UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
| x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the Quarterly Period Ended June 30, 2006
| ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
0-23270
Commission File Number
Dominion Homes, Inc.
(Exact name of registrant as specified in its charter)
| Ohio | 31-1393233 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
5000 Tuttle Crossing Blvd., Dublin, Ohio
(Address of principal executive offices)
43016-5555
(Zip Code)
(614) 356-5000
(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 x 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 x | Non-accelerated filer ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes ¨ No x
Number of common shares outstanding as of July 31, 2006: 8,498,660
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
Dominion Homes, Inc.
Consolidated Balance Sheets
(In thousands, except share information)
| June 30, 2006 (unaudited) | December 31, 2005 | |||||||
| Assets | ||||||||
Cash and cash equivalents | $ | 705 | $ | 3,554 | ||||
Accounts receivable: | ||||||||
Due from financial institutions for residential closings | 1,620 | 3,941 | ||||||
Other | 1,614 | 948 | ||||||
Real estate inventories: | ||||||||
Land and land development costs | 300,592 | 323,594 | ||||||
Homes under construction | 84,135 | 86,980 | ||||||
Land held for sale | 17,567 | 12,481 | ||||||
Other | 3,358 | 3,220 | ||||||
Total real estate inventories | 405,652 | 426,275 | ||||||
Prepaid expenses and other | 14,499 | 8,792 | ||||||
Deferred income taxes | 1,044 | 1,485 | ||||||
Property and equipment, at cost | 14,435 | 15,317 | ||||||
Less accumulated depreciation | (8,879 | ) | (8,755 | ) | ||||
Total property and equipment | 5,556 | 6,562 | ||||||
Total assets | $ | 430,690 | $ | 451,557 | ||||
| Liabilities and Shareholders’ Equity | ||||||||
Liabilities: | ||||||||
Accounts payable | $ | 8,222 | $ | 11,465 | ||||
Deposits on homes and land under contract | 1,506 | 1,483 | ||||||
Accrued liabilities | 17,962 | 28,536 | ||||||
Note payable, banks | 207,628 | 205,240 | ||||||
Term debt | 9,300 | 9,300 | ||||||
Total liabilities | 244,618 | 256,024 | ||||||
Commitments and contingencies | ||||||||
Shareholders’ equity: | ||||||||
Common shares, without stated value, 12,000,000 shares authorized, 8,827,311 shares issued and 8,494,765 shares outstanding on June 30, 2006 and 8,565,261 shares issued and 8,244,715 shares outstanding on December 31, 2005 | 62,981 | 63,851 | ||||||
Deferred compensation | (27 | ) | (901 | ) | ||||
Retained earnings | 123,919 | 133,792 | ||||||
Accumulated other comprehensive income | 2,085 | 1,677 | ||||||
Treasury stock, at cost (332,546 shares at June 30, 2006 and 320,546 shares at December 31, 2005) | (2,886 | ) | (2,886 | ) | ||||
Total shareholders’ equity | 186,072 | 195,533 | ||||||
Total liabilities and shareholders’ equity | $ | 430,690 | $ | 451,557 | ||||
The accompanying notes are an integral part of the consolidated financial statements.
1
Dominion Homes, Inc.
Consolidated Statements of Operations
(In thousands, except share and per share amounts)
(Unaudited)
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2006 | 2005 | 2006 | 2005 | |||||||||||||
Revenues | $ | 75,835 | $ | 105,207 | $ | 137,620 | $ | 197,850 | ||||||||
Cost of real estate sold | 68,310 | 82,830 | 121,021 | 156,779 | ||||||||||||
Gross profit | 7,525 | 22,377 | 16,599 | 41,071 | ||||||||||||
Selling, general and administrative | 13,467 | 17,244 | 28,240 | 33,292 | ||||||||||||
Income (loss) from operations | (5,942 | ) | 5,133 | (11,641 | ) | 7,779 | ||||||||||
Gain on sale of investment | — | — | 1,800 | — | ||||||||||||
Interest expense | (2,568 | ) | (1,873 | ) | (4,876 | ) | (3,564 | ) | ||||||||
Income (loss) before income taxes | (8,510 | ) | 3,260 | (14,717 | ) | 4,215 | ||||||||||
Provision for income taxes | (2,583 | ) | 741 | (4,844 | ) | 1,054 | ||||||||||
Net income (loss) | $ | (5,927 | ) | $ | 2,519 | $ | (9,873 | ) | $ | 3,161 | ||||||
Earnings (loss) per share | ||||||||||||||||
Basic | $ | (0.73 | ) | $ | 0.31 | $ | (1.22 | ) | $ | 0.39 | ||||||
Diluted | $ | (0.73 | ) | $ | 0.31 | $ | (1.22 | ) | $ | 0.39 | ||||||
Weighted average shares outstanding | ||||||||||||||||
Basic | 8,114,174 | 8,054,648 | 8,104,494 | 8,049,844 | ||||||||||||
Diluted | 8,114,174 | 8,203,815 | 8,104,494 | 8,206,933 | ||||||||||||
The accompanying notes are an integral part of the consolidated financial statements.
2
Dominion Homes, Inc.
Consolidated Statement of Changes in Shareholders’ Equity
(In thousands)
(Unaudited)
| Common Shares | Deferred Compensation | Retained Earnings | Accumulated Other Comprehensive | Treasury Stock | Total | ||||||||||||||||||||||
| Liability | Trust Shares | ||||||||||||||||||||||||||
Balance, December 31, 2005 | $ | 63,851 | $ | 81 | $ | (982 | ) | $ | 133,792 | $ | 1,677 | $ | (2,886 | ) | $ | 195,533 | |||||||||||
Net loss | — | — | — | (9,873 | ) | — | — | (9,873 | ) | ||||||||||||||||||
Unrealized hedging gain, net of deferred taxes of ($184) | — | — | — | — | 408 | — | 408 | ||||||||||||||||||||
Comprehensive loss | (9,465 | ) | |||||||||||||||||||||||||
Shares awarded | 21 | — | — | — | — | — | 21 | ||||||||||||||||||||
Exercise of stock options | 24 | — | — | — | — | — | 24 | ||||||||||||||||||||
Stock based compensation benefit | (47 | ) | — | — | — | — | — | (47 | ) | ||||||||||||||||||
Unearned compensation reclass as of | (868 | ) | 868 | — | — | — | — | — | |||||||||||||||||||
Deferred compensation | — | (129 | ) | 135 | — | — | — | 6 | |||||||||||||||||||
Balance, June 30, 2006 | $ | 62,981 | $ | 820 | $ | (847 | ) | $ | 123,919 | $ | 2,085 | $ | (2,886 | ) | $ | 186,072 | |||||||||||
The accompanying notes are an integral part of the consolidated financial statements.
3
Dominion Homes, Inc.
Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
| Six Months Ended June 30, | ||||||||
| 2006 | 2005 | |||||||
Cash flows from operating activities: | ||||||||
Net income (loss) | $ | (9,873 | ) | $ | 3,161 | |||
Adjustments to reconcile net income to cash used in operating activities: | ||||||||
Depreciation and amortization | 1,678 | 1,729 | ||||||
Amortization of unearned compensation | (47 | ) | 225 | |||||
Net loss on impaired real estate inventories | 2,695 | 2,398 | ||||||
Gain on sale of land | (456 | ) | (824 | ) | ||||
Gain on sale of investment in Centennial Home Mortgage, LLC | (1,800 | ) | — | |||||
Loss on disposal of fixed assets | 74 | 161 | ||||||
Issuance of common shares for compensation | 21 | 35 | ||||||
Deferred income taxes | 256 | 1,052 | ||||||
Changes in assets and liabilities: | ||||||||
Accounts receivable | 1,829 | (898 | ) | |||||
Real estate inventories | 11,800 | (20,324 | ) | |||||
Prepaid expenses and other | (4,418 | ) | (1,412 | ) | ||||
Accounts payable | (3,243 | ) | 9,957 | |||||
Deposits on homes and land under contract | 23 | 772 | ||||||
Accrued liabilities | (4,130 | ) | (5,918 | ) | ||||
Net cash used in operating activities | (5,591 | ) | (9,886 | ) | ||||
Cash flows from investing activities: | ||||||||
Purchase of property and equipment | (948 | ) | (1,189 | ) | ||||
Proceeds from sale of property | 549 | 840 | ||||||
Proceeds from sale of investment in Centennial Home Mortgage, LLC | 1,838 | — | ||||||
Investment in Centennial Home Mortgage, LLC | (75 | ) | — | |||||
Net cash provided by (used in) investing activities | 1,364 | (349 | ) | |||||
Cash flows from financing activities: | ||||||||
Payments on note payable banks | (64,100 | ) | (45,839 | ) | ||||
Proceeds from note payable banks | 66,488 | 57,850 | ||||||
Payments on term debt | — | (455 | ) | |||||
Payments of financing fees | (1,034 | ) | (100 | ) | ||||
Payments on capital lease obligations | — | (471 | ) | |||||
Proceeds from issuance of common shares | 24 | 37 | ||||||
Net cash provided by financing activities | 1,378 | 11,022 | ||||||
Net change in cash and cash equivalents | (2,849 | ) | 787 | |||||
Cash and cash equivalents, beginning of period | 3,554 | 6,710 | ||||||
Cash and cash equivalents, end of period | $ | 705 | $ | 7,497 | ||||
Supplemental disclosures of cash flow information: | ||||||||
Interest paid (net of amounts capitalized) | $ | 6,381 | $ | 3,411 | ||||
Income taxes paid | $ | 275 | $ | 2,278 | ||||
Land acquired by seller financing | $ | — | $ | 3,619 | ||||
The accompanying notes are an integral part of the consolidated financial statements.
4
DOMINION HOMES, INC.
Notes to the Consolidated Financial Statements
(Unaudited)
| 1. | Basis of Presentation |
The accompanying unaudited consolidated financial statements of Dominion Homes, Inc. and its subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The December 31, 2005 balance sheet data were derived from audited financial statements but do not include all disclosures required by accounting principles generally accepted in the United States of America. These consolidated financial statements should be read in conjunction with the December 31, 2005 audited consolidated financial statements contained in the Annual Report on Form 10-K for the year ended December 31, 2005.
The financial information included herein reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the results for interim periods. The results of operations for the three and six months ended June 30, 2006 are not necessarily indicative of the results of operations to be expected for the full year.
