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Ryland Group 10-K 2007 Documents found in this filing:United States Securities and Exchange Commission Washington, D.C. 20549 Form 10-K
For the transition period from to Commission File Number 001-08029 The Ryland Group, Inc. (Exact name of registrant as specified in its charter)
24025 Park Sorrento, Suite 400, Calabasas, California 91302 Registrant’s telephone number, including area code: (818) 223-7500 Securities registered pursuant to Section 12(b) of the Exchange Act:
Securities registered pursuant to Section 12(g) of the Exchange Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act of 1933, as amended (the “Securities Act”). Yes x No o Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o 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 Exchange Act 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 o 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 registrant’s 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. o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether
the registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act). The aggregate market value of the common stock of The Ryland Group, Inc. held by nonaffiliates of the registrant (43,509,472 shares) at June 30, 2006, was $1,895,707,695. The number of shares of common stock of The Ryland Group, Inc. outstanding on February 12, 2007, was 42,572,875. Documents Incorporated by Reference
2 The Ryland Group, Inc.
3 Part I Item 1. Business With headquarters in Southern California, The Ryland Group, Inc., a Maryland corporation (the “Company”), is one of the nation’s largest homebuilders and a leading mortgage-finance company. It is a Fortune 500 company and is traded on the New York Stock Exchange under the symbol “RYL.” Founded in 1967, the Company has built more than 265,000 homes. In addition, Ryland Mortgage Company and its subsidiaries (“RMC”) has provided mortgage financing and related services for more than 225,000 homebuyers. The Company consists of six segments: four geographically-determined homebuilding regions, financial services, and corporate. The Company’s operations span all significant aspects of the homebuying process—from design, construction and sale to mortgage origination, title insurance, escrow and insurance services. The homebuilding operations are, by far, the most substantial part of its business, comprising approximately 98 percent of consolidated revenues in 2006. The homebuilding segments generate nearly all of their revenues from the sale of completed homes, with a lesser amount from the sale of land and lots. In addition to building single-family detached homes, the homebuilding segments also build attached homes, such as town homes and condominiums, including some mid-rise buildings, which share common walls and roofs. The Company builds homes for entry-level buyers, as well as for first- and second-time move-up buyers. The Company’s prices range from $98,000 to more than $800,000, with the average price of a home closed during 2006 being $295,000. The financial services segment offers mortgage, title, escrow and insurance services to its homeowners and subcontractors. Over the last 13 years, the Company has concentrated on expanding its operations by investing its available capital into both existing and new markets. It has believed that measured “organic” growth avoids the risk, debt, intangible assets and distractions associated with external acquisitions. The Company focuses on achieving a high return on invested capital and establishing profitable operations in each of its markets. New communities are evaluated based on return and profitability benchmarks, and both senior and local management are incentivized based on their ability to achieve such returns. Management continually monitors the land acquisition process, sales revenues, margins and returns achieved in each of the Company’s markets as part of its capital evaluation process. The Company is highly diversified throughout the United States, with no more than 10 percent of its deployed capital allocated to any given market. It believes diversification not only minimizes its exposure to economic and market fluctuations, but also enhances its growth potential. Capital is strategically allocated to avoid concentration in any given geographic area and to circumvent the accompanying risk associated with excessive dependence on local market anomalies. Subject to macroeconomic and local market conditions, the Company plans to either manage its exposure or to expand its presence in its existing markets in an effort to be among the largest builders in each of those markets. It also intends to continue diversification by selectively entering new markets, primarily through establishing start-up or satellite operations in markets near its existing divisions. The Company’s national scale has provided increased opportunities for negotiation of volume discounts and rebates from material suppliers. Additionally, it has greater access to a lower cost of capital due to the strength of its balance sheet, as well as to its lending and capital markets relationships. The Company’s economies of scale and diversification have contributed to significant improvements in its operating margins during periods of growth and mitigated its overall risk in periods of declining housing demand. Committed to product innovation, the Company conducts ongoing research into consumer preferences and trends. It is constantly adapting and improving its house plans, design features, customized options and mortgage programs. It strives to offer value, selection, location and quality to all homebuyers. 4 The Company is dedicated to building quality homes and customer relationships. With customer satisfaction as a major priority, it continues to make innovative enhancements designed to attract homebuyers. During 2006, the Company launched a new expanded Web site to include online systems for tracking requests, processing issues and improving customer interaction. In addition, the Company uses a third party to analyze customer feedback and to better serve its homebuyers’ needs. The Company enters into land development joint ventures, from time to time, as a means of building lot positions, reducing its risk profile and enhancing its return on capital. It occasionally partners with developers, other homebuilders or financial investors to develop finished lots for sale to the joint ventures’ members or other third parties. Aside from being an added value to customers, the financial services segment greatly enhances the Company’s profitability while limiting its risk. A competitively high capture rate for mortgage financing and other services allows the homebuilder to monitor its backlog and closing process. Risk is further reduced because substantially all loans are sold to a third party within one day of the date they close. The third party then services and manages the loans and assumes the credit risk of borrower default. Homebuilding General The Company’s homes are built on-site and marketed in four major geographic regions, or segments. At December 31, 2006, the Company operated in the following metropolitan areas:
The Company has decentralized operations to provide more flexibility to its local division presidents and management teams. Each of its 22 homebuilding divisions across the country generally consists of a division president, a controller and other management personnel focused on land entitlement, acquisition and development; sales, construction, customer service, and purchasing; as well as accounting and administrative personnel. The Company’s operations in each of its homebuilding markets may differ due to a number of market-specific factors. These factors include regional economic conditions and job growth; land availability and local land development; consumer preferences; competition from other homebuilders; and home resale activity. The Company not only considers each of these factors upon entering into new markets, but also in determining the extent of its operations and capital allocation in existing markets. The Company’s local management teams are familiar with these factors, and their market experience and expertise are critical in making decisions regarding local operations. The Company provides oversight and centralizes key elements of its homebuilding business through its corporate and regional offices. The Company has four regional offices, each generally consisting of a region president; a chief financial officer; real estate legal counsel; and additional management personnel focused on human resources, marketing and operations. Regional offices provide oversight 5 and standardization where appropriate. The staff in each of these offices monitors activities by using various operational metrics in order to achieve Company return benchmarks. The Company markets attached and detached single-family homes, which are generally targeted to entry-level and first- and second-time move-up buyers. Its diverse product line is tailored to the local styles and preferences found in each of its geographic markets. The product line offered in a particular community is determined in conjunction with the land acquisition process and is dependent upon a number of factors, including consumer preferences, competitive product offerings and development costs. Architectural services are generally outsourced to increase creativity and to ensure that the Company’s home designs are consistent with local market trends. Homebuyers are able to customize certain features of their homes by selecting from numerous options and upgrades displayed in the Company’s model homes and design centers. These design centers, which are conveniently located in most of the Company’s markets, also represent an increasing source of additional revenue and profit for the Company. Custom options contributed approximately 12 percent of revenues in 2006 and resulted in significantly higher margins in comparison to base homes. Land Acquisition and Development The Company’s objective is to control a portfolio of building lots sufficient to meet its anticipated homebuilding requirements for a period of approximately four to five years. The Company acquires land only after completing due diligence and feasibility studies. The land acquisition process is controlled by a corporate land approval committee to help ensure that transactions meet the Company’s standards for financial performance and risk. In the ordinary course of its homebuilding business, the Company utilizes both direct acquisition and option contracts to control building lots for use in the sale and construction of homes. The Company’s direct land acquisition activities include the bulk purchase of finished lots from developers and the purchase of undeveloped entitled land from third parties. The Company generally does not purchase