and the total expected home closings for the community. The specific identification method is used to accumulate home construction costs.
We capitalize interest cost into homebuilding inventories. Each layer of capitalized interest is amortized over a period that approximates the average life of communities under development. Interest expense is allocated over the period based on the cyclical timing of unit settlements.
Cost of revenues includes the construction cost, average lot cost, estimated warranty costs, and commissions and closing costs applicable to the home. The construction cost of the home includes amounts paid through the closing date of the home, plus an appropriate accrual for costs incurred but not yet paid, based on an analysis of budgeted construction cost. This accrual is reviewed for accuracy based on actual payments made after closing compared with the amount accrued, and adjustments are made if needed. Total community land acquisition and development costs are based on an analysis of budgeted costs compared with actual costs incurred to date and estimates to complete. The development cycles for our communities range from under one year to in excess of ten years for certain master planned communities. Adjustments to estimated total land acquisition and development costs for the community affect the amounts costed for the communitys remaining lots.
In accordance with ASC 360-10, we record valuation adjustments on land inventory when events and circumstances indicate that they may be impaired and when the cash flows estimated to be generated by those assets are less than their carrying amounts. For communities that demonstrate indicators of impairment, we compare the expected undiscounted cash flows for these communities to their carrying value. For those communities whose carrying values exceed the expected undiscounted cash flows, we calculate the fair value of the community. Impairment charges are required to be recorded if the fair value of the communitys inventory is less than its carrying value.
We generally determine the fair value of each communitys inventory using a combination of market comparable transactions, where available, and discounted cash flow models. These estimated cash flows are significantly impacted by estimates related to expected average selling prices and sale incentives, expected sales paces and cancellation rates, expected land development and construction timelines, and anticipated land development, construction, and overhead costs. Such estimates must be made for each individual community and may vary significantly between communities. Due to uncertainties in the estimation process, the significant volatility in demand for new housing, and the long life cycles of many communities, actual results could differ significantly from such estimates.
Investments in unconsolidated entities
We have investments in a number of unconsolidated entities, including joint ventures, with independent third parties. Many of these unconsolidated entities purchase, develop, and/or sell land and homes in the United States and Puerto Rico. The equity method of accounting is used for unconsolidated entities over which we have significant influence; generally this represents partnership equity or common stock ownership interests of at least 20% and not more than 50%. Under the equity method of accounting, we recognize our proportionate share of the profits and losses of these entities. Certain of these entities sell land to us. In these situations, we defer the recognition of profits from such activities until the time the related homes are sold. The cost method of accounting is used for investments in which we have less than a 20% ownership interest and do not have the ability to exercise significant influence.
We evaluate our investments in unconsolidated entities for recoverability in accordance with ASC 323, Investments Equity Method and Joint Ventures. If we determine that a loss in the value of the investment is other than temporary, we write down the investment to its estimated fair value. Any such losses are recorded to equity in (earnings) loss of unconsolidated entities in the Consolidated Statements of Operations. Additionally, each unconsolidated entity evaluates its long-lived assets, such as inventory, for recoverability in accordance with ASC 360-10. Our proportionate share of any such impairments under ASC 360-10 are also recorded to equity in (earnings)
Critical Accounting Policies and Estimates (continued)
Investments in unconsolidated entities (continued)
loss of unconsolidated entities in the Consolidated Statements of Operations. Evaluations of recoverability under both ASC 323 and ASC 360-10 are primarily based on projected cash flows. Due to uncertainties in the estimation process and the significant volatility in demand for new housing, actual results could differ significantly from such estimates.
Residential mortgage loans
In accordance with ASC 825, Financial Instruments (ASC 825), we use the fair value option for our residential mortgage loans available-for-sale. ASC 825 permits entities to measure various financial instruments and certain other items at fair value on a contract-by-contract basis. Election of the fair value option for residential mortgage loans available-for-sale allows a better offset of the changes in fair values of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. Changes in the fair value of these loans are reflected in revenues as they occur.
Loans held for investment consist of a portfolio of loans that either have been repurchased from investors or were not saleable upon closing. These loans are carried at cost and reviewed for impairment when recoverability becomes doubtful.