The Company reclassified the recognition of previously capitalized interest related to land development and home construction costs from interest expense to cost of real estate sold. The reclassifications increased cost of real estate sold and decreased interest expense by approximately $1,054,000 and $1,919,000 for the three and six months ended June 30, 2005. The reclassifications had no effect on net income and were made to reflect recent reporting changes made within the homebuilding industry.
| 2. | Share-Based Compensation |
Prior to January 1, 2006, the Company accounted for its stock option and restricted share awards under the recognition and measurement principles of Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and related interpretations. As a result, no compensation cost was previously recognized for stock option awards granted to employees because all stock option awards granted have exercise prices equal to the market value of the underlying common shares of the Company on the grant date. Compensation cost related to restricted share awards was determined at the date of grant and adjusted for changes in the fair value of the restricted shares until the performance criteria, if applicable, was met. The fair value of the restricted share awards was recorded as unearned compensation expense, a reduction of shareholders’ equity, and amortized on a straight-line basis over the vesting period.
As of January 1, 2006, the Company adopted FASB Statement No. 123R,Share-Based Payment (“FAS 123R”), which revises FASB Statement No. 123,Accounting for Stock-Based
5
Compensation. FAS 123R applies to all new awards granted, all awards modified, repurchased, or cancelled after the required effective date, and to the unvested portion of previously granted awards outstanding as of the required effective date. FAS 123R requires all share-based payments, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. The Company has elected to apply the modified prospective approach for existing share-based payment awards outstanding at the date of adoption. This method requires the Company to value stock option and non-vested share awards granted prior to the adoption of FAS 123R under the fair value method and recognize expense for the unvested portion of awards over the remaining vesting period.
The following table illustrates the pro-forma effects on net income and earnings per share as if the Company had accounted for share-based compensation using the fair value method, as required by FAS 123R, for the three months and six months ended June 30, 2005:
| Three Months Ended June 30, 2005 | Six Months Ended June 30, 2005 | |||||||
Net income, as reported | $ | 2,519,000 | $ | 3,161,000 | ||||
Add: stock based compensation expense included in reported net income, net of related tax effects | 172,000 | 169,000 | ||||||
Deduct: stock-based compensation expense determined using the fair value method, net of related tax effects | (421,000 | ) | (492,000 | ) | ||||
Pro forma net income | $ | 2,270,000 | $ | 2,838,000 | ||||
Earnings per share | ||||||||
Basic as reported | $ | 0.31 | $ | 0.39 | ||||
Basic pro forma | $ | 0.28 | $ | 0.35 | ||||
Diluted as reported | $ | 0.31 | $ | 0.39 | ||||
Diluted pro forma | $ | 0.28 | $ | 0.35 | ||||
The Company uses the Black-Scholes model to value its new stock option award grants under FAS 123R. Non-vested share awards granted to employees are valued based on the market price of the Company’s common shares on the date of grant. In addition, the Company estimates forfeitures in calculating the compensation expense related to all share-based payment awards. Compensation cost arising from stock option and non-vested share awards granted to employees is recognized as expense using the straight-line method over the vesting period. In addition, FAS 123R requires the Company to reflect the benefits of tax deductions in excess of recognized compensation cost to be reported as both a financing cash inflow and an operating cash outflow. No such benefits were recorded during the first six months of 2006.
As indicated, the fair value of new stock option award grants is estimated on the date of grant using a Black-Scholes option-pricing model that uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of the Company’s shares. The Company uses historical data to estimate stock option exercise and the period of time that
6
stock options are expected to be outstanding. The risk-free rate for periods within the contractual life of the stock option is based on the U.S. Treasury yield curve at the time of stock option grant.
| 2006 | 2005 | 2004 | |||||||
Expected volatility | 59 | % | 168 | % | 70 | % | |||
Expected dividends | 0 | % | 0 | % | 0 | % | |||
Expected term (in years) | 8 | 8 | 5 | ||||||
Risk-free rate | 5.02 | % | 4.20 | % | 3.50 | % |
A summary of the Company’s stock options outstanding as of June 30, 2006 and changes during the periods then ended is presented below:
| Three Months Ended June 30, 2006 | Six Months Ended June 30, 2006 | |||||||||||
Options: | Shares | Weighted Average Exercise Price | Shares | Weighted Average Exercise Price | ||||||||
Outstanding at beginning of period | 102,000 | $ | 22.00 | 136,333 | $ | 21.85 | ||||||
Granted | 12,500 | $ | 10.57 | 12,500 | $ | 10.57 | ||||||
Cancelled or forfeited | (4,000 | ) | $ | 24.26 | (33,333 | ) | $ | 24.25 | ||||
Exercised | — | $ | — | (5,000 | ) | $ | 4.75 | |||||
Outstanding at end of period | 110,500 | $ | 20.63 | 110,500 | $ | 20.63 | ||||||
Exercisable options | 83,100 | $ | 20.83 | 83,100 | $ | 20.83 | ||||||
Unvested options | 27,400 | $ | 20.00 | 27,400 | $ | 20.00 | ||||||
Outstanding at end of period | 110,500 | $ | 20.63 | 110,500 | $ | 20.63 | ||||||
As of June 30, 2006, there was $248,000 of unrecognized compensation cost related to 27,400 unvested stock options outstanding. Valuations of the options granted and exercised during the three months and six months ended June 30, 2006 were as follows:
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||
| 2006 | 2005 | 2006 | 2005 | |||||||||
Weighted average fair value of options granted | $ | 10.57 | $ | 14.48 | $ | 10.57 | $ | 14.48 | ||||
Intrinsic value of stock options exercised | — | $ | 11,000 | $ | 26,000 | $ | 173,000 | |||||
7
A summary of the weighted average remaining contractual term and intrinsic value of options outstanding and exercisable as of June 30, 2006 is presented below:
| Weighted Average Remaining Contractual Term (in years) | Aggregate Intrinsic Value | ||||
Options outstanding at period end | 8.03 | $ | — | ||
Options exercisable at period end | 7.90 | $ | — | ||
A summary of the Company’s non-vested restricted share awards outstanding as of June 30, 2006 and changes during the periods then ended is presented below:
| Three Months Ended June 30, 2006 | Six Months Ended June 30, 2006 | |||||||||||
Non-vested Restricted Shares | Shares | Weighted Average Grant Date Fair Value | Shares | Weighted Average Grant Date Fair Value | ||||||||
Outstanding at beginning of period | 320,000 | $ | 15.26 | 152,000 | $ | 21.69 | ||||||
Granted | 100,000 | $ | 10.57 | 280,000 | $ | 10.47 | ||||||
Forfeited | (25,000 | ) | $ | 10.42 | (37,000 | ) | $ | 14.89 | ||||
Vested | (30,000 | ) | $ | 10.27 | (30,000 | ) | $ | 10.27 | ||||
Outstanding at end of period | 365,000 | $ | 14.72 | 365,000 | $ | 14.72 | ||||||
As of June 30, 2006, there was approximately $1,054,000 of total unrecognized compensation cost related to non-vested restricted share awards outstanding. That cost is expected to be recognized over a weighted average period of 2.7 years. Unearned compensation is included in common shares in the Consolidated Balance Sheet as of the FAS 123R adoption date. The total fair value of shares vested during 2006 was approximately $315,000.
A summary of the Company’s total share-based compensation expense (benefit) for the three months and six months ended June 30, 2006 is as follows:
| Three Months Ended June 30, 2006 | Six Months Ended June 30, 2006 | |||||||
Vesting of stock option awards | $ | 107,000 | $ | 125,000 | ||||
Vesting of restricted share awards | 207,000 | 517,000 | ||||||
Forfeiture of restricted share awards | (19,000 | ) | (73,000 | ) | ||||
Reversal of previously recognized share-based compensation expense | (616,000 | ) | (616,000 | ) | ||||
Share-based compensation benefit | (321,000 | ) | (47,000 | ) | ||||
Income tax expense related to share-based compensation awards | 331,000 | 231,000 | ||||||
Total share-based compensation expense, net of tax | $ | 10,000 | $ | 184,000 | ||||
8
During the second quarter 2006, the Company reversed previously recognized share-based compensation expense of $616,000 related to restricted share awards for which the Company determined the restrictions were not probable of achievement.
| 3. | Capitalized Interest |
The Company capitalizes interest costs during the land development and home construction periods. Capitalized interest is included in land and land development costs and homes under construction in the Consolidated Balance Sheets. Capitalized interest related to the costs of land development and home construction is included in cost of real estate sold in the period for which the home is closed.
The summary of the total interest is as follows:
Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2006 | 2005 | 2006 | 2005 | |||||||||||||
Interest incurred | $ | 4,071,000 | $ | 2,959,000 | $ | 7,795,000 | $ | 5,686,000 | ||||||||
Interest capitalized | (1,503,000 | ) | (1,086,000 | ) | (2,919,000 | ) | (2,122,000 | ) | ||||||||
Interest expensed directly | $ | 2,568,000 | $ | 1,873,000 | $ | 4,876,000 | $ | 3,564,000 | ||||||||
Capitalized interest, beginning of period | $ | 5,727,000 | $ | 4,769,000 | $ | 5,007,000 | $ | 4,598,000 | ||||||||
Interest capitalized | 1,503,000 | 1,086,000 | 2,919,000 | 2,122,000 | ||||||||||||
Capitalized interest charged to cost of real estate sold | (962,000 | ) | (1,054,000 | ) | (1,658,000 | ) | (1,919,000 | ) | ||||||||
Capitalized interest, end of period | $ | 6,268,000 | $ | 4,801,000 | $ | 6,268,000 | $ | 4,801,000 | ||||||||
| 4. | Note Payable, Banks |
On December 3, 2003, the Company entered into a Second Amended and Restated Credit Agreement (the “Facility”). On March 30, 2006, the Company and the participant banks in the Facility amended the Facility to, among other things, decrease the amount of the Facility, change the borrowing base limitations, revise various financial covenants, impose additional business restrictions and secure borrowings under the Facility by liens on substantially all of the Company’s assets, including real estate. The Facility terminates on May 31, 2007, unless extended by mutual agreement.
As of June 30, 2006, the Company was in compliance with all of the financial covenants of the Facility and had $937,000 available to borrow under the Facility, after adjustment for borrowing base limitations. However, as a result of lower than expected sales in the first and second quarter of 2006, the Company believes that it is unlikely that it will be able to satisfy the ratio of uncommitted land to consolidated tangible net worth covenant in the Facility at December 31, 2006, and the minimum interest coverage ratio covenant at September 30, 2006 and December 31, 2006. The failure to satisfy these covenants would constitute a breach of, and potentially a default under, the Facility. The Company is pursuing measures to avoid a default under the Facility and to execute its 2006 plan to reduce land inventories and outstanding debt. These measures include aggressively pursuing land sales, negotiating waivers or amendments with our existing bank group, and exploring alternative sources of financing. The Company is currently in negotiations with its bank group to either execute an extension of the Facility or enter into a new facility by December 31, 2006. Note payable, banks includes outstanding borrowings of $204,100,000 and $205,000,000 at June 30, 2006 and December 31, 2005, respectively.