unentitled or unzoned land. Although control of lot inventory through the use of option contracts minimizes the Company’s investment, such a strategy is not viable in certain markets due to the absence of third-party land developers. In other markets, competitive conditions may prevent the Company from controlling quality lots solely through the use of option contracts. In such situations, the Company may acquire undeveloped entitled land and/or finished lots on a bulk basis. The Company utilizes the selective development of land to gain access to prime locations, increase margins and position itself as a leader in the area through its influence over a community’s character, layout and amenities. After determining the size, style, price range, density, layout and overall design of a community, the Company obtains governmental and other approvals necessary to begin the development process. Land is then graded; roads, utilities, amenities and other infrastructures are installed; and the individual home sites are created. At December 31, 2006, the Company had cash deposits and outstanding letters of credit totaling $187.8 million in connection with option agreements and land purchase contracts having a total purchase price of $1.5 billion. These options and commitments expire at various dates through 2018. Materials Costs Substantially all materials used in construction are available from a number of sources, but may fluctuate in price due to various factors. In order to increase purchasing efficiencies, the Company not only standardizes certain building materials and products, but also acquires such products through national supply contracts. The Company has, on occasion, experienced shortages of certain materials. If shortages were to occur in the future, such shortages could result in longer construction times and higher costs than those experienced in the past. 6 Construction Substantially all on-site construction is performed for a fixed price by independent subcontractors selected on a competitive-bid basis. The Company generally requires a minimum of three competitive bids for each phase of construction. Construction activities are supervised by the Company’s production team, which schedules and coordinates subcontractor work, monitors quality, and ensures compliance with local zoning and building codes. The Company requires substantially all of its subcontractors to have general liability insurance (including construction defect coverage) and workmans compensation insurance. Construction time for homes depends on weather, availability of labor or subcontractors, materials, home size, geological conditions and other factors. The duration of the home construction process is generally between three and six months. The Company has an integrated financial and homebuilding management system that assists in scheduling production and controlling costs. Through this system, the Company monitors construction status and job costs incurred for each home during each phase of construction. The system provides for detailed budgeting and allows the Company to track and control actual costs, versus construction bids, for each community and subcontractor. The Company has, on occasion, experienced shortages of skilled labor in certain markets. If shortages were to occur in the future, such shortages could result in longer construction times and higher costs than those experienced in the past. The Company, its subcontractors and its suppliers maintain insurance, subject to deductibles and self-insured amounts, to protect against various risks associated with homebuilding activities, including, among others, general liability, “all-risk” property, workmans compensation, automobile and employee fidelity. The Company accrues for its expected costs associated with the deductibles and self-insured amounts. Marketing The Company generally markets its homes to entry-level and first- and second-time move-up buyers through targeted product offerings in each of the communities in which it operates. The Company’s marketing strategy is determined during the land acquisition and feasibility stage of a community’s development. Employees and independent real estate brokers sell the Company’s homes, generally by showing furnished models. A new order is reported when a customer’s sales contract has been signed by the homebuyer and approved by the Company, subject to cancellation. The Company normally starts construction of a home when a customer has selected a lot, chosen a floor plan and received preliminary mortgage approval. However, construction may begin prior to this in order to satisfy market demand for completed homes and to facilitate construction scheduling and/or cost savings. Homebuilding revenues are recognized when home sales are closed, title and possession are transferred to the buyer and there is no significant continuing involvement. The Company advertises in newspapers and trade publications, as well as with marketing brochures and newsletters. It also uses billboards, radio and television advertising, and its Web site to market the location, price range and availability of its homes. The Company also attempts to operate in conspicuously located communities that permit it to take advantage of local traffic patterns. Model homes play a significant role in the Company’s marketing efforts by creating an attractive atmosphere and displaying options and upgrades. The Company’s sales contracts typically require an earnest money deposit. The amount of earnest money required varies between markets and communities. Additionally, buyers are generally required to pay additional deposits when they select options or upgrades for their homes. Most of the Company’s sales contracts stipulate that when homebuyers cancel the homebuyers’ contracts with the Company, it has the right to retain the homebuyers’ earnest money and option deposits; however, its operating divisions may choose to refund part or all of such deposits. The Company’s sales contracts may also include contingencies that permit homebuyers to cancel and receive a refund of their deposits if they cannot obtain mortgage financing at prevailing or specified interest rates within a specified time period. The Company’s contracts may also include other contingencies, such 7 as the sale of an existing home. The length of time between the signing of a sales contract for a home and delivery of the home to the buyer may vary, depending on customer preferences, permit approval and construction cycles. Customer Service and Warranties The Company’s operating divisions are responsible for pre-closing quality control inspections and responding to homebuyers’ post-closing needs. The Company believes that prompt and courteous acknowledgment of its homebuyers’ needs during and after construction reduces post-closing repair costs, enhances its reputation for quality and service, and ultimately leads to repeat and referral business. The subcontractors, who perform most of the actual construction, also provide warranties on workmanship. The Company provides each homeowner with product warranties covering workmanship and materials for one year, certain mechanical systems for two years and structural systems for ten years from the time of closing. The Company believes its warranty program meets or exceeds terms customarily offered in the homebuilding industry. Seasonality The Company experiences seasonal variations in its quarterly operating results and capital requirements. Historically, new order activity is higher during the spring and summer months. This is primarily due to the preference of many homebuyers to act during those periods. As a result, it typically has more homes under construction, closes more homes, and has greater revenues and operating income in the third and fourth quarters of the year. Financial Services The Company’s financial services segment provides mortgage-related products and services, as well as insurance services, to its homebuyers and subcontractors. The Company’s financial services segment includes RMC, Ryland Homes Insurance Company (“RHIC”), LPS Holdings Corporation and its subsidiaries (“LPS”) and Columbia National Risk Retention Group, Inc. (“CNRRG”). By aligning its operations with the Company’s homebuilding segments, the financial services segment leverages this relationship to provide lending services to homebuyers. In addition to being a valuable asset to customers, the financial services segment greatly enhances the Company’s profitability. Providing mortgage financing and other services to its customers allows the homebuilding segments to better monitor their backlog and closing process. Substantially all loans are sold to a third party within one business day of the date they close. The third party then services and manages the loans and assumes the credit risk of borrower default. Insurance services provide subcontractors with construction-related insurance in the western markets. Additionally, the financial services segment provides insurance for liability risks, specifically homeowners’ warranty coverage, arising in connection with the homebuilding business of the Company. Loan Origination In 2006, RMC’s mortgage origination operations consisted primarily of loans, which were originated in connection with the sale of the Company’s homes. During the year, mortgage operations originated 11,744 loans, totaling $3.0 billion, of which 99.7 percent was for purchases of homes built by the Company and the remaining amount was for either purchases of homes built by others, purchases of existing homes or the refinancing of existing mortgage loans. RMC arranges various types of mortgage financing, including conventional, Federal Housing Administration (“FHA”) and Veterans Administration (“VA”) mortgages, with various fixed- and adjustable-rate features. RMC is approved to originate loans that conform to the guidelines established by the Federal Home Loan Mortgage Corporation (“FHLMC”) and the Federal National Mortgage Association (“FNMA”). RMC sells the loans it originates, along with the related servicing rights, to others. 