Mortgage loan allowances and loan origination liabilities
Our mortgage operations have established liabilities for anticipated losses associated with mortgage loans originated and sold to investors that may result from certain representations and warranties that the loans sold meet certain requirements, including representations as to underwriting standards, the type of collateral, the existence of primary mortgage insurance and the validity of certain borrower representations in connection with the loan. We establish liabilities for such anticipated losses based upon, among other things, the level of current and estimated probable future repurchase demands made by investors, our ability to cure the defects identified in the repurchase demands, and the severity of loss upon repurchase.
From time to time, our mortgage operations will be required to repurchase certain loans we originated and sold to third parties. If a repurchased loan is performing, it is classified as a residential mortgage loan available-for-sale and recorded at fair value. Such repurchased loans are typically re-sold to third party investors. If a repurchased loan is nonperforming, the loan is classified as loans held for investment. We establish an allowance for such loans based on our historical loss experience and current loss trends.
Although we consider our mortgage loan allowances and loan origination liabilities to be adequate, there can be no assurance that these allowances and liabilities will prove to be sufficient over time to cover ultimate losses in connection with our loan originations. These allowances and liabilities may prove to be inadequate due to unanticipated adverse changes in the economy, the mortgage market, or discrete events adversely affecting specific borrowers.
We recorded a significant amount of goodwill related to the Centex merger completed in 2009. Goodwill, which represents the cost of acquired companies in excess of the fair value of the net assets at the acquisition date, is subject to annual impairment testing in the fourth quarter of each year or when events or changes in circumstances indicate the carrying amount may not be recoverable. In the fourth quarter of 2009, we recorded a goodwill impairment of $563.0 million as part of our annual goodwill impairment test. In addition to the annual impairment test in 2010, we performed an event-driven assessment as of September 30, 2010 in light of certain unfavorable indicators.
We test goodwill at the reporting unit level, which represents an operating segment or one level below. Because goodwill is assigned at the reporting unit level after an acquisition and reflects the current overall operating structure of the business, it no longer retains its association with a particular acquisition. We allocated goodwill resulting from the Centex merger to 24 reporting units, of which 23 reporting units related to our Homebuilding reporting segments and one reporting unit related to our Financial Services reporting segment. As a result of the impairment tests in the fourth quarter of 2009 and impairment tests in 2010, we have recorded cumulative impairments of the goodwill acquired with the Centex merger totaling $1.2 billion. As a result, our remaining goodwill totals $240.5 million at December 31, 2010 allocated amongst 13 of our Homebuilding reporting units. Goodwill for the other 11 reporting units included in the original allocation of goodwill has been written-off due to either impairment or disposal.
Critical Accounting Policies and Estimates (continued)
We evaluate the recoverability of goodwill by following a two step process. Step one of the goodwill impairment test involves comparing the carrying value of each of our reporting units to their estimated fair value. We determine the fair value of each reporting unit using accepted valuation methods, including the use of discounted cash flows supplemented by market-based assessments of fair value. The fair values are significantly impacted by estimates related to current market valuations, current and future economic conditions in each of our geographical markets, including the demand for new housing, and our strategic plans within each of our geographical markets. The discounted cash flow valuations involve the use of certain key assumptions, including projected revenue growth, profitability, and working capital levels as well as market-based discount rates (a discount rate of 10.0% was used for all reporting units in the 2010 and 2009 goodwill impairment tests based on a market-based weighted-average cost of capital for the homebuilding industry). In performing these valuations, we rely on our internal forecasts trended toward long-term averages that vary by reporting unit based on a combination of historical performance and our expectations for the future. Due to uncertainties in the estimation process and the significant volatility in demand for new housing, actual results could differ significantly from such estimates. As a result of step one of the September 2010 goodwill impairment test, we determined that the carrying value exceeded the fair value for the majority of our reporting units with goodwill. We perform step two of the goodwill impairment test for any reporting unit whose carrying value exceeds its fair value. Step two involves allocating the fair value of the reporting unit to its assets and liabilities, with the excess representing implied goodwill. An impairment loss is recognized if the recorded goodwill exceeds the implied goodwill. As a result of Step 2 at both September 30, 2010 and October 31, 2009, we determined that a significant portion of our goodwill balance was impaired. We also performed our annual assessment of the recoverability of goodwill as of October 31, 2010, which determined that no additional impairments existed.
