UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

 

 

COMMISSION FILE NUMBER: 001-32322

 

TECHNICAL OLYMPIC USA, INC.

(Exact name of registrant as specified in its charter)

 

 

 

(Registrant’s telephone number, including area code)
(954) 364-4000

 

(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 þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check one):

Large Accelerated Filer o     Accelerated Filer þ     Non-Accelerated Filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 59,590,519 shares of common stock as of November 8, 2006.

 

TECHNICAL OLYMPIC USA, INC.

 

INDEX

 

 

TECHNICAL OLYMPIC USA, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

 

 

See accompanying notes to consolidated financial statements.

TECHNICAL OLYMPIC USA, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

See accompanying notes to consolidated financial statements.

TECHNICAL OLYMPIC USA, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See accompanying notes to consolidated financial statements.

TECHNICAL OLYMPIC USA, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006

 

 

Business

 

Technical Olympic USA, Inc. is a homebuilder with a geographically diversified national presence. We operate in various metropolitan markets in ten states, located in four major geographic regions: Florida, the Mid-Atlantic, Texas, and the West. We design, build, and market detached single-family residences, town homes and condominiums. We also provide title insurance and mortgage brokerage services to our homebuyers and others. Generally, we do not retain or service the mortgages that we originate but, rather, sell the mortgages and related servicing rights.

 

Organization

 

Technical Olympic S.A. owns approximately 67% of our outstanding common stock. Technical Olympic S.A. is a publicly-traded Greek company whose shares are traded on the Athens Stock Exchange.

 

 

Basis of Presentation

 

The consolidated financial statements include our accounts and those of our subsidiaries. Our accounting and reporting policies conform to United States generally accepted accounting principles and general practices within the homebuilding industry. These accounting principles require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

 

All significant intercompany balances and transactions have been eliminated in the consolidated financial statements.

 

Due to our normal operating cycle being in excess of one year, we present unclassified consolidated statements of financial condition.

 

Certain prior period amounts have been reclassified to conform to the current period’s presentation.

 

Segment Reporting

 

We have modified our disclosure of reportable segments in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures About Segments of an Enterprise and Related Information (“SFAS 131”). We had historically aggregated our homebuilding operating segments into a single reportable segment, but have restated our segment disclosure for the three and nine months ended September 30, 2005 to present disaggregated information for our four homebuilding reportable segments (see Note 11). The restatement has no impact on our consolidated statement of financial condition as of December 31, 2005, consolidated statements of operations and related earnings per share amounts for the three and nine months ended September 30, 2005 or consolidated statement of cash flows for the nine months ended September 30, 2005.

 

Interim Presentation

 

The accompanying unaudited consolidated financial statements reflect all adjustments, consisting primarily of normal recurring items that, in the opinion of management, are considered necessary for a fair presentation of the financial position, results from operations, and cash flows for the periods presented. Results of operations achieved through September 30, 2006 are not necessarily indicative of those that may be achieved for the year ending December 31, 2006. Certain information and footnote disclosures normally

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

included in financial statements presented in accordance with United States generally accepted accounting principles have been omitted from the accompanying financial statements. The financial statements included as part of this Form 10-Q should be read in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005.

 

For the three months ended September 30, 2006 and 2005, we have eliminated inter-segment Financial Services revenues of $1.4 million and $2.7 million, respectively. For the nine months ended September 30, 2006 and 2005, we have eliminated inter-segment Financial Services revenues of $3.6 million and $6.5 million, respectively.

 

Earnings Per Share

 

Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share is computed based on the weighted average number of shares of common stock and gives effect to all potential shares that were dilutive and outstanding during the period. Potential common shares are securities, such as stock options or other common stock equivalents, that may entitle the holder to obtain common stock during the reporting period or after the end of the reporting period. Dilutive securities are not included in the weighted average number of shares when inclusion would increase the earnings per share or decrease the loss per share.

 

The following table represents a reconciliation of weighted average shares outstanding:

 

 

Revenue Recognition

 

In accordance with SFAS No. 66, Accounting for the Sales of Real Estate (“SFAS 66”), we deferred approximately $2.2 million in profit related to certain homes that were delivered for which our mortgage subsidiary originated interest-only loans or loans with high loan to value ratios which did not meet the initial and continuing investment requirements under SFAS 66, and the loans were still held for sale at September 30, 2006. This profit will be recognized upon the sale of the loans to a third party, with non-recourse provisions, which generally occurs within 45 days from the date the loan is originated.