8 Title and Escrow Services Cornerstone Title Company, a wholly-owned subsidiary of RMC, doing business as Ryland Title Company, provides title services and acts as a title insurance agent primarily for the Company’s homebuyers. At December 31, 2006, it provided title services in Arizona, Colorado, Florida, Georgia, Illinois, Indiana, Maryland, Minnesota, Nevada, North Carolina, Ohio, South Carolina, Texas and Virginia. The Company also operates Ryland Escrow Company, which performs escrow and closing functions for the Company’s homebuyers in California. During 2006, Ryland Title Company and Ryland Escrow Company provided these services to 96.3 percent of the Company’s homebuyers in the markets in which they operate, compared to 96.9 percent during 2005. LPS is a wholly-owned subsidiary of the Company and was formed to operate certain limited purpose subsidiaries, including Ryland Escrow Company. Insurance Services Ryland Insurance Services (“RIS”), a wholly-owned subsidiary of RMC, provides insurance services to the Company’s homebuyers. At December 31, 2006, RIS was licensed to operate in all of the states in which the Company’s homebuilding segments operate. During 2006, it provided insurance services to 62.4 percent of the Company’s homebuyers, compared to 60.4 percent during 2005. RHIC is a wholly-owned subsidiary of the Company that provides insurance services to the homebuilding segments’ subcontractors in certain markets. CNRRG is a wholly-owned subsidiary of the Company. CNRRG was established to directly insure liability risks, specifically homeowners’ warranty coverage, arising in connection with the homebuilding business of the Company. Corporate Corporate is a non-operating business segment whose purpose is to support operations. Corporate departments are responsible for establishing operational policies and internal control standards; implementing strategic initiatives; and monitoring compliance with policies and controls throughout the Company’s operations. Corporate acts as an internal source of capital and provides financial, human resources, information technology, insurance, legal, marketing, national purchasing and tax compliance services. In addition, it performs administrative functions associated with a publicly traded entity. Real Estate and Economic Conditions The Company is significantly affected by fluctuations in economic activity, interest rates and levels of consumer confidence. The effects of these fluctuations differ among the various geographic markets in which the Company operates. Higher interest rates may affect the ability of buyers to qualify for mortgage financing and decrease demand for new homes. As a result, rising interest rates generally will decrease the Company’s home sales and mortgage originations. The Company’s business is also affected by local economic conditions, such as employment rates and housing demand, in the markets in which it operates. Some of these markets have, at times, experienced a significant decline in housing demand. Inventory risk can be substantial for homebuilders. The market value of land, lots and housing inventories fluctuates as a result of changing market and economic conditions. The Company must continuously locate and acquire land not only for expansion into new markets, but also for replacement and expansion of land inventory within current markets. The Company employs various measures, including a corporate land approval process and a continuous review by senior management, designed to control inventory risk. However, it cannot assure that these measures will avoid or eliminate this risk. 9 Competition The Company competes in each of its markets with a large number of national, regional and local homebuilding companies. Some of these national companies are larger than the Company and most have greater financial resources than in the past. The strength and expanded presence of national homebuilders, plus the continued viability of regional and local homebuilders, has increased competition in many markets. This competition could make it more difficult to acquire suitable land at acceptable prices, force an increase in selling incentives or decrease sales. Any of these could have an adverse impact on the Company’s financial performance or results of operations. The Company also competes with other housing alternatives, including existing homes and rental properties. Principal competitive factors in the homebuilding industry include price; design; quality; reputation; relationship with developers; accessibility of subcontractors; availability and location of lots; and availability of customer financing. The Company’s financial services segment competes with other mortgage bankers to arrange financing for homebuyers. Principal competitive factors include interest rates and other features of mortgage loan products available to the consumer. Regulatory and Environmental Matters The homebuilding segments are subject to various local, state and federal laws, ordinances, rules and regulations pertaining to zoning, building design, construction, stormwater permitting and discharge, and similar matters, as well as to open space, wetlands and environmentally protected areas. These include local regulations that impose restrictive zoning and density requirements to limit the number of homes that can be built within the boundaries of a particular area, as well as other municipal or city planning issues. The Company may also experience periodic delays in homebuilding projects due to regulatory compliance, municipal appeals and other governmental planning processes in any of the areas in which it operates. RMC is subject to the rules and regulations of FHA, FHLMC, FNMA, VA and the Department of Housing and Urban Development (“HUD”) with respect to originating, processing and selling mortgage loans. In addition, there are other federal and state laws and regulations that affect not only these activities, but also RMC’s title, escrow and insurance brokerage operations. These rules and regulations prohibit discrimination and establish underwriting guidelines that include provisions for inspections and appraisals; require credit reports on prospective borrowers; and fix maximum loan amounts. RMC is required to submit audited financial statements to various regulatory agencies annually, and each regulatory entity has its own financial requirements. The Company’s affairs are also subject to examination by these regulatory agencies and by state agencies, at all times, to assure compliance with applicable regulations, policies and procedures. Mortgage origination activities are subject to the Equal Credit Opportunity Act, the Federal Truth-in-Lending Act and the Real Estate Settlement Procedures Act (“RESPA”), as well as to associated regulations that prohibit discrimination and require the disclosure of certain information to mortgagors concerning credit and settlement costs. RHIC is registered and licensed under Section 431, Article 19 of the Hawaii Revised Statutes and is required to meet certain minimum capital and surplus requirements. Additionally, no dividends may be paid without prior approval of the Hawaii Insurance Commissioner. Employees At December 31, 2006, the Company had 2,810 employees. The Company considers its employee relations to be good. No employees are represented by a collective bargaining agreement. 10 Web Site Access to Reports The Company files annual, quarterly and special reports; proxy statements; and other information with the U.S. Securities and Exchange Commission (“SEC”) under the Exchange Act. Any document the Company files may be read at the SEC’s public reference room, Room 1580 at 100 F Street, NE, Washington, D.C. 20549. Please call the SEC toll-free at 1-800-SEC-0330 for information regarding its public reference room. The Company files information electronically with the SEC. The Company’s SEC filings are available from the SEC’s Web site at www.sec.gov. Reports, proxy and information statements, and other information regarding issuers that file electronically are readily obtainable there. Stockholders, securities analysts and others seeking information about the Company’s business operations and financial performance can receive copies of its 2006 Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, all amendments to those reports and other publications filed with the SEC in Washington, D.C., without charge, by contacting the treasurer’s office at (818) 223-7677; by writing to The Ryland Group, Inc., Investor Relations, 24025 Park Sorrento, Suite 400, Calabasas, California 91302; or via e-mail at investors@ryland.com. In addition, all filings with the SEC, news releases and quarterly earnings announcements, including live audio and replays of the most recent quarterly earnings conference calls, can be accessed free of charge on the Company’s Web site at www.ryland.com. Information on the Company’s Web site is not part of this report. The Company makes its Annual Report 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 available on its Web site as soon as possible after it electronically files such material with, or furnishes it to, the SEC. To retrieve any of this information, visit www.ryland.com, select “Investors” and scroll down the page to “SEC Filings.” Item 1A. Risk Factors If real estate and economic conditions deteriorate, the Company’s revenue and profit may decrease. The Company can be significantly affected by the cyclical nature of the homebuilding industry, which is sensitive to fluctuations in general and local economic conditions, interest rates, housing demand, employment levels, availability of financing and levels of consumer confidence. The effects of these fluctuations differ among the various geographic markets in which it operates. Sales of new homes are affected by market conditions for resale homes and rental properties. Its business is also affected by local economic conditions, such as employment rates and housing demand in the markets in which the Company builds homes. The markets in which it operates can experience mild to significant declines in housing demand. The Company is currently experiencing a decline in market demand in many of its markets. If market demand significantly changes, the Company is subject to inventory risk. Inventory risk can be substantial for homebuilders. The market value of the Company’s land, building lots and housing inventories fluctuates as a result of changing market and economic conditions. In addition, inventory carrying costs can result in losses in poorly performing projects or markets. In the event of significant changes in economic or market conditions, the Company may dispose of land or housing inventories on a basis that may result in a loss or may be required to write down or reduce the carrying value of its inventory. In the course of its business, the Company continuously seeks and makes acquisitions of land for expansion into new markets, as well as for replacement and expansion of land inventory within its current markets. Although it employs various measures, including its land approval process and continued review by senior management designed to manage inventory risks, the Company cannot assure that these measures will enable it to avoid or eliminate its inventory risk. 11 Construction costs can fluctuate and impact the Company’s margins. The homebuilding industry has, from time to time, experienced significant difficulties, including: shortages of qualified trades people; reliance on local subcontractors who may be inadequately capitalized; shortages of materials; and volatile increases in the cost of materials, particularly increases in the price of