The below table summarizes our 2010 goodwill impairment test results ($000s omitted):
As reflected in the above table, $228.0 million of the goodwill remaining at December 31, 2010 (the sum of lines (a) and (b)) relates to goodwill allocated to 11 reporting units that are at increased risk of future impairment. Our overall outlook and cash flow projections for each reporting unit involve the use of certain key assumptions, many of which are interdependent upon each other. A change in any one or combination of these assumptions could impact the estimated fair value of a reporting unit. If our expectations of future results and cash flows decrease significantly or other economic conditions deteriorate, goodwill may be further impaired. Also, while not directly triggering an impairment of goodwill, a significant decrease in our market capitalization in the future may indicate that the fair value of one or more of our reporting units has decreased. Should subsequent analysis confirm that a decrease has occurred for one or more reporting units, an impairment of goodwill may result. A hypothetical 10% decrease in the fair value of each reporting unit would have resulted in an additional impairment loss of approximately $159.9 million related to the 11 reporting units with goodwill balances remaining at December 31, 2010.
Critical Accounting Policies and Estimates (continued)
The below table summarizes the goodwill at increased risk of future impairment by reportable segment as of December 31, 2010 ($000s omitted):
We will continue to monitor each of our reporting units and perform goodwill impairment testing when events or changes in circumstances indicate the carrying amount may not be recoverable. See Note 3 to the Condensed Consolidated Financial Statements for additional discussion of our goodwill impairment.
We have recorded intangible assets related to tradenames acquired with the Centex merger completed in 2009 and the Del Webb merger completed in 2001, which are being amortized over their estimated useful lives. The carrying values and ultimate realization of these assets are dependent upon estimates of future earnings and benefits that we expect to generate from their use. If we determine that the carrying values of intangible assets may not be recoverable based upon the existence of one or more indicators of impairment, we use a projected undiscounted cash flow method to determine if impairment exists. If the carrying values of the intangible assets exceed the expected undiscounted cash flows, then we measure impairment as the difference between the fair value of the asset and the recorded carrying value. If our expectations of future results and cash flows decrease significantly or if our strategy related to the use of such intangible assets changes, the related intangible assets may be impaired.
Allowance for warranties
Home purchasers are provided with a limited warranty against certain building defects, including a one-year comprehensive limited warranty and coverage for certain other aspects of the homes construction and operating systems for periods of up to ten years. We estimate the costs to be incurred under these warranties and record a liability in the amount of such costs at the time product revenue is recognized. Factors that affect our warranty liability include the number of homes sold, historical and anticipated rates of warranty claims, and the cost per claim. We periodically assess the adequacy of our recorded warranty liability for each geographic market in which we operate and adjust the amounts as necessary. Actual warranty costs in the future could differ from our estimates.
We maintain, and require the majority of our subcontractors to maintain, general liability insurance coverage, including coverage for certain construction defects. We also maintain property, errors and omissions, workers compensation, and other business insurance coverage. These insurance policies protect us against a portion of the risk of loss from claims. However, we retain a significant portion of the overall risk for such claims either through policies issued by our captive insurance subsidiaries or through our own self-insured per occurrence and aggregate retentions, deductibles, and available policy limits. The availability of general liability insurance for the homebuilding industry and its subcontractors has become increasingly limited and more expensive in recent years. In certain instances, we may offer our subcontractors the opportunity to purchase insurance through one of our captive insurance subsidiaries or to participate in a project specific insurance program provided by us. Any policy issued by the captive insurance subsidiaries represents self-insurance of these risks by us. While general liability coverage for the homebuilding industry is complex and our coverage varies significantly based on the policy year, in recent years we have generally been self-insured for $5.0 million to $7.5 million on a per occurrence basis and up to $60.0 million on an annual aggregate basis, at which point our excess or reinsurance coverage begins.
Critical Accounting Policies and Estimates (continued)
Self-insured risks (continued)
We generally reserve for costs associated with insurance claims and their related lawsuits (including expected legal fees) based on an actuarial analysis of our historical claims. The actuarial analysis includes an estimate of claims incurred but not reported. These estimates make up a significant portion of our estimates and are subject to a high degree of uncertainty due to a variety of factors, including changes in claims reporting and resolution patterns, third party recoveries, insurance industry practices, the regulatory environment, and legal precedent. State regulations vary, but construction defect claims are reported and resolved over an extended period often exceeding ten years. As a result, actual costs could differ significantly from estimated costs.