For a more detailed description of the Facility, see Note 6, Note Payable, Banks, in the Notes to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.
9
| 5. | Derivative Instruments and Hedging Activities |
The Company has entered into various interest rate swap agreements, which effectively convert variable interest rates to fixed interest rates on approximately $120,000,000 of outstanding debt at June 30, 2006. The Company has designated and accounted for the interest rate swap agreements as cash flow hedges as described in Note 9, Derivative Instruments and Hedging Activities, in the Notes to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.
At June 30, 2006 and December 31, 2005, the Company had assets related to the interest rate swap agreements of $3,288,000 and $2,696,000, respectively. These assets are included in prepaid expenses and other in the Consolidated Balance Sheets. For the six months ended June 30, 2006, the Company recorded other comprehensive income of $408,000, net of tax, related to the increase in the value of the interest rate swap agreements.
During the three and six month periods ended June 30, 2006 and 2005, all interest rate swap agreements were considered effective hedges and there were not any gains or losses recognized in earnings for hedge ineffectiveness.
The weighted average fixed interest rate on interest rate swaps outstanding at June 30, 2006 of 3.31% does not reflect a variable margin that the Company pays to the lender based on the Company’s interest coverage ratio, as defined in the Facility. The variable margin ranges from 1.75% to 3.25% and is determined quarterly. The variable margin was 2.50% for the first and second quarters of 2006.
| 6. | Earnings (Loss) per Share |
A reconciliation of the weighted average common shares used in basic and diluted earnings (loss) per share calculations is as follows:
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||
| 2006 | 2005 | 2006 | 2005 | |||||
Weighted average shares - basic | 8,114,174 | 8,054,648 | 8,104,494 | 8,049,844 | ||||
Common share equivalents | — | 149,167 | — | 157,089 | ||||
Weighted average shares - diluted | 8,114,174 | 8,203,815 | 8,104,494 | 8,206,933 | ||||
Common share equivalents include stock options and restricted common shares. Restricted common shares are included in common share equivalents when performance contingencies are achieved.
The effect of dilutive restricted shares and stock options is excluded from common share equivalents for the three and six months ended June 30, 2006 in accordance with FAS 128, based upon the pretax loss for the three and six month periods then ended. As of June 30, 2005, there were 60,000 restricted shares for which the performance contingencies had not been achieved
10
and which were excluded from each of the three and six months diluted earnings per share calculations. As of June 30, 2005, there were 183,000 and 180,500 stock options which were antidilutive and which were excluded from the three months and six months diluted earnings per share calculations, respectively.
| 7. | Warranty Costs |
The Company provides a two-year warranty covering the roof, windows, doors and all mechanical elements of its homes, including the heating, plumbing and electrical systems. The Company also offers a 30-year warranty covering all major structural components in its Millennium Series, Independence Series and Tradition Series homes and a 10-year structural warranty on its Metropolitan Series and Grand Reserve Series homes. The Company initially provides an estimated amount of warranty cost for each home at the date of closing based on historical warranty experience. Factors that affect the Company’s warranty liability include the number of homes closed, historical warranty claims and cost per claim. Warranty expense (income) was $494,000 and ($103,000) for the three month period ending on June 30, 2006 and 2005, respectively. Accrued warranty cost was $1,942,000 and $2,326,000 at June 30, 2006 and 2005, respectively.
A reconciliation of the changes in the warranty liability for the three months ended June 30, 2006, is as follows:
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2006 | 2005 | 2006 | 2005 | |||||||||||||
Balance at the beginning of the period | $ | 1,937,000 | $ | 2,864,000 | $ | 2,010,000 | $ | 3,175,000 | ||||||||
Net change for warranties reserved and changes in estimates during the period | 494,000 | (103,000 | ) | 699,000 | (87,000 | ) | ||||||||||
Settlements made (in cash or in kind) during the period | (489,000 | ) | (435,000 | ) | (767,000 | ) | (762,000 | ) | ||||||||
Balance at the end of the period | $ | 1,942,000 | $ | 2,326,000 | $ | 1,942,000 | $ | 2,326,000 | ||||||||
| 8. | Contingencies |
On February 21, 2006, a purported class action lawsuit was filed against Dominion Homes Financial Services (“DHFS”). The complaint includes claims for breach for contract, breach of fiduciary duty, and fraudulent representations and material omissions in connection with the financing of plaintiffs’ condominium homes located in the Village of Polaris Park (“VPP”), where the Company has been unable to obtain final U.S. Department of Housing and Urban Development (“HUD”) approval for FHA-insured mortgages. The complaint seeks damages, including actual damages, punitive damages, and attorneys’ fees and costs, for, among other things, the alleged loss of certain FHA-insured mortgage features, including loan assumability, and for the defendants’ failure to notify plaintiffs of the status of their mortgages.
11
On February 21, 2006, a purported class action lawsuit was filed against the Company, DHFS, named and unnamed appraisers who have worked with the Company, and unnamed charitable organizations who have provided the Company’s customers with down payment assistance funds in the last several years. Plaintiffs purport to bring the claim on behalf of purchasers of the Company’s homes from 1999 to the present who received such funds. The complaint also alleges that the defendants extended credit without regard to the actual value of their homes, knowing that the result would be higher default and foreclosure rates in its communities. The complaint seeks injunctive or declaratory relief, compensatory damages, punitive damages and attorneys’ fees and costs. On May 2, 2006, the Company and DHFS filed a motion for judgment on the pleadings with respect to plaintiff’s claim for breach of the Ohio Consumer Sales Practices Act (“OCSPA”) on the grounds that this claim was barred by the two-year applicable statute of limitations. On June 12, 2006, the Court granted this motion with respect to plaintiffs’ claims for money damages under the Ohio Consumer Sales Practices Act, but denied the motion with respect to plaintiffs’ claims for rescission under the OCSPA.
On February 23, 2006, a similar lawsuit was filed against the Company. The complaint alleges, among other things, that plaintiffs suffered financial injuries as a result of the defendants’ participation in fraudulent conduct by DHFS related to down payment assistance programs in violation of federal and Ohio law. The complaint seeks monetary damages and attorneys’ fees and costs.
All of the above lawsuits are in the preliminary discovery phase. No determination has been made that any of these cases can be maintained as a class action. The Company believes each of these lawsuits is without merit and intends to vigorously defend against all of the claims and allegations in the complaints.
In addition to the foregoing actions, the Company’s mortgage operations were recently subjected to review by HUD. On July 18, 2006, the Company received a letter from HUD stating that HUD accepted DHFS’s revised Quality Control Plan and closed that matter. In addition, HUD accepted the information supplied by DHFS with respect to all remaining open items under review and indicated that a further response by DHFS on these findings was not required. On July 19, 2006, the Company received a letter from HUD indicating that they had completed their review of the Company’s Kentucky operations and closed the review with no issues raised. The Company has also received requests for documents and files related to the financing of the Company’s homes at VPP from the Ohio Attorney General. The Company will continue to comply with any additional requests from these and other regulatory agencies. Due to the uncertainty as to the outcome of the foregoing matters, management cannot make an estimate of exposure, if any, at this time.
The Company is involved in various other legal proceedings, most of which arise in the ordinary course of business and some of which are covered by insurance. In the opinion of the Company’s management, none of the claims relating to such other legal proceedings will have a material adverse effect on the financial condition or results of operations of the Company.
12
| 9. | Land Purchase Commitments |
Cancelable contractual obligations consist of options under which the Company has the right, but not the obligation, to purchase land or developed lots and contingent purchase contracts under which the Company’s obligation to purchase land is subject to the satisfaction of zoning, utility, environmental, title or other contingencies. At June 30, 2006, the Company had $11,017,000 of cancelable contractual obligations for which the Company had determined that it was reasonably likely that it will complete the land or lot purchase. Good faith deposits on these contracts were $560,000 and are recorded in land and land development costs in the Consolidated Balance Sheet at June 30, 2006. An additional $533,000 of related pre-acquisition and due diligence costs are recorded in land and land development costs related to these cancelable contractual obligations. In addition, $1,150,000 of performance bonds and irrevocable letters of credit were outstanding as collateral for these cancelable contractual obligations at June 30, 2006.
At June 30, 2006, the Company was in the process of evaluating $6,214,000 of additional cancelable contractual obligations for which it had not yet determined whether it is reasonably likely that it will complete the land or lot purchase. Good faith deposits on these contracts were $608,000 and are recorded in land and land development costs in the Consolidated Balance Sheet at June 30, 2006. In addition, $688,000 of related pre-acquisition and due diligence costs is recorded in land and land development costs related to these contractual obligations. However, as of June 30, 2006, we have reserved for $872,000 of the $1,296,000 related pre-acquisition costs, due diligence costs and deposits based on management’s assessment of the likelihood of completing the land or lot purchase.
| 10. | Income Taxes |
The Company typically provides for income taxes in interim periods based on its annual estimated effective tax rate. The Company estimates the annual effective tax rate based upon its forecast of annual pre-tax results. To the extent that actual pre-tax results differ from the forecast estimates applied at the end of the most recent interim period, the actual income tax rate recognized in 2006 could be materially different from the estimated rate as of the end of the second quarter.
Income Tax expense for the second quarter of 2006 and 2005 reflects estimated annual effective income tax rates of 33.1% and 35.4%, respectively. The actual effective income tax rates for the second quarter of 2006 and 2005 were 30.3% and 22.7%, respectively. The actual tax rate for the second quarter of 2005 was below the annual estimated effective tax rate due primarily to a reduction of $820,00 in estimated tax liabilities as a result of favorable tax audit settlements. Income tax expense for the first six months of 2006 and 2005 reflects estimated annual effective income tax rates of 33.1% and 35.4%, respectively. The decrease in estimated annual effective tax rate is primarily due to differences in estimated pre-tax earnings (loss) for 2006 compared to 2005.
| 11. | Joint Venture Arrangement |
On March 31, 2006, the Company, the Company’s mortgage financing services subsidiary (DHFS), Wells Fargo Bank, N.A. and its wholly owned subsidiary Wells Fargo Ventures, LLC (collectively “Wells Fargo”) formed a new joint venture, Centennial Home Mortgage, LLC (“Centennial”). DHFS contributed $75,000 in cash and various assets to establish Centennial.
13
Then, pursuant to the Assignment of Interest Agreement between the parties, Wells Fargo paid DHFS $1,838,000 for a 50.1% controlling interest in the joint venture and DHFS retained ownership of the remaining 49.9% of Centennial. A gain of $1,800,000 is recorded on the sale of the investment in Centennial Home Mortgage, LLC in the Company’s Consolidated Statement of Operations for the first quarter 2006. DHFS received $938,000 on March 31, 2006 and the remaining $900,000 on April 3, 2006. Centennial is currently operating as a full-service mortgage bank to the Company’s customers and the general public and is an operating subsidiary of Wells Fargo Bank, N.A. The Company is in the process of exiting the operations of DHFS and expects to have completed the processing of the current pipeline of loan activity by the end of the third quarter of 2006. The Company accounts for its investment in Centennial Home Mortgage, LLC using the equity method.
14
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
We are a leading builder of high-quality homes in Central Ohio (primarily the Columbus Metropolitan Statistical Area) and Louisville and Lexington, Kentucky. Our customer-driven focus targets entry-level and move-up home buyers. We offer a variety of homes that are differentiated by price, size, standard features and available options. Our homes range in price from approximately $100,000 to more than $360,000 and in size from approximately 1,000 to 3,500 square feet.
The Company’s geographic markets were historically relatively stable markets for new home sales. During 2001 through 2003, new home sales in our markets were particularly strong and resulted in record sales levels for the Company. Then, during mid-2004, new home sales in our markets began to slow and that trend has continued through June 30, 2006. We believe the primary reasons for this slowdown include a decline in the overall demand for homes, increased interest rates, a lower level of consumer confidence and slower economic activity in our markets.
This trend of fewer home sales in our markets impacted second quarter 2006 financial results as revenues declined by 27.9% to $75.8 million from the delivery of 398 homes, compared to $105.2 million from the delivery of 548 homes during the same period the previous year. The Company’s average delivered home price for the second quarter of 2006 declined slightly to approximately $188,900 from approximately $189,600 for the second quarter of the previous year, principally due to higher sales discounts. Reduced revenues, combined with a higher cost of sales as a percentage of revenues, resulted in a net loss of $5.9 million, or $0.73 per diluted share, for the second quarter of 2006 compared to net income of $2.5 million, or $0.31 per diluted share, for the three months ended June 30, 2005.
Gross profit for the second quarter of 2006 was $7.5 million compared to $22.4 million for the second quarter of 2005, principally due to the delivery of 150 fewer homes and a decline in the Company’s gross profit margin to 9.9% from 21.3%. Gross profit for the second quarter of 2006 was reduced by a $2.1 million non-cash charge to cost of sales for deposits and pre-acquisition costs incurred for land that the Company decided not to purchase and increased by a $456,000 gain from the sale of land with a cost of $2.5 million. Included in cost of sales for the second quarter of 2005 is a similar charge of $1.4 million and an $824,000 gain from the sale of land with a cost of $718,000. These transactions reduced the reported second quarter 2006 and 2005 gross profit margins by 2.2% and 0.5%, respectively.
Selling, general and administrative expenses declined by $3.8 million for the three months ended June 30, 2006 compared to the three months ended June 30, 2005, primarily as a result of a reduction in the number of employees and cost savings initiated late in 2005 and during the first six months of 2006. The cost savings programs implemented during 2006 are expected to reduce the level of selling, general and administrative expense by an additional 10% during the second half of 2006. We expect to continue to reduce our cost structure to generate additional cost savings. Interest expense increased by $695,000, reflecting both higher average borrowings outstanding and a higher average borrowing interest rate.
15
During the three months ended June 30, 2006, we sold 356 homes, with a sales value of $66.2 million, compared to 655 homes, with a sales value of $123.1 million, during the three months ended June 30, 2005. Our backlog at June 30, 2006 was 548 sales contracts, with a sales value of $109.5 million, compared to a backlog of 887 sales contracts, with a sales value of $177.1 million, at June 30, 2005.
The Company had 55 active sales communities at June 30, 2006 compared to 61 at June 30, 2005. Effective June 30, 2006, the Company began reporting its number of active sales communities by geographic location rather than by series of homes. This change was implemented due to the development of a limited number of master planned communities that contain as many as five different series of homes. In most cases these master planned communities are in a single geographic location and are usually promoted using a similar, common community name. This change reduced the number of active sales communities reported at June 30, 2005 to 61 from 63.
On March 31, 2006, Dominion Homes Financial Services (“DHFS”), Wells Fargo Bank, N.A., and its wholly owned subsidiary Wells Fargo Ventures, LLC (collectively, “Wells Fargo”) formed a new joint venture, Centennial Home Mortgage, LLC (“Centennial”). Centennial is currently operating as a full-service mortgage bank to our customers and the general public. Centennial provides our customers access to a full range of competitively priced mortgage products from a nationally recognized and AAA rated mortgage lender and loan servicer. We expect DHFS to cease operations in the third quarter of 2006 after it has fully satisfied all commitments to borrowers for loans that have been approved but not yet funded. We anticipate our share of stabilized joint venture income from Centennial will be comparable to the contribution that was provided by DHFS.
DHFS’s mortgage operations have been undergoing a review the U.S. Department of Housing and Urban Development (“HUD”). During July 2006 the Company received letters from HUD indicating that items under review for both Ohio and Kentucky operations were accepted and that no further response from the Company was required, effectively closing the review without further consequence to the Company.
Safe Harbor Statement under the Private Securities Litigation Act of 1995
We desire to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 (the “PSLRA”). This Quarterly Report on Form 10-Q contains various “forward–looking statements” within the meaning of the PSLRA and other applicable securities laws. Such statements can be identified by the use of the forward-looking words “anticipate,” “estimate,” “project,” “believe,” “intend,” “expect,” “hope” or similar words. These statements discuss future expectations, contain projections regarding future developments, operations or financial conditions, or state other forward-looking information. These forward-looking statements involve various important risks, uncertainties and other factors which could
16
cause our actual results for 2006 and beyond to differ materially from those expressed in the forward-looking statements. Certain of these important factors are described in our Annual Report on Form 10-K for the year ended December 31, 2005, and include the following risks and uncertainties:
| • | availability of financing and our ability to refinance our indebtedness; |
| • | short and long term interest rates; |
| • | changes in governmental regulations; |
| • | employment levels and job growth; |
| • | availability and affordability of mortgage financing for home buyers; |
| • | availability and cost of building lots; |
| • | availability of materials (including lumber) and labor; |
| • | fluctuating costs of materials and labor; |
| • | adverse weather conditions and natural disasters; |
| • | consumer confidence and housing demand; |
| • | competitive overbuilding; |
| • | changing demographics; |
| • | cost overruns; |
| • | changes in tax laws; |
| • | changes in local government fees; |
| • | availability and cost of rental property and resale prices of existing homes; and |
| • | other risks described in our reports and filings with the Securities and Exchange Commission. |
In addition, domestic terrorist attacks and the threat or the involvement of the United States in international armed conflict may also adversely affect general economic conditions, consumer confidence and the homebuilding markets.
17
Seasonality and Variability in Quarterly Results
We experience significant seasonality and quarter-to-quarter variability in our homebuilding activity. With the exception of 2004, closings and related revenues have typically increased in the second half of the year. We believe this seasonality reflects the tendency of home buyers to shop for a new home in the spring with the goal of closing in the fall or winter. Weather conditions can also accelerate or delay the scheduling of closings.
The following table sets forth certain data for each of our last eight quarters:
Three Months Ended | Revenues | Closings | Sales Contracts* | Backlog At Period End | |||||
| (in thousands) | (in units) | (in units) | (in units) | ||||||
June 30, 2004 | $ | 148,181 | 778 | 510 | 1,067 | ||||
Sept. 30, 2004 | $ | 162,623 | 820 | 598 | 845 | ||||
Dec. 31, 2004 | $ | 115,494 | 605 | 392 | 632 | ||||
Mar. 31, 2005 | $ | 92,643 | 478 | 626 | 780 | ||||
June 30, 2005 | $ | 105,207 | 548 | 655 | 887 | ||||
Sept. 30, 2005 | $ | 106,330 | 549 | 433 | 771 | ||||
Dec. 31, 2005 | $ | 111,520 | 571 | 230 | 430 | ||||
Mar. 31, 2006 | $ | 61,785 | 315 | 475 | 590 | ||||
June 30, 2006 | $ | 75,835 | 398 | 356 | 548 | ||||
| * | Net of cancellations. |
We recognize revenues and cost of real estate sold at the time of closing. “Closings” or “deliveries” occur when ownership has transferred to the home buyer. We include a home in “sales contracts” when a home buyer signs our standard sales contract which requires a deposit and generally has no contingencies other than for purchaser financing or for the sale of an existing home, or both. We include a home in “backlog” when a home buyer signs our standard sales contract, but the closing has not occurred as of the end of the period.
Homes included in “sales contracts” in the foregoing table are net of cancellations. Most cancellations occur when home buyers cannot qualify for financing; however some cancellations may occur prior to or during the construction process.