lumber, drywall and cement, which are significant components of home construction costs. The Company may not be able to recapture increased costs by raising prices either because of market conditions or because the Company fixes its prices at the time home sales contracts are signed. If interest rates rise further, then the Company’s business may decline and profitability may be reduced. Interest rates can significantly affect the Company’s lines of business. Higher interest rates affect the ability of buyers to qualify for mortgage financing and decrease demand for new homes. As a result, rising interest rates can decrease its home sales and mortgage originations. Further, the level and expected direction of interest rates can adversely affect the profitability of sales. Any of these factors could have an adverse impact on the Company’s results of operations or financial position. Because the Company’s industry is competitive, the business practices of other homebuilders can have an impact on the Company’s financial results and cause these results to decline. The residential housing industry is highly competitive. The Company competes in each of its markets with a large number of national, regional and local homebuilding companies. This competition could make it more difficult to acquire suitable land at acceptable prices, force it to increase selling incentives or lower its sales per community. Any of these could have an adverse impact on the Company’s financial performance or results of operations. It also competes with other housing alternatives, including existing homes and rental housing. Principal competitive factors in homebuilding are home price, design, quality, reputation, relationship with developers, accessibility of subcontractors, availability and location of lots, and availability of customer financing. The Company’s financial services segment competes with other mortgage bankers to arrange financing for homebuyers. Principal competitive factors include interest rates and other features of mortgage loan products available to the consumer. Because the Company’s business is subject to various regulatory and environmental limitations, it may not be able to conduct its business as planned. The Company’s homebuilding segments are subject to various local, state and federal laws, statutes, ordinances, rules and regulations concerning zoning, building design, construction, stormwater permitting and discharge and similar matters, as well as open space, wetlands and environmentally protected areas. These include local regulations that impose restrictive zoning and density requirements in order to limit the number of homes that can be built within the boundaries of a particular area, as well as other municipal or city land planning restrictions, requirements or limitations. The Company may also experience periodic delays in homebuilding projects due to regulatory compliance, municipal appeals and other government planning processes in any of the areas in which it operates. The Company’s financial services segment is subject to the rules and regulations of FHA, FHLMC, FNMA, VA and HUD with respect to originating, processing, selling and servicing mortgage loans. Mortgage origination activities are further subject to the Equal Credit Opportunity Act, Federal Truth-in-Lending Act and RESPA and their associated regulations. These and other federal and state statutes and regulations, among other things, prohibit discrimination and establish underwriting guidelines which include provisions for audits, inspections and appraisals, require credit reports on prospective borrowers, fix maximum loan amounts and require the disclosure of certain information concerning credit and settlement costs. The Company is required to submit audited financial statements annually, and each agency or other entity has its own financial requirements. The Company’s affairs are also subject to examination by these entities at all times to assure compliance with applicable regulations, policies and procedures. 12 Natural disasters may have a significant impact on the Company’s business. The climates and geology of many of the states in which the Company operates present increased risks of natural disasters. To the extent that hurricanes, severe storms, earthquakes, droughts, floods, wildfires or other natural disasters or similar events occur, its business in those states may be adversely affected. Because this report contains forward-looking statements, it may not prove to be accurate. This report and other Company releases and filings with the SEC may contain forward-looking statements. The Company generally identifies forward-looking statements using words like “believe,” “intend,” “expect,” “may,” “should,” “plan,” “project,” “contemplate,” “anticipate,” “target,” “estimate,” “foresee,” “goal,” “likely,” “will” or similar statements. Because these statements reflect its current views concerning future events, these statements involve risks, uncertainties and assumption, including the risks and uncertainties identified in this report. Actual results may differ significantly from the results discussed in these forward-looking statements. The Company does not undertake to update its forward-looking statements or risk factors to reflect future events or circumstances. Item 1B. Unresolved Staff Comments None. Item 2. Properties The Company leases office space for its corporate headquarters in Calabasas, California and for its IT Department and RMC’s operations center in Scottsdale, Arizona. In addition, the Company leases office space in the various markets in which it operates. Item 3. Legal Proceedings Contingent liabilities may arise from obligations incurred in the ordinary course of business or from the usual obligations of on-site housing producers for the completion of contracts. On January 15, 2004, a securities class action was filed against the Company and two of its officers in the United States District Court for the Northern District of Texas. The action alleges violations of the federal securities laws in connection with the disclosure by the Company of new home sales for the fourth quarter of 2003. In September 2005, the Court dismissed the action because the lead plaintiff previously selected by the Court had failed to state a claim upon which relief could be granted. As a result, the Court also dismissed the class action complaint. Subsequently, a different member of the purported class asked to be substituted as a new lead plaintiff. In June 2006, the Court granted that request and reinstated the action. The Company and the individual defendants intend to vigorously defend themselves. The Company is party to various other legal proceedings generally incidental to its businesses. Based on evaluation of these matters and discussions with counsel, management believes that liabilities arising from these matters will not have a material adverse effect on the financial condition of the Company. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2006. 13 Executive Officers of the Company The following sets forth certain information regarding the executive officers of the Company:
14 The Board of Directors elects all officers. There are no family relationships between any director or executive officer, or arrangements or understandings pursuant to which the officers listed above were elected. See the Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders (the “2007 Proxy Statement”) for a description of the Company’s employment and severance arrangements with certain of its executive officers, which is filed pursuant to Regulation 14A under the Exchange Act. Part II Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters Market for Common Equity, Common Stock Prices and Dividends The Company lists its common shares on the NYSE, trading under the symbol “RYL.” The latest reported sale price of the Company’s common stock on February 12, 2007, was $53.51, and there were approximately 1,652 common stockholders of record. The table below presents high and low market prices and dividend information for the Company.
Issuer Purchases of Equity Securities The following table summarizes the Company’s purchases of its own equity securities during the 12 months ended December 31, 2006:
On December 12, 2005, the Company announced that it had received authorization from its Board of Directors to purchase shares totaling $250.0 million, or approximately 3.5 million shares, based on the Company’s stock price on that date. At December 31, 2006, there were approximately 487,000 shares 15 available for purchase in accordance with this authorization based on the Company’s stock price on that date. This authorization does not have an expiration date. On December 6, 2006, the Company announced that it had received authorization from its Board of Directors to purchase shares totaling $175.0 million, or approximately 3.1 million shares, based on the Company’s stock price on that date. As of December 31, 2006, no shares had been purchased in accordance with this authorization. This authorization does not have an expiration date. Performance
Graph COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN* Among The Ryland Group, Inc., the S & P 500
Index and the Dow Jones U.S. Home Construction Index
*$100 invested on 12/31/01 in stock or index-including reinvestment of dividends. Securities
Authorized for Issuance Under Equity Compensation Plans 16 Item 6. Selected Financial Data
1Earnings before interest, taxes, depreciation and amortization (“EBITDA”) is a measure commonly used in the homebuilding industry and is presented to assist in understanding the ability of the operations of the Company to generate cash beyond that which is needed to service existing interest requirements and ongoing tax obligations. EBITDA equals net earnings before (a) interest expense; (b) previously capitalized interest amortized to cost of sales; (c) income taxes; and (d) depreciation and amortization. EBITDA is not a financial measure recognized in accordance with generally accepted accounting principles (“GAAP”). EBITDA should neither be considered an alternative to net earnings determined in accordance with GAAP as an indicator of operating performance nor an alternative to cash flows from operating activities determined in accordance with GAAP as a measure of liquidity. 2EBITDA/interest incurred is calculated as EBITDA (defined above) divided by total interest incurred, which is the sum of interest expense and capitalized interest for the period. 3Return on beginning equity is calculated as net earnings divided by total stockholders’ equity at the beginning of the period. 17 The following table sets forth the computation of EBITDA for each period presented.
A reconciliation of EBITDA to net cash provided by operations, the most directly comparable GAAP measure, is provided below for each period presented.