Adjustments to estimated reserves are recorded in the period in which the change in estimate occurs. Our recorded reserves for all insurance claims totaled $813.8 million and $566.7 million at December 31, 2010 and 2009, respectively, substantially all of which relates to general liability insurance. The increase in the liability at December 31, 2010 was due to recording additional expense to insurance reserves during 2010 as a result of experiencing greater than anticipated frequency of newly reported claims and an increase in specific case reserves related to known claims for homes closed in prior periods. Substantially all of these increases related to general liability reserves. The recorded reserves included an actuarial assessment of incurred but not reported claims, which represented approximately 76% and 75% of the total general liability reserves at December 31, 2010 and 2009, respectively. Changes in the number and timing of reported claims and the estimates of specific claim values will significantly impact estimates of future reserves, which are reflected by the incurred but not reported reserve.
In certain instances, we have the ability to recover a portion of its costs under various insurance policies or from our subcontractors or other third parties. Estimates of such amounts are recorded when recovery is considered probable. The actuarial analyses of the reserves also consider historical third party recovery rates. Our insurance policies are maintained with highly-rated underwriters for whom we believe counterparty default risk is not significant.
We calculate the fair value of stock options using the Black-Scholes option pricing model. Determining the fair value of share-based awards at the grant date requires judgment in developing assumptions, which involve a number of variables. These variables include, but are not limited to, the expected stock price volatility over the term of the awards, the expected dividend yield, and expected stock option exercise behavior. In addition, we also use judgment in estimating the number of share-based awards that are expected to be forfeited.
We calculate our provision for income taxes using the asset and liability method, under which deferred tax assets and liabilities are recognized by identifying the temporary differences arising from the different treatment of items for tax and accounting purposes. In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. Our assessment considers, among other matters, the nature, frequency, and magnitude of current and cumulative income and losses, forecasts of future profitability, the duration of statutory carryback or carryforward periods, our experience with operating loss and tax credit carryforwards being used before expiration, and tax planning alternatives. The ultimate realization of deferred tax assets is primarily dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. In determining the future tax consequences of events that have been recognized in our financial statements or tax returns, judgment is required. Differences between the anticipated and actual outcomes of these future tax consequences could have a material impact on our consolidated results of operations or financial position.
We follow the provisions of ASC 740, Income Taxes (ASC 740), which prescribes a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. ASC 740 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, and disclosure. Significant judgment is required to evaluate uncertain tax positions. Evaluations of our tax positions consider changes in facts or circumstances, changes in law, correspondence with taxing authorities, and settlements of audit issues.
New Accounting Pronouncements
See Note 1 to the Consolidated Financial Statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are subject to interest rate risk on our rate-sensitive financing to the extent long-term rates decline. The following tables set forth, as of December 31, 2010 and 2009, our rate-sensitive financing obligations, principal cash flows by scheduled maturity, weighted-average interest rates, and estimated fair value ($000s omitted).
Pulte Mortgage, operating as a mortgage banker, is also subject to interest rate risk. Interest rate risk begins when we commit to lend money to a customer at agreed-upon terms (i.e., commit to lend at a certain interest rate for a certain period of time). The interest rate risk continues through the loan closing and until the loan is sold to an investor. During 2010 and 2009, this period of interest rate exposure averaged approximately 60 days. In periods of rising interest rates, the length of exposure will generally increase due to customers locking in an interest rate sooner as opposed to letting the interest rate float.
We minimize interest rate risk by hedging our loan commitments and closed loans through derivative financial instruments. These financial instruments include cash forward placement contracts on mortgage-backed securities, whole loan investor commitments, options on treasury future contracts, and options on cash forward placement contracts on mortgage-backed securities. We do not use any derivative financial instruments for trading purposes.
Hypothetical changes in the fair values of our financial instruments arising from immediate parallel shifts in long-term mortgage rates of plus 50, 100, and 150 basis points would not be material to our financial results.
At December 31, 2010, our aggregate net investment exposed to foreign currency exchange rate risk includes our remaining non-operating investments in Mexico, which approximated $0.2 million.