 

Stock-Based Compensation

 

Prior to January 1, 2006, we accounted for stock option awards granted under our share-based payment plan in accordance with the recognition and measurement provisions of Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees, (“APB 25”) and related Interpretations, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation, (“SFAS 123”). Share-based employee compensation expense was not recognized in our consolidated statement of operations prior to January 1, 2006, except for certain options with performance-based accelerated vesting criteria and certain outstanding common stock purchase rights, as all other stock option awards granted under the plan had an exercise price equal to or greater than the market value of the common stock on the date of the grant. Effective January 1, 2006, we adopted the

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

provisions of SFAS 123 (revised 2004), Share-Based Payment, (“SFAS 123R”) using the modified-prospective-transition method. Under this transition method, compensation expense recognized during the nine months ended September 30, 2006 included: (a) compensation expense for all share-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all share-based awards granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. In accordance with the modified-prospective-transition method, results for prior periods have not been restated. Additionally, in connection with the adoption of SFAS 123R, we recognized a cumulative change in accounting principle of $2.0 million, net of tax, related to certain common stock purchase rights that were accounted for under the variable accounting method. The cumulative effect of the change in accounting principle of $3.2 million, gross of tax, was not material and therefore was included in selling, general and administrative expenses with the related tax effect of $1.2 million included in the provision for income taxes rather than displayed separately as a cumulative change in accounting principle in the consolidated statements of operations. The adoption of SFAS 123R resulted in a charge of $10.7 million and $6.8 million to income before provision for income taxes and net income, respectively, for the nine months ended September 30, 2006. The impact of adopting SFAS 123R on both basic and diluted earnings was $0.11 per share. See Note 10 for more information on the impact of SFAS 123R on our consolidated financial statements.

 

Recent Accounting Pronouncements

 

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of SFAS 109, (“FIN 48”). FIN 48 provides interpretive guidance for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006 (our fiscal year beginning January 1, 2007). We are currently reviewing the effect of this Interpretation on our consolidated financial statements.

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 (our fiscal year beginning January 1, 2008), and interim periods within those fiscal years. We are currently reviewing the effect of this statement on our consolidated financial statements.

 

On September 13, 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”) regarding the process of quantifying financial statement misstatements. SAB 108 expresses the Staff’s views regarding the diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build up of improper amounts on the balance sheet. SAB 108 is effective for fiscal years ending after November 16, 2006 and will be effective for our December 31, 2006 year end. We are currently reviewing the effect of this statement on our consolidated financial statements.

 

TECHNICAL OLYMPIC USA, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

A summary of homebuilding interest capitalized in inventory is as follows (dollars in millions):

 

 

In the ordinary course of business, we enter into contracts to purchase homesites and land held for development. At September 30, 2006 and December 31, 2005, we had refundable and non-refundable deposits aggregating $224.0 million and $218.5 million, respectively, included in inventory in the accompanying consolidated statements of financial condition. Our liability for nonperformance under such contracts is generally limited to forfeiture of the related deposits.

 

Homebuilders may enter into option contracts for the purchase of land or homesites with land sellers and third-party financial entities, some of which qualify as Variable Interest Entities (“VIEs”) under FASB Interpretation No. 46 (Revised), Consolidation of Variable Interest Entities (“FIN 46(R)”). FIN 46(R) addresses consolidation by business enterprises of VIEs in which an entity absorbs a majority of the expected losses, receives a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Obligations for inventory not owned in our consolidated statements of financial condition represent liabilities associated with our land banking and similar activities, including obligations in VIEs which have been consolidated by us and in which we have a less than 50% ownership interest, and the creditors have no recourse against us. As a result, the obligations have been specifically excluded from the calculation of leverage ratios pursuant to the terms of our revolving credit facility.