18 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements Note: Certain statements in this annual report may be regarded as “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, and may qualify for the safe harbor provided for in Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements represent the Company’s expectations and beliefs concerning future events, and no assurance can be given that the results described in this annual report will be achieved. These forward-looking statements can generally be identified by the use of statements that include words such as “anticipate,” “believe,” “estimate,” “expect,” “foresee,” “goal,” “intend,” “likely,” “may,” “plan,” “project,” “should,” “target,” “will” or other similar words or phrases. All forward-looking statements contained herein are based upon information available to the Company on the date of this annual report. Except as may be required under applicable law, the Company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. These forward-looking statements are subject to risks, uncertainties and other factors, many of which are outside of the Company’s control, that could cause actual results to differ materially from the results discussed in the forward-looking statements. The factors and assumptions upon which any forward-looking statements herein are based are subject to risks and uncertainties which include, among others: · economic changes nationally or in the Company’s local markets, including volatility and increases in interest rates, inflation, changes in consumer demand and confidence levels and the state of the market for homes in general; · the availability and cost of land; · increased land development costs on projects under development; · shortages of skilled labor or raw materials used in the production of houses; · increased prices for labor, land and raw materials used in the production of houses; · increased competition; · failure to anticipate or react to changing consumer preferences in home design; · increased costs and delays in land development or home construction resulting from adverse weather conditions; · potential delays or increased costs in obtaining necessary permits as a result of changes to laws, regulations or governmental policies (including those that affect zoning, density, building standards and the environment); · delays in obtaining approvals from applicable regulatory agencies and others in connection with the Company’s communities and land activities; · the risk factors set forth in this Form 10-K; and · other factors over which the Company has little or no control. 19 Overview/Results of Operations During 2006, the homebuilding industry continued to experience a softening of demand for new homes. Over the last several years, the price appreciation of homes was relatively high in most markets and, in turn, attracted speculation. As price appreciation slowed, consumer confidence and demand declined causing national homebuilders to experience increasing inventories, which resulted in a dramatic rise in the number of homes available for sale. The Company experienced a decrease in sales orders due to this lower demand, as well as to an increase in sales contract cancellations. As a result, the Company modified its operating strategy to compete in this changing environment by increasing advertising, sales price discounts and other incentives to generate sales; by striving to reduce inventory and commitments to purchase land in the future through contract renegotiations and cancellations; by decreasing its overhead expense to more closely match projected volume levels; and by renegotiating contracts with subcontractors and suppliers. Despite this challenging environment, the Company’s earnings, revenues and deliveries of homes represented the second-best year in the Company’s history. Although results were indicative of the more challenging economic climate, they also reflected the Company’s ability to deliver strong returns through geographic diversification while managing risk in uncertain conditions. The Company also achieved additional economies as a result of its variable-cost structure, consolidation of operations and cost-saving initiatives. It improved its Fortune 500 ranking and maintained its investment-grade rating while lowering leverage and the average interest rate on its debt. The Company continues to make investments in new marketing initiatives, product development, customer service, training and technology, all of which are critical to capturing market share while improving the customer’s experience and streamlining processes. The Company reported consolidated net earnings of $359.9 million, or $7.83 per diluted share, for 2006, compared to $447.1 million, or $9.03 per diluted share, for 2005 and $320.5 million, or $6.36 per diluted share, for 2004. The net earnings decrease for 2006, compared to 2005, resulted from a broad trend toward softening demand in residential housing and a more competitive sales environment in most markets, as well as from inventory valuation adjustments and write-offs of deposits and preacquisition costs that accompanied selective local market weakness. The rise in the Company’s net earnings from 2004 to 2005 was primarily due to higher revenues, increased operating margins and decreased expenses for its homebuilding operations. Total revenues for 2006 were $4.8 billion, a decrease of $60.4 million or 1.3 percent, from 2005 that resulted from a decline in closing volume, partially offset by an increase in average sales price. Total revenues for 2005 exceeded 2004 levels by $865.7 million, or 21.9 percent. Homebuilding pretax operating margins were 12.3 percent for 2006, compared to 15.8 percent for 2005 and 13.6 percent for 2004. The decrease in margins in 2006 from 2005 was due to increased price concessions and sales incentives in most markets, inventory valuation adjustments and option deposit write-offs. EBITDA was $662.8 million for the year ended December 31, 2006, compared to $810.4 million and $602.7 million for the same period in 2005 and 2004, respectively. The Company’s ratio of EBITDA to interest incurred was 9.2 for the year ended December 31, 2006, compared to 12.2 for 2005 and 11.3 for 2004. In an effort to position itself for competitive industry conditions in 2007, the Company generated cash flows in 2006 from its operations by maintaining profitability, while reducing land acquisition and construction activity. The Company had 15,353 fewer lots under control, or a 20.3 percent decrease at December 31, 2006, versus year-end 2005, as a result of terminating marginal option contracts. Inventory growth was more moderate during 2006 in order to balance lower order volume with an ability to gain market share in the event of stabilizing demand. Goodwill of $18.2 million remained unchanged in 2006 from 2005 and was among the lowest in the industry. The Company’s debt-to-capital ratio was 38.6 percent at December 31, 2006, as compared to 40.1 percent for the 20 same period in 2005. The weighted-average rate of interest for the Company’s debt was 5.8 percent and 6.3 percent at December 31, 2006 and 2005, respectively.
Stockholders’ equity increased 9.8 percent, or $135.1 million, during 2006, compared to an increase of 30.2 percent, or $319.2 million, during 2005. As a result of balancing cash outlays with inventory management, leverage objectives and common stock repurchases, stockholders’ equity per share increased 19.5 percent to $35.46 in 2006, compared to $29.68 in 2005. The Company’s book value at December 31, 2006, was 98.8 percent tangible. The Company is not a significant participant in off-balance sheet financing outside of traditional option contracts with land developers and its investments in joint ventures represent less than one percent of its total assets. Its balance sheet continues to reflect the Company’s strength, low-risk strategy and transparency. During 2006, the Company continued to deliver solid returns to stockholders while maintaining its strategically low-risk model. In addition, it has focused on realigning the business to prepare for a prolonged downturn, should it occur, and developing competitive advantages through training and technology initiatives. Return on beginning equity was 26.2 percent, return on beginning capital1 was 17.0 percent and inventory was turned 1.3 times. The Company’s cost of capital has declined. Despite a challenging industry environment, the Company’s stockholder returns remained among the highest in the industry and Fortune 500 companies. Homebuilding The Company’s homebuilding operations consist of four geographically-determined regional reporting segments: North, Southeast, Texas and West. New orders represent sales contracts that have been signed by the homebuyer and approved by the Company, subject to cancellation. The dollar value of new order contracts decreased $1.9 billion, or 37.5 percent, to $3.2 billion for the year ended December 31, 2006, from $5.1 billion for the year ended December 31, 2005, and $4.4 billion for the same period in 2004 due to slowing demand and to increases in cancellation rates. Unit orders decreased 36.4 percent in 2006 and increased 3.8 percent in 2005. Cancellation rates totaled 37.1 percent and 22.3 percent for the years ended December 31, 2006 and 2005, respectively. The combined homebuilding operations reported pretax earnings of $573.1 million for 2006, compared to $744.2 million for 2005 and $525.5 million for 2004. Homebuilding results in 2006 decreased from 2005 primarily due to an environment of slowing demand that resulted in declining prices and valuations, which in turn led to a decline in gross profit margins and closing volume, offset by a 6.1 percent increase in average closing price. Homebuilding results in 2005 increased from 2004 due to higher average closing prices, gross profit margins and closing volume. Homebuilding revenues fell 1.5 percent for 2006, compared to 2005, due to a 7.7 percent decrease in closings, partially offset by a 6.1 percent increase in average closing price. The decline in closings in 2006 was due to slowing market trends and a more competitive sales environment in most markets. The increase in the average closing price was primarily due to the delivery of homes in 2006 that were sold in 2005 under more favorable market conditions than currently exist. Homebuilding revenues increased 22.2 percent for 2005, compared to 2004, due to a 10.4 percent rise in closings and a 21 10.8 percent increase in average closing price. The rise in closings in 2005 was due to a higher backlog at the beginning of the year and a 3.8 percent increase in new home orders during the year. Consistent with its policy of managing land investments according to return and risk targets, the Company executed several land and lot sales during the year. Homebuilding revenues for the year ended December 31, 2006, included $94.3 million from land and lot sales, compared to $96.9 million for 2005 and $74.2 million for 2004, which contributed net gains of $24.8 million, $23.9 million and $25.2 million to pretax earnings in 2006, 2005 and 2004, respectively.