SPECIAL NOTES CONCERNING FORWARD-LOOKING STATEMENTS
As a cautionary note, except for the historical information contained herein, certain matters discussed in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, and Item 7a, Quantitative and Qualitative Disclosures About Market Risk, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to a number of risks, uncertainties and other factors that could cause our actual results, performance, prospects or opportunities, as well as those of the markets we serve or intend to serve, to differ materially from those expressed in, or implied by, these statements. You can identify these statements by the fact that they do not relate to matters of a strictly factual or historical nature and generally discuss or relate to forecasts, estimates or other expectations regarding future events. Generally, the words believe, expect, intend, estimate, anticipate, project, may, can, could, might, will and similar expressions identify forward-looking statements, including statements related to expected operating and performing results, planned transactions, planned objectives of management, future developments or conditions in the industries in which we participate and other trends, developments and uncertainties that may affect our business in the future.
Such risks, uncertainties and other factors include, among other things: interest rate changes and the availability of mortgage financing; continued volatility in, and potential deterioration of, the debt and equity markets; competition within industries in which PulteGroup operates; the availability and cost of land and other raw materials used by PulteGroup in its homebuilding operations; the availability and cost of insurance covering risks associated with PulteGroups businesses; shortages and the cost of labor; weather related slowdowns; slow growth initiatives and/or local building moratoria; governmental regulation directed at or affecting the housing market, the homebuilding industry or construction activities; uncertainty in the mortgage lending industry, including revisions to underwriting standards and repurchase requirements associated with the sale of mortgage loans; the interpretation of or changes to tax, labor and environmental laws; economic changes nationally or in PulteGroups local markets, including inflation, deflation, changes in consumer confidence and preferences and the state of the market for homes in general; legal or regulatory proceedings or claims; required accounting changes; terrorist acts and other acts of war; and other factors of national, regional and global scale, including those of a political, economic, business and competitive nature. See Item 1A Risk Factors for a further discussion of these and other risks and uncertainties applicable to PulteGroups business. PulteGroup undertakes no duty to update any forward-looking statement whether as a result of new information, future events or changes in PulteGroups expectations.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CONSOLIDATED BALANCE SHEETS
December 31, 2010 and 2009
($000s omitted, except per share data)
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
For the years ended December 31, 2010, 2009, and 2008
(000s omitted, except per share data)
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
AND COMPREHENSIVE INCOME (LOSS)
For the years ended December 31, 2010, 2009, and 2008
($000s omitted, except per share data)
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31, 2010, 2009, and 2008
See Notes to Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Basis of presentation
On March 18, 2010, Pulte Homes, Inc. changed its name to PulteGroup, Inc. (PulteGroup), a publicly-held holding company traded on the New York Stock Exchange under the ticker symbol PHM. The consolidated financial statements include the accounts of PulteGroup and all of its direct and indirect subsidiaries (the Company) and variable interest entities in which the Company is deemed to be the primary beneficiary. While the Companys subsidiaries engage primarily in the homebuilding business, the Company also has mortgage banking operations, conducted principally through Pulte Mortgage LLC (Pulte Mortgage), and title operations.
On August 18, 2009, the Company completed the acquisition of Centex Corporation (Centex) through the merger of PulteGroups merger subsidiary with and into Centex pursuant to the Agreement and Plan of Merger dated as of April 7, 2009 among PulteGroup, Pi Nevada Building Company, and Centex. As a result of the merger, Centex became a wholly-owned subsidiary of PulteGroup. Accordingly, the results of Centex are included in the Companys consolidated financial statements from the date of the merger.
Use of estimates
The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Certain prior period amounts have been reclassified to conform to the current year presentation.
The financial statements of the Companys foreign subsidiaries were measured using the local currency as the functional currency. Assets and liabilities of these subsidiaries were translated at exchange rates as of the balance sheet date. Revenues and expenses were translated at average exchange rates in effect during the year. Realized foreign currency transaction gains and losses were not significant during 2010, 2009, and 2008.
The Company evaluated subsequent events up until the time the financial statements were filed with the Securities and Exchange Commission.
