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EX-32.2 - SECTION 906 CERTIFICATION OF CFO - WILLIAM LYON HOMESdex322.htm
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EX-32.1 - SECTION 906 CERTIFICATION OF CEO - WILLIAM LYON HOMESdex321.htm
EX-31.2 - SECTION 302 CERTIFICATION OF CFO - WILLIAM LYON HOMESdex312.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2011

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 001-31625

 

 

WILLIAM LYON HOMES

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   33-0864902
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
4490 Von Karman Avenue  
Newport Beach, California   92660
(Address of principal executive offices)   (Zip Code)

(949) 833-3600

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 

 

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  ¨    NO  x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every interactive data file required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 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).    YES  ¨    NO  ¨

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. (Check one):

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   x  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  ¨    NO  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class of Common Stock

 

Outstanding at
May 25, 2011

Common stock, par value $.01

  1,000

 

 

 


Table of Contents

WILLIAM LYON HOMES

INDEX

 

          Page
No.
 

PART I. FINANCIAL INFORMATION

  

Item 1.

   Financial Statements:   
   Consolidated Balance Sheets — March 31, 2011 (unaudited) and December 31, 2010      4   
   Consolidated Statements of Operations — Three Months Ended March 31, 2011 and 2010 (unaudited)      5   
   Consolidated Statement of Equity — Three Months Ended March 31, 2011 (unaudited)      6   
   Consolidated Statements of Cash Flows — Three Months Ended March 31, 2011 and 2010 (unaudited)      7   
   Notes to Consolidated Financial Statements      8   
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      31   
Item 3.    Quantitative and Qualitative Disclosures About Market Risk      48   
Item 4.    Controls and Procedures      48   
Item 4T.    Not Applicable      48   
PART II. OTHER INFORMATION      49   
Item 1.    Legal Proceedings      49   
Item 1A.    Risk Factors      49   
Item 2.    Not Applicable      49   
Item 3.    Not Applicable      49   
Item 4.    Not Applicable      49   
Item 5.    Not Applicable      49   
Item 6.    Exhibits      49   
SIGNATURES      50   
EXHIBIT INDEX      51   

 

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Table of Contents

NOTE ABOUT FORWARD-LOOKING STATEMENTS

Investors are cautioned that certain statements contained in this Quarterly Report on Form 10-Q, as well as some statements by the Company in periodic press releases and some oral statements by Company officials to securities analysts during presentations about the Company are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”). Statements which are predictive in nature, which depend upon or refer to future events or conditions, or which include words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “estimates”, “hopes”, and similar expressions constitute forward-looking statements. In addition, any statements concerning future financial performance (including future revenues, earnings or growth rates), ongoing business strategies or prospects, and possible future Company actions, which may be provided by management are also forward-looking statements as defined in the Act. Forward-looking statements are based upon expectations and projections about future events and are subject to assumptions, risks and uncertainties about, among other things, the Company, economic and market factors and the homebuilding industry.

Actual events and results may differ materially from those expressed or forecasted in the forward-looking statements due to a number of factors. The principal factors that could cause the Company’s actual performance and future events and actions to differ materially from such forward-looking statements include, but are not limited to, worsening in general economic conditions either nationally or in regions in which the Company operates, worsening in the markets for residential housing, further decline in real estate values resulting in further impairment of the Company’s real estate assets, volatility in the banking industry and credit markets, terrorism or other hostilities involving the United States, whether an ownership change occurred which could, under certain circumstances, have resulted in the limitation of the Company’s ability to offset prior years’ taxable income with net operating losses, changes in home mortgage interest rates, changes in generally accepted accounting principles or interpretations of those principles, changes in prices of homebuilding materials, labor shortages, adverse weather conditions, the occurrence of events such as landslides, soil subsidence and earthquakes that are uninsurable, not economically insurable or not subject to effective indemnification agreements, changes in governmental laws and regulations, inability to comply with financial and other covenants under the Company’s debt instruments, whether the Company is able to refinance the outstanding balances of its debt obligations at their maturity, the timing of receipt of regulatory approvals and the opening of projects and the availability and cost of land for future growth. These and other risks and uncertainties are more fully described in Item 1A. “Risk Factors” as contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. While it is impossible to identify all such factors, factors which could cause actual results to differ materially from those estimated by the Company include, but are not limited to, those factors or conditions described under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The Company’s past performance or past or present economic conditions in the Company’s housing markets are not indicative of future performance or conditions. Investors are urged not to place undue reliance on forward-looking statements. In addition, the Company undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events or changes to projections over time unless required by federal securities law.

 

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Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements.

WILLIAM LYON HOMES

CONSOLIDATED BALANCE SHEETS

(in thousands except number of shares and par value per share)

 

     March 31,
2011
    December 31,
2010
 
     (unaudited)        
ASSETS     

Cash and cash equivalents — Notes 1 and 6

   $ 45,447      $ 71,286   

Restricted cash — Note 1

     641        641   

Receivables

     16,861        18,499   

Real estate inventories — Notes 2 and 4

    

Owned

     501,252        488,906   

Not owned

     47,408        55,270   

Property & equipment, less accumulated depreciation of $4,515 and $4,816 at March 31, 2011 and December 31, 2010, respectively

     1,159        1,230   

Deferred loan costs

     11,516        12,404   

Other assets

     3,264        768   
                
   $ 627,548      $ 649,004   
                
LIABILITIES AND EQUITY     

Accounts payable

   $ 8,526      $ 6,904   

Accrued expenses

     40,401        41,722   

Liabilities from inventories not owned — Note 9

     47,408        55,270   

Notes payable — Note 5

     29,115        30,541   

Senior Secured Term Loan due October 20, 2014 — Note 5

     206,000        206,000   

7  5/8% Senior Notes due December 15, 2012 — Note 5

     66,704        66,704   

10  3/4% Senior Notes due April 1, 2013 — Note 5

     138,688        138,619   

7  1/2% Senior Notes due February 15, 2014 — Note 5

     77,867        77,867   
                
     614,709        623,627   
                

Commitments and contingencies — Note 9

    

Equity:

    

Stockholders’ equity

    

Common stock, par value $.01 per share; 3,000 shares authorized; 1,000 shares outstanding at March 31, 2011 and December 31, 2010, respectively

     —          —     

Additional paid-in capital

     48,867        48,867   

Accumulated deficit

     (46,278     (35,053
                
     2,589        13,814   

Noncontrolling interest — Note 2

     10,250        11,563   
                
     12,839        25,377   
                
   $ 627,548      $ 649,004   
                

See accompanying notes.

 

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WILLIAM LYON HOMES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands)

(unaudited)

 

     Three Months Ended
March 31,
 
     2011     2010  

Operating revenue

    

Home sales

   $ 36,574      $ 37,862   

Construction services — Note 1

     2,226        5,301   
                
     38,800        43,163   
                

Operating costs

    

Cost of sales — homes

     (31,885     (31,362

Construction services — Note 1

     (1,837     (3,247

Sales and marketing

     (4,089     (3,587

General and administrative

     (7,200     (6,002

Other

     (562     (894
                
     (45,573     (45,092
                

Equity in income of unconsolidated joint ventures

     207        412   
                

Operating loss

     (6,566     (1,517

Interest expense, net of amounts capitalized

     (4,778     (7,094

Other income, net

     167        92   
                

Loss before benefit from income taxes

     (11,177     (8,519
                

Benefit from income taxes — Note 8

     —          65   
                

Consolidated net loss

     (11,177     (8,454

Less: Net income — noncontrolling interest

     (48     (30
                

Net loss attributable to William Lyon Homes

   $ (11,225   $ (8,484
                

See accompanying notes.

 

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Table of Contents

WILLIAM LYON HOMES

CONSOLIDATED STATEMENT OF EQUITY

Three Months Ended March 31, 2011

(in thousands)

(unaudited)

 

     Common Stock      Additional
Paid-In
Capital
     Retained
Earnings
    Non-
Controlling
Interest
    Total  
     Shares      Amount            

Balance — December 31, 2010

     1       $ —         $ 48,867       $ (35,053   $ 11,563      $ 25,377   

Net (loss) income

     —           —           —           (11,225     48        (11,177

Cash distributions from members of consolidated entities, net

     —           —           —           —          (1,361     (1,361
                                                   

Balance — March 31, 2011

     1       $ —         $ 48,867       $ (46,278   $ 10,250      $ 12,839   
                                                   

See accompanying notes.

 

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Table of Contents

WILLIAM LYON HOMES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

     Three Months Ended
March 31,
 
     2011     2010  

Operating activities

    

Consolidated net loss

   $ (11,177   $ (8,454

Adjustments to reconcile consolidated net loss to net cash provided by operating activities:

    

Depreciation and amortization

     74        135   

Equity in income of unconsolidated joint ventures

     (207     (412

Loss on disposition of fixed asset

     —          110   

Benefit from income taxes

     —          (65

Net changes in operating assets and liabilities:

    

Restricted cash

     —          (4

Receivables

     1,638        (222

Income tax refunds receivable

     —          107,054   

Real estate inventories — owned

     (12,277     (70,630

Deferred loan costs

     888        833   

Other assets

     (2,455     9,069   

Accounts payable

     1,622        (1,694

Accrued expenses

     (1,321     4,484   
                

Net cash (used in) provided by operating activities

     (23,215     40,204   
                

Investing activities

    

Investments in and advances to unconsolidated joint ventures

     —          (40

Distributions of income from unconsolidated joint ventures

     166        392   

Purchases of property and equipment, net

     (3     (21
                

Net cash provided by investing activities

     163        331   
                

Financing activities

    

Proceeds from borrowing on notes payable, net

     —          4,590   

Principal payments on notes payable

     (1,426     (12,449

Noncontrolling interest (distributions) contributions, net

     (1,361     737   
                

Net cash used in financing activities

     (2,787     (7,122
                

Net (decrease) increase in cash and cash equivalents

     (25,839     33,413   

Cash and cash equivalents — beginning of period

     71,286        117,587   
                

Cash and cash equivalents — end of period

   $ 45,447      $ 151,000   
                

Supplemental disclosures of non-cash items:

    

Net change in real estate inventories not owned and liabilities from inventories not owned

   $ 7,862      $ —     
                

Increase in real estate inventories owned and seller note payable

   $ —        $ 10,652   
                

See accompanying notes

 

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Table of Contents

WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1 — Basis of Presentation and Significant Accounting Policies

Operations

William Lyon Homes, a Delaware corporation, and subsidiaries (the “Company”) are primarily engaged in designing, constructing and selling single family detached and attached homes in California, Arizona and Nevada.

Basis of Presentation

The unaudited consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and in accordance with the rules and regulations of the Securities and Exchange Commission. The consolidated financial statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. The consolidated financial statements included herein should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

The interim consolidated financial statements have been prepared in accordance with the Company’s customary accounting practices. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a presentation in accordance with U.S. generally accepted accounting principles have been included. Operating results for the three months ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.

The preparation of the Company’s financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of the assets and liabilities as of March 31, 2011 and December 31, 2010 and revenues and expenses for the periods presented. Accordingly, actual results could differ from those estimates. The significant accounting policies using estimates include real estate inventories and cost of sales, impairment of real estate inventories, warranty reserves, loss contingencies, sales and profit recognition, income taxes, and accounting for variable interest entities. The current economic environment increases the uncertainty inherent in these estimates and assumptions.

The consolidated financial statements include the accounts of the Company and all majority-owned and controlled subsidiaries and joint ventures, and certain joint ventures and other entities which have been determined to be variable interest entities in which the Company is considered the primary beneficiary (see Note 2). Investments in joint ventures which have not been determined to be variable interest entities in which the Company is considered the primary beneficiary are accounted for using the equity method because the Company has a 50% or less voting or economic interest (and thus such joint ventures are not controlled by the Company). The accounting policies of the joint ventures are substantially the same as those of the Company. All significant intercompany accounts and transactions have been eliminated in consolidation.

Financial Condition and Liquidity

For the period ended March 31, 2011, the Company incurred net loss of $11.2 million. As discussed in Note 5 to “Notes to Consolidated Financial Statements”, the Company has certain financial covenants with its lenders, including a tangible net worth covenant of $75.0 million, relating to the Senior Secured Term Loan due 2014 (the “Term Loan”) and the Senior Notes. As of March 31, 2011, the tangible net worth of the Company was $1.3 million.

Related to the Company’s Term Loan and as reported on the Company’s current report on Form 8-K dated March 18, 2011, the Company reached an agreement with the Lenders under the Senior Secured Term Loan Agreement (the “Term Loan Agreement”) that amended the Term Loan to permit the Company’s tangible net worth to fall below $75.0 million for two consecutive quarters. In addition, as reported on the Company’s current report on Form 8-K dated April 21, 2011, the Company reached a subsequent agreement with the lenders under the Term Loan to waive any non-compliance with the tangible net worth covenant and with certain other technical requirements through July 19, 2011, subject to certain terms and conditions. Management of the Company believes that it is in the best interests of the lenders of the Term Loan to extend the waiver and work with the Company on a solution, if the Company’s tangible net worth remains below $75.0 million on July 19, 2011.

Under the indentures governing the Company’s Senior Notes (the “Senior Notes Indentures”), if the Company’s consolidated tangible net worth falls below $75.0 million for any two consecutive fiscal quarters, California Lyon will be required to make an offer to purchase up to 10% of each class of Senior Notes originally issued at a purchase price equal to 100% of the principal amount, plus accrued and unpaid interest, if any. Any such offer to purchase must be made within 65 days after the second quarter ended for which the Company’s tangible net worth is less than $75.0 million. However, California Lyon may reduce the principal amount of the notes to be purchased by the aggregate principal amount of all notes previously redeemed.

The Company’s consolidated tangible net worth was less than $75.0 million for the quarters ended December 31, 2010 and March 31, 2011. The Company has determined and calculated that California Lyon’s redemptions of Senior Notes during the period from 2008 to 2010 would reduce California Lyon’s repurchase obligations as follows: California Lyon would not be obligated to repurchase any of its 7 5/8% Senior Notes due 2012 (the “7 5/8% Senior Notes”), as a result of California Lyon’s previous redemption of $83.3 million in aggregate principal amount of the 7 5/8% Senior Notes; California Lyon would not be obligated to repurchase any of the 10 3/4% Senior Notes due 2013 (the “10 3/4% Senior Notes”), as a result of California Lyon’s previous redemption of $110.7 million in aggregate principal amount of its 10 3/4% Senior Notes; and California Lyon would not be obligated to repurchase any of its 7 1/2% Senior Notes due 2014 (the “7 1/2% Senior Notes”) as a result of California Lyon’s previous redemption of $72.1 million in aggregate principal amount of the 7 1/2% Senior Notes.

The ability of the Company to meet its obligations on its indebtedness will depend to a large degree on its future performance. The Company cannot be certain that its cash flow will be sufficient to allow it to pay principal and interest on its debt, support its operations and meet its other obligations. In addition, the Company cannot be certain that it will be able to comply with the financial covenants under its debt obligations. If the Company is not able to meet any of the foregoing

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

obligations, it may be required to refinance all or part of its existing debt, sell assets or borrow more money. The Company may not be able to do so on terms acceptable to it, if at all. In addition, the terms of existing or future indentures and credit or other agreements governing the Term Loan, Senior Note obligations and other indebtedness may restrict the Company from pursuing any of these alternatives.

The management of the Company, with the approval of the board of directors, has retained the services of an outside consulting firm to institute and implement all required programs to accomplish management’s objectives and to work with management in the analysis and process of renegotiating, refinancing, repaying or restructuring debt maturities and loan terms, including covenants. In addition, the Company is currently working through the process of requesting a financing proposal from the investment banking community. The Company has requested proposals for a debt financing to use in some combination of debt refinance or capital restructuring of the Term Loan and the Senior Notes.

The Company believes the debt markets are a viable option due to the growing demand for high yield paper in 2011, according to a publication by a global investment bank (unaudited), as evidenced by $105.8 billion in high yield paper issued through April 2011 in the U.S. market, which is 16% more than had been placed through the same time period in 2010. For the year ended December 31, 2010, high yield paper saw a record $259.3 billion placed in the U.S. market. Additionally, high yield mutual funds have reported year to date 2011 inflows of $9.0 billion after 2010 inflows of $12.2 billion. The Company has also identified other competitors that received financing to repay or extend existing maturities.

Management of the Company continues to analyze its liquidity based on its current capital structure and existing cash forecast as well as factoring in the potential of acceleration of the Term Loan. Management believes it has adequate sources of liquidity to fund the Company and meet its obligations for at least the next year, from the date of this filing. Also, the Company is evaluating sales of certain real estate inventories to generate the cash necessary to repay the Term Loan, should an extension not be reached. The Company’s balance of real estate inventories owned at March 31, 2011 was $501.3 million.

Real Estate Inventories and Related Indebtedness

Real estate inventories are carried at cost net of impairment losses, if any. Real estate inventories consist primarily of land deposits, raw land, lots under development, finished lots, homes under construction, completed homes and model homes of real estate projects. All direct and indirect land costs, offsite and onsite improvements and applicable interest and other carrying charges are capitalized to real estate projects during periods when the project is under development. Land, offsite costs and all other common costs are allocated to land parcels benefited based upon relative fair values before construction. Onsite construction costs and related carrying charges (principally interest and property taxes) are allocated to the individual homes within a phase based upon the relative sales value of the homes. The Company relieves its accumulated real estate inventories through cost of sales for the estimated cost of homes sold. Selling expenses and other marketing costs are expensed in the period incurred. A provision for warranty costs relating to the Company’s limited warranty plans is included in cost of sales and accrued expenses at the time the sale of a home is recorded. The Company generally reserves one percent of the sales price of its homes against the possibility of future charges relating to its one-year limited warranty and similar potential claims. Factors that affect the Company’s warranty liability include the number of homes under warranty, historical and anticipated rates of warranty claims, and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the amounts as necessary. Changes in the Company’s warranty liability during the three months ended March 31 are as follows (in thousands):

 

     March 31  
     2011     2010  

Warranty liability, beginning of period

   $ 16,341      $ 21,365   

Warranty provision during period

     432        356   

Warranty payments during period

     (1,428     (1,582

Warranty charges related to pre-existing warranties during period

     379        580   
                

Warranty liability, end of period

   $ 15,724      $ 20,719   
                

Interest incurred under the Term Loan, the 7 5/8% Senior Notes, 10 3/4% Senior Notes, 7 1/2% Senior Notes and other notes payable, as more fully discussed in Note 5 of “Notes to Consolidated Financial Statements”, is capitalized to qualifying real estate projects under development. Any additional interest charges related to real estate projects not under development are expensed in the period incurred. During the three months ended March 31, 2011 and 2010, the Company recorded $4.8 million and $7.1 million, respectively, of interest expense, related to a lesser amount of real estate assets which qualify for interest capitalization relative to the interest incurred on the Company’s outstanding debt.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

Construction Services

The Company accounts for construction management agreements using the Percentage of Completion Method in accordance with FASB ASC Topic 605 Revenue Recognition (“ASC 605”). Under ASC 605, the Company records revenues and expenses as work on a contracted project progresses, and based on the percentage of costs incurred to date compared to the total estimated costs of the contract. Based on the provisions of ASC 605, the Company has recorded construction services revenues and expenses of $2.2 million and $1.8 million respectively for the three months ended March 31, 2011 and $5.3 million and $3.2 million respectively, for the three months ended March 31, 2010, in the accompanying consolidated statement of operations.

The Company entered into construction management agreements to build, sell and market homes in certain communities. For such services, the Company will receive fees (generally 3 to 5 percent of the sales price, as defined) and may, under certain circumstances, receive additional compensation if certain financial thresholds are achieved.

Cash and Cash Equivalents

Short-term investments with a maturity of three months or less when purchased are considered cash equivalents. The Company’s cash and cash equivalents balance exceeds federally insurable limits as of March 31, 2011. The Company monitors the cash balances in its operating accounts and adjusts the cash balances as appropriate; however, these cash balances could be negatively impacted if the underlying financial institutions fail or are subject to other adverse conditions in the financial markets. To date, the Company has experienced no loss or lack of access to cash in its operating accounts.

Restricted Cash

Restricted cash consists of deposits made by the Company to a bank account as collateral for the use of letters of credit to guarantee the Company’s financial obligations under certain other contractual arrangements in the normal course of business. Under the terms of the Term Loan disclosed in Note 5, all of the Company’s standby letters of credit are secured by cash.

Use of Estimates

The preparation of the Company’s financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of the assets and liabilities as of March 31, 2011 and December 31, 2010 and revenues and expenses for the three months ended March 31, 2011 and 2010. Accordingly, actual results could differ from those estimates. The significant accounting policies using estimates include real estate inventories and cost of sales, impairment of real estate inventories, warranty reserves, loss contingencies, sales and profit recognition, and accounting for variable interest entities. The current economic environment increases the uncertainty inherent in these estimates and assumptions.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

Subsequent Events

The Company follows the guidance in ASC Topic 855. Subsequent Events (“ASC 855”), which provides guidance to establish general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. ASC 855 sets forth (i) the period after the balance sheet date during which management of a reporting entity evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, (ii) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and (iii) the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. Pursuant to ASC 855 the Company’s management has evaluated subsequent events through the date that the consolidated financial statements were issued for the period ended March 31, 2011.

Impact of New Accounting Pronouncements

In 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820), which requires some new disclosures and clarifies some existing disclosure requirements about fair value measurement as set forth in ASC 820-10. ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. The adoption of these provisions by the Company did not have and are not expected to have a material effect on its consolidated financial statements.

In 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the IASB (the Boards) on fair value measurement and results in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” ASU 2011-04 is effective during interim and annual periods beginning after December 15, 2011. The effect of adoption of these provisions on the Company’s consolidated financial statements has not yet been analyzed.

Note 2 — Variable Interest Entities and Noncontrolling Interests

The FASB issued guidance now codified as ASC 810, Consolidation, which addresses the consolidation of variable interest entities (“VIEs”). Under this guidance, arrangements that are not controlled through voting or similar rights are accounted for as VIEs. An enterprise is required to consolidate a VIE if it is the primary beneficiary of the VIE. The primary beneficiary is an enterprise that has the power to direct the activities of the VIE that most significantly impact its economic performance and the obligation to absorb losses or the right to receive benefits from the VIE that could be potentially significant to the VIE.

A VIE is created when (i) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties or (ii) equity holders either (a) lack direct or indirect ability to make decisions about the entity through voting or similar rights, (b) are not obligated to absorb expected losses of the entity or (c) do not have the right to receive expected residual returns of the entity if they occur.

Based on the provisions of this guidance, the Company has concluded that under certain circumstances when the Company (i) enters into option agreements for the purchase of land or lots from an entity and pays a non-refundable deposit, (ii) enters into land banking arrangements or (iii) enters into arrangements with a financial partner for the formation of joint ventures which engage in homebuilding and land development activities, a VIE may be created under condition (ii) (b) or (c) of the previous paragraph. The Company may be deemed to have provided subordinated financial support, which refers to variable interests that will absorb some or all of an entity’s expected losses if they occur. For each VIE created, in order to determine if the Company is the primary beneficiary, the Company considers various factors including, but not limited to, voting rights, risks, involvement in the operations of the VIE, ability to make major decisions, contractual obligations including distributions of income and loss, and computations of expected losses and residual returns based on the probability of future cash flow. If the Company has been determined to be the primary beneficiary of the VIE, the assets, liabilities and operations of the VIE are consolidated with the Company’s financial statements.

Joint Ventures

Certain joint ventures have been determined to be VIEs under ASC 810 in which the Company is considered the primary beneficiary. Accordingly, the assets, liabilities and operations of these VIEs have been consolidated with the Company’s financial statements. The Company did not recognize any gain or loss on initial consolidation of the VIE since the joint ventures were previously accounted for on an unconsolidated basis using the equity method of accounting.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

The joint ventures which have been determined to be VIEs are each engaged in homebuilding and land development activities. Certain of these joint ventures have not obtained construction financing from outside lenders, but are financing their activities through equity contributions from each of the joint venture partners. Creditors of these VIEs have no recourse against the general credit of the Company. The liabilities of each VIE are restricted to the assets of each VIE. Additionally, the creditors of the Company have no access to the assets of the VIEs. Income allocations and cash distributions to the Company are based on predetermined formulas between the Company and their joint venture partners as specified in the applicable partnership or operating agreements. The Company generally receives, after partners’ priority returns and return of partners’ capital, approximately 50% of the profits and cash flows from the joint ventures.

As of March 31, 2011, the assets and liabilities of the consolidated VIEs totaled $14.2 million and $0.8 million, respectively. In addition, the Company’s interest in the consolidated VIEs is $3.1 million and the members’ interest in the consolidated VIEs is $10.3 million, which is reported as noncontrolling interest on the accompanying consolidated balance sheet.

As of December 31, 2010, the assets and liabilities of the consolidated VIEs totaled $15.4 million and $0.8 million, respectively. In addition, the Company’s interest in the consolidated VIEs was $3.1 million and the members’ interest in the consolidated VIEs was $11.6 million, which is reported as noncontrolling interest on the accompanying consolidated balance sheet.

Note 3 — Segment Information

The Company operates one principal homebuilding business. In accordance with FASB ASC Topic 280, Segment Reporting (“ASC 280”), the Company has determined that each of its operating divisions is an operating segment. Corporate is a non-operating segment.

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision-maker in deciding how to allocate resources and in assessing performance. The Company’s chief executive officer and chief operating officer have been identified as the chief operating decision makers. The Company’s chief operating decision makers direct the allocation of resources to operating segments based on the profitability and cash flows of each respective segment.

The Company’s homebuilding operations design, construct and sell a wide range of homes designed to meet the specific needs in each of it markets. In accordance with the aggregation criteria defined by ASC 280, the Company’s homebuilding operating segments have been grouped into four reportable segments: Southern California, consisting of an operating division with operations in Orange, Los Angeles, San Bernardino and San Diego counties; Northern California, consisting of an operating division with operations in Contra Costa, Sacramento, San Joaquin, Santa Clara, Solano and Placer counties; Arizona, consisting of operations in the Phoenix, Arizona metropolitan area; and Nevada, consisting of operations in the Las Vegas, Nevada metropolitan area.

Corporate is a non-operating segment that develops and implements strategic initiatives and supports the Company’s operating divisions by centralizing key administrative functions such as finance and treasury, information technology, risk management and litigation and human resources.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

Segment financial information relating to the Company’s homebuilding operations was as follows:

 

     Three Months Ended
March 31,
 
     2011     2010  
     (in thousands)  

Homebuilding revenues:

    

Southern California

   $ 20,141      $ 21,381   

Northern California

     9,403        7,947   

Arizona

     3,453        4,099   

Nevada

     3,577        4,435   
                

Total homebuilding revenues

   $ 36,574      $ 37,862   
                
     Three Months Ended
March 31,
 
     2011     2010  
     (in thousands)  

(Loss) income before benefit from income taxes:

    

Southern California

   $ (2,532   $ (4,664

Northern California

     (1,224     711   

Arizona

     (777     (1,023

Nevada

     (2,394     (1,010

Corporate

     (4,250     (2,533
                

Total homebuilding loss before benefit from income taxes

   $ (11,177   $ (8,519
                

 

     March 31,
2011
     December 31,
2010
 
     (in thousands)  

Homebuilding assets:

     

Southern California

   $ 232,512       $ 239,510   

Northern California

     58,147         60,542   

Arizona

     201,008         194,635   

Nevada

     65,458         58,827   

Corporate (1)

     70,423         95,490   
                 

Total homebuilding assets

   $ 627,548       $ 649,004   
                 

 

(1) Comprised primarily of cash, receivables, deferred loan costs and other assets.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

Note 4 — Real Estate Inventories

Real estate inventories consist of the following (in thousands):

 

     March 31,
2011
     December 31,
2010
 

Inventories owned: (1)

     

Deposits

   $ 28,589       $ 27,939   

Land and land under development

     306,884         298,677   

Homes completed and under construction

     118,382         114,592   

Model homes

     47,397         47,698   
                 

Total

   $ 501,252       $ 488,906   
                 

Inventories not owned: (2)

     

Other land options contracts - land banking arrangement

   $ 47,408       $ 55,270   
                 

 

(1) Beginning in 2008, the Company temporarily suspended all development, sales and marketing activities at certain projects which were in various stages of development. Management of the Company concluded that this strategy was necessary under the prevailing market conditions and would allow the Company to market the properties at some future time when market conditions may have improved. Certain of these projects were restarted beginning in 2010; and, as markets continue to improve, management continues to evaluate and analyze the marketplace to potentially activate temporarily suspended projects in 2011 and beyond. The Company has incurred costs related to these certain projects of $14.3 million as of March 31, 2011, of which $9.0 million is included in Land and land under development and $5.3 million is included in Model homes. The Company may bring more of these projects to market in 2011.
(2) Represents the consolidation of a land banking arrangement which does not obligate the Company to purchase the lots, however, based on certain factors, the Company has determined it is economically compelled to purchase the lots in the land banking arrangement and has been consolidated. Amounts are net of deposits.

The Company accounts for its real estate inventories (including land, construction in progress, completed inventory, including models, and inventories not owned) under FASB ASC 360 Property, Plant, & Equipment (“ASC 360”).

ASC 360 requires impairment losses to be recorded on real estate inventories when indicators of impairment are present and the undiscounted cash flows estimated to be generated by real estate inventories are less than the carrying amount of such assets. Indicators of impairment include a decrease in demand for housing due to softening market conditions, competitive pricing pressures which reduce the average sales prices of homes including an increase in sales incentives offered to buyers, slowing sales absorption rates, decreases in home values in the markets in which the Company operates, significant decreases in gross margins and a decrease in project cash flows for a particular project.

For land, construction in progress, completed inventory, including model homes, and inventories not owned, the Company estimates expected cash flows at the project level by maintaining current budgets using recent historical information and current market assumptions. The Company updates project budgets and cash flows of each real estate project on a quarterly basis to determine whether the estimated remaining undiscounted future cash flows of the project are more or less than the carrying amount (net book value) of the asset. If the undiscounted cash flows are more than the net book value of the project, then there is no impairment. If the undiscounted cash flows are less than the net book value of the asset, then the asset is deemed to be impaired and is written-down to its fair value.

Fair value represents the amount at which an asset could be bought or sold in a current transaction between willing parties (i.e., other than a forced liquidation sale). Management determines the estimated fair value of each project by determining the present value of estimated future cash flows at discount rates that are commensurate with the risk of each project. The estimation process involved in determining if assets have been impaired and in the determination of fair value is inherently uncertain because it requires estimates of future revenues and costs, as well as future events and conditions. Estimates of revenues and costs are supported by the Company’s budgeting process, and are based on recent sales in backlog, pricing required to get the desired pace of sales, pricing of competitive projects, incentives offered by competitors and current estimates of costs of development and construction.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

Under the provisions of ASC 360, the Company is required to make certain assumptions to estimate undiscounted future cash flows of a project, which include: (i) estimated sales prices, including sales incentives, (ii) anticipated sales absorption rates and sales volume, (iii) project costs incurred to date and the estimated future costs of the project based on the project budget and pace of construction of the homes, (iv) the carrying costs related to the time a project is actively selling until it closes the final unit in the project, and (v) alternative strategies including selling the land to a third party or temporarily suspending development of the project. Each project has different assumptions and is based on management’s assessment of the current market conditions that exist in each project location. The Company’s assumptions include moderate absorption increases in certain projects beginning in 2013. In addition, the Company has assumed some moderate reduction in sales incentives in certain projects.

The assumptions and judgments used by the Company in the estimation process to determine the future undiscounted cash flows of a project and its fair value are inherently uncertain and require a substantial degree of judgment. The realization of the Company’s real estate inventories is dependent upon future uncertain events and market conditions. Due to the subjective nature of the estimates and assumptions used in determining the future cash flows of a project, the uncertainty in the current housing market, the uncertainty in the banking and credit markets and the pace of the national economic recovery, actual results could differ materially from current estimates.

Management assesses land deposits for impairment when estimated land values are deemed to be less than the agreed upon contract price. The Company considers changes in market conditions, the timing of land purchases, the ability to renegotiate with land sellers the terms of the land option contracts in question, the availability and best use of capital, and other factors. The Company records abandoned land deposits and related pre-acquisition costs in cost of sales-lots, land and other in the consolidated statements of operations in the period that it is abandoned. During the three months ended March 31, 2011 and 2010, the Company did not record any impairments related to abandoned land deposits (not under land banking arrangements) and related pre-acquisition costs.

Note 5 — Senior Notes and Secured Indebtedness

As of March 31, 2011, the Company had the following outstanding Term Loan, 7 5/8% Senior Notes, 10 3/4% Senior Notes and 7 1/2% Senior Notes (in thousands):

 

Senior Secured Term Loan due October 20, 2014

   $ 206,000   

7 5/8% Senior Notes due December 15, 2012

     66,704   

10 3/4% Senior Notes due April 1, 2013

     138,688   

7 1/2% Senior Notes due February 15, 2014

     77,867   
        
   $ 489,259   
        

Term Loan

William Lyon Homes, Inc., a California corporation and wholly-owned subsidiary of the Company (“California Lyon”) is a party to a Senior Secured Term Loan Agreement (the “Term Loan Agreement”), dated October 20, 2009, with ColFin WLH Funding, LLC, as Administrative Agent (“Admin Agent”), ColFin WLH Funding, LLC, as Initial Lender and Lead Arranger (“ColFin”) and the other Lenders who may become assignees of ColFin (collectively, with ColFin, the “Lenders”).

The Term Loan Agreement provides for a first lien secured loan of $206.0 million, secured by substantially all of the assets of California Lyon, the Company (excluding stock in California Lyon and other specified excluded assets) and certain wholly-owned subsidiaries. The Term Loan is guaranteed by the Company.

California Lyon received the first installment of $131.0 million in October 2009, and its second installment of $75.0 million in December 2009. Under the Term Loan Agreement, California Lyon is restricted from future borrowings, and, if necessary, will be required to repay existing borrowings in order to maintain required loan-to-value ratios such that: (i) the aggregate amount of outstanding loans under the Term Loan Agreement may not exceed 60% of the aggregate value of the properties securing the facility, with valuation based on the lower of appraised value (if any) and discounted net present value of the cash flows, and (ii) the aggregate amount of secured debt may not exceed 60% of the aggregate value of the properties owned by California Lyon and its subsidiaries, with valuation based on the lower of appraised value (if any) and discounted net present value of the cash flows. California Lyon is currently in compliance with the above requirements. The net proceeds to the Company from the first installment of the Term Loan, after giving effect to attorney fees, loan fees and other miscellaneous costs associated with the loan transaction, and repayment of the revolving credit facilities and redemption of the Senior Notes, were $34.6 million. A portion of the $75.0 million proceeds from the second installment was used to fund additional land acquisitions in 2009 and 2010.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

The Term Loan bears interest at a rate of 14.0%. However, the Term Loan Agreement also provides that, upon any repayment of any portion of the principal amount under the Term Loan (whether or not at maturity), California Lyon will pay an exit fee equal to the difference (if positive) between (x) the interest that would have been accrued and been then payable on the repaid portion if the interest rate under the Term Loan Agreement were 15.625% and (y) the internal rate of return realized by the Lenders on such repaid portion, taking into account all cash amounts actually received by the Lenders with respect thereto other than any make whole payments described below.

Based on the current outstanding balance of the Term Loan, interest payments are $28.8 million annually.

Upon any prepayment of any portion of the Term Loan prior to its scheduled maturity (other than any prepayment required in connection with a payment of all or any portion of the outstanding principal balance of any of the Senior Notes Indentures), the Term Loan Agreement provides that California Lyon make a “make whole payment” equal to an amount, if positive, of the present value of all future payments of interest which would become due with respect to such prepaid amount from the date of prepayment thereof through and including the maturity date, discounted at a rate of 14%.

The Term Loan is scheduled to mature on October 20, 2014; however, in the event that any portion of the outstanding principal amounts (the “Repaid Senior Note Principal”) of the Senior Notes is repaid (whether or not at maturity), the Lenders may elect to require California Lyon to repay that portion of the outstanding loan as bears the same ratio to the entire Term Loan outstanding as the Repaid Senior Note Principal bears to the entire amounts then outstanding under all of the Senior Notes Indentures. All or a portion of the Term Loan may also be accelerated upon certain other events described in the Term Loan Agreement. The lenders waived the requirement for such repayment in connection with the Senior Note redemptions which occurred from 2008 to 2010 and which are described below.

The Term Loan Agreement requires that the Company’s Minimum Tangible Net Worth (as defined therein) not fall below $75.0 million at the end of any two consecutive fiscal quarters. However, as discussed below, the Company has obtained temporary relief with respect to this covenant. The Term Loan Agreement also contains covenants that limit the ability of California Lyon and the Company to, without prior approval from Lenders, among other things: (i) incur liens; (ii) incur additional indebtedness; (iii) transfer or dispose of assets; (iv) merge, consolidate or alter their line of business; (v) guarantee obligations; (vi) engage in affiliated party transactions; (vii) declare or pay dividends or make other distributions or repurchase stock; (viii) make advances, loans or investments; (ix) repurchase debt (including under the Senior Notes Indentures); and (x) engage in change-of-control transactions.

The Term Loan Agreement contains customary events of default, including, without limitation, failure to pay when due amounts in respect of the loan or otherwise under the Term Loan Agreement; failure to comply with certain agreements or covenants contained in the Term Loan Agreement for a period of 10 days (or, in some cases, 30 days) after the administrative agent’s notice of such non-compliance; acceleration of more than $10.0 million of certain other indebtedness; and certain insolvency and bankruptcy events.

Under the Term Loan, the Company is required to comply with a number of covenants, the most restrictive of which require the Company to maintain:

 

   

A tangible net worth, as defined, of at least $75.0 million (this covenant was modified as described below);

 

   

A minimum borrowing base such that the indebtedness under the Term Loan does not exceed 60% of the Borrowing Base, with the “Borrowing Base” being calculated as (1) the discounted cash flows of each project securing the loan (collateral value), plus (2) unrestricted cash and (3) escrow proceeds receivable, as defined;

 

   

Total secured indebtedness (including the indebtedness under the Term Loan and under all other Construction Notes payable) less than or equal to the Maximum Permitted Secured Indebtedness under the Term Loan Agreement (which is generally 60% of the total secured debt collateral value as calculated under the Term Loan Agreement, which value generally does not include cash assets); and

 

   

Excluded Assets of no more than $20.0 million, with “Excluded Assets” being defined generally as the sum total of certain deposit accounts, payroll accounts, unrestricted cash accounts, and the Company’s total investment in joint ventures.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

The Company’s covenant compliance for the Term Loan at March 31, 2011 is detailed in the table set forth below (dollars in millions):

 

Covenant and Other Requirements

   Actual at
March 31,
2011
    Covenant
Requirements at
March 31,
2011

Tangible Net Worth (1)

   $ 1.3      ³$75.0

Ratio of Term Loan to Borrowing Base

     49.4   £60%

Secured Indebtedness (as a percentage of collateral value)

     54.9   £60%

Excluded Assets

   $ 12.0      £$20.0

 

(1) Tangible Net Worth was calculated based on the stated amount of equity less intangible assets of $11.5 million as of March 31, 2011. This covenant has been amended as described below.

As reported on the Company’s current report on Form 8-K dated March 18, 2011, the Company reached an agreement with the Lenders under the Term Loan that amended the Term Loan to permit the Company’s tangible net worth to fall below $75.0 million for two consecutive quarters. In addition, as reported on the Company’s current report on Form 8-K, dated April 21, 2011, the Company reached a subsequent agreement with the Lenders under the Term Loan to waive any non-compliance with the tangible net worth covenant and with certain other technical requirements through July 19, 2011, subject to certain terms and conditions.

Except as noted above, as of and for the period ending March 31, 2011, the Company is in compliance with the covenants under the Term Loan.

If market conditions deteriorate, the Company believes that its ability to comply with financial covenants contained in the Company’s Term Loan will continue to be negatively impacted. Under these circumstances, the Company could be required to seek additional covenant relief to avoid future noncompliance with the financial covenants in the Term Loan Agreement. If the Company is unable to obtain requested covenant relief or is unable to obtain a waiver for any covenant non-compliance, the Company’s obligation to repay indebtedness under the Term Loan and the Senior Notes could be accelerated. The Company can give no assurance that in such an event, the Company would have, or be able to obtain, sufficient funds to pay all debt that the Company would then be required to repay.

7 5/8% Senior Notes

On November 22, 2004, California Lyon issued $150.0 million principal amount of the 7 5/8% Senior Notes, resulting in net proceeds to the Company of approximately $148.5 million. Of the initial $150.0 million, $66.7 million in aggregate principal amount remained outstanding as of March 31, 2011 and the date hereof. In August 2010, the Company redeemed, in a privately negotiated transaction, $0.5 principal amount of its outstanding 7 5/8% Senior Notes at a cost of $0.4 million plus accrued interest.

Interest on the 7 5/8% Senior Notes is payable semi-annually on December 15 and June 15 of each year. Based on the current outstanding principal amount of the 7 5/8% Senior Notes, the Company’s semi-annual interest payments are $2.5 million.

The 7 5/8% Senior Notes are redeemable at the option of California Lyon, in whole or in part, at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest, if any.

10 3/4% Senior Notes

On March 17, 2003, California Lyon issued $250.0 million of the 10 3/4% Senior Notes at a price of 98.493% to the public, resulting in net proceeds to the Company of approximately $246.2 million. The redemption price reflected a discount to yield 11% under the effective interest method, and the notes have been reflected net of the unamortized discount in the consolidated balance sheet. Of the initial $250.0 million, $138.7 million aggregate principal amount remained outstanding as of March 31, 2011 and the date hereof. In July 2010, the Company redeemed, in a privately negotiated transaction, $10.5 million principal amount of its outstanding 10 3/4% Senior Notes at a cost of $9.0 million plus accrued interest. In August 2010, the Company redeemed, in privately negotiated transactions, $19.5 million principal amount of its outstanding 10 3/4% Senior Notes at a cost of $16.9 million plus accrued interest.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

Interest on the 10 3/4% Senior Notes is payable on April 1 and October 1 of each year. Based on the current outstanding principal amount of the 10 3/4% Senior Notes, the Company’s semi-annual interest payments are $7.4 million.

The 10 3/4% Senior Notes are redeemable at the option of California Lyon, in whole or in part, at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest, if any.

7 1/2% Senior Notes

On February 6, 2004, California Lyon issued $150.0 million principal amount of the 7 1/2% Senior Notes, resulting in net proceeds to the Company of approximately $147.6 million. Of the initial $150.0 million, $77.9 million aggregate principal amount remained outstanding as of March 31, 2011 and the date hereof. In August 2010, the Company redeemed, in a privately negotiated transaction, $6.8 million principal amount of its outstanding 7 1/2% Senior Notes at a cost of $5.1 million plus accrued interest.

Interest on the 7 1/2% Senior Notes is payable on February 15 and August 15 of each year. Based on the current outstanding principal amount of 7 1/2% Senior Notes, the Company’s semi-annual interest payments are $2.9 million.

The 7 1/2% Senior Notes are redeemable at the option of California Lyon, in whole or in part, at a redemption price equal to 100% of the principal amount plus a premium declining ratably to par, plus accrued and unpaid interest, if any.

General Terms of the Senior Notes

The Senior Notes are senior unsecured obligations of California Lyon and are unconditionally guaranteed on a senior unsecured basis by the Company, and by all of the Company’s existing and certain of its future restricted subsidiaries. The Senior Notes and the guarantees rank senior to all of the Company’s and the guarantors’ debt that is expressly subordinated to the Senior Notes and the guarantees, but are effectively subordinated to all of the Company’s and the guarantors’ senior secured indebtedness to the extent of the value of the assets securing that indebtedness.

Upon a change of control as described in the Senior Notes Indentures, California Lyon will be required to offer to purchase the Senior Notes at a purchase price equal to 101% of the principal amount, plus accrued and unpaid interest, if any.

Under the Senior Notes Indentures, if the Company’s consolidated tangible net worth falls below $75.0 million for any two consecutive fiscal quarters, California Lyon will be required to make an offer to purchase up to 10% of each class of Senior Notes originally issued at a purchase price equal to 100% of the principal amount, plus accrued and unpaid interest, if any. Any such offer to purchase must be made within 65 days after the second quarter ended for which the Company’s tangible net worth is less than $75.0 million. However, California Lyon may reduce the principal amount of the notes to be purchased by the aggregate principal amount of all notes previously redeemed.

The Company’s tangible net worth was less than $75.0 million as of December 31, 2010 and March 31, 2011. However, the Company has determined and calculated that California Lyon’s redemptions of Senior Notes during the period from 2008 to 2010 would reduce California Lyon’s repurchase obligations as follows: California Lyon would not be obligated to repurchase any of the 7 5/8% Senior Notes, as a result of California Lyon’s previous redemption of $83.3 million in aggregate principal amount of the 7 5/8% Senior Notes; California Lyon would not be obligated to repurchase any of the 10 3/4% Senior Notes, as a result of California Lyon’s previous redemption of $110.7 million in aggregate principal amount of the 10 3/4% Senior Notes; and California Lyon would not be obligated to repurchase any of the 7 1/2% Senior Notes, as a result of California Lyon’s previous redemption of $72.1 million in aggregate principal amount of the 7 1/2% Senior Notes.

California Lyon is 100% owned by the Company. Each subsidiary guarantor is 100% owned by California Lyon or the Company. All guarantees of the Senior Notes are full and unconditional and all guarantees are joint and several. There are no significant restrictions under the Senior Notes Indentures on the ability of the Company or any guarantor to obtain funds from subsidiaries by dividend or loan.

The Senior Notes Indentures contain covenants that limit the ability of the Company and its restricted subsidiaries to, among other things: (i) incur additional indebtedness; (ii) pay dividends or make other distributions or repurchase stock; (iii) make investments; (iv) sell assets; (v) incur liens; (vi) enter into agreements restricting the ability of the Company’s restricted subsidiaries (other than California Lyon) to pay dividends; (vii) enter into transactions with affiliates; and (viii) consolidate, merge or sell all or substantially all of the Company’s and California Lyon’s assets. These covenants are subject to a number of important exceptions and qualifications as described in the Senior Notes Indentures.

As of and for the period ending March 31, 2011, the Company was in compliance with the Senior Note covenants.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

The foregoing summary is not a complete description of the Senior Notes and is qualified in its entirety by reference to the Senior Notes Indentures.

Prior Redemptions of the Senior Notes

During the year ended December 31, 2010, the Company redeemed, in privately negotiated transactions, $37.3 million principal amount of its outstanding Senior Notes at a cost of $31.3 million, plus accrued interest. The net gain resulting from the redemptions, after giving effect to amortization of related deferred loan costs, was $5.6 million.

On June 10, 2009, California Lyon consummated a cash tender offer (the “Tender Offer”) to redeem a portion of its outstanding Senior Notes. The principal amount of Senior Notes redeemed by California Lyon on settlement of the Tender Offer totaled $53.2 million, including $29.1 million of the 7 5/8% Senior Notes, $2.4 million of the 10 3/4% Senior Notes, and $21.7 million of the 7 1/2% Senior Notes. The aggregate Tender Offer consideration paid totaled $14.9 million, plus accrued interest. The net gain resulting from the Tender Offer, after closing costs, was $37.0 million.

Also, during 2009 the Company redeemed, in privately negotiated transactions, a total of $103.7 million principal amount of the outstanding Senior Notes at a cost of $62.1 million, plus accrued interest. The net gain resulting from the redemption, after giving effect to amortization of related deferred loan costs, was $41.1 million. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition and Liquidity” and Note 5 of “Notes to Consolidated Financial Statements” for more information relating to the Term Loan of the Company.

In October 2008, the Company redeemed, in privately negotiated transactions, $71.9 million principal amount of the outstanding Senior Notes at a cost of $16.7 million, plus accrued interest. The net gain resulting from the redemption, after giving effect to amortization of related deferred loan costs, was $54.0 million.

Construction Notes Payable

At March 31, 2011, the Company had two construction notes payable totaling $22.4 million. One of the notes matures in July 2011 and bears interest at rates based on either LIBOR or prime with an interest rate floor of 6.5% and an outstanding principal balance of $13.9 million as of March 31, 2011. Interest is calculated on the average daily balance and is paid following the end of each month. While the Company was previously required to maintain minimum tangible net worth of $90.0 million under this note, the Company and the lender have amended the note to eliminate the tangible net worth covenant in exchange for a principal payment of $2.0 million. As a result of the payment of $2.0 million, which was made in April 2011, the outstanding principal balance is $11.9 million. The Company is currently in negotiations with the lender to extend the maturity of the loan and to modify the covenants.

The other construction note had a remaining balance at March 31, 2011 of $8.5 million. This note was previously due to mature in July 2010; however, in conjunction with a partial payment of principal on that loan, the Company and the lender entered into a new loan agreement in 2010 for the then remaining outstanding principal of $10.0 million, which will mature in May 2015. The new loan bears interest payable monthly at a fixed rate of 12.5%, with quarterly principal payments of $500,000 beginning in July 2010. The interest rate decreases to 10.0% when the principal balance is reduced to $7.5 million.

Seller Financing

At March 31, 2011, the Company had $6.7 million of notes payable outstanding related to a land acquisition for which seller financing was provided, which is included in notes payable in the accompanying consolidated balance sheet. The seller financing note is due at various dates through 2012 and bears interest at 7.0%. Interest is calculated on the principal balance outstanding and is accrued and paid to the seller at the time each residential unit is closed. In addition, the Company makes an annual interest payment on the outstanding principal balance related to any remaining residential units.

 

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Table of Contents

WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

CONSOLIDATING BALANCE SHEET

March 31, 2011

(in thousands)

 

     Unconsolidated               
     Delaware
Lyon
     California
Lyon
    Guarantor
Subsidiaries
     Non-Guarantor
Subsidiaries
     Eliminating
Entries
    Consolidated
Company
 
ASSETS   

Cash and cash equivalents

   $ —         $ 44,107      $ 111       $ 1,229       $ —        $ 45,447   

Restricted cash

     —           641        —           —           —          641   

Receivables

     —           13,397        314         3,150         —          16,861   

Real estate inventories

               

Owned

     —           491,162        —           10,090         —          501,252   

Not owned

     —           47,408        —           —           —          47,408   

Property and equipment, net

     —           1,159        —           —           —          1,159   

Deferred loan costs

     —           11,516        —           —           —          11,516   

Other assets

     —           3,112        152         —           —          3,264   

Investments in subsidiaries

     2,589         3,280        —           —           (5,869     —     

Intercompany receivables

     —           —          203,396         12         (203,408     —     
                                                   
   $ 2,589       $ 615,782      $ 203,973       $ 14,481       $ (209,277   $ 627,548   
                                                   
LIABILITIES AND EQUITY   

Accounts payable

   $ —         $ 7,977      $ 22       $ 527       $ —        $ 8,526   

Accrued expenses

     —           40,104        226         71         —          40,401   

Liabilities from inventories not owned

     —           47,408        —           —           —          47,408   

Notes payable

     —           29,115        —           —           —          29,115   

Senior Secured Term Loan

     —           206,000        —           —           —          206,000   

7  5/8% Senior Notes

     —           66,704        —           —           —          66,704   

10  3/4% Senior Notes

     —           138,688        —           —           —          138,688   

7  1/2% Senior Notes

     —           77,867        —           —           —          77,867   

Intercompany payables

     —           203,055        —           353         (203,408     —     
                                                   

Total liabilities

     —           816,918        248         951         (203,408     614,709   

Equity

               

Stockholders’ equity (accumulated deficit)

     2,589         (201,136     203,725         13,530         (16,119     2,589   

Noncontrolling interest

     —           —          —           —           10,250        10,250   
                                                   
   $ 2,589       $ 615,782      $ 203,973       $ 14,481       $ (209,277   $ 627,548   
                                                   

 

- 20 -


Table of Contents

WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

CONSOLIDATING BALANCE SHEET

December 31, 2010

(in thousands)

 

     Unconsolidated               
     Delaware
Lyon
     California
Lyon
    Guarantor
Subsidiaries
     Non-Guarantor
Subsidiaries
     Eliminating
Entries
    Consolidated
Company
 
ASSETS   

Cash and cash equivalents

   $ —         $ 69,499      $ 131       $ 1,656       $ —        $ 71,286   

Restricted cash

     —           641        —           —           —          641   

Receivables

     —           15,034        316         3,149         —          18,499   

Real estate inventories

               

Owned

     —           478,010        —           10,896         —          488,906   

Not owned

     —           55,270        —           —           —          55,270   

Property and equipment, net

     —           1,230        —           —           —          1,230   

Deferred loan costs

     —           12,404        —           —           —          12,404   

Other assets

     —           612        156         —           —          768   

Investments in subsidiaries

     13,814         3,286        —           —           (17,100     —     

Intercompany receivables

     —           —          203,480         12         (203,492     —     
                                                   
   $ 13,814       $ 635,986      $ 204,083       $ 15,713       $ (220,592   $ 649,004   
                                                   
LIABILITIES AND STOCKHOLDERS’ EQUITY   

Accounts payable

   $ —         $ 6,221      $ 27       $ 656       $ —        $ 6,904   

Accrued expenses

     —           41,435        216         71         —          41,722   

Liabilities from inventories not owned

     —           55,270        —           —           —          55,270   

Notes payable

     —           30,541        —           —           —          30,541   

Senior Secured Term Loan

     —           206,000        —           —           —          206,000   

7 5/8% Senior Notes

     —           66,704        —           —           —          66,704   

10 3/4% Senior Notes

     —           138,619        —           —           —          138,619   

7 1/2% Senior Notes

     —           77,867        —           —           —          77,867   

Intercompany payables

     —           203,355        —           137         (203,492     —     
                                                   

Total liabilities

     —           826,012        243         864         (203,492     623,627   

Equity

               

Stockholders’ equity (accumulated deficit)

     13,814         (190,026     203,840         14,849         (28,663     13,814   

Noncontrolling interest

     —           —          —           —           11,563        11,563   
                                                   
   $ 13,814       $ 635,986      $ 204,083       $ 15,713       $ (220,592   $ 649,004   
                                                   

 

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Table of Contents

WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

CONSOLIDATING STATEMENT OF OPERATIONS

Three Months Ended March 31, 2011

(in thousands)

 

     Unconsolidated              
     Delaware
Lyon
    California
Lyon
    Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminating
Entries
    Consolidated
Company
 

Operating revenue

            

Sales

   $ —        $ 31,691      $ 3,453      $ 1,430      $ —        $ 36,574   

Construction services

     —          2,226        —          —          —          2,226   

Management fees

     —          65        —          —          (65     —     
                                                
     —          33,982        3,453        1,430        (65     38,800   
                                                

Operating costs

            

Cost of sales

     —          (27,575     (3,179     (1,196     65        (31,885

Construction services

     —          (1,837     —          —          —          (1,837

Sales and marketing

     —          (3,636     (267     (186     —          (4,089

General and administrative

     —          (7,126     (73     (1     —          (7,200

Other

     —          (562     —          —          —          (562
                                                
     —          (40,736     (3,519     (1,383     65        (45,573
                                                

Equity in income of unconsolidated joint ventures

     —          207        —          —          —          207   
                                                

Loss from subsidiaries

     (11,225     (71     —          —          11,296        —     
                                                

Operating (loss) income

     (11,225     (6,618     (66     47        11,296        (6,566

Interest expense, net of amounts capitalized

     —          (4,778     —          —          —          (4,778

Other income (expense), net

     —          218        (47     (4     —          167   
                                                

Consolidated net (loss) income

     (11,225     (11,178     (113     43        11,296        (11,177

Less: Net income—noncontrolling interest

     —          —          —          —          (48     (48
                                                

Net (loss) income attributable to William Lyon Homes

   $ (11,225   $ (11,178   $ (113   $ 43      $ 11,248      $ (11,225
                                                

 

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Table of Contents

WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

CONSOLIDATING STATEMENT OF OPERATIONS

Three Months Ended March 31, 2010

(in thousands)

 

     Unconsolidated     Eliminating
Entries
    Consolidated
Company
 
     Delaware
Lyon
    California
Lyon
    Guarantor
Subsidiaries
    Non- Guarantor
Subsidiaries
     

Operating revenue

            

Sales

   $ —        $ 33,763      $ 4,099      $ —        $ —        $ 37,862   

Construction services

     —          5,301        —          —          —          5,301   
                                                
     —          39,064        4,099        —          —          43,163   
                                                

Operating costs

            

Cost of sales

     —          (27,510     (3,880     28        —          (31,362

Construction services

     —          (3,247     —          —          —          (3,247

Sales and marketing

     —          (3,336     (229     (22     —          (3,587

General and administrative

     —          (5,919     (74     (9     —          (6,002

Other

     —          (894     —          —          —          (894
                                                
     —          (40,906     (4,183     (3     —          (45,092
                                                

Equity in income of unconsolidated joint ventures

     —          412        —          —          —          412   
                                                

Loss from subsidiaries

     (8,484     (62     (2     —          8,548        —     
                                                

Operating loss

     (8,484     (1,492     (86     (3     8,548        (1,517

Interest expense, net of amounts capitalized

     —          (7,094     —          —          —          (7,094

Other income (expense), net

     —          99        (60     53        —          92   
                                                

(Loss) income before benefit from income taxes

     (8,484     (8,487     (146     50        8,548        (8,519

Benefit from income taxes

     —          65        —          —          —          65   
                                                

Consolidated net (loss) income

     (8,484     (8,422     (146     50        8,548        (8,454

Less: Net income—noncontrolling interest

     —          —          —          —          (30     (30
                                                

Net (loss) income attributable to William Lyon Homes

   $ (8,484   $ (8,422   $ (146   $ 50      $ 8,518      $ (8,484
                                                

 

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Table of Contents

WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

CONSOLIDATING STATEMENT OF CASH FLOWS

Three Months Ended March 31, 2011

(in thousands)

 

     Unconsolidated              
     Delaware
Lyon
    California
Lyon
    Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminating
Entries
    Consolidated
Company
 

Operating activities

            

Net (loss) income

   $ (11,225   $ (11,178   $ (113   $ 43      $ 11,296      $ (11,177

Adjustments to reconcile net loss to net cash (used in) provided by operating activities:

            

Depreciation and amortization

     —          60        14        —          —          74   

Equity in income of unconsolidated joint ventures

     —          (207     —          —          —          (207

Equity in loss of subsidiaries

     11,225        71        —          —          (11,296     —     

Net changes in operating assets and liabilities:

            

Receivables

     —          1,637        2        (1     —          1,638   

Real estate inventories—owned

     —          (13,083     —          806        —          (12,277

Deferred loan costs

     —          888        —          —          —          888   

Other assets

     —          (2,459     4        —          —          (2,455

Accounts payable

     —          1,756        (5     (129     —          1,622   

Accrued expenses

     —          (1,331     10        —          —          (1,321
                                                

Net cash (used in) provided by operating activities

     —          (23,846     (88     719        —          (23,215
                                                

Investing activities

            

Net change in investment in and advances to unconsolidated joint ventures

     —          166        —          —          —          166   

Purchases of property and equipment

     —          11        (14     —          —          (3

Investments in subsidiaries

     —          (65     —          —          65        —     
                                                

Net cash provided by (used in) investing activities

     —          112        (14     —          65        163   
                                                

Financing activities

            

Principal payments on notes payable

     —          (1,426     —          —          —          (1,426

Noncontrolling interest contributions, net

     —          —          —          —          (1,361     (1,361

Advances to affiliates

     —          —          (2     (1,362     1,364        —     

Intercompany receivables/payables

     —          (232     84        216        (68     —     
                                                

Net cash (used in) provided by financing activities

     —          (1,658     82        (1,146     (65     (2,787
                                                

Net decrease in cash and cash equivalents

     —          (25,392     (20     (427     —          (25,839

Cash and cash equivalents at beginning of period

     —          69,499        131        1,656        —          71,286   
                                                

Cash and cash equivalents at end of period

   $ —        $ 44,107      $ 111      $ 1,229      $ —        $ 45,447   
                                                

 

- 24 -


Table of Contents

WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

CONSOLIDATING STATEMENT OF CASH FLOWS

Three Months Ended March 31, 2010

(in thousands)

 

     Unconsolidated              
     Delaware
Lyon
    California
Lyon
    Guarantor
Subsidiaries
    Non-Guarantor
Subsidiaries
    Eliminating
Entries
    Consolidated
Company
 

Operating activities

            

Net (loss) income

   $ (8,484   $ (8,422   $ (146   $ 50      $ 8,548      $ (8,454

Adjustments to reconcile net (loss) income to net cash provided (used in) by operating activities:

            

Depreciation and amortization

     —          96        39        —          —          135   

Equity in income of unconsolidated joint ventures

     —          (412     —          —          —          (412

Loss on disposition of fixed asset

     —          —          110        —          —          110   

Equity in loss of subsidiaries

     8,484        62        2        —          (8,548     —     

Benefit from income taxes

     —          (65     —          —          —          (65

Net changes in operating assets and liabilities:

            

Restricted cash

     —          (4     —          —          —          (4

Receivables

     —          (144     1        (79     —          (222

Income tax refund receivable

     —          107,054        —          —          —          107,054   

Real estate inventories—owned

     —          (70,239     —          (391     —          (70,630

Deferred loan costs

     —          833        —          —          —          833   

Other assets

     —          9,474        6        (411     —          9,069   

Accounts payable

     —          (1,548     (74     (72     —          (1,694

Accrued expenses

     —          4,597        (113     —          —          4,484   
                                                

Net cash provided by (used in) operating activities

     —          41,282        (175     (903     —          40,204   
                                                

Investing activities

            

Net change in investment in and advances to unconsolidated joint ventures

     —          352        —          —          —          352   

Purchases of property and equipment

     —          105        (126     —          —          (21

Investments in subsidiaries

     —          (77     (2     —          79        —     

Advances to affiliates

     —          —          —          —          —          —     
                                                

Net cash provided by (used in) investing activities

     —          380        (128     —          79        331   
                                                

Financing activities

            

Proceeds from borrowings on notes payable

     —          4,590        —          —          —          4,590   

Principal payments on notes payable

     —          (12,449     —          —          —          (12,449

Noncontrolling interest contributions, net

     —          —          —          —          326        326   

Advances to affiliates

     —          —          —          731        (731     —     

Intercompany receivables/payables

     —          (254     320        19        326        411   
                                                

Net cash (used in) provided by financing activities

     —          (8,113     320        750        (79     (7,122
                                                

Net increase (decrease) in cash and cash equivalents

     —          33,549        17        (153     —          33,413   

Cash and cash equivalents at beginning of period

     —          115,247        111        2,229        —          117,587   
                                                

Cash and cash equivalents at end of period

   $ —        $ 148,796      $ 128      $ 2,076      $ —        $ 151,000   
                                                

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

Note 6 — Fair Value of Financial Instruments

In accordance with FASB ASC Topic 820 Fair Value Measurements and Disclosure, the Company is required to disclose the estimated fair value of financial instruments. As of March 31, 2011, the Company used the following assumptions to estimate the fair value of each type of financial instrument for which it is practicable to estimate:

 

   

Cash and Cash Equivalents — The carrying amount is a reasonable estimate of fair value. The Company’s cash balances primarily consist of short-term liquid investments and demand deposits.

 

   

Construction Notes Payable — For certain notes, the carrying amount is a reasonable estimate of fair value because the maturities occur within one year. Certain other notes were discounted at an interest rate that is commensurate with market rates of similar secured real estate financing.

 

   

Seller Financing — The carrying amount is a reasonable estimate of fair value because the note originated during the current period and has a short term maturity.

 

   

Senior Secured Term Loan — As reported in an affiliate of the lender’s Annual Report on Form 10-k for the year ending December 31, 2010, the fair value of the loan is estimated using inputs such as discounted cash flow projections, current interest rates available for similar instruments and other quantitative and qualitative factors, however this amount does not represent the amount the Company expects to pay. Considerable judgment is necessary to interpret market data and develop estimated fair value. The use of different assumptions or methodologies could have a material effect on the estimated fair value amounts. Fair value includes the carrying amount of the loan plus a portion of the “make-whole” amount as defined in the related loan agreement.

 

   

Senior Notes Payable — The Senior Notes are traded over the counter and their fair values were based upon quotes from industry sources, as of March 31, 2011.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

The estimated fair values of financial instruments are as follows (in thousands):

 

     March 31, 2011      December 31, 2010  
     Carrying
Amount
     Fair
Value
     Carrying
Amount
     Fair
Value
 

Financial assets:

           

Cash and equivalents

   $ 45,447       $ 45,447       $ 71,286       $ 71,286   

Financial liabilities:

           

Construction notes payable

   $ 22,399       $ 22,465       $ 22,899       $ 22,899   

Seller financing

     6,716         6,716         7,642         7,642   

Senior Secured Term Loan due 2014

   $ 206,000       $ 230,800       $ 206,000       $ 230,800   

7 5/8% Senior Notes due 2012

   $ 66,704       $ 58,408       $ 66,704       $ 56,785   

10 3/4% Senior Notes due 2013

   $ 138,688       $ 112,782       $ 138,619       $ 119,933   

7 1/2 % Senior Notes due 2014

   $ 77,867       $ 56,191       $ 77,867       $ 56,049   

Effective January 1, 2008, the Company implemented the requirements of FASB ASC Topic 820 for the Company’s financial assets and liabilities. FASB ASC Topic 820 establishes a framework for measuring fair value, expands disclosures regarding fair value measurements and defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. FASB ASC Topic 820 requires the Company to maximize the use of observable market inputs, minimize the use of unobservable market inputs and disclose in the form of an outlined hierarchy the details of such fair value measurements. FASB ASC Topic 820 specifies a hierarchy of valuation techniques based on whether the inputs to a fair value measurement are considered to be observable or unobservable in a marketplace. The three levels of the hierarchy are as follows:

 

   

Level 1 — quoted prices for identical assets or liabilities in active markets;

 

   

Level 2 — quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; and model-derived valuations in which significant inputs and significant value drivers are observable in active markets; and

 

   

Level 3 — valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

Non-financial Instruments

The Company adopted ASC 820 in 2008; however, disclosure of certain non-financial portions of the statement were deferred until the 2009 reporting period. These non-financial homebuilding assets are those assets for which the Company recorded valuation adjustments during the first half of 2009 on a nonrecurring basis. See Note 4, “Real Estate Inventories” for further discussion of the valuation of real estate inventories and within “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Note 7 — Related Party Transactions

For the three months ended March 31, 2011 and 2010, the Company incurred reimbursable on-site labor costs of $45,000 and $62,000, respectively, for providing customer service to real estate projects developed by entities controlled by William Lyon and William H. Lyon. At March 31, 2011 and December 31, 2010, $30,000 and $38,000, respectively, was due to the Company for reimbursable on-site labor costs.

The Company earned fees of $92,000 and $155,000 during the periods ended March 31, 2011 and 2010, respectively, related to a Human Resources and Payroll Services contract between the Company and an entity controlled by General William Lyon and William H. Lyon. Effective April 1, 2011, the Company and this entity amended the Human Resources and Payroll Services contract to provide that the affiliate will now pay to the Company a base monthly fee of $21,335 and a variable monthly fee equal to $23 multiplied by the number of active employees employed by such entity (which will initially result in a variable monthly fee of approximately $8,000). The amended contract also provides that the Company will be reimbursed by such affiliate for a pro rata share of any bonuses paid to the Company’s Human Resources staff (other than any bonus paid to the Vice President of Human Resources). The Company believes that the compensation being paid to it for the services provided to the affiliate is at a market rate of compensation, and that as a result of the fees that are paid to the Company under this contract, the overall cost to the Company of its Human Resources department will be reduced.

On September 3, 2009, Presley CMR, Inc., a California corporation (“Presley CMR”) and wholly owned subsidiary of California Lyon, entered into an Aircraft Purchase and Sale Agreement (“PSA”) with an affiliate of General William Lyon to sell the aircraft described above. The PSA provided for an aggregate purchase price for the Aircraft of $8.3 million, (which value was the appraised fair market value of the Aircraft), which consists of: (i) cash in the amount of $2.1 million to be paid at closing and (ii) a promissory note from the affiliate in the amount of $6.2 million, which is included in receivables in the accompanying consolidated balance sheet at March 31, 2011 and December 31, 2010. The Company receives semiannual interest payments of approximately $132,000 in March and September, the most recent payment was received in March 2011. The note is due in September 2016.

For the three months ended March 31, 2011 and 2010, the Company incurred charges of $197,000 and $197,000, respectively, related to rent on its corporate office, from a trust of which William H. Lyon is the sole beneficiary. The Company is considering its options in light of current usage and market conditions.

Note 8 — Income Taxes

On November 6, 2009, an expanded carry back election was signed into law as part of the Worker, Homeownership, and Business Assistance Act of 2009. As a result of this legislation, the Company elected to carry back for five years the taxable losses generated in 2009. In March 2010, the Company received a tax refund of $102.1 million.

The Company accounts for income taxes in accordance with FASB ASC Topic 740, Income Taxes (“ASC 740”). ASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be considered “more-likely-than-not” to be sustained upon examination by taxing authorities. The Company has taken positions in certain taxing jurisdictions for which it is more likely than not that previously unrecognized tax benefits will be recognized. In addition, the Company has elected to recognize interest and penalties related to uncertain tax positions in the income tax provision. In accordance with the provisions of ASC 740, effective January 1, 2007, the Company recorded an income tax refund receivable of $5.7 million and recognized the associated tax benefit as an increase in additional paid-in capital. In connection therewith, the Company recorded interest receivable of $1.1 million and recognized the associated tax benefit as an increase in retained earnings. Since recording the income tax refund, the Company has received refunds and accrued additional interest, leaving approximately $5.2 million of income tax refunds and interest receivable on the consolidated balance sheet at December 31, 2009. The Company received the balance of the refunds and interest, totaling $5.2 million in the first quarter of 2010. At December 31, 2010 and March 31, 2011, the Company has no unrecognized tax benefits.

        As of January 1, 2011, the Company has gross federal and state net operating loss carry forwards totaling approximately $115.5 million and $386.3 million respectively. Federal net operating loss carry forwards will begin to expire in 2028; state net operating loss carry forwards begin to expire in 2013.

Due to the “change of ownership” provision of the Tax Reform Act of 1986, utilization of the Company’s net operating loss carry forwards may be subject to an annual limitation against taxable income in future periods. As a result of the annual limitation, a portion of these carry forwards may expire before ultimately becoming available to reduce future income tax liabilities.

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

The Company has federal alternative minimum tax credit carry forwards totaling $2.7 million which do not expire.

In addition, as of January 1, 2011, the Company has unused built-in losses of $7.9 million which are available to offset future income and expire in 2011. The Company’s ability to utilize the foregoing tax benefits will depend upon the amount of its future taxable income and may be limited under certain circumstances.

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. The Company is subject to U.S. federal income tax examination for calendar tax years ending 2004 through 2010. The Company is subject to various state income tax examinations for calendar tax years ending 2006 through 2010.

Note 9 — Commitments and Contingencies

The Company’s commitments and contingent liabilities include the usual obligations incurred by real estate developers in the normal course of business. In the opinion of management, these matters will not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

The Company is a defendant in various lawsuits related to its normal business activities. In the opinion of management, disposition of the various lawsuits will have no material effect on the consolidated financial statements of the Company.

In some jurisdictions in which the Company develops and constructs property, assessment district bonds are issued by municipalities to finance major infrastructure improvements. As a land owner benefited by these improvements, the Company is responsible for the assessments on its land. When properties are sold, the assessments are either prepaid or the buyers assume the responsibility for the related assessments. Assessment district bonds issued after May 21, 1992 are accounted for under the provisions of 91-10, “Accounting for Special Assessment and Tax Increment Financing Entities” issued by the Emerging Issues Task Force of the Financial Accounting Standards Board on May 21, 1992, now codified as FASB ASC Topic 970-470, Real Estate – Debt, and recorded as liabilities in the Company’s consolidated balance sheet, if the amounts are fixed and determinable.

As of March 31, 2011, the Company had $0.6 million in deposits as collateral for outstanding irrevocable standby letters of credit to guarantee the Company’s financial obligations under certain contractual arrangements in the normal course of business. The standby letters of credit were secured by cash as reflected as restricted cash on the accompanying consolidated balance sheet. The beneficiary may draw upon these letters of credit in the event of a contractual default by the Company relating to each respective obligation. These letters of credit generally have a stated term of 12 months and have varying maturities throughout 2011, at which time the Company may be required to renew to coincide with the term of the respective arrangement.

The Company also had outstanding performance and surety bonds of $84.7 million at March 31, 2011 related principally to its obligations for site improvements at various projects. The Company does not believe that draws upon these bonds, if any, will have a material effect on the Company’s financial position, results of operations or cash flows.

The Company has provided unsecured environmental indemnities to certain lenders, joint venture partners and land sellers. In each case, the Company has performed due diligence on the potential environmental risks including obtaining an independent environmental review from outside environmental consultants. These indemnities obligate the Company to reimburse the guaranteed parties for damages related to environmental matters. There is no term or damage limitation on these indemnities; however, if an environmental matter arises, the Company could have recourse against other previous owners.

See Note 5 for additional information relating to the Company’s guarantee arrangements.

Land Banking Arrangements

The Company enters into purchase agreements with various land sellers. As a method of acquiring land in staged takedowns, thereby minimizing the use of funds from the Company’s available cash or other corporate financing sources and limiting the Company’s risk, the Company transfers the Company’s right in such purchase agreements to entities owned by third parties (“land banking arrangements”). These entities use equity contributions and/or incur debt to finance the acquisition and development of the previous land being purchased. The entities grant the Company an option to acquire lots in staged takedowns. In consideration for this option, the Company makes a non-refundable deposit of 15% to 25% of the total purchase price. The Company is under no obligation to purchase the balance of the lots, but would forfeit remaining deposits and could be subject to penalties if the lots were not purchased. The Company does not have legal title to these

 

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WILLIAM LYON HOMES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)

 

entities or their assets and has not guaranteed their liabilities. These land banking arrangements help the Company manage the financial and market risk associated with land holdings. FASB ASC Topic 810 requires the consolidation of the assets, liabilities and operations of the Company’s land banking arrangements that are VIEs, of which none existed at March 31, 2011.

The Company participates in one land banking arrangement, which is not a VIE in accordance with FASB ASC Topic 810, but which is consolidated in accordance with FASB ASC Topic 470, Debt. Under the provisions of FASB ASC Topic 470, the Company has determined it is economically compelled, based on certain factors, to purchase the land in the land banking arrangement. The Company has recorded the remaining purchase price of the land of $47.4 million, which is included in real estate inventories not owned and liabilities from inventories not owned in the accompanying consolidated balance sheet as of March 31, 2011.

In 2011, the Company purchased 23 lots from its land banking arrangement for a total purchase price of $7.9 million. In conjunction with the purchase, the Company reduced real estate inventories not owned and liabilities from inventories not owned in the amount of $7.9 million.

Summary information with respect to the Company’s consolidated land banking arrangement is as follows as of March 31, 2011 (dollars in thousands):

 

Total number of land banking projects

     1   
        

Total number of lots

     625   
        

Total purchase price

   $ 161,465   
        

Balance of lots still under option and not purchased:

  

Number of lots

     225   
        

Purchase price

   $ 47,408   
        

Forfeited deposits if lots are not purchased

   $ 25,234   
        

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

WILLIAM LYON HOMES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

The following discussion of results of operations and financial condition should be read in conjunction with the consolidated financial statements and notes thereto included in Item 1, as well as the information presented in the Annual Report on Form 10-K for the year ended December 31, 2010.

Results of Operations

Since early 2006, the U.S. housing market has been negatively impacted by declined consumer confidence, restrictive mortgage standards, and large supplies of foreclosure, resale and new homes, among other factors. When combined with a prolonged economic downturn, high unemployment levels, and uncertainty in the U.S. economy, these conditions have contributed to decreased demand for housing, declining sales prices, and increasing pricing pressure, which hinders the Company’s ability to attract new home buyers. As a result, the Company has experienced operating losses, beginning in 2007 and continuing into 2011. Such losses resulted from a combination of reduced homebuilding gross margins, losses on land sales to generate cash flow and significant non-cash impairment losses on real estate assets. On November 6, 2009, the Worker, Homeownership, and Business Assistance Act of 2009 (“the Act”) was enacted into law, which extended and expanded the homebuyer federal tax credit until April 30, 2010. The Act, which was applicable to net new home orders under contract by April 30, 2010 and closed by September 30, 2010, favorably impacted our home sales during the early part of 2010, but also contributed to an industry-wide decline in net new home orders in the latter part of 2010 and into 2011.

The U.S. housing market and broader economy remain in a period of uncertainty; however, there are signs of stabilization in certain of our local markets, though at near historically low levels.

Entering 2011, there are indications that certain 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, including, but not limited to: (i) high levels of unemployment, which correlates to low levels of consumer confidence; (ii) continued foreclosure activity with immeasurable shadow inventory; (iii) upward trending mortgage rates, as the current level of low mortgage rates is not expected to remain in the long-term; (iv) increased costs and standards related to FHA loans, which continue to be a significant source of homebuyer financing; and (v) increase in the cost of building materials.

The Company continues to operate with the assumption that difficult market conditions will continue at least during 2011. The Company continues to review acquisitions of select land positions where it makes strategic and economic sense to do so, targeting finished lots in core coastal markets, near high employment centers or transportation corridors. In addition, management continues to evaluate owned lots and land parcels to determine if values support holding the parcels for future project development or selling to generate cash flow.

In Southern California, net new home orders per average sales location decreased to 9.9 during the period ended March 31, 2011 from 14.4 for the same period in 2010. In Northern California, net new home orders per average sales location increased to 9.8 during the 2011 period from 8.3 during the 2010 period. In Arizona, net new home orders per average sales location increased to 15.5 during the period ended March 31, 2011 from 7.3 for the same period in 2010. In Nevada, net new home orders per average sales location increased to 4.2 during the 2011 period from 3.8 during the 2010 period. In Northern California, the cancellation rate decreased to 9% in the 2011 period compared to 11% in the 2010 period. In Arizona, the cancellation rate decreased to 11% in the 2011 period compared to 31% in the 2010 period. In Nevada, the cancelation rate increased to 25% in the 2011 period compared to 21% in the 2010 period. The cancelation rate in Southern California remained unchanged at 17% for the periods ending March 31, 2011 and 2010.

The Company experienced decreased homebuilding gross margin percentages of 12.8% for the period ending March 31, 2011 compared to 17.2% in the 2010 period particularly impacted by a decrease in Southern California’s homebuilding gross margin percentages to 15.3% in the 2011 period compared to 16.4% in the 2010 period and a decrease in Northern California’s homebuilding gross margin percentages to 8.8% in the 2011 period compared to 26.5% in the 2010 period. In Arizona, homebuilding gross margin percentages increased to 9.0% in the 2011 period from 5.8% in the 2010 period. In Nevada, homebuilding gross margin percentages decreased to 13.0% in the 2011 period from 14.5% in the 2010 period.

 

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Comparisons of Three Months Ended March 31, 2011 to March 31, 2010

On a consolidated basis, the number of net new home orders for the three months ended March 31, 2011 decreased 6% to 170 homes from 181 homes for the three months ended March 31, 2010. The number of homes closed on a consolidated basis for the three months ended March 31, 2011, decreased 16% to 111 homes from 132 homes for the three months ended March 31, 2010. On a consolidated basis, the backlog of homes sold but not closed as of March 31, 2011 was 143, down 41% from 243 homes a year earlier. However, the backlog of homes sold but not closed increased 70% from 84 since December 31, 2010.

Homes in backlog are generally closed within three to six months. The dollar amount of backlog of homes sold but not closed on a consolidated basis as of March 31, 2011 was $54.3 million, down 32% from $79.7 million as of March 31, 2010. The cancellation rate of buyers who contracted to buy a home but did not close escrow at the Company’s projects was 15% during the three months ended March 31, 2011 compared to 19% during the three months ended March 31, 2010. The inventory of completed and unsold homes was 54 homes as of March 31, 2011, up slightly from 50 homes at March 31, 2010, however down 50% from 107 homes at December 31, 2010.

The average number of sales locations during the quarter ended March 31, 2011 was 19, consistent with 19 in the comparable period a year ago.

The Company’s number of new home orders per average sales location decreased slightly to 9.0 for the three months ended March 31, 2011 as compared to 9.5 for the three months ended March 31, 2010. This was attributable to Southern California, which decreased from 14.4 per location at March 31, 2010 to 9.9 per location at March 31, 2011, offset by Northern California, which increased to 9.8 per location at March 31, 2011 from 8.3 per location at March 31, 2010, Arizona, which increased to 15.5 per location at March 31, 2011 from 7.3 per location at March 31, 2010, and Nevada, which increased to 4.2 per location during the 2011 period compared to 3.8 per location in the 2010 period.

 

     Three Months Ended
March 31,
    Increase (Decrease)  
     2011     2010     Amount     %  

Number of Net New Home Orders

        

Southern California

     69        115        (46     (40 )% 

Northern California

     49        25        24        96

Arizona

     31        22        9        41

Nevada

     21        19        2        11
                          

Total

     170        181        (11     (6 )% 
                          

Cancellation Rate

     15     19     (21 )%   
                          

Net new home orders in each segment, except Southern California, increased period over period. In Southern California, net new home orders decreased 40% from 115 in the 2010 period to 69 in the 2011 period. In Northern California, net new home orders increased 96% from 25 in the 2010 period to 49 in the 2011 period.

Cancellation rates decreased to 15% for the three month period ended March 31, 2011 from 19% for the three month period ended March 31, 2010. The change includes a decrease in Northern California’s cancellation rate to 9% in the 2011 period from 11% in the 2010 period, a decrease in Arizona’s cancellation rate to 11% in the 2011 period from 31% in the 2010 period and an increase in Nevada’s cancellation rate to 25% in the 2011 period from 21% in the 2010 period. The cancellation rate in Southern California remained consistent year over year at 17% for the periods ending March 31, 2011 and 2010.

 

     Three Months Ended
March 31,
     Increase (Decrease)  
     2011      2010      Amount     %  

Average Number of Sales Locations

          

Southern California

     7         8         (1     (13 )% 

Northern California

     5         3         2        67

Arizona

     2         3         (1     (33 )% 

Nevada

     5         5         —          0
                            

Total

     19         19         —          0
                            

 

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The average number of sales locations for the Company remained consistent for the period ending March 31, 2011 compared to the period ending 2010. Northern California increased 67% to 5 for the 2011 period from 3 for the 2010 period. Southern California and Arizona each decreased by one average sales location due to final deliveries in certain projects, offset by the opening of new projects in Southern California.

 

     March 31,      Increase (Decrease)  
     2011      2010      Amount     %  

Backlog (units)

          

Southern California

     60         203         (143     (70 )% 

Northern California

     44         12         32        267

Arizona

     15         18         (3     (17 )% 

Nevada

     24         10         14        140
                            

Total

     143         243         (100     (41 )% 
                            

The Company’s backlog at March 31, 2011 decreased 41% from 243 units at March 31, 2010 to 143 units at March 31, 2011, primarily resulting from a decrease in net new home orders during the period driven by the Southern California division, with a 70% decrease. The decrease in backlog at quarter end reflects a decrease in total net new order activity of 6% to 170 homes in the 2011 period from 181 homes in the 2010 period, and the 16% decrease in the number of homes closed to 111 in the 2011 period from 132 in the 2010 period.

 

     March 31,      Increase (Decrease)  
     2011      2010      Amount     %  
     (dollars in thousands)  

Backlog (dollars)

          

Southern California

   $ 30,664       $ 70,955       $ (40,291     (57 )% 

Northern California

     17,019         3,892         13,127        337

Arizona

     1,971         2,677         (706     (26 )% 

Nevada

     4,646         2,193         2,453        112
                            

Total

   $ 54,300       $ 79,717       $ (25,417     (32 )% 
                            

The dollar amount of backlog of homes sold but not closed as of March 31, 2011 was $54.3 million, down 32% from $79.7 million as of March 31, 2010. The decrease in backlog during this period reflects a decrease in net new order activity of 6% to 170 homes in the 2011 period compared to 181 homes in the 2010 period. In addition, the dollar amount of backlog is affected by recent average sales prices for new home orders. The Company experienced an increase of 16% in the average sales price of homes in backlog to $379,700 as of March 31, 2011 compared to $328,100 as of March 31, 2010. The decrease in the dollar amount of backlog of homes sold but not closed as described above generally results in a decrease in operating revenues in the subsequent period as compared to the previous period.

In Southern California, the dollar amount of backlog decreased 57% to $30.7 million as of March 31, 2011 from $80.0 million as of March 31, 2010, which is attributable to a 40% decrease in net new home orders in Southern California to 69 homes in the 2011 period compared to 115 homes in the 2010 period, offset by a 46% increase in the average sales price of homes in backlog to $511,100 as of March 31, 2011 compared to $349,500 as of March 31, 2010. In Southern California, the cancellation rate remained unchanged at 17% for the period ended March 31, 2011 and 2010.

In Northern California, the dollar amount of backlog more than tripled to $17.0 million as of March 31, 2011 from $3.9 million as of March 31, 2010, which is attributable to a 96% increase in net new home orders in Northern California to 49 homes in the 2011 period compared to 25 homes in the 2010 period, along with a 19% increase in the average sales price of homes in backlog to $386,800 as of March 31, 2011 compared to $324,300 as of March 31, 2010. In Northern California, the cancellation rate decreased to 9% for the period ended March 31, 2011 from 11% for the period ended March 31, 2010.

In Arizona, the dollar amount of backlog decreased 26% to $2.0 million as of March 31, 2011 from $2.7 million as of March 31, 2010, which is attributable to a 12% decrease in the average sales price of homes in backlog to $131,400 as of March 31, 2011 compared to $148,700 as of March 31, 2010, offset by a 41% increase in net new home orders in Arizona to 31 homes in the 2011 period compared to 22 homes in the 2010 period. In Arizona, the cancellation rate decreased to 11% for the period ended March 31, 2011 from 31% for the period ended March 31, 2010.

In Nevada, the dollar amount of backlog increased 112% to $4.6 million as of March 31, 2011 from $2.2 million as of March 31, 2010, which is attributable to a 140% increase in the number of units in backlog to 24 in the 2011 period from 10 in the 2010 period, along with an 11% increase in net new home orders in Nevada to 21 homes in the 2011 period compared

 

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to 19 homes in the 2010 period, offset by a 12% decrease in the average sales price of homes in backlog to $193,600 as of March 31, 2011 compared to $219,300 as of March 31, 2010. In Nevada, the cancellation rate increased to 25% for the period ended March 31, 2011 from 21% for the period ended March 31, 2010.

 

     Three Months Ended
March 31,
     Increase (Decrease)  
     2011      2010      Amount     %  

Number of Homes Closed

          

Southern California

     43         70         (27     (39 )% 

Northern California

     24         19         5        26

Arizona

     24         21         3        14

Nevada

     20         22         (2     (9 )% 
                            

Total

     111         132         (21     (16 )% 
                            

During the three months ended March 31, 2011, the number of homes closed decreased 16% to 111 in the 2011 period from 132 in the 2010 period. The decrease in home closings is primarily attributable to a 39% decrease in Southern California to 43 homes closed in the 2011 period compared to 70 homes closed in the 2010 period. In addition, the Company was able to convert 100% of its units in backlog at December 31, 2010 into closings during the period ending March 31, 2011.

 

     Three Months Ended
March 31,
     Increase (Decrease)  
     2011      2010      Amount     %  
     (dollars in thousands)  

Home Sales Revenue

          

Southern California

   $ 20,141       $ 21,381       $ (1,240     (6 )% 

Northern California

     9,403         7,947         1,456        18

Arizona

     3,453         4,099         (646     (16 )% 

Nevada

     3,577         4,435         (858     (19 )% 
                            

Total

   $ 36,574       $ 37,862       $ (1,288     (3 )% 
                            

The decrease in homebuilding revenue of 3% to $36.6 million for the period ending 2011 from $37.9 million for the period ending 2010 is primarily attributable to a decrease in the number of homes closed to 111 during the 2011 period from 132 in the 2010 period, offset by an increase in the average sales price of homes closed to $329,500 during the 2011 period from $286,800 during the 2010 period. This increase is attributable to a change in product mix, which included an increase in the number of homes closed with a sale price in excess of $500,000 from zero in the 2010 period to 25 in the 2011 period due to a change in product mix.

 

     Three Months Ended
March 31,
     Increase (Decrease)  
     2011      2010      Amount     %  

Average Sales Price of Homes Closed

          

Southern California

   $ 468,400       $ 305,400       $ 163,000        53

Northern California

     391,800         418,300         (26,500     (6 )% 

Arizona

     143,900         195,200         (51,300     (26 )% 

Nevada

     178,900         201,600         (22,700     (11 )% 
                            

Total

   $ 329,500       $ 286,800       $ 42,700        15
                            

The average sales price of homes closed during the 2011 period decreased in three segments due primarily to a change in product mix. However, in Southern California the overall average sales price increase is primarily due to a change in product mix, in which the number of homes closed with a sale price in excess of $500,000 was zero in the 2010 period and 21 in the 2011 period.

 

     Three Months Ended
March 31,
    Increase
(Decrease)
 
     2011     2010    

Homebuilding Gross Margin Percentage

      

Southern California

     15.3     16.4     (1.1 )% 

Northern California

     8.8     26.5     (17.7 )% 

Arizona

     9.0     5.8     3.2

Nevada

     13.0     14.5     (1.5 )% 
                        

Total

     12.8     17.2     (4.4 )% 
                        

 

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Homebuilding gross margin percentage during the 2011 period decreased to 12.8% from 17.2% during the 2010 period which is primarily attributable to an increase in the average cost per homes closed of 21% from $237,600 in the 2010 period to $287,300 in the 2011 period offset by a 15% increase in the average sales price of home closed of $329,500 in the 2011 period from $286,600 in the 2010 period.

Homebuilding gross margins may be negatively impacted by a weak economic environment, which includes homebuyers’ reluctance to purchase new homes, increases in foreclosure rates, tightening of mortgage loan origination requirements, high cancellation rates, which could affect our ability to maintain existing home prices and/or home sales incentive levels, and continued deterioration in the demand for new homes in our markets, among other things.

Construction Services Revenue

Construction services revenue, which was all recorded in Southern California, was $2.2 million in the 2011 period compared with $5.3 million in the 2010 period. See Note 1 of “Notes to Consolidated Financial Statements” for further discussion.

Impairment Loss on Real Estate Assets

The Company evaluates homebuilding assets for impairment when indicators of impairments are present. Given the current market conditions in the homebuilding industry since 2006, the Company evaluates all homebuilding assets for impairments on a quarterly basis. Indicators of potential impairment include, but are not limited to, a decrease in housing market values and sales absorption rates. For the three months ended March 31, 2011 and March 31, 2010, there were no impairment charges recorded.

The Company continues to evaluate land values to determine whether to hold for development or to sell at current prices, which may lead to additional impairment on real estate assets.

 

     Three Months Ended
March 31,
     Increase (Decrease)  
     2011      2010      Amount     %  
     (dollars in thousands)  

Sales and Marketing Expenses

          

Homebuilding

          

Southern California

   $ 1,958       $ 2,331       $ (373     (16 )% 

Northern California

     1,137         595         542        91

Arizona

     267         228         39        17

Nevada

     727         433         294        68
                            

Total

   $ 4,089       $ 3,587       $ 502        14
                            

Sales and marketing expense increased 14% to $4.1 million in the 2011 period from $3.6 million in the 2010 period, primarily attributable to an increase in sales office and model operations expense of $0.2 million from $0.7 million in the 2010 period to $0.9 million in the 2011 period and an increase in salesperson commissions and salaries of $0.3 million from $0.7 million in the 2010 period to $1.0 million in the 2011 period, due to opening of new model complexes, in which marketing costs are higher during the opening of a project versus the end of a project.

 

     Three Months Ended
March 31,
     Increase (Decrease)  
     2011      2010      Amount     %  
     (dollars in thousands)        

General and Administrative Expenses

          

Homebuilding

          

Southern California

   $ 1,049       $ 1,289       $ (240     (19 )% 

Northern California

     450         536         (86     (16 )% 

Arizona

     476         588         (112     (19 )% 

Nevada

     670         475         195        41

Corporate

     4,555         3,114         1,441        46
                            

Total

   $ 7,200       $ 6,002       $ 1,198        20
                            

General and administrative expenses increased $1.2 million to $7.2 million in the 2011 period from $6.0 million in the 2010 period primarily due to outside services incurred in association with the Term Loan.

 

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Other Items

Other operating costs decreased to $0.6 million in the 2011 period compared to $0.9 million in the 2010 period. The decrease is due to a reduction in property tax expense incurred on projects in which development was temporarily suspended in the 2010 period, some of which were later restarted or sold.

Equity in income of unconsolidated joint ventures decreased to income of $0.2 million in the 2011 period from income of $0.4 million in the 2010 period, primarily due to a decrease in homes closed in the Company’s mortgage joint venture.

During the period ending March 31, 2011, the Company incurred interest related to its outstanding debt of $14.7 million, of which $9.9 million was capitalized, resulting in net interest expense of $4.8 million. During the period ending March 31, 2010, the Company incurred interest related to its outstanding debt of $15.8 million, of which $8.7 million was capitalized, resulting in net interest expense of $7.1 million.

 

     Three Months Ended
March 31,
    Increase (Decrease)  
     2011     2010     Amount     %  
     (dollars in thousands)        

(Loss) Income Before Benefit from Income Taxes

        

Homebuilding

        

Southern California

   $ (2,532   $ (4,664   $ 2,132        (46 )% 

Northern California

     (1,224     711        (1,935     (272 )% 

Arizona

     (777     (1,023     246        (24 )% 

Nevada

     (2,394     (1,010     (1,384     137

Corporate

     (4,250     (2,533     (1,717     68
                          

Total

   $ (11,177   $ (8,519   $ (2,658     31
                          

In Southern California, loss before benefit from income taxes improved 46% to a loss of $(2.5) million in the 2011 period from a loss of $(4.7) million in the 2010 period. The decrease in loss is primarily attributable to (i) a decrease in sales and marketing expense from $2.3 million in the 2010 period to $2.0 million in the 2011 period, (ii) a decrease in general and administrative expense from $1.3 million in the 2010 period to $1.0 million in the 2011 period, (iii) offset by a decrease in homebuilding gross margins to 15.3% in the 2011 period from 16.4% in the 2010 period.

In Northern California, (loss) income before benefit from income taxes changed to a loss of $(1.2) million in the 2011 period from income of $0.7 million in the 2010 period. The increase in loss is primarily attributable to a decrease in homebuilding gross margins to 8.8% in the 2011 period from 26.5% in the 2010 period in addition to an increase in sales and marketing expense to $1.1 million in the 2011 period from $0.6 million in the 2010 period, due to the opening of new project model complexes.

In Arizona, loss before benefit from income taxes decreased 24% to a loss of $(0.8) million in the 2011 period from a loss of $(1.0) million in the 2010 period. The decrease in loss is primarily attributable to an increase in homebuilding gross margins to 9.0% in the 2011 period from 5.8% in the 2010 period in addition to a decrease in general and administrative expense from $0.6 million in the 2010 period to $0.5 million in the 2011 period.

In Nevada, loss before benefit from income taxes increased 137% to a loss of $(2.4) million in the 2011 period from a loss of $(1.0) million in the 2010 period. The increase in loss is primarily attributable to (i) an increase in sales and marketing expense from $0.4 million in the 2010 period to $0.7 million in the 2011 period, (ii) an increase in general and administrative expense from $0.5 million in the 2010 period to $0.7 million in the 2011 period, (iii) and a decrease in homebuilding gross margins to 13.0% in the 2011 period from 14.5% in the 2010 period.

The Corporate segment is a non-homebuilding segment in which the Company develops and implements strategic initiatives and supports the Company’s operating divisions by centralizing key administrative functions such as finance and treasury, information technology, tax planning, internal audit, risk management and litigation and human resources. The Company records the gain from retirement of senior notes and income tax provisions and benefits at the corporate segment. The increase in loss before benefit from income taxes to $(4.3) million in the 2011 period from loss of $(2.5) million in the 2010 period is attributable to a 46% increase in general and administrative expenses to $4.6 million in the 2011 period from $3.1 million in the 2010 period.

Net Loss

As a result of the foregoing factors, net loss for the three months ended March 31, 2011 was $11.2 million compared to net loss for the three months ended March 31, 2010 of $8.5 million.

 

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Lots Owned and Controlled

The table below summarizes the Company’s lots owned and controlled as of the periods presented:

 

     March,      Increase (Decrease)  
     2011      2010      Amount     %  

Lots Owned

          

Southern California

     879         1,224         (345     (28 )% 

Northern California

     592         762         (170     (22 )% 

Arizona

     5,812         4,964         848        17

Nevada

     2,771         2,590         181        7
                            

Total

     10,054         9,540         514        5
                            

Lots Controlled(1)

          

Southern California

     114         533         (419     (79 )% 

Northern California

     303         —           303        100

Arizona

     —           767         (767     (100 )% 
                            

Total

     417         1,300         (883     (68 )% 
                            

Total Lots Owned and Controlled

     10,471         10,840         (369     (3 )% 
                            

 

(1) Lots controlled may be purchased by the Company as consolidated projects or may be purchased by newly formed joint ventures.

Financial Condition and Liquidity

Since early 2006, the U.S. housing market has been negatively impacted by declined consumer confidence, restrictive mortgage standards, and large supplies of foreclosure, resale and new homes, among other factors. When combined with a prolonged economic downturn, high unemployment levels, and uncertainty in the U.S. economy, these conditions have contributed to decreased demand for housing, declining sales prices, and increasing pricing pressure, which hinders the Company’s ability to attract new home buyers. As a result, the Company has experienced operating losses, beginning in 2007 and continuing into 2011. Such losses resulted from a combination of reduced homebuilding gross margins, losses on land sales to generate cash flow and significant impairment losses on real estate inventories.

The U.S. housing market and broader economy remain in a period of uncertainty; however, there are signs of stabilization in certain of our local markets, though at near historically low levels.

Entering 2011, there are indications that certain 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, including, but not limited to: (i) high levels of unemployment, which correlates to low levels of consumer confidence; (ii) continued foreclosure activity with immeasurable shadow inventory; (iii) upward trending mortgage rates, as the current level of low mortgage rates is not expected to remain in the long-term; (iv) increased costs and standards related to FHA loans, which continue to be a significant source of homebuyer financing; and (v) increase in the cost of building materials.

The Company continues to operate with the assumption that difficult market conditions will continue at least during 2011. The Company continues to review acquisitions of select land positions where it makes strategic and economic sense to do so, targeting finished lots in core coastal markets, near high employment centers or transportation corridors. In addition, management continues to evaluate owned lots and land parcels to determine if values support holding the parcel for future project development or selling to generate cash flow.

In Southern California, net new home orders per average sales location decreased to 9.9 during the period ended March 31, 2011 from 14.4 for the same period in 2010. In Northern California, net new home orders per average sales location increased to 9.8 during the 2011 period from 8.3 during the 2010 period. In Arizona, net new home orders per average sales location increased to 15.5 during the period ended March 31, 2011 from 7.3 for the same period in 2010. In Nevada, net new home orders per average sales location increased to 4.2 during the 2011 period from 3.8 during the 2010 period. In Northern California, the cancellation rate decreased to 9% in the 2011 period compared to 11% in the 2010 period. In Arizona, the cancellation rate decreased to 11% in the 2011 period compared to 31% in the 2010 period. In Nevada, the cancelation rate increased to 25% in the 2011 period compared to 21% in the 2010 period. The cancelation rate in Southern California remained unchanged at 17% for the periods ending March 31, 2011 and 2010.

 

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The Company experienced decreased homebuilding gross margin percentages of 12.8% for the period ending March 31, 2011 compared to 17.2% in the 2010 period particularly impacted by a decrease in Southern California’s homebuilding gross margin percentages to 15.3% in the 2011 period compared to 16.4% in the 2010 period and a decrease in Northern California’s homebuilding gross margin percentages to 8.8% in the 2011 period compared to 26.5% in the 2010 period. In Arizona, homebuilding gross margin percentages increased to 9.0% in the 2011 period from 5.8% in the 2010 period. In Nevada, homebuilding gross margin percentages decreased to 13.0% in the 2011 period from 14.5% in the 2010 period.

For the period ended March 31, 2011, the Company experienced a decrease in homebuilding revenues of 3% from the prior year period due to a 16% decrease in the number of homes closed, offset by a 15% increase in the average price of homes closed. In response to the declining demand for housing in the homebuilding industry, the management of the Company continues to focus on generating positive cash flow, reducing overall debt levels and improving liquidity. Management of the Company intends to manage cash flow by reducing inventory levels and expenditures for temporarily suspended projects. For the period ended March 31, 2011, the Company’s net cash used in operations was $23.2 million which included $7.9 million related to the purchase of lots from the Company’s existing land banking arrangement.

In reaction to the declining market, the Company temporarily suspended the development, sales and marketing activities at certain of its projects which are in the early stages of development. The Company has concluded that this strategy was necessary under the prevailing market conditions at the time and believes that it will allow the Company to market the properties at some future time when market conditions may have improved. As of March 31, 2011, two of these projects had been restarted and are actively selling. As markets continue to improve, management continues to evaluate and analyze the market place to potentially activate the remaining suspended projects in 2011 and beyond.

The Company provides for its ongoing cash requirements principally from internally generated funds from the sales of real estate, outside borrowings and by forming new joint ventures with venture partners that provide a substantial portion of the capital required for certain projects. California Lyon currently has outstanding 7 5/8% Senior Notes due 2012, 10 3/4% Senior Notes due 2013, 7 1/2% Senior Notes due 2014, and a 14% Term Loan due 2014. The Company, California Lyon and their subsidiaries have financed, and may in the future finance, certain projects and land acquisitions with construction loans secured by real estate inventories, seller-provided financing and land banking transactions.

Under the Term Loan, the Senior Notes and the Company’s other debt obligations, the Company and its subsidiaries are subject to a number of covenants, including financial covenants. The Company’s recent financial performance (including the $111.9 million non-cash impairment write-down for 2010), has made it more difficult for the Company to comply with these covenants. If the Company is unable to comply with its covenants and obligations under any of these instruments, and is not able to enter into amendments eliminating or modifying the covenants or obtain waivers from the holders of the instruments, the holders of one or more of the debt instruments could cause the acceleration of the debt instruments and require the Company to repay all principal and interest owing under the debt instruments. In addition, the acceleration of maturity under one debt instrument could result in the holders of other debt instruments having the right to accelerate the maturity of those debt instruments.

 

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The ability of the Company to meet its obligations on its indebtedness will depend to a large degree on its future performance which in turn will be subject, in part, to factors beyond its control, such as prevailing economic conditions, either nationally or in regions in which the Company operates, the outbreak of war or other hostilities involving the United States, mortgage and other interest rates, changes in prices of homebuilding materials, weather, the occurrence of events such as landslides, soil subsidence and earthquakes that are uninsurable, not economically insurable or not subject to effective indemnification agreements, availability of labor and homebuilding materials, changes in governmental laws and regulations, the timing of receipt of regulatory approvals and the opening of projects, and the availability and cost of land for future development. The Company cannot be certain that its cash flow will be sufficient to allow it to pay principal and interest on its debt, support its operations and meet its other obligations. If the Company is not able to meet those obligations, it may be required to refinance all or part of its existing debt, sell assets or borrow more money. The Company may not be able to do so on terms acceptable to it, if at all. There is no assurance, however, that future cash flows will be sufficient to meet the Company’s future capital needs. In addition, the amount and types of indebtedness that the Company may incur may be limited by the terms of the indentures and credit or other agreements governing the Company’s Senior Notes obligations, Term Loan and other indebtedness. In addition, the terms of existing or future indentures and credit or other agreements governing the Company’s Senior Note obligations, revolving credit facilities and other indebtedness may restrict the Company from pursuing any of these alternatives.

Term Loan

William Lyon Homes, Inc., a California corporation and wholly-owned subsidiary of the Company (“California Lyon”) is a party to a Senior Secured Term Loan Agreement (the “Term Loan Agreement”), dated October 20, 2009, with ColFin WLH Funding, LLC, as Administrative Agent (“Admin Agent”), ColFin WLH Funding, LLC, as Initial Lender and Lead Arranger (“ColFin”) and the other Lenders who may become assignees of ColFin (collectively, with ColFin, the “Lenders”).

The Term Loan Agreement provides for a first lien secured loan of $206.0 million, secured by substantially all of the assets of California Lyon, the Company (excluding stock in California Lyon) and certain wholly-owned subsidiaries. The Term Loan is guaranteed by the Company.

California Lyon received the first installment of $131.0 million in October 2009, and its second installment of $75.0 million in December 2009. Under the Term Loan Agreement, California Lyon is restricted from future borrowings, and, if necessary, will be required to repay existing borrowings in order to maintain required loan-to-value ratios such that: (i) the aggregate amount of outstanding loans under the Term Loan Agreement may not exceed 60% of the aggregate value of the properties securing the facility, with valuation based on the lower of appraised value (if any) and discounted net present value of the cash flows, and (ii) the aggregate amount of secured debt may not exceed 60% of the aggregate value of the properties owned by California Lyon and its subsidiaries, with valuation based on the lower of appraised value (if any) and discounted net present value of the cash flows. California Lyon is currently in compliance with the above requirements. The net proceeds to the Company from the first installment of the Term Loan, after giving effect to attorney fees, loan fees and other miscellaneous costs associated with the loan transaction, and repayment of the revolving credit facilities and redemption of the Senior Notes, were $34.6 million. A portion of the $75.0 million proceeds from the second installment was used to fund additional land acquisitions in 2009 and 2010.

The Term Loan bears interest at a rate of 14.0%. However, the Term Loan Agreement also provides that, upon any repayment of any portion of the principal amount under the Term Loan (whether or not at maturity), California Lyon will pay an exit fee equal to the difference (if positive) between (x) the interest that would have been accrued and been then payable on the repaid portion if the interest rate under the Term Loan Agreement were 15.625% and (y) the internal rate of return realized by the Lenders on such repaid portion, taking into account all cash amounts actually received by the Lenders with respect thereto other than any make whole payments described below.

Based on the current outstanding balance of the Term Loan, interest payments are $28.8 million annually.

Upon any prepayment of any portion of the Term Loan prior to its scheduled maturity (other than any prepayment required in connection with a payment of all or any portion of the outstanding principal balance of any of indentures governing the Senior Notes (the “Senior Notes Indentures”), the Term Loan Agreement provides that California Lyon make a “make whole payment” equal to an amount, if positive, of the present value of all future payments of interest which would become due with respect to such prepaid amount from the date of prepayment thereof through and including the maturity date, discounted at a rate of 14%.

The Term Loan is scheduled to mature on October 20, 2014; however, in the event that any portion of the outstanding principal amounts (the “Repaid Senior Note Principal”) of the Senior Notes is repaid (whether or not at maturity), the Lenders may elect to require California Lyon to repay that portion of the outstanding loan as bears the same ratio to the entire Term Loan outstanding as the Repaid Senior Note Principal bears to the entire amounts then outstanding under all of the

 

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Senior Notes Indentures. All or a portion of the Term Loan may also be accelerated upon certain other events described in the Term Loan Agreement. The lenders waived the requirement for such repayment in connection with the Senior Note redemptions which occurred from 2008 to 2010 and which are described below.

The Term Loan Agreement requires that the Company’s Minimum Tangible Net Worth (as defined therein) not fall below $75.0 million at the end of any two consecutive fiscal quarters. However, as discussed below, the Company has obtained temporary relief with respect to this covenant. The Term Loan Agreement also contains covenants that limit the ability of California Lyon and the Company to, without prior approval from Lenders, among other things: (i) incur liens; (ii) incur additional indebtedness; (iii) transfer or dispose of assets; (iv) merge, consolidate or alter their line of business; (v) guarantee obligations; (vi) engage in affiliated party transactions; (vii) declare or pay dividends or make other distributions or repurchase stock; (viii) make advances, loans or investments; (ix) repurchase debt (including under the Senior Notes Indentures); and (x) engage in change-of-control transactions.

The Term Loan Agreement contains customary events of default, including, without limitation, failure to pay when due amounts in respect of the loan or otherwise under the Term Loan Agreement; failure to comply with certain agreements or covenants contained in the Term Loan Agreement for a period of 10 days (or, in some cases, 30 days) after the administrative agent’s notice of such non-compliance; acceleration of more than $10.0 million of certain other indebtedness; and certain insolvency and bankruptcy events.

Under the Term Loan, the Company is required to comply with a number of covenants, the most restrictive of which require the Company to maintain:

 

   

A tangible net worth, as defined, of at least $75.0 million (this covenant was modified as described below);

 

   

A minimum borrowing base such that the indebtedness under the Term Loan does not exceed 60% of the Borrowing Base, with the “Borrowing Base” being calculated as (1) the discounted cash flows of each project securing the loan (collateral value), plus (2) unrestricted cash and (3) escrow proceeds receivable, as defined;

 

   

Total secured indebtedness (including the indebtedness under the Term Loan and under all other Construction Notes payable) less than or equal to the Maximum Permitted Secured Indebtedness under the Term Loan Agreement (which is generally 60% of the total secured debt collateral value as calculated under the Term Loan Agreement, which value generally does not include cash assets); and

 

   

Excluded Assets of no more than $20.0 million, with “Excluded Assets” being defined generally as the sum total of certain deposit accounts, payroll accounts, unrestricted cash accounts, and the Company’s total investment in joint ventures.

The Company’s covenant compliance for the Term Loan at March 31, 2011 is detailed in the table set forth below (dollars in millions):

 

Covenant and Other Requirements

   Actual at
March 31,
2011
    Covenant
Requirements at
March 31,
2011

Tangible Net Worth (1)

   $ 1.3      ³$75.0

Ratio of Term Loan to Borrowing Base

     49.4   £60%

Secured Indebtedness (as a percentage of collateral value)

     54.9   £60%

Excluded Assets

   $ 12.0      £$20.0

 

(1) Tangible Net Worth was calculated based on the stated amount of equity less intangible assets of $11.5 million as of March 31, 2011. This covenant has been amended as described below.

The management of the Company, with the approval of the board of directors, has retained the services of an outside consulting firm to institute and implement all required programs to accomplish management’s objectives and to work with management in the analysis and process of renegotiating, refinancing, repaying or restructuring debt maturities and loan terms, including covenants. In addition, the Company is currently working through the process of requesting a financing proposal from the investment banking community. The Company has requested proposals for a debt financing to use in some combination of debt refinance or capital restructuring of the Term Loan and the Senior Notes.

The Company believes the debt markets are a viable option due to the growing demand for high yield paper in 2011 as evidenced by $105.8 billion in high yield paper issued through April 2011 in the U.S. market, which is 16% more than had been placed through the same time period in 2010. For the year ended December 31, 2010, high yield paper saw a record $259.3 billion placed in the U.S. market. Additionally, high yield mutual funds have reported year to date 2011 inflows of $9.0 billion after 2010 inflows of $12.2 billion. The Company has also identified other competitors that received financing to repay or extend existing maturities.

 

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Management of the Company continues to analyze its liquidity based on its current capital structure and existing cash forecast as well as factoring in the potential of acceleration of the Term Loan. Management believes it has adequate sources of liquidity to fund the Company and meet its obligations for at least the next year, from the date of this filing.

As reported on the Company’s current report on Form 8-K dated March 18, 2011, the Company reached an agreement with the Lenders under the Term Loan that amended the Term Loan to permit the Company’s tangible net worth to fall below $75.0 million for two consecutive quarters. In addition, as reported on the Company’s current report on Form 8-K dated April 21, 2011, the Company reached a subsequent agreement with the Lenders under the Term Loan to waive any non-compliance with the tangible net worth covenant and with certain other technical requirements through July 19, 2011, subject to certain terms and conditions.

Except as noted above, as of and for the period ending March 31, 2011, the Company is in compliance with the covenants under the Term Loan.

If market conditions improve, the Company believes that its ability to comply with financial covenants may be improved. Conversely, if market conditions deteriorate, the Company believes that its ability to comply with financial covenants contained in the Company’s Term Loan will continue to be negatively impacted. Under these circumstances, the Company could be required to seek additional covenant relief to avoid future noncompliance with the financial covenants in the Term Loan Agreement. If the Company is unable to obtain requested covenant relief or is unable to obtain a waiver for any covenant non-compliance, the Company’s obligation to repay indebtedness under the Term Loan and the Senior Notes could be accelerated. The Company can give no assurance that in such an event, the Company would have, or be able to obtain, sufficient funds to pay all debt that the Company would then be required to repay.

The foregoing summary is not a complete description of the Term Loan and is qualified in its entirety by reference to the Term Loan Agreement.

Senior Notes

During the year ended December 31, 2010, California Lyon redeemed, in privately negotiated transactions (i) $30.0 million principal amount of its outstanding 10 3/4% Senior Notes at a cost of $25.9 million plus accrued interest, (ii) $0.5 million principal amount of its outstanding 7 5/8% Senior Notes at a cost of $0.4 million plus accrued interest, and (iii) $6.8 million principal amount of its outstanding 7  1/2% Senior Notes at a cost of $5.1 million plus accrued interest. The Lenders under the Term Loan consented to these redemptions and waived their right to require any prepayment of the Term Loan in connection therewith. The net gain resulting from these redemptions, after giving effect to amortization of related deferred loan costs and other fees, was approximately $5.6 million.

After giving effect to these Senior Note redemptions, in addition to all prior Senior Note redemptions, California Lyon now has the following principal amounts of Senior Notes outstanding (in thousands):

 

     March 31,
2011
 

7 5/8% Senior Notes due December 15, 2012

   $ 66,704   

10 3/4% Senior Notes due April 1, 2013

     138,688   

7 1/2% Senior Notes due February 15, 2014

     77,867   
        
   $ 283,259   
        

7  5/8% Senior Notes

On November 22, 2004, California Lyon issued $150.0 million principal amount of the 7  5/8% Senior Notes, resulting in net proceeds to the Company of approximately $148.5 million. Of the initial $150.0 million, $66.7 million in aggregate principal amount remained outstanding as of March 31, 2011 and the date hereof. In August 2010, the Company redeemed, in a privately negotiated transaction, $0.5 principal amount of its outstanding 7 5/8% Senior Notes at a cost of $0.4 million plus accrued interest.

Interest on the 7  5/8% Senior Notes is payable semi-annually on December 15 and June 15 of each year. Based on the current outstanding principal amount of the 7 5/8% Senior Notes, the Company’s semi-annual interest payments are $2.5 million.

 

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The 7  5/8% Senior Notes are redeemable at the option of California Lyon, in whole or in part, at a redemption price equal to 100% of the principal amount, plus accrued and unpaid interest, if any.

10 3/4% Senior Notes

On March 17, 2003, California Lyon issued $250.0 million of the 10 3/4% Senior Notes at a price of 98.493% to the public, resulting in net proceeds to the Company of approximately $246.2 million. The redemption price reflected a discount to yield 11% under the effective interest method, and the notes have been reflected net of the unamortized discount in the consolidated balance sheet. Of the initial $250.0 million, $138.7 million aggregate principal amount remained outstanding as of March 31, 2011 and the date hereof. In July 2010, the Company redeemed, in a privately negotiated transaction, $10.5 million principal amount of its outstanding 10 3/4% Senior Notes at a cost of $9.0 million plus accrued interest. In August 2010, the Company redeemed, in privately negotiated transactions, $19.5 million principal amount of its outstanding 10 3/4% Senior Notes at a cost of $16.9 million plus accrued interest.

Interest on the 10  3/4% Senior Notes is payable on April 1 and October 1 of each year. Based on the current outstanding principal amount of the 10 3/4% Senior Notes, the Company’s semi-annual interest payments are $7.4 million.

The 10  3/4% Senior Notes are redeemable at the option of California Lyon, in whole or in part, at a redemption price equal to 100% of the principal amount, plus accrued and unpaid interest, if any.

7 1/2% Senior Notes

On February 6, 2004, California Lyon issued $150.0 million principal amount of the 7 1/2% Senior Notes, resulting in net proceeds to the Company of approximately $147.6 million. Of the initial $150.0 million, $77.9 million aggregate principal amount remained outstanding as of March 31, 2011 and the date hereof. In August 2010, the Company redeemed, in a privately negotiated transaction, $6.8 million principal amount of its outstanding 7 1/2% Senior Notes at a cost of $5.1 million plus accrued interest.

Interest on the 7 1/2% Senior Notes is payable on February 15 and August 15 of each year. Based on the current outstanding principal amount of 7 1/2% Senior Notes, the Company’s semi-annual interest payments are $2.9 million.

The 7 1/2% Senior Notes are redeemable at the option of California Lyon, in whole or in part, at a redemption price equal to 100% of the principal amount plus a premium declining ratably to par, plus accrued and unpaid interest, if any.

General Terms of the Senior Notes

The Senior Notes are senior unsecured obligations of California Lyon and are unconditionally guaranteed on a senior unsecured basis by the Company, and by all of the Company’s existing and certain of its future restricted subsidiaries. The Senior Notes and the guarantees rank senior to all of the Company’s and the guarantors’ debt that is expressly subordinated to the Senior Notes and the guarantees, but are effectively subordinated to all of the Company’s and the guarantors’ senior secured indebtedness to the extent of the value of the assets securing that indebtedness.

Upon a change of control as described in the respective indentures governing the Senior Notes Indentures, California Lyon will be required to offer to purchase the Senior Notes at a purchase price equal to 101% of the principal amount, plus accrued and unpaid interest, if any.

Under the Senior Notes Indentures, if the Company’s consolidated tangible net worth falls below $75.0 million for any two consecutive fiscal quarters, California Lyon will be required to make an offer to purchase up to 10% of each class of Senior Notes originally issued at a purchase price equal to 100% of the principal amount, plus accrued and unpaid interest, if any. Any such offer to purchase must be made within 65 days after the second quarter ended for which the Company’s tangible net worth is less than $75.0 million. However, California Lyon may reduce the principal amount of the notes to be purchased by the aggregate principal amount of all notes previously redeemed.

 

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The Company’s tangible net worth was less than $75.0 million as of December 31, 2010 and March 31, 2011. However, the Company has determined and calculated that California Lyon’s redemptions of Senior Notes during the period from 2008 to 2010 would reduce California Lyon’s repurchase obligations as follows: California Lyon would not be obligated to repurchase any of the 7 5/8% Senior Notes, as a result of California Lyon’s previous redemption of $83.3 million in aggregate principal amount of the 7 5/8% Senior Notes; California Lyon would not be obligated to repurchase any of the 10 3/4% Senior Notes, as a result of California Lyon’s previous redemption of $110.7 million in aggregate principal amount of the 10 3/4% Senior Notes; and California Lyon would not be obligated to repurchase any of the 7 1/2% Senior Notes, as a result of California Lyon’s previous redemption of $72.1 million in aggregate principal amount of the 7 1/2% Senior Notes.

California Lyon is 100% owned by the Company. Each subsidiary guarantor is 100% owned by California Lyon or the Company. All guarantees of the Senior Notes are full and unconditional and all guarantees are joint and several. There are no significant restrictions under the Senior Notes Indentures on the ability of the Company or any guarantor to obtain funds from subsidiaries by dividend or loan.

The Senior Notes Indentures contain covenants that limit the ability of the Company and its restricted subsidiaries to, among other things: (i) incur additional indebtedness; (ii) pay dividends or make other distributions or repurchase stock; (iii) make investments; (iv) sell assets; (v) incur liens; (vi) enter into agreements restricting the ability of the Company’s restricted subsidiaries (other than California Lyon) to pay dividends; (vii) enter into transactions with affiliates; and (viii) consolidate, merge or sell all or substantially all of the Company’s and California Lyon’s assets. These covenants are subject to a number of important exceptions and qualifications as described in the Senior Notes Indentures.

As of and for the period ending March 31, 2011, the Company was in compliance with the Senior Notes covenants.

The foregoing summary is not a complete description of the Senior Notes and is qualified in its entirety by reference to the Senior Notes Indentures.

Prior Redemptions of the Senior Notes

During the year ended December 31, 2010, the Company redeemed, in privately negotiated transactions, $37.3 million principal amount of its outstanding Senior Notes at a cost of $31.3 million, plus accrued interest. The net gain resulting from the redemptions, after giving effect to amortization of related deferred loan costs, was $5.6 million.

On June 10, 2009, California Lyon consummated a cash tender offer (the “Tender Offer”) to redeem a portion of its outstanding Senior Notes, on the terms and subject to the conditions set forth in its offer to redeem, as amended. The principal amount of Senior Notes redeemed by California Lyon on settlement of the Tender Offer totaled $53.2 million, including $29.1 million of the 7 5/8% Senior Notes, $2.4 million of the 10 3/4% Senior Notes, and $21.7 million of the 7 1/2% Senior Notes. The aggregate Tender Offer consideration paid totaled $14.9 million, plus accrued interest. The net gain resulting from the Tender Offer, after closing costs, was $37.0 million.

Also, during 2009 the Company redeemed, in privately negotiated transactions, a total of $103.7 million principal amount of the outstanding Senior Notes at a cost of $62.1 million, plus accrued interest. The net gain resulting from the redemption, after giving effect to amortization of related deferred loan costs, was $41.1 million. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition and Liquidity” and Note 5 of “Notes to Consolidated Financial Statements” for more information relating to the Term Loan of the Company.

In October 2008, the Company redeemed, in privately negotiated transactions, $71.9 million principal amount of the outstanding Senior Notes at a cost of $16.7 million, plus accrued interest. The net gain resulting from the redemption, after giving effect to amortization of related deferred loan costs, was $54.0 million.

Construction Notes Payable

At March 31, 2011, the Company had two construction notes payable totaling $22.4 million. One of the notes matures in July 2011 and bears interest at rates based on either LIBOR or prime with an interest rate floor of 6.5% and an outstanding principal balance of $13.9 million as of March 31, 2011. Interest is calculated on the average daily balance and is paid following the end of each month. While the Company was previously required to maintain minimum tangible net worth of $90.0 million under this note, the Company and the lender have amended the note to eliminate the tangible net worth covenant in exchange for a principal payment of $2.0 million. As a result of the payment of $2.0 million, which was made in April 2011, the outstanding principal balance is $11.9 million. The Company is currently in negotiations with the lender to extend the maturity of the loan and to modify the covenants.

 

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The other construction note had a remaining balance at March 31, 2011 of $8.5 million. This note was previously due to mature in July 2010; however, in conjunction with a partial payment of principal on that loan, the Company and the lender entered into a new loan agreement in 2010 for the then remaining outstanding principal of $10.0 million, which will mature in May 2015. The new loan bears interest payable monthly at a fixed rate of 12.5%, with quarterly principal payments of $500,000 beginning in July 2010. The interest rate decreases to 10.0% when the principal balance is reduced to $7.5 million.

Seller Financing

At March 31, 2011, the Company had $6.7 million of notes payable outstanding related to a land acquisition for which seller financing was provided, which is included in notes payable in the accompanying consolidated balance sheet. The seller financing notes are due at various dates through 2012 and bears interest at 7.0%. Interest is calculated on the principal balance outstanding and is accrued and paid to the seller at the time each residential unit is closed. In addition, the Company makes an annual interest payment on the outstanding principal balance related to any remaining residential units.

Land Banking Arrangements

As a method of acquiring land in staged takedowns, thereby minimizing the use of funds from the Company’s available cash or other corporate financing sources and limiting the Company’s risk, the Company transfers its right in such purchase agreements to entities owned by third parties (“land banking arrangements”). These entities use equity contributions and/or incur debt to finance the acquisition and development of the land being purchased. The entities grant the Company an option to acquire lots in staged takedowns. In consideration for this option, the Company makes a non-refundable deposit of 15% to 25% of the total purchase price. The Company is under no obligation to purchase the balance of the lots, but would forfeit remaining deposits and could be subject to penalties if the lots were not purchased. The Company does not have legal title to these entities or their assets and has not guaranteed their liabilities. These land banking arrangements help the Company manage the financial and market risk associated with land holdings. The use of these land banking arrangements is dependent on, among other things, the availability of capital to the option provider, general housing market conditions and geographic preferences.

In addition, the Company participates in one land banking arrangement that is not a VIE in accordance with FASB ASC 810, but which is consolidated in accordance with FASB ASC Topic 470, Debt. Under the provisions of FASB ASC 470, the Company has determined it is economically compelled, based on certain factors, to purchase the land in the land banking arrangements. Therefore, the Company has recorded the remaining purchase price of the land of $47.4 million, which is included in real estate inventories not owned and liabilities from inventories not owned in the accompanying balance sheet as of March 31, 2011.

In 2011, the Company purchased 23 lots from its land banking arrangement for a total purchase price of $7.9 million. In conjunction with the purchase, the Company reduced real estate inventories not owned and liabilities from inventories not owned in the amount of $7.9 million.

Summary information with respect to the Company’s land banking arrangements is as follows as of March 31, 2011 (dollars in thousands):

 

Total number of land banking projects

     1   
        

Total number of lots

     625   
        

Total purchase price

   $ 161,465   
        

Balance of lots still under option and not purchased:

  

Number of lots

     225   
        

Purchase price

   $ 47,408   
        

Forfeited deposits if lots are not purchased

   $ 25,234   
        

Joint Venture Financing

The Company and certain of its subsidiaries are general partners or members in joint ventures involved in the development and sale of residential projects. As described more fully in Critical Accounting Policies—Variable Interest Entities, certain joint ventures have been determined to be variable interest entities in which the Company is considered the primary beneficiary. Accordingly, the assets, liabilities and operations of these joint ventures have been consolidated with the Company’s financial statements as of and for the three months ended March 31, 2011 and 2010. Because the Company did not consolidate or de-consolidate any variable interest entities as a result of adoption, the adoption of FASB ASC 810 did not affect the Company’s consolidated net income. The financial statements of joint ventures in which the Company is not considered the primary beneficiary are not consolidated with the Company’s financial statements. The Company’s

 

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investments in unconsolidated joint ventures are accounted for using the equity method because the Company has a 50% or less voting or economic interest (and thus such joint ventures are not controlled by the Company). Based upon current estimates, substantially all future development and construction costs incurred by the joint ventures will be funded by the venture partners or from the proceeds of construction financing obtained by the joint ventures.

As of March 31, 2011, the Company’s investment in and advances to unconsolidated joint ventures was $1.3 million and the venture partners’ investment in such joint ventures was $1.3 million. As of March 31, 2011, these joint ventures had repaid all financing from construction lenders.

Assessment District Bonds

In some jurisdictions in which the Company develops and constructs property, assessment district bonds are issued by municipalities to finance major infrastructure improvements and fees. Such financing has been an important part of financing master-planned communities due to the long-term nature of the financing, favorable interest rates when compared to the Company’s other sources of funds and the fact that the bonds are sold, administered and collected by the relevant government entity. As a landowner benefited by the improvements, the Company is responsible for the assessments on its land. When the Company’s homes or other properties are sold, the assessments are either prepaid or the buyers assume the responsibility for the related assessments. See Note 11 of “Notes to Consolidated Financial Statements.”

Cash Flows — Comparison of Three Months Ended March 31, 2011 to Three Months Ended March 31, 2010

Net cash (used in) provided by operating activities decreased to a use of $(23.2) million in the 2011 period from a source of $40.2 million in the 2010 period. The change was primarily a result of (i) an increase in real estate inventories-owned of $12.3 million in the 2011 period compared to an increase of $70.6 million in the 2010 period, (ii) a decrease in income tax refunds receivable of $107.0 million in the 2010 period with no comparable amount in the 2011 period, (iii) a decrease in other assets of $2.5 million in the 2011 period compared to an increase of $9.1 million in the 2010 period, and (iv) consolidated net loss of $11.2 million in the 2011 period compared to consolidated net loss of $8.5 million in the 2010 period.

Net cash provided by investing activities decreased to $0.2 million in the 2011 period from $0.3 million in the 2010 period. The change was primarily a result of a decrease in distributions of income from unconsolidated joint ventures of $0.2 million in the 2011 period compared to $0.4 million in the 2010 period.

Net cash used in financing activities decreased to $2.8 million in the 2011 period from $7.1 million in the 2010 period, primarily as a result of the decrease in net paydowns to $1.4 million in the 2011 period from $7.6 million in the 2010 period. In addition, distributions to noncontrolling interests increased to $1.4 million in the 2011 period compared to contributions from noncontrolling interests of $0.7 million in the 2010 period.

Off-Balance Sheet Arrangements

The Company enters into certain off-balance sheet arrangements including joint venture financing, option arrangements, land banking arrangements and variable interests in consolidated and unconsolidated entities. These arrangements are more fully described above and in Notes 2 and 9 of “Notes to Consolidated Financial Statements”. In addition, the Company is party to certain contractual obligations, including land purchases and project commitments, which are detailed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

 

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Description of Projects