Gross profit margins from home sales averaged 21.8 percent for 2006, a decrease from 25.2 percent for 2005 and 23.2 percent for 2004. The decline was primarily attributable to a more competitive market that resulted in an increase in price concessions and sales incentives; inventory valuation adjustments; and deposit write-offs during the year. Price concessions and sales incentives totaled 7.1 percent for the year ended December 31, 2006, versus 4.8 percent for the same period in 2005. The Company evaluates its land and housing inventory in accordance with the provisions of Statement of Financial Accounting Standards No. 144 (“SFAS 144”), “Accounting for the Impairment or Disposal of Long-Lived Assets” on a quarterly basis and more frequently if impairment indicators exist. In certain markets where conditions have deteriorated due to decreased demand and increased competition for fewer buyers, selective land or inventory positions have declined in value and become impaired. The Company has written down certain impaired inventories by $62.9 million and $800,000 during 2006 and 2005, respectively, to their estimated fair values. From time to time, a community’s projected profitability may not produce returns commensurate with the Company’s requirements, and the Company cancels the option and writes off the deposit. During 2006, the Company wrote off residential land option deposits totaling $10.9 million. Impairment adjustments and deposit write-offs primarily impacted the West region and were included in “Cost of goods sold.” (See “Housing Inventories” within Note A, “Summary of Significant Accounting Policies.”) The Company generated the strongest gross margins in its Baltimore, Charleston, Jacksonville, Las Vegas, Orlando, Phoenix, Tampa and Washington, D.C., markets, while its Denver, Fort Myers and Ohio Valley markets were the most challenging. Selling, general and administrative expenses, as a percentage of revenue, were 9.5 percent for 2006, 9.4 percent for 2005 and 9.8 percent for 2004. Selling, general and administrative expenses, as a percentage of revenue, remained relatively flat from the prior year due to cost reduction efforts in the face of declining revenues in various markets and a decrease in compensation that was commensurate with lower earnings, partially offset by $6.9 million in feasibility cost write-offs, resulting from the abandonment of certain projects. The decrease in selling, general and administrative expenses, as a percentage of revenue, in 2005 compared to 2004, was primarily attributable to leverage obtained through a substantial rise in closings in the Atlanta, Charlotte, Inland Empire, Jacksonville, Las Vegas, Phoenix and Texas markets, which was accompanied by more moderate increases in marketing and general and administrative expenses, partially offset by higher incentive compensation expense due to improved earnings. In 2006 and 2005, the homebuilding segments capitalized all interest incurred. The rise in capitalized interest resulted from increased development activity relative to homebuilding construction activity. 22 Homebuilding Segments New orders for 2006 decreased 31.1 percent in the North, 43.8 percent in the Southeast, 12.6 percent in Texas and 54.7 percent in the West. In 2006, the decline in new orders was primarily due to a softening in demand in most markets and a more competitive sales environment. Market uncertainty and heightened pricing competition among homebuilders led to rising cancellation rates by homebuyers and were a major factor in this order decline. New orders for 2005 increased 12.4 percent in the Southeast and 12.2 percent in Texas, but decreased 1.9 percent in the North and 7.2 percent in the West. In 2005, new order trends were generally driven by historically low interest rates and expansion plans, but they declined slightly in the fourth quarter in the North and West due, in part, to the moderating effect increased price appreciation had on consumer demand and to product shortages in Las Vegas that resulted, in part, from delays in development, processing and approval times for new projects. NEW ORDERS
The increase in cancellation rates was highest in the western and Florida markets, which experienced more extreme price appreciation in recent years. The Company experiences seasonal variations in its quarterly operating results and capital requirements. Historically, new order activity is higher in the spring and summer months. As a result, it typically has more homes under construction, closes more homes, and has greater revenues and operating income in the third and fourth quarters of the year. This is primarily due to the preference of many homebuyers to act during those periods. 23 CLOSINGS
Outstanding contracts denote the Company’s backlog of homes sold but not closed, which are generally built and closed, subject to cancellation, over the subsequent two quarters. The Company had outstanding contracts for 4,206 units at December 31, 2006. The $1.3 billion value of outstanding contracts at December 31, 2006, represents a decrease of 50.6 percent from December 31, 2005, due to a 50.3 percent decline in unit orders. Average sales price increases resulted, in part, from a change in mix that was weighted toward higher-priced homes. Outstanding contracts at December 31, 2006, represented approximately 35 percent of 2007 targeted closings. OUTSTANDING CONTRACTS
24 STATEMENTS OF EARNINGS
25 Homebuilding Segments 2006 versus 2005 North – Homebuilding revenues decreased by 13.8 percent to $1.2 billion in 2006 from $1.4 billion in 2005 primarily due to a 17.5 percent decline in the number of homes delivered in all of the markets in this segment, partially offset by a 3.2 percent increase in average closing price. Gross margins from home sales were 23.4 percent in 2006, compared to 26.5 percent in 2005. Gross margins on home sales decreased in 2006 primarily due to increased price concessions and sales incentives totaling 7.9 percent in 2006, versus 5.9 percent in 2005. Southeast – Homebuilding revenues were $1.5 billion in 2006, compared to $1.3 billion in 2005, an increase of 21.0 percent, primarily due to a 4.9 percent rise in the number of homes delivered and a 15.4 percent increase in the average sales price of homes delivered. Gross margins on home sales were 25.9 percent in 2006, compared to 23.4 percent in 2005. Gross margins on home sales increased in 2006 primarily due to a 15.4 percent rise in average sales price and to a change in mix in prices and profitability of homes delivered, partially offset by an increase in price concessions and sales incentives. Price concessions and sales incentives for the year ended December 31, 2006 and 2005 were 5.6 percent and 3.4 percent, respectively. Texas – Homebuilding revenues increased by 12.3 percent to $695.4 million in 2006 from $619.3 million in 2005 primarily due to a 5.4 percent increase in the number of homes delivered and a 9.0 percent increase in the average sales price of homes delivered. Gross margins on home sales were 18.5 percent in 2006, compared to 17.9 percent in 2005. West – Homebuilding revenues decreased $219.7 million, or 15.1 percent, to $1.2 billion in 2006, compared to $1.5 billion in 2005, primarily due to a 23.1 percent decline in the number of homes delivered, partially offset by an 8.1 percent increase in average closing price. Gross margins from home sales were 16.8 percent in 2006, compared to 28.4 percent in 2005. Gross margins on home sales decreased in 2006 due to an increase in sales incentives, inventory valuation adjustments and deposit write-offs. Price concessions and sales incentives for the year ended December 31, 2006 and 2005 were 8.7 percent and 3.5 percent, respectively. Homebuilding Segments 2005 versus 2004 North – Homebuilding revenues increased by 8.1 percent to $1.4 billion in 2005 from $1.3 billion in 2004 primarily due to an increase in the number of homes delivered in the Twin Cities market and an increase in the average sales price of homes delivered in all of the markets in this segment. Southeast – Homebuilding revenues were $1.3 billion in 2005, compared to $1.0 billion in 2004, an increase of 24.4 percent, primarily due to a rise in the number of homes delivered and a 10.4 percent increase in the average sales price of homes delivered. Gross margins on home sales were 23.4 percent in 2005, compared to 21.3 percent in 2004. Gross margins on home sales increased in 2005 primarily due to rising demand and sales prices. Texas – Homebuilding revenues increased by 16.1 percent to $619.3 million in 2005 from $533.3 million in 2004 primarily due to a rise in the number of homes delivered and an increase in the average sales price of homes delivered. Gross margins on home sales were 17.9 percent in 2005, compared to 17.6 percent in 2004. West – Homebuilding revenues increased $421.9 million, or 40.6 percent, to $1.5 billion in 2005, compared to $1.0 billion in 2004, primarily due to a rise in the number of homes delivered in the Inland Empire, Las Vegas and Phoenix markets, plus a 14.1 percent increase in the average sales price of homes delivered. Gross margins from home sales were 28.4 percent in 2005, compared to 23.6 percent in 2004. This increase was due to a significant rise in price appreciation. 26 Financial Services The Company’s financial services segment provides mortgage-related products and services, as well as insurance services to its homebuyers and subcontractors. By aligning its operations with the Company’s homebuilding segments, the financial services segment leverages this relationship to provide lending services to homebuyers. In addition to being a valuable asset to customers, the financial services segment greatly enhances the Company’s profitability. Providing mortgage financing and other services to its customers allows the homebuilder to better monitor its backlog and closing process. Substantially all loans are sold to a third party within one business day of the date they close. The third party then services and manages the loans and assumes the credit risk of borrower default. Insurance services provide subcontractors with construction-related insurance in the western markets. Additionally, the financial services segment provides insurance for liability risks, specifically homeowners’ warranty coverage, arising in connection with the homebuilding business of the Company. FINANCIAL SERVICES STATEMENT OF EARNINGS
In 2006, RMC’s mortgage origination operations consisted primarily of mortgage loans originated in connection with the sale of the Company’s homes. The number of mortgage originations was 11,744 for 2006, compared to 12,774 for 2005 and 11,920 for 2004. During 2006, total dollar originations were $3.0 billion, of which 99.7 percent was for purchases of homes built by the Company and the remaining amount was for either purchases of homes built by others, purchases of existing homes or the refinancing of existing mortgage loans. The capture rate of mortgages originated for customers of the Company’s homebuilding operations was 81.9 percent in 2006 and 2005, compared to 84.2 percent in 2004. The financial services segment reported pretax earnings of $67.7 million for 2006, compared to $59.4 million for 2005 and $56.7 million for 2004. The increase in 2006 was primarily due to increased income from insurance services and a 6.5 percent rise in average loan size, offset by an 8.1 percent decrease in loans originated. The increase in 2005 versus 2004 was primarily due to a 7.2 percent increase in loans originated and a rise in average loan size, as well as increased profitability from title, escrow and insurance operations. Revenues for the financial services segment were $103.3 million for 2006, compared to $91.8 million for 2005. This rise was attributable to a $12.6 million increase in title, escrow and insurance revenues, partially offset by reduced interest income from a declining investment portfolio and reduced revenue from the sales of mortgages and mortgage servicing rights. In 2005, revenues for the financial services segment increased 8.4 percent to $91.8 million from $84.7 million in 2004 due to increased revenues from loan origination activities and title, escrow and insurance operations, partially offset by reduced interest income from the declining investment portfolio. 27 General and administrative expenses increased for the year ended December 31, 2006, compared to 2005, primarily as a result of additional expenses incurred in the Company’s insurance operations. General and administrative expenses rose for the year ended December 31, 2005, compared to 2004, primarily as a result of additional expenses incurred in both the Company’s mortgage operations and its title and insurance operations. Interest expense decreased 72.2 percent for the year ended December 31, 2006, compared to 2005, due to continued runoff and redemption of the Company’s mortage-backed securities portfolio. In 2005, interest expense decreased 27.4 percent, compared to 2004, primarily as a result of a continued decline in bonds payable and short-term notes payable, which resulted from continued runoff of the underlying collateral and from the sale and redemption of portions of the Company’s mortgage-backed securities portfolio. Corporate Corporate expenses were $66.0 million for 2006, $74.3 million for 2005 and $60.9 million for 2004. Excluding stock option expense required by a change in accounting principle, corporate expense was $60.8 million for the year ended December 31, 2006. Corporate expense for 2006, as compared to 2005, declined primarily due to lower executive compensation expense that resulted from a decline in earnings and stock price. Corporate expense for 2005, as compared to 2004, rose primarily as a result of an increase in support and training costs that was commensurate with anticipated growth; a rise in incentive compensation, which was due to increases in the Company’s results and financial performance; and costs incurred as a result of the Company’s compliance with Section 404 of the Sarbanes-Oxley Act of 2002. The Company ended the year with $215.0 million in cash, no borrowings against its revolving credit facility and a lower cost of funds. In 2006, the Company recorded an expense of approximately $7.7 million associated with the early redemption of $150.0 million of its 9.1 percent senior subordinated notes due June 2011, of which it owned $6.5 million, at a stated call price of 104.6 percent of the principal amount. In 2005, the Company recorded an expense of approximately $8.3 million associated with the early redemption of $150.0 million of its 9.8 percent senior notes due September 2010, of which it owned $3.0 million, at a stated call price of 104.9 percent of the principal amount. Investments in Joint Ventures At December 31, 2006, the Company had an interest in 12 active joint ventures in the Atlanta, Austin, Chicago, Dallas, Denver, Las Vegas, Orlando and Phoenix markets, three of which were consolidated. These joint ventures exist for the purpose of acquisition and co-development of lots, which are then sold to the Company, its joint venture partners or others, at market prices. Depending on the number of joint ventures and the level of activity in the entities, annual earnings from the Company’s investment in joint ventures will vary significantly. The Company’s proportionate share of losses from unconsolidated joint ventures in 2006, totaled $260,000, compared to earnings of $315,000 in 2005 and $5.8 million in 2004. The earnings in 2004 were primarily attributable to a $5.4 million gain on the sale of land to a third party in one joint venture in Atlanta. The Company’s investment in unconsolidated joint ventures was $13.5 million at December 31, 2006, compared to $10.2 million at December 31, 2005. (See “Investments in Joint Ventures” within Note A, “Summary of Significant Accounting Policies.”) Income Taxes Income taxes for fiscal years 2006, 2005 and 2004 were provided at effective tax rates of 36.5 percent, 38.0 percent and 38.5 percent, respectively. The decrease in the effective tax rate for 2006, as compared to 2005, was primarily attributable to prior years’ tax provisions no longer required due 28 to the expiration of various tax statutes. The decrease in the effective tax rate for 2005 and 2004 was primarily attributable to a new tax deduction on qualified production activities created by the American Jobs Creation Act of 2004. (See Note H, “Income Taxes.”) Financial Condition and Liquidity Cash requirements for the Company are generally provided from internally generated funds and outside borrowings. Net earnings provided cash flows of $359.9 million in 2006, $447.1 million in 2005 and $320.5 million in 2004. New debt was issued during the year ended December 31, 2006, that provided cash flows of $250.0 million, compared to $500.0 million for the same period in 2005. Repayment of senior and senior subordinated notes used $243.5 million and $147.0 million for the years ended December 31, 2006 and 2005, respectively. Additionally, net changes in other assets, payables and other liabilities used $216.9 million in 2006; and provided cash flows of $175.4 million in 2005 and $104.4 million in 2004. The cash provided was invested principally in inventory of $182.7 million, $491.0 million and $585.6 million in 2006, 2005 and 2004, respectively; as well as in stock repurchases of $250.1 million, $176.2 million and $118.3 million for the same periods in 2006, 2005 and 2004. Dividends totaled $0.48, $0.30 and $0.21 per share for the annual periods ended December 31, 2006, 2005 and 2004, respectively. During 2006, stockholders’ equity rose $135.1 million, while debt increased $28.1 million, decreasing the Company’s leverage.
Consolidated inventories owned by the Company increased to $2.5 billion at December 31, 2006, from $2.3 billion at December 31, 2005. The Company attempts to maintain a projected four- to five-year supply of land, with nearly half controlled through options. At December 31, 2006, the Company controlled 60,318 lots, with 31,251 lots owned and 29,067 lots, or 48.2 percent, under option. The Company has historically funded the acquisition of land and the exercise of land options through a combination of operating cash flows, capital transactions and borrowings under its revolving credit facility. The Company expects these sources to continue to be adequate to fund future obligations with regard to the acquisition of land and the exercise of land options; therefore, it does not anticipate that the exercise of land options will have a material adverse effect on its liquidity. In an effort to increase liquidity, models have been sold and leased back on a selective basis for generally three to eighteen months. The Company owned 66.9 percent and 80.7 percent of its model homes at December 31, 2006 and 2005, respectively. The homebuilding segments’ borrowings include senior notes, an unsecured revolving credit facility and nonrecourse secured notes payable. Senior notes outstanding totaled $900.0 million at December 31, 2006. Senior and senior subordinated notes outstanding totaled $893.5 million at December 31, 2005. In 2006, the Company redeemed $150.0 million of its 9.1 percent senior subordinated notes due June 2011, of which it owned $6.5 million. The redemption price was 104.6 percent of the principal amount of the notes outstanding, plus accrued interest as of the redemption date. The Company recognized a $7.7 million loss related to the early retirement of these senior subordinated notes in the third quarter of 2006. Additionally, the Company’s 8.0 percent senior notes, which totaled $100.0 million, matured in August 2006. In January 2006, the Company replaced its $500.0 million revolving credit facility with a new $750.0 million revolving credit facility. In November 2006, the Company increased this revolving 29 credit facility from $750.0 million to $1.1 billion through its accordion feature. The credit agreement, which matures in January 2011, also provides access to an additional $366.5 million of financing through an accordion feature under which the aggregate commitment may be increased up to $1.5 billion, subject to the availability of additional lending commitments. The $1.1 billion revolving credit facility includes a $75.0 million swing-line facility and a $600.0 million sublimit for issuance of standby letters of credit. Amounts borrowed under the credit agreement are guaranteed on a joint and several basis by substantially all of the Company’s wholly-owned homebuilding subsidiaries. Such guarantees are full and unconditional. Interest rates on outstanding borrowings are determined either by reference to LIBOR, with margins determined based on changes in its leverage ratio and credit ratings, or by reference to an alternate base rate. The credit agreement contains various customary affirmative, negative and financial covenants. The Company was in compliance with these covenants at December 31, 2006. (See Note F, “Debt.”) The Company uses its unsecured revolving credit facility to finance increases in its homebuilding inventory and working capital, when necessary. There were no borrowings outstanding under the current or previous agreements at December 31, 2006 or 2005, respectively. Under the respective agreements, the Company had letters of credit outstanding that totaled $192.9 million at December 31, 2006, and $185.6 million at December 31, 2005. Unused borrowing capacity under the respective facilities totaled $940.6 million and $314.4 million at December 31, 2006 and 2005, respectively. The $150.0 million of 5.4 percent senior notes due June 2008; the $250.0 million of 5.4 percent senior notes due May 2012; the $250.0 million of 6.9 percent senior notes due June 2013; and the $250.0 million of 5.4 percent senior notes due January 2015 are subject to certain covenants that include, among other things, restrictions on additional secured debt and the sale of assets. At December 31, 2006, the Company was in compliance with these covenants. In 2006, the Company terminated its treasury interest rate locks (“treasury locks”), which were entered into in 2005 to facilitate the replacement of some of its higher-rate senior and senior subordinated debt. (See Note D, “Derivative Instruments.”) To finance its land purchases, the Company may also use seller-financed nonrecourse secured notes payable. At December 31, 2006, such notes payable outstanding amounted to $50.1 million, compared to $28.5 million at December 31, 2005. In 2005, the Company redeemed $150.0 million of its 9.8 percent senior notes due September 2010, of which it owned $3.0 million. The notes were redeemed at a stated call price of 104.9 percent of the principal amount, plus accrued and unpaid interest. The Company recorded an expense of $8.3 million related to the early retirement of this debt. Although the Company no longer issues mortgage-backed securities and mortgage-participation securities, some of its limited-purpose subsidiaries continued to hold collateral for previously issued mortgage-backed bonds in which the Company maintained a residual interest. Revenues, expenses and portfolio balances declined as mortgage collateral pledged to secure the bonds decreased due to scheduled payments and prepayments, as well as to the sale and redemption of a majority of the investment portfolio during 2005 and 2004. The Company filed a shelf registration statement with the SEC for up to $1.0 billion of its debt and equity securities on April 11, 2005. At December 31, 2006, $600.0 million remained available under this registration statement due to the issuance of $250.0 million of senior notes in May 2005, of which $100.0 million was applied to a previous shelf registration statement, and the issuance of $250.0 million of senior notes in May 2006. The registration statement provides that securities may be offered, from time to time, in one or more series and in the form of senior, subordinated or con- 30 vertible debt; preferred stock; preferred stock represented by depository shares; common stock; stock purchase contracts; stock purchase units; and warrants to purchase both debt and equity securities. In the future, the Company intends to continue to maintain effective shelf registration statements that will facilitate access to the capital markets. The timing and amount of future offerings, if any, will depend on market and general business conditions. During 2006, the Company repurchased 4.7 million shares of its common stock at a cost of $250.1 million. In December, the Company’s Board of Directors authorized the purchase of additional shares totaling $175.0 million. At December 31, 2006, the Company had existing authorization from its Board of Directors to purchase a total of approximately 3.7 million shares at a cost of $201.6 million, based on the Company’s stock price on that date. Outstanding shares at December 31, 2006, were 42,612,525, versus 46,368,143 for December 31, 2005, a decrease of 8.1 percent. The Company granted fewer stock options in 2006 that, when combined with common stock repurchases and lower stock prices, lowered dilution. The following table provides a summary of the Company’s contractual cash obligations and commercial commitments at December 31, 2006, and the effect such obligations are expected to have on liquidity and cash flow in future periods.
The Company believes that its current cash position, cash generation capabilities, amounts available under its revolving credit facility and ability to access the capital markets in a timely manner with its existing shelf registration statement are adequate to meet its cash needs for the foreseeable future. Off–Balance Sheet Arrangements In the ordinary course of business, the Company enters into land and lot option purchase contracts in order to procure land or lots for the construction of homes. Land and lot option purchase contracts enable the Company to control significant lot positions with a minimal capital investment and substantially reduce the risks associated with land ownership and development. The Company had $187.8 million in cash deposits and letters of credit to purchase land and lots with a total purchase price of $1.5 billion at December 31, 2006. Only $34.2 million of the $1.5 billion in land and lot option purchase contracts contain specific performance provisions. Additionally, the Company’s liability is generally limited to forfeiture of the nonrefundable deposits, letters of credit and other nonrefundable amounts incurred. Pursuant to Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” the Company consolidated $263.9 million of inventory not owned at December 31, 2006, $186.0 million of which pertained to land and lot option purchase contracts and $77.9 million of which pertained to three of the Company’s homebuilding joint ventures. (See “Variable Interest Entities” and “Investments in Joint Ventures” within Note A, “Summary of Significant Accounting Policies.”) At December 31, 2006, the Company had outstanding letters of credit totaling $192.9 million and development or performance bonds totaling $482.2 million, issued by third parties, to secure performance under various contracts and obligations relating to land or municipal improvement. The 31 Company expects that the obligations secured by these letters of credit and performance bonds will generally be satisfied in the ordinary course of business and in accordance with applicable contractual terms. To the extent that the obligations are fulfilled, the related letters of credit and performance bonds will be released, and the Company will not have any continuing obligations. The Company has no material third-party guarantees other than those associated with its $1.1 billion revolving credit facility, its senior notes and its investments in joint ventures. (See “Investments in Joint Ventures” within Note A, “Summary of Significant Accounting Policies;” and Note K, “Supplemental Guarantor Information.”) Critical Accounting Policies Preparation of the Company’s consolidated financial statements requires the use of judgment in the application of accounting policies and estimates of inherently uncertain matters. Listed below are those policies that management believes are critical and require the use of complex judgment in their application. Management has discussed the critical accounting policies with the Audit Committee of its Board of Directors and the Audit Committee has reviewed the disclosure. There are items within the financial statements that require estimation, but are not considered critical. Share-Based Payments On January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R) (“SFAS 123(R)”) “Share-Based Payment,” which requires that compensation expense be measured and recognized at an amount equal to the fair value of share-based payments granted under compensation arrangements. The Company calculates the fair value of stock options by using the Black-Scholes-Merton option-pricing model. The determination of 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 the expected stock option exercise behavior. Additionally, judgment is also required in estimating the number of share-based awards that are expected to forfeit. If actual results differ significantly from these estimates, stock-based compensation expense and the Company’s consolidated results of operations could be materially impacted. The Company believes the accounting for stock-based compensation is a critical accounting policy because it requires the use of complex judgment in its application. Use of Estimates In budgeting land acquisitions, development and homebuilding construction costs associated with real estate projects, the Company evaluates market conditions; material and labor costs; buyer preferences; construction timing; and provisions for insurance and warranty obligations. The Company accrues its best estimate of the probable cost for resolution of legal claims. Estimates, which are based on historical experience and other assumptions, are reviewed continually, updated when necessary and believed to be reasonable under the circumstances. Management believes that the timing and scope of its evaluation procedures are proper and adequate. Changes in assumptions relating to such factors, however, could have a material effect on the Company’s results of operations for a particular quarterly or annual period. Income Recognition Revenues and cost of sales are recorded at the time each home or lot is closed, title and possession are transferred to the buyer and there is no significant continuing involvement in accordance with Statement of Financial Accounting Standards No. 66 (“SFAS 66”), “Accounting for Sales of Real Estate.” In order to match revenues with related expenses, land, land development, interest, taxes and other related costs (both incurred and estimated to be incurred in the future) are allocated to the cost of 32 homes closed, based upon the relative sales value basis of the total number of homes to be constructed in each community, in accordance with Statement of Financial Accounting Standards No. 67 (“SFAS 67”), “Accounting for Costs and Initial Rental Operations of Real Estate Projects.” Estimated land, common area development and related costs of planned communities (including the cost of amenities) are allocated to individual parcels or communities on a relative sales value basis. Changes to estimated costs, subsequent to the commencement of the delivery of homes, are allocated to the remaining undelivered homes in the community. Home construction and related costs are charged to the cost of homes closed under the specific-identification method. Inventory Valuation Housing projects and land held for development (inventory) and sale are stated at either the lower of cost or net realizable value. Inventory includes land and development costs; direct construction costs; capitalized indirect construction costs; capitalized interest; and real estate taxes. It may take one to three years to develop, sell and deliver all of the homes in a typical community. The Company assesses these assets for recoverability in accordance with the provisions of Statement of Financial Accounting Standards No. 144 (“SFAS 144”), “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS 144 requires that long-lived assets and assets held-for-sale be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of housing inventories is measured by comparing the carrying amount of an asset to future undiscounted net cash flows expected to be generated by that asset or by the sales of comparable assets. Assets held-for-sale are carried at the lower of cost or fair value, less selling costs. 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