Cash and equivalents
Cash and equivalents include institutional money market investments and time deposits with a maturity of three months or less when acquired. Cash and cash equivalents also include $250.0 million and $415.1 million maintained in liquidity reserve accounts as compensating balances at December 31, 2010 and 2009, respectively. See Note 9.
The Company maintains certain cash balances that are restricted as to their use. Restricted cash consists of customer deposits on home sales which are temporarily restricted by regulatory requirements until title transfers to the homebuyer as well as certain other accounts with restrictions.
Investments in unconsolidated entities
The Company has investments in a number of unconsolidated entities, including joint ventures, with independent third parties. Many of these unconsolidated entities purchase, develop, and/or sell land and homes in
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Investments in unconsolidated entities (continued)
the United States and Puerto Rico. The equity method of accounting is used for unconsolidated entities over which the Company has significant influence; generally this represents ownership interests of at least 20% and not more than 50%. Under the equity method of accounting, the Company recognizes its proportionate share of the profits and losses of these entities. Certain of these entities sell land to the Company. In these situations, the Company defers the recognition of profits from such activities until the time the related homes are sold. The cost method of accounting is used for investments in which the Company has less than a 20% ownership interest and does not have the ability to exercise significant influence.
The Company evaluates its investments in unconsolidated entities for recoverability in accordance with Accounting Standards Codification (ASC) 323, Investments Equity Method and Joint Ventures (ASC 323). If the Company determines that a loss in the value of the investment is other than temporary, the Company writes down the investment to its estimated fair value. Any such losses are recorded to equity in (earnings) loss of unconsolidated entities in the Consolidated Statements of Operations. Additionally, each unconsolidated entity evaluates its long-lived assets, such as inventory, for recoverability in accordance with ASC 360-10, Property, Plant, and Equipment Impairment or Disposal of Long-Lived Assets (ASC 360-10). The Companys proportionate share of any such impairments is also recorded to equity in (earnings) loss of unconsolidated entities in the Consolidated Statements of Operations. Evaluations of recoverability under both ASC 323 and ASC 360-10 are primarily based on projected cash flows. Due to uncertainties in the estimation process and the significant volatility in demand for new housing, actual results could differ significantly from such estimates. See Note 7.
In certain instances, the Company may accept consideration for land sales or other transactions in the form of a note receivable. The counterparties for these transactions are generally land developers or other strategic investors. The Company considers the creditworthiness of the counterparty when evaluating the relative risk and return involved in pursuing the applicable transaction. Due to the unique facts and circumstances surrounding each receivable, the Company actively monitors each individual receivable separately and assesses the need for an allowance for each receivable on an individual basis. Factors considered as part of this assessment include the counterpartys payment history, the value of any underlying collateral, communications with the counterparty, knowledge of the counterpartys financial condition and plans, and the current and expected economic environment. Allowances are recorded when it becomes likely that some amount will not be collectible and are reported net of allowance for credit losses within other assets in the Consolidated Balance Sheet. Notes receivable are written off when it is determined that collection efforts will no longer be pursued. Interest income is recognized as earned. The amount of impaired or past due notes receivable was not material at December 31, 2010.
The following represents the Companys notes receivable and related allowance for credit losses at December 31, 2010 ($000s omitted):
The Company also records other receivables from various parties in the normal course of business, including amounts due from municipalities, insurance companies, and vendors. Such receivables are generally non-interest bearing and non-collateralized, payable either on demand or upon the occurrence of a specified event, and are generally reported in other assets in the Consolidated Balance Sheet. See Residential mortgage loans available-for-sale and Loans held for investment in Note 1 for discussion of the Companys receivables related to mortgage operations.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Intangible assets consist of trademarks and tradenames acquired in connection with the 2009 acquisition of Centex and the 2001 acquisition of Del Webb. These intangible assets were valued at the acquisition date utilizing proven valuation procedures and are generally being amortized over a 20-year life. The acquired cost and accumulated amortization of the Companys intangible assets were $259.0 million and $83.6 million, respectively, at December 31, 2010, and $259.0 million and $70.5 million, respectively, at December 31, 2009. Amortization expense totaled $13.1 million in 2010, $14.0 million in 2009 (including $4.0 million related to the fair value of customer backlog acquired with the Centex merger that was fully amortized as of December 31, 2009), and $8.2 million in 2008. Amortizati