18
Results of Operations
The following table sets forth, for the periods indicated, certain items from our Consolidated Statements of Operations expressed as percentages of total revenues, as well as certain operating data:
Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2006 | 2005 | 2006 | 2005 | |||||||||||||
Consolidated Statements of | ||||||||||||||||
Revenues | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | ||||||||
Cost of real estate sold | 90.1 | 78.7 | 87.9 | 79.2 | ||||||||||||
Gross profit | 9.9 | 21.3 | 12.1 | 20.8 | ||||||||||||
Selling, general and administrative | 17.8 | 16.4 | 20.5 | 16.8 | ||||||||||||
Income (loss) from operations | (7.8 | ) | 4.9 | (8.4 | ) | 4.0 | ||||||||||
Gain on sale of investment in Centennial Home Mortgage, LLC | — | — | 1.3 | — | ||||||||||||
Interest expense | (3.4 | ) | (1.8 | ) | (3.5 | ) | (1.9 | ) | ||||||||
Income (loss) before income taxes | (11.2 | ) | 3.1 | (10.6 | ) | 2.1 | ||||||||||
Provision for income taxes | (3.4 | ) | 0.7 | (3.5 | ) | 0.5 | ||||||||||
Net income (loss) | (7.8 | )% | 2.4 | % | (7.1 | )% | 1.6 | % | ||||||||
Operating Data (unaudited) | ||||||||||||||||
Homes: | ||||||||||||||||
Sales contracts, net of cancellations | 356 | 655 | 831 | 1,281 | ||||||||||||
Closings | 398 | 548 | 713 | 1,026 | ||||||||||||
Backlog at period end | 548 | 887 | 548 | 887 | ||||||||||||
Average sales price of homes closed during the period (in thousands) | $ | 189 | $ | 190 | $ | 191 | $ | 190 | ||||||||
Average sales value of homes in backlog at period end (in thousands) | $ | 200 | $ | 200 | $ | 200 | $ | 200 | ||||||||
Aggregate sales value of homes in backlog at period end (in thousands) | $ | 109,605 | $ | 177,121 | $ | 109,605 | $ | 177,121 | ||||||||
Second Quarter 2006 Compared to Second Quarter 2005
Revenues. Our revenues for the second quarter of 2006 were $75.8 million from the delivery of 398 homes, compared to $105.2 million from the delivery of 548 homes during the same period the previous year. There were no sale/lease backs during the second quarter of 2006, but second quarter 2005 revenues included the sale of 20 model homes, with a sales value of $3.2 million, which we leased back for use as sales models. The average delivery price of homes during the second quarter of 2006 decreased to $188,900 compared to $189,600 for the second quarter of 2005 primarily due to larger sales discounts that were offered to our customers. Second quarter 2006 revenues include fee revenue from our mortgage financing services subsidiary of $618,000 compared to $1.3 million for the second quarter of 2005.
19
Gross Profit. Our gross profit margin for the second quarter of 2006 declined 11.4% to 9.9% from 21.3% for the second quarter of 2005. This decline in the gross profit margin is primarily the result of larger sales discounts, which increased to 8.1% of revenues from 3.4% of revenues quarter to quarter. The gross profit margin for the second quarter of 2006 and 2005 reflects the following changes in major home building costs: land 19.7% versus 18.1%, construction costs 59.5% versus 54.0% and other costs 7.2% versus 6.9%. The other cost item includes a $2.1 million non-cash charge to cost of sales related to deposits and pre-acquisition costs incurred for land that the Company decided not to purchase and a $456,000 gain from the sale of land. Included in cost of sales for the second quarter of 2005 is a similar charge of $1.4 million and an $824,000 gain from the sale of land. These transactions impacted the second quarter 2006 and 2005 gross profit margin by 2.2% and 0.5%, respectively.
Selling, General and Administrative Expenses. Our selling, general and administrative expenses decreased to $13.5 million for the three months ended June 30, 2006 compared to $17.2 million for the three months ended June 30, 2005, principally as a result of delivering fewer homes and our efforts to better align the scale of our operations with the current sales pace. As a percentage of revenues, selling general and administrative expenses were 17.8% and 16.4% for the second quarter 2006 and 2005, respectively. We made significant reductions in our number of employees during the fourth quarter of 2005 and the second quarter of 2006 and are continuing to aggressively pursue additional cost saving measures.
Interest Expense. Our interest expense was $2.6 million for the second quarter of 2006 compared to $1.9 million for the second quarter of 2005. The increase is due to having higher average borrowings outstanding and a higher average borrowing interest rate, offset by $417,000 more interest capitalized during the second quarter of 2006 than the second quarter of 2005. Our average revolving line of credit borrowings outstanding increased to $217.3 million for the second quarter of 2006 compared to $203.8 million for the second quarter of 2005 due to increased investment in land and land development. In addition, the weighted average borrowing rate for the second quarter of 2006, excluding amortization of bank fees, increased to 6.6% from 5.5% for the second quarter of 2005.
Provision (Benefit) for Income Taxes.Our income tax benefit for the second quarter of 2006 was $2.6 million compared to income tax expense of $741,000 for the second quarter of 2005. The Company typically provides for income taxes in interim periods based on its annual estimated effective tax rate. Income tax expense for the second quarter of 2006 and 2005 reflects estimated annual effective income tax rates of 33.1% and 35.4%, respectively. The actual effective income tax rates for the second quarter of 2006 and 2005 were 30.3% and 22.7%, respectively. The actual tax rate for the second quarter of 2005 was below the annual estimated effective tax rate due primarily to a reduction of $820,000 in estimated tax liabilities as a result of favorable tax audit settlements.
20
First Six Months 2006 Compared to First Six Months 2005
Revenues. Our revenues for the first six months of 2006 were $137.6 million from the delivery of 713 homes compared to $197.8 million from the delivery of 1,026 homes during the same period in the previous year. There were no sale/lease backs during the first six months of 2006, but the first six months of 2005 revenues included the sale of 20 model homes, with a sales value of $3.2 million, which we leased back for use as sales models. The average delivery price of homes during the first six months of 2006 decreased to $191,100 compared to $191,300 for the first six months of 2005. The first six months of 2006 revenues include fee revenue from our mortgage financing services subsidiary of $1.3 million compared to $2.3 million for the first six months of 2005.
Gross Profit.Our gross profit margin for the first six months of 2006 declined by 8.7% to 12.1% from 20.8% for the first six months of 2005. This decline in the gross profit margin is primarily the result of larger sales discounts, which increased to 6.8% of revenues from 3.0% of revenues period to period. The gross profit margin for the first six months of 2006 and 2005 reflects the following changes in major home building costs: land 19.1% versus 17.9%, construction costs 58.1% versus 53.4% and other costs 7.0% versus 7.1%. The other cost item includes a $2.7 million non-cash charge to cost of sales related to deposits and pre-acquisition costs incurred for land that the Company decided not to purchase and a $456,000 gain from the sale of land. Included in cost of sales for the first six months of 2005 is a similar charge of $2.4 million and an $824,000 gain from the sale of land. These transactions impacted the first six months of 2006 and 2005 gross profit margin by 1.6% and 0.8%, respectively.
Selling, General and Administrative Expenses. Our selling, general and administrative expenses decreased to $28.2 million for the first six months of 2006 compared to $33.3 million for the first six months of 2005, principally as a result of delivering fewer homes and our efforts to better align the scale of our operations with our current sales pace. We made significant reductions in our number of employees during the fourth quarter of 2005 and the second quarter of 2006 and are continuing to aggressively pursue additional cost saving measures. As a percentage of revenues, selling, general and administrative expenses were 20.5% and 16.8% for the first six months of 2006 and 2005, respectively.
Gain on Sale of Investment. In connection with our formation of a joint venture with Wells Fargo Bank for the first six months of 2006 and 2005 that operates as a mortgage bank for our customers and the general public, we transferred the assets of DHFS to Centennial Home Mortgage, LLC and then sold a 50.1% interest in Centennial Home Mortgage, LLC to an affiliate of Wells Fargo, which sale generated a gain of $1.8 million during the first quarter of 2006.
Interest Expense. Our interest expense was $4.9 million for the first six months of 2006 compared to $3.6 million for the first six months of 2005. The increase is due to having higher average borrowings outstanding and a higher average borrowing interest rate, offset by $797,000 more interest capitalized during the first six months of 2006 than the first six months of 2005. Our average revolving line of credit borrowings outstanding increased to $215.0 million for the first six months of 2006 compared to $201.9 million for the first six months of 2005 due to increased investment in land and land development. In addition, the weighted average borrowing rate for the first six months of 2006, excluding amortization of bank fees, increased to 6.5% from 5.3% for the first six months of 2005.
21
Provision (Benefit) for Income Taxes. Our income tax benefit for the first six months of 2006 was $4.8 million compared to tax expense of $1.1 million for the first six months of 2005. The Company typically provides for income taxes in interim periods based on its annual estimated effective tax rate. Income tax expense for the first six months of 2006 and 2005 reflects estimated annual effective tax rates of 33.1% and 35.4%, respectively. The actual effective income tax rates for the first six months of 2006 and 2005 were 32.9% and 25.0%, respectively. The actual tax rate for the first six months of 2005 was below the annual estimated effective tax rate due primarily to a reduction of $820,000 in estimated tax liabilities as a result of favorable tax audit settlements.
Liquidity and Capital Resources
Historically, our capital needs have depended on sales volume, asset turnover, land acquisition and inventory levels. Our traditional sources of capital have been internally generated cash, bank borrowings and seller financing. At times, we also have sold our common shares in the public market. We have incurred indebtedness in the past and expect to incur indebtedness in the future to fund our operations and our investment in land. We expect the cash flow from our sales in backlog, proceeds from the sale of land and developed lots and funds from our Senior Unsecured Revolving Credit Facility (the “Facility”) to allow us to meet our short-term cash obligations. The primary reason that we could require additional capital are sustained operating deficits, expansion in our existing markets, expansion into new markets or purchase of a home building company.
On March 30, 2006, the Company and the participant banks in our Facility amended the Facility (the “Amendment”) to, among other things, decrease the amount of the Facility, change the borrowing base limitations, revise various financial covenants, impose additional business restrictions and secure borrowings under the Facility by liens on substantially all of the Company’s assets, including real estate. The amount of the Facility was reduced from $300 million to $240 million at the closing of the Amendment and will subsequently be reduced to $225 million as of September 30, 2006 and to $200 million as of December 31, 2006 and thereafter. The note payable banks was approximately $207.6 million at June 30, 2006, which includes outstanding borrowings under the Facility of approximately $204.1 million at June 30, 2006 and disbursements issued, but not yet presented to the bank group of $3.5 million.
We had $937,000 available to borrow under the Facility at June 30, 2006. The amount available to borrow under the Facility is limited based on a calculation that factors in cash, various components of inventory and outstanding borrowings and letters of credit.
We have slowed the acquisition of additional land and delayed the commencement of construction activities for land not already in the development process. We have also identified various land parcels and developed lots that we are offering for sale and have classified these parcels and lots as land held for sale at June 30, 2006. We will continue to evaluate our land holdings and expect
22
that we will identify additional excess inventory that will be offered for sale. We believe that by limiting our land acquisition and development activities, selling undeveloped land and developed lots and reducing our developed lot inventories through the sale of new homes, we will be able to significantly reduce our total investment in land inventories during 2006 and apply a significant portion of the proceeds toward reducing outstanding borrowings under the Facility. The terms of the Facility require us to pay an unused commitment fee on the difference between the total amount of the Facility and the outstanding obligations under the Facility. In order to minimize the amount of the unused commitment fee, we elected to reduce the total amount of the Facility during 2006 in accordance with our planned reduction in outstanding borrowings.
The Amendment includes the revision of certain financial covenants. The tangible net worth requirement was increased to $175 million as of March 31, 2006. The maximum allowable leverage ratio was reduced from 2.25 to 2.00 at June 30, 2006 and to 1.75 at December 31, 2006. The ratio of uncommitted land to consolidated tangible net worth was reduced from a maximum of 1.90 at December 31, 2005 to 1.75 at March 31, 2006, 1.70 at September 30, 2006 and 1.55 at December 31, 2006. The minimum interest coverage ratio was decreased from 1.90 at December 31, 2005 to 1.30 at March 31, 2006, 0.80 at June 30, 2006, 0.60 at September 30, 2006 and December 31, 2006 and 1.00 at March 31, 2007. Additional fee tiers have also been included that will be applicable when interest coverage is less than 1.75. The Amendment includes a limitation on the total value of developed unsold lots and lots under development of $155 million at June 30, 2006, $150 million at September 30, 2006 and $145 million at December 31, 2006 and thereafter. The definition of the borrowing base calculation was revised in the Amendment and we granted a lien on substantially all of our assets, including our real estate, as collateral for the Facility.
At June 30, 2006, the Company was in compliance with all of the financial covenants of the Facility. However, as a result of lower than expected sales in the first and second quarters of 2006, we believe that it is unlikely that we will be able to satisfy the ratio of uncommitted land to consolidated tangible net worth covenant in the Facility at December 31, 2006, and the minimum interest coverage ratio covenant at September 30, 2006, and December 31, 2006. Our failure to satisfy these covenants would constitute a breach of, and potentially a default under, the Facility. We are pursuing measures to avoid a default under the Facility and to execute our 2006 plan to reduce land inventories and outstanding debt. These measures include aggressively pursuing land sales, negotiating waivers or amendments with our existing bank group, and exploring alternative sources of financing. The Facility is currently scheduled to expire in May 2007. We are currently in negotiations with our bank group to either execute an extension of the Facility or enter into a new facility by December 31, 2006.
Sources and Uses of Cash for the First Six Months of 2006 Compared to the First Six Months of 2005
For the six months ended June 30, 2006, we used $5.6 million of cash to fund our operations. Significant items that contributed to this included a decrease of $10.6 million in accrued liabilities due to the payment of bonuses, and other items that were accrued at December 31, 2005 and a decrease of $3.2 million in accounts payable as a result of our reduced land development activities. The net decrease in our real estate inventories provided cash of $11.8 million
23
which partially offset the above cash outflows. Our financing activities provided $1.4 million of cash, primarily related to net borrowings of $2.4 million under our Facility offset by cash outlays related to the costs of the recent amendment of the Facility of $1.0 million.
For the six months ended June 30, 2005, we used $9.9 million of cash to fund our operations, including a net additional $17.1 million investment in our real estate inventories. We also purchased $1.2 million of property and equipment which was partially offset by $840,000 of proceeds from the sale of property and equipment. Our financing activities provided $11.0 million of cash, primarily related to net borrowings of $12.0 million under our Facility.
Real Estate Inventories
We generally do not purchase land for resale. However, when land that we own no longer fits into our development plans, we offer this land for sale, primarily to other homebuilders and commercial developers.
We attempt to maintain a land inventory that is sufficient to meet our anticipated lot needs for the next four to six years. Based on the 1,833 homes delivered during the 12 months ended June 30, 2006, our land inventories represented an 8.2 year supply at June 30, 2006. At June 30, 2006, we owned lots or land that we estimate could be developed into approximately 15,099 lots, including 1,813 lots in Kentucky. Included in the 15,099 lots are 781 lots that we have determined no longer fit into our sales plans and that we are offering for sale to other homebuilders or commercial developers.
At June 30, 2006, we also controlled, through option agreements or contingent contracts, land that we estimate could be developed into approximately 1,494 additional lots, all of which are in Ohio. We hold additional contingent agreements for land that may allow us to develop additional lots that are not included in these totals. However, based on our land review process, we have concluded that it is unlikely that all of the contingencies contained in these other agreements will be satisfied in the near future. Consequently, we did not consider these contingent agreements when estimating the total amount of land or number of lots that we control. The option agreements that we determined were more than likely to have the contingencies satisfied expire at various dates through 2010. We decide whether to exercise any particular option or otherwise acquire additional land based upon our assessment of a number of factors, including our existing land inventory at the time, the status of purchase contingencies and our evaluation of the future demand for our homes.
The following table sets forth an estimate of our land inventory as of June 30, 2006 and includes (a) land that we own and (b) land that we control under option agreements and contingent contracts and that has already been zoned for our needs or which we otherwise believe is reasonably likely to result in a purchase. The estimated number of lots is based on our current development plans, but the number of lots may change if our development plans change.
24
Land Inventory | Finished Lots | Lots Under Development | Unimproved Land Estimated Lots | Estimated Total Number of Lots | Inventory Value | ||||||
Land we own: | |||||||||||
Central Ohio | 1,776 | 976 | 9,936 | 12,688 | $ | 265,692,000 | |||||
Kentucky | 285 | 390 | 955 | 1,630 | 33,699,000 | ||||||
Land we control: | |||||||||||
Central Ohio | — | — | 1,494 | 1,494 | 1,201,000 | ||||||
Kentucky | — | — | — | — | — | ||||||
Held for sale: | |||||||||||
Central Ohio | — | 40 | 558 | 598 | 13,561,000 | ||||||
Kentucky | — | 46 | 137 | 183 | 4,006,000 | ||||||
Total Land Inventory | 2,061 | 1,452 | 13,080 | 16,593 | $ | 318,159,000 | |||||
Our total estimated lots at June 30, 2006 is a 15.7% decrease from the total estimated lots at June 30, 2005. At June 30, 2006, we had 332 inventory homes, including 47 in Kentucky, in various stages of construction, representing an aggregate investment of $22.7 million, compared to 270 single-family inventory homes, including 63 in Kentucky, in various stages of construction, representing an aggregate investment of $21.9 million, at June 30, 2005. We do not include inventory homes in our number of sales or reported backlog.
Contractual Obligations
Note Payable, Banks. On December 3, 2003, we entered into a Second Amended and Restated Credit Agreement (the “Facility”) that terminates on May 31, 2007.
Effective March 30, 2006, the Company and the participants in our bank credit facility amended the facility to, among other things, reduce the ratio of uncommitted land to consolidated tangible net worth and the minimum interest coverage ratio. We believe that it is unlikely that we will be able to satisfy the minimum interest coverage ratio covenant at September 30, 2006 and December 31, 2006, and the land to tangible net worth covenant at December 31, 2006. The Company is pursuing measures to address this situation, including aggressively pursuing land sales, negotiating waivers or amendments with the bank group under the Facility, and exploring alternative financing sources. See “Liquidity and Capital Resources” at page 22 of this Report.
For a more detailed description of the Facility, including restrictions it imposes on our business activities, see Note 6, Note Payable, Banks, in the Notes to the Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2005.
The Facility provides for a variable rate of interest on our borrowings. The variable rate is the three month LIBOR rate plus a margin based on our interest coverage ratio, which ranges from 1.75% to 3.25%, and is determined quarterly. The margin was 2.50% for the first and second quarters of 2006. In order to reduce the risks caused by interest rate fluctuations, we have
25
entered into interest rate swap contracts that fix the interest rate on a portion of our borrowings under the Facility. At June 30, 2006, we had fixed the interest rate on $120.0 million of our outstanding borrowings. Additional information regarding the interest rate swap contracts we have entered into is set forth under the heading “Quantitative and Qualitative Disclosures About Market Risk” in Item 3 of this Report.
Seller Financing. From time to time, we purchase land with seller financing. As of June 30, 2006, we held land for development that was partially financed with term debt that had an outstanding aggregate balance of approximately $9.3 million at interest rates ranging from 5.0% to 7.5%.
Operating Leases.We believe the best use of our Facility is to finance real estate inventories and other investments in our homebuilding operations. Other assets that support our homebuilding operations such as office facilities, model homes, vehicles and equipment, are financed through operating lease obligations. We believe our operating leases are properly classified as off balance sheet transactions. Our minimum rental commitment under such non-cancelable operating leases was approximately $10.1 million at June 30, 2006. For further information on our leases, see Note 8, Operating Lease Commitments, and Note 11, Related Party Transactions, in the Notes to the Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2005.
Land Purchase Commitments. On June 30, 2006, we did not have any contractual obligations to purchase residential lots or unimproved land, however, we did have cancelable obligations to purchase lots on unimproved land pursuant to option agreements or contingent contracts.
The following is a summary of our contractual obligations at June 30, 2006 (in thousands):
| Payments Due by Period | |||||||||||||||
Contractual obligations: | Total | Less than 1 year | 1 – 3 years | 3 – 5 years | After 5 years | ||||||||||
Note payable, banks(a) | $ | 207,628 | $ | 207,628 | $ | — | $ | — | $ | — | |||||
Term debt | 9,300 | 811 | 1,622 | 5,242 | 1,625 | ||||||||||
Operating leases | 10,118 | 2,642 | 3,145 | 1,262 | 3,069 | ||||||||||
Total contractual cash obligations | $ | 227,046 | $ | 211,081 | $ | 4,767 | $ | 6,504 | $ | 4,694 | |||||
| (a) | The interest obligation associated with the note payable, banks will be based upon the outstanding principal and the related variable rate of interest through its maturity date of May 31, 2007 (see Note 4 to the Consolidated Financial Statements for more details). |
Off-balance Sheet Arrangements
Performance Bonds and Irrevocable Letters of Credit.We are liable for performance bonds of $46.9 million and irrevocable letters of credit of $7.3 million at June 30, 2006. These
26
instruments were issued to municipalities and other individuals to ensure performance and completion of certain land development activities and as collateral for contingent land purchase commitments. We do not anticipate incurring any liability with respect to these instruments.
Variable Interest Entities. From time to time, we selectively enter into joint ventures with other homebuilders to own and develop communities. Through the creation of joint venture partnerships and limited liability companies, these joint ventures engage in land development activities for the purpose of distributing developed lots to the partners in the joint venture. The partners in the joint ventures acquire substantially all of the lots developed by the joint ventures and fund the development costs in proportion to their equity interest. We receive our percentage interest in the lots developed in the form of capital distributions. At June 30, 2006, we had ownership interests in seven such active joint ventures with ownership interests ranging from 33% to 50%. These joint ventures generally do not hold debt securities, except for seller requested financing arrangements upon purchasing the land for the joint ventures. We have determined that our land development joint ventures do not qualify as variable interest entities that would require consolidation in our financial statements.
In managing our land inventories, we enter into land option and contingent purchase contracts with third parties to acquire unimproved land and developed lots, which depending on the circumstances may qualify as variable interest entities under FIN 46. These contracts may be with individual land owners or entities that hold land for sale and generally require us to pay or issue one or a combination of the following: refundable deposits, non-refundable deposits and letters of credit. We have evaluated all of our land options and contingent purchase contracts and have concluded that, at June 30, 2006, we did not have any outstanding contracts requiring consolidation as a result of the application of FIN 46R.
Cancelable contractual obligations consist of options under which we have the right, but not the obligation, to purchase land and contingent purchase contracts under which our obligation to purchase land is subject to the satisfaction of zoning, utility, environmental, title or other contingencies. We continually evaluate our cancelable contractual obligations to purchase unimproved land and developed lots. At June 30, 2006, we had $11.0 million of cancelable contractual obligations for which we had determined it is reasonably likely that we will complete the land or lot purchase. Our good faith deposits and related due diligence costs on these contracts were $1.1 million at June 30, 2006. In addition, $1.2 million of performance bonds and irrevocable letters of credit were outstanding as collateral for these contingent land purchase commitments at June 30, 2006. Assuming that the contingencies are satisfied and that no other significant obstacles to development arise, we expect to purchase most of the residential lots and unimproved land that are subject to these cancelable contractual obligations within the next several years. We expect to fund our land acquisition and development obligations from internally generated cash and from the borrowing capacity under the Facility.
We are in the process of evaluating $6.2 million of additional cancelable contractual obligations for which we have not yet determined whether it is reasonably likely that we will complete the land or lot purchase. Good faith deposits and related due diligence costs on these contracts were $1.3 million at June 30, 2006. Good faith deposits and related due diligence costs
27
are normally charged to earnings when we determine the purchase of the land or lots will not be completed. However, as of June 30, 2006, we had reserved for $872,000 of the $1.3 million of good faith deposits and related due diligence costs based on management’s assessment of the likelihood of completing the land or lot purchase.
The following is a summary of our commercial commitments under off-balance sheet arrangements at June 30, 2006 (in thousands):
| Amount of Commitment Expiration Per Period | |||||||||||||||
Commercial commitments: | Total Amounts Committed | Less than 1 year | 1 –3 years | 3 –5 years | After 5 years | ||||||||||
Letters of credit | $ | 7,312 | $ | 2,473 | $ | 224 | $ | 4,615 | $ | — | |||||
Performance bonds | 46,872 | 41,158 | 5,319 | 395 | — | ||||||||||
Cancelable land contracts | 11,017 | 2,668 | 5,453 | 2,896 | — | ||||||||||
Total commercial commitments | $ | 65,201 | $ | 46,299 | $ | 10,996 | $ | 7,906 | $ | — | |||||
Inflation and Other Cost Increases
We are not always able to reflect all of our cost increases in the sales price of our homes because competitive pressures and other factors sometimes require us to maintain or discount our sales prices. While we attempt to maintain material, labor and subcontractor costs from the date a sales contract with a customer is accepted until the date construction is completed, we may incur unanticipated costs which cannot be passed on to the customer. For example, delays in construction of a home can cause the mortgage commitment to expire and can require us, if mortgage interest rates have increased, to pay significant amounts to the mortgage lender to extend the original mortgage interest rate. In addition, during periods of high construction activities, we may incur additional costs to obtain subcontractors when certain trades are not readily available, which can result in lower gross profits. Periods of rapid price increases can result in lower gross profits.
Recently Issued Accounting Pronouncements
In June 2006, the FASB issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, and disclosure relating to uncertain tax positions. FIN 48 will become effective for the Company on January 1, 2007. The Company is currently evaluating the impact FIN 48 will have on its results of operations and financial condition.
28
Item 3. Quantitative and Qualitative Disclosures About Market Risk
As of June 30, 2006, we were a party to eleven interest rate swap contracts with an aggregate notional amount of $120.0 million, as reflected in the table below. We enter into swap contracts to minimize earnings fluctuations caused by interest rate volatility associated with our variable rate debt. The swap contracts allow us to have variable rate borrowings and to select the level of fixed rate debt for the Company as a whole. Under the swap contracts, we agree with other parties to exchange, at specified intervals, the difference between fixed interest rate and floating interest rate amounts calculated by reference to an agreed notional amount. Our current intention is to maintain a range of approximately 40% to 60% of our debt at a fixed interest rate through the use of interest rate swaps. However, market conditions and timing affect the Company’s ability to maintain this balance between fixed and variable interest rates. Therefore at any time, this percentage may be more or less depending on specific circumstances. At June 30, 2006, our level of fixed rate debt under the Facility, after considering the effect of the interest rate swaps, was approximately 58%. We do not enter into derivative financial instrument transactions for speculative purposes. As of June 30, 2006, we were party to the following interest rate swap contracts:
Notional Amount | Start Date | Maturity Date | Fixed Rate* | |||
10,000,000 | Oct. 24, 2003 | Oct. 2, 2006 | 2.85% | |||
10,000,000 | Oct. 24, 2003 | Jan. 2, 2007 | 2.87% | |||
10,000,000 | Mar. 30, 2004 | Apr. 2, 2007 | 2.47% | |||
10,000,000 | Mar. 30, 2004 | Apr. 2, 2007 | 2.51% | |||
10,000,000 | May 7, 2004 | Apr. 2, 2007 | 3.30% | |||
10,000,000 | May 7, 2004 | Apr. 2, 2007 | 3.30% | |||
10,000,000 | May 9, 2003 | Apr. 3, 2008 | 3.01% | |||
10,000,000 | May 9, 2003 | May 3, 2008 | 3.04% | |||
10,000,000 | Sept. 8, 2004 | Aug. 31, 2008 | 3.74% | |||
10,000,000 | Sept. 8, 2004 | Sept. 9, 2008 | 3.74% | |||
20,000,000 | Apr. 15, 2005 | June 30, 2009 | 4.45% | |||
$120,000,000 | ||||||
| * | Does not reflect a variable rate margin that ranges from 1.75% to 3.25% and was 2.50% at June 30, 2006. |
Interest on our variable rate liabilities is LIBOR plus a variable margin ranging from 1.75% to 3.25%. Cash flows for interest on $120.0 million of variable rate liabilities that are subject to interest rate derivatives are the contractual average fixed pay rate plus the variable margin (2.50% at June 30, 2006 and 2.0% at December 31, 2005). The notional amount is used to calculate the contractual payments to be exchanged under the contract. The notional amount of the variable rate liabilities eligible to be fixed with interest rate swaps was $205.0 million at June 30, 2006 and at December 31, 2005. The remaining variable rate liabilities at June 30, 2006 and December 31, 2005 of $1.9 million and $0, respectively, are based on the prime rate rather than LIBOR. The fair value of the derivatives at June 30, 2006 and December 31, 2005 was an asset of $3.3 million and $2.7 million, respectively. We do not expect a gain to be realized from the $3.3 million asset because we expect to retain the swap contracts to maturity.
29
The following table provides information regarding the debt instruments and interest rate derivatives that we held at June 30, 2006. For the debt instruments, the table presents principal calendar year cash flows that exist by maturity date and the related average interest rate. For the interest rate derivatives, the table presents the notional amounts and expected interest rates that exist by contractual dates. All dollar amounts in the following table are in thousands.
| 2006 | 2007 | 2008 | 2009 | TOTAL | ||||||||||||||||||||
| June 30, 2006 | Dec. 31, 2005 | |||||||||||||||||||||||
Debt Instruments | ||||||||||||||||||||||||
Variable rate | $ | 207,628 | $ | 207,628 | $ | 205,240 | ||||||||||||||||||
Average interest rate* | 6.62 | % | 5.29 | % | ||||||||||||||||||||
Interest Rate Derivatives | ||||||||||||||||||||||||
Notional amount | $ | 120,000 | $ | 110,000 | $ | 60,000 | $ | 20,000 | $ | 120,000 | $ | 120,000 | ||||||||||||
Average pay rate | 3.31 | % | 3.35 | % | 3.74 | % | 4.45 | % | 3.31 | % | 3.21 | % | ||||||||||||
Average receive rate | 4.98 | % | 4.98 | % | 4.97 | % | 4.96 | % | 4.98 | % | 3.34 | % | ||||||||||||
| * | Includes effect of interest rate swap agreements and excludes amortization of bank fees. |
Item 4. Controls and Procedures
Disclosure Controls and Procedures
With the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) as of the end of the period covered by this Report (“Disclosure Controls”). Based on that evaluation, our principal executive officer and principal financial officer have concluded that as of the end of the period covered by this Report, the Company’s Disclosure Controls were effective for the purpose of ensuring that information required to be disclosed by the Company under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified within the Securities and Exchange Commission’s rules and forms; and (2) accumulated and communicated to management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
No change has occurred in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the quarter ended June 30, 2006, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
30
PART II - OTHER INFORMATION
Item 1. Legal Proceedings.
On February 21, 2006, a purported class action lawsuit captionedStuart, et. al. v. Dominion Homes Financial Services, Inc., et. al., Case No. C206137 was filed in the U.S. District Court, Southern District of Ohio, Eastern Division, against Dominion Homes Financial Services, Inc., a subsidiary of the Company (“DHFS”), and National City Mortgage Co. The complaint includes statutory claims, claims for breach of contract, breach of fiduciary duty, and fraudulent representations and material omissions in connection with the financing of plaintiffs’ condominium homes located in the Village at Polaris Park (“VPP”), where the Company was unable to obtain final HUD approval for FHA-insured mortgages. The plaintiffs purport to bring the claim on behalf of homeowners in VPP who were allegedly promised FHA mortgages through and from the defendants. The complaint seeks damages, including actual damages, statutory damages, punitive damages, and attorneys’ fees and costs, for, among other things, the alleged loss of certain FHA-insured mortgage features, including loan assumability. Plaintiffs also seek statutory damages for the defendants’ alleged failure to notify plaintiffs of the status of their mortgages.
On February 21, 2006, a purported class action lawsuit captionedRece, et. al. v. Dominion Homes, Inc., et. al., Case No. 06CVH202335 was filed in the Court of Common Pleas, Franklin County, Ohio against the Company, DHFS, named and unnamed appraisers who have worked with the Company, and unnamed charitable organizations who have provided the Company’s customers with down payment assistance funds in the last several years. Plaintiffs purport to bring the claim on behalf of purchasers of the Company’s homes from 1999 to the present who received such funds and allege, among other things, that the defendants misrepresented the value of the plaintiffs’ homes and obtained an improper benefit by artificially inflating the sales price of homes to purchasers receiving down payment assistance funds. The complaint also alleges that the defendants engaged in predatory lending practices against the plaintiffs and other consumers by extending them credit without regard to the actual value of their homes, knowing that the result would be higher default and foreclosure rates in its communities. The complaint seeks injunctive or declaratory relief, compensatory damages, punitive damages and attorneys’ fees and costs. On May 2, 2006, the Company and DHFS filed a motion for judgment on the pleadings with respect to plaintiff’s claim for breach of the Ohio Consumer Sales Practices Act (“OCSPA”) on the grounds that this claim was barred by the two-year applicable statute of limitations. On June 12, 2006, the Court granted this motion with respect to plaintiffs’ claims for money damages under the Ohio Consumer Sales Practices Act, but denied the motion with respect to plaintiffs’ claims for rescission under the OCSPA.
On February 23, 2006, a similar purported class action lawsuit captionedRudawsky, et. al. v. Borrer, et. al., Case No. C206144 was filed in the U.S. District Court, Southern District of Ohio, Eastern Division, against the Company, our Chairman, Chief Executive Officer and President, certain affiliates and current and former officers of the Company, and The Nehemiah Corporation of America by plaintiff homeowners, who purchased homes from the Company using Nehemiah down payment assistance funds. The complaint alleges, among other things, that plaintiffs suffered financial injuries as a result of the defendants’ participation in fraudulent conduct related to the Nehemiah down payment assistance program in violation of
31
federal statutes and Ohio law. The complaint further alleges that defendants fraudulently misrepresented and concealed the cost and operation of the Nehemiah program from plaintiffs. Plaintiffs purport to bring the claim on behalf of customers of the Company who purchased a home from 1999 to present using down payment assistance from Nehemiah. The complaint seeks monetary damages and attorneys fees and costs.
All of the above lawsuits are in the preliminary discovery phase. No determination has been made that any of these cases can be maintained as a class action. The Company believes each of these lawsuits is without merit and intends to vigorously defend against all of the claims and allegations in the complaints.
In addition to the foregoing actions, the Company’s mortgage operations were recently subjected to review by HUD. On July 18, 2006, the Company received a letter from HUD stating that HUD accepted DHFS’s revised Quality Control Plan and closed that matter. In addition, HUD accepted the information supplied by DHFS with respect to all remaining open items under review and indicated that a further response by DHFS on these findings was not required. On July 19, 2006, the Company received a letter from HUD indicating that they had completed their review of the Company’s Kentucky operations and closed the review with no issues raised. Due to the uncertainty as to the outcome of the foregoing matters, management cannot make an estimate of exposure, if any, at this time.
We are involved in various other legal proceedings, most of which arise in the ordinary course of business and some of which are covered by insurance. In the opinion of our management, none of the claims relating to such proceedings will have a material adverse effect on our financial condition or results of operations.
Item 1A. Risk Factors.
We believe it is unlikely that we will be able to satisfy certain financial covenants in our bank credit facility at September 30, 2006 and December 31, 2006. If we are not able to satisfy these covenants, or obtain waivers of or amendments to the covenants, our lenders could declare a default and demand repayment. Our current bank credit facility requires that we maintain a ratio of uncommitted land to consolidated tangible net worth of 1.70 at September 30, 2006, and 1.55 at December 31, 2006, and a minimum interest coverage ratio of 0.60 at September 30, 2006, and December 31, 2006. Unless we are able to reduce our projected operating losses in the third and fourth quarters, reduce our land holdings, or obtain alternative sources of financing in the short term, we believe it is unlikely that we will be able to satisfy the interest coverage ratio covenants at September 30, 2006, and December 31, 2006, and the land to tangible net worth covenant at December 31, 2006. Our failure to meet these covenants would permit our lenders to declare a default under our bank credit facility and to pursue the remedies available to them under the bank credit facility. If we are unable to negotiate waivers or amendments to these covenants from our lenders, they could, among other remedies, terminate our ability to make any new borrowings, accelerate the repayment of all existing borrowings under the bank credit facility and foreclose on their liens on substantially all of our assets. If our lenders declared a default, there is no assurance that we would be able to obtain financing to pay amounts owed under the bank credit facility and it is likely that we would have to consider seeking protection from our creditors under the federal bankruptcy laws.
32
Interest rate increases or changes in federal lending programs could adversely affect sales of our homes. Virtually all purchasers of our homes finance their purchase through third party lenders who offer conventional and government-insured mortgage financing. A material increase in mortgage interest rates or unfavorable changes to these lending programs would adversely affect the ability of prospective home buyers, particularly our targeted entry-level home buyers, to obtain mortgage financing. We also depend on the availability and cost of mortgage financing for buyers of the current homes owned by potential purchasers of our homes. Prior to purchasing our homes, some of our home buyers must sell their current homes, and these sales depend on the availability and cost of mortgage financing. In addition, because many of our home buyers use government-insured mortgage financing, a material reduction in the scope or funding of government-insured mortgage programs could have a material adverse effect on our sales.
In particular, a substantial number of our home buyers use down payment assistance programs, which allow home buyers to receive gift funds from non-profit corporations to be used as a down payment. At one time, the Department of Housing and Urban Development (“HUD”) proposed rules which would have prohibited the use of gift fund programs in conjunction with government-insured mortgage loans. HUD subsequently withdrew these proposed rules, but has continued to increase its regulation of gift fund programs. Recently, the Internal Revenue Service (“IRS”) issued a ruling challenging the tax exempt status of non-profit corporations that provide down payment assistance which are funded largely by homebuilders and sellers. The ruling may limit the ability of certain non-profit corporations to fund down payment assistance programs for government-insured mortgage loans. If, as a result of the IRS ruling, or regulatory or other action, certain of the gift fund programs that our customers utilize would no longer be available to them, we would expect to work to provide other financing alternatives, and seek out different down payment programs for our customers that meet HUD and IRS guidelines. There can be no assurance, however, that any such alternative programs would be as attractive to our customers as the programs offered today and that our sales would not suffer. We currently are the subject of two purported class action lawsuits that challenge our participation in gift fund programs. See Part II - Item 1, “Legal Proceedings” of this Form 10-Q.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. Not applicable
Item 3. Defaults Upon Senior Securities. Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders.
| (a) | On May 10, 2006, the Company held its Annual Meeting of Shareholders. |
| (b) | See paragraph (c) below. |
33
| (c) | At the Annual Meeting, the Company’s shareholders elected one Class I Director and four Class II Directors to the Board of Directors by the following vote: |
Director Nominees | Class | Shares Voted For | Shares Withheld | |||
Robert R. McMaster | I | 7,515,214 | 39,481 | |||
David S. Borror | II | 7,502,876 | 51,819 | |||
Donald A. Borror | II | 7,501,510 | 53,815 | |||
R. Andrew Johnson | II | 7,511,614 | 43,081 | |||
Carl A. Nelson, Jr. | II | 7,510,069 | 44,626 |
The term of office of the Company’s existing Class I Directors, Douglas G. Borror, David S. Blom and Zuheir Sofia, continued after the Annual Meeting.
At the Annual Meeting, the Company’s shareholders also approved amendments to the Company’s Amended and Restated 2003 Stock Option and Incentive Equity Plan to: (a) increase the authorized number of common shares available for issuance from 500,000 common shares to 1,250,000 common shares, (b) allow for the award of whole shares to non-employee directors of the Company, which shall be issued in lieu of cash fees for Board service to which these directors might otherwise be entitled, and (c) to clarify that the restrictions on price and vesting of awards under the 2003 Incentive Equity Plan will not apply to grants of time-based restricted shares that vest in equal increments of not more than 33 1/3 percent. The amendments were approved by the following vote:
Shares Voted For | Shares Voted Against | Shares Abstaining | ||
5,575,617 | 992,874 | 585 |
| (d) | Not applicable. |
Item 5. Other Information. Not applicable.
Item 6. Exhibits.
Exhibits filed with this Quarterly Report on Form 10-Q are attached hereto or incorporated by reference herein. For a list of our exhibits, see “Index to Exhibits” (following the signature page).
34
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
| DOMINION HOMES, INC. | ||||||
(Registrant) | ||||||
Date: August 8, 2006 | By: | /s/ Douglas G. Borror
| ||||
Douglas G. Borror | ||||||
Chairman, Chief Executive Officer | ||||||
(Principal Executive Officer) | ||||||
Date: August 8, 2006 | By: | /s/ William G. Cornely
| ||||
William G. Cornely | ||||||
Senior Vice President of Finance and | ||||||
Chief Financial Officer | ||||||
(Principal Financial Officer) | ||||||
35
INDEX TO EXHIBITS
| Exhibit No. | Description | Location | ||
| 3.1 | Amended and Restated Articles of Incorporation of Dominion Homes, Inc., reflecting all amendments (for purposes of Commission reporting compliance only). | Incorporated by reference to Exhibit 4(a)(3) to the 1997 Form S-8. | ||
| 3.2 | Amended and Restated Code of Regulations of Dominion Homes, Inc. | Incorporated by reference to Exhibit 3.2 to the Company’s June 30, 2000 Form 10-Q (File No. 0-23270). | ||
| 4.1 | Specimen of Stock Certificate of Dominion Homes, Inc. | Incorporated by reference to Exhibit 2.2 to the Company’s Form 8-A/A filed April 30, 2003 (File No. 0-23270). | ||
| 10.1 | Employment Agreement with Jeffrey A. Croft. | Incorporated by reference to Exhibit 10.1 to the Company’s Form 8-K dated May 3, 2006 (File No. 0-23270). | ||
| 10.2 | Restricted Share Agreement with Jeffrey A. Croft | Incorporated by reference to Exhibit 10.2 to the Company’s Form 8-K dated May 10, 2006 (File No. 0-23270). | ||
| 10.3 | 2006 Amended Director Compensation Plan. | Filed herewith. | ||
| 10.4 | Dominion Homes, Inc. Amended and Restated 2003 Stock Option and Incentive Equity Plan (as amended May 10, 2006) | Incorporated by reference to Exhibit 10.1 to the Company’s Form 8-K dated May 10, 2006 (File No. 0-23270). | ||
| 31.1 | Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | Filed herewith. | ||
| 31.2 | Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | Filed herewith. | ||
| 32 | Certification pursuant to Rule 13a-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code. | Filed herewith. | ||
36