 

In applying FIN 46(R) to our homesite option contracts and other transactions with VIEs, we make estimates regarding cash flows and other assumptions. We believe that our critical assumptions underlying these estimates are reasonable based on historical evidence and industry practice. Based on our analysis of transactions entered into with VIEs, we determined that we are the primary beneficiary of certain of these homesite option contracts. Consequently, FIN 46(R) requires us to consolidate the assets (homesites) at their fair value, although (1) we have no legal title to the assets, (2) our maximum exposure to loss is generally limited to the deposits or letters of credits placed with these entities, and (3) creditors, if any, of these entities have no recourse against us. The effect of FIN 46(R) at September 30, 2006 was to increase inventory by $72.0 million, excluding deposits of $6.1 million, which had been previously recorded, with a corresponding increase to “obligations for inventory not owned” in the accompanying consolidated statement of financial condition. Additionally, we have entered into arrangements with VIEs to acquire homesites in which our variable interest is insignificant and, therefore, we have determined that we are not the primary beneficiary and are not required to consolidate the assets of such VIEs.

 

From time to time, we transfer title to certain parcels of land to unrelated third parties and enter into options with the purchasers to acquire fully developed homesites. As we have retained a continuing involvement in these properties, in accordance with SFAS No. 66 we have accounted for these transactions as financing arrangements. At September 30, 2006, $232.0 million of inventory not owned and obligations for inventory not owned related to sales where we have retained a continuing involvement.

 

TECHNICAL OLYMPIC USA, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we carry long-lived assets at the lower of the carrying amount or fair value. We evaluate an asset for impairment when events and circumstances indicate that they may be impaired. Impairment is evaluated by estimating future undiscounted cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the expected undiscounted future cash flows is less than the carrying amount of the assets, an impairment loss is recognized. Fair value, for purposes of calculating impairment, is measured based on estimated future cash flows, discounted at a market rate of interest. During the three and nine months ended September 30, 2006, we recorded an impairment loss of $29.8 million and $35.3 million, respectively, which is included in cost of sales — home sales in the accompanying consolidated statement of operations as compared to $1.3 million for the three and nine months ended September 30, 2005. During the three and nine months ended September 30, 2006, we also recorded a charge of $20.0 million and $22.3 million, respectively, in deposits and abandonment costs, which are included in cost of sales — land sales in the accompanying consolidated statement of operations, related to land that we no longer intend to purchase or build on, as compared to $ — and $0.6 million for the three and nine months ended September 30, 2005.

 

 

 

On August 1, 2005, through a joint venture (the “Transeastern JV”), of which one of our subsidiaries is a member, we completed the acquisition of substantially all of the homebuilding assets and operations of Transeastern Properties, Inc. (“Transeastern”) headquartered in Coral Springs, Florida. The other member of the joint venture is an entity controlled by the former majority owners of Transeastern. The Transeastern JV acquired Transeastern’s homebuilding assets, including work in process, finished lots and certain land option rights, for approximately $826.2 million (which included the assumption of $112.0 million of liabilities, net of $30.8 million of cash).

 

TECHNICAL OLYMPIC USA, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The Transeastern JV was funded with $675.0 million of third party debt capacity (of which $560.0 million was drawn upon acquisition), a $20.0 million subordinated loan from us and $165.0 million of equity, of which $90.0 million was contributed by us. Our $20.0 million subordinated loan to the Transeastern JV, bears interest at 18% per annum and is only payable once certain conditions and covenants under the JV agreement and the joint venture’s bank borrowings are met.

 

As of September 30, 2006, the Transeastern JV had $625.0 million of third party debt outstanding, which includes $400.0 million relating to a senior credit agreement, $137.5 million relating to a senior mezzanine credit agreement and $87.5 million relating to a junior mezzanine credit agreement (collectively, “the Credit Agreements”). Deutsche Bank serves as the administrative agent (the “Administrative Agent”) for each of the Credit Agreements. The Credit Agreements are secured by the Transeastern JV’s assets, which are discussed in further detail below, and ownership interests. We are responsible for certain indemnity and completion obligations in the event that the Transeastern JV fails to fulfill certain of its obligations under the Credit Agreements. The other member of the joint venture also executed an agreement with respect to indemnification. (See Limited Guarantees section below).

 

When the Transeastern JV was formed in August of 2005, it had more than 3,000 homes in backlog and projected 2006 deliveries of approximately 3,500 homes. Since that time, the Florida housing market has become more challenging, characterized by weak demand, an over supply of new and existing homes available for sale, increased competition, and an overall lack of buyer urgency. These conditions have caused elevated cancellation rates and downward pressure on margins, due to increased sales incentives and higher advertising and broker commissions. These conditions have caused significant liquidity problems for the Transeastern JV. In September 2006, management of the Transeastern JV developed and distributed to its members financial projections that indicated the joint venture would not have the ability to continue as a going concern under the current debt structure, at which time it began discussions with its lenders. The joint venture and its lenders are currently engaged in discussions with respect to the debt and equity structure of the joint venture and the outcome of these discussions is currently unknown and will likely remain unknown for some period of time.

 

As a result of these factors, we evaluated the recoverability of our investment in the Transeastern JV, under APB 18, The Equity Method of Accounting for Investments in Common Stock (“APB 18”), and have determined our investment to be fully impaired. At September 30, 2006, our investment in the Transeastern JV amounted to $143.6 million, which includes $35.0 million of member loans receivable and $16.2 million of receivables for management fees, advances and interest due to us from the Transeastern JV. During the three months ended September 30, 2006, we wrote-off our $143.6 million investment, which is included in loss from joint ventures in the accompanying consolidated statement of operations.

 

At September 30, 2006, the Transeastern JV had total assets of $978.0 million of which $428.1 million represented land and construction in progress. For the three months ended September 30, 2006, the Transeastern JV had revenues of $180.2 million and net income of $9.9 million. For the nine months ended September 30, 2006, the Transeastern JV had revenues of $501.2 million and net income of $26.7 million. The joint venture has not completed its impairment analysis as it relates to inventory and other intangible assets. We expect that the completion of this analysis during the three months ended December 31, 2006, will have a material impact on the total assets of the joint venture; however, the amount is currently unknown.

 

During the six months ended June 30, 2006, we purchased several parcels of land for an aggregate purchase price of $39.4 million from the Transeastern JV. In connection with these transactions, the Transeastern JV realized a gain of $14.1 million. We deferred our share of that gain, $7.1 million, and have recorded it as a reduction in the basis of the underlying property. While we may make purchases in the future, during the quarter ended September 30, 2006, no such purchases have occurred.

 

Limited Guarantees

 

Upon formation of the Transeastern JV, we entered into agreements relating to completion of work on property in process at the time of execution of the Credit Agreements, August 1, 2005, in the event the

 

TECHNICAL OLYMPIC USA, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Transeastern JV failed to do so (the “Completion Guarantees”) and carve out guarantees to indemnify the lenders for losses resulting from fraud, misappropriation and similar acts by the Transeastern JV or full repayment of the loans in the event the Transeastern JV voluntarily filed for bankruptcy protection (the “Carve Out Guarantees” and collectively with the Completion Guarantees, the “Guarantees”). The other member of the joint venture also entered into Carve Out Guarantees.

 

On October 31, 2006 and November 1, 2006, we received letters (the “Demand Letters”) from Deutsche Bank demanding payment under the Completion and Carve Out Guarantees. The Demand Letters allege that the Transeastern JV has failed to comply with certain of its obligations pursuant to the Credit Agreements. The Demand Letters allege potential defaults and that events of default have occurred under the Guarantees that have triggered our obligations to pay all of the outstanding obligations under each of the Credit Agreements. We do not believe that our obligations pursuant to the Guarantees have been triggered and we have formally disputed these allegations. We are in discussions with the Administrative Agent and the lenders concerning this situation.

 

Under the Completion Guarantees, we are responsible to pay and discharge all “project costs” (as such term is defined in the Completion Guarantees) in accordance with the Credit Agreements on projects on which “development activities” had commenced on August 1, 2005. We are further responsible for paying, bonding or otherwise removing any mechanics’ liens that may be filed with respect to a project. In addition, we are responsible for completing or causing the completion of all development activities with respect to a project. Notwithstanding the receipt of the Demand Letters, work is progressing on these projects. However, if applicable portions of certain projects are not completed by the Transeastern JV, our preliminary analysis indicates that the liability could approximate $25.0 million based on current estimates of costs to complete. There are significant disagreements between the lenders and us as to the extent of our liability under the Completion Guarantees. These disagreements include the number of properties that are encompassed within the guarantees and the extent of the construction which must be completed. Should the interpretations of the lenders ultimately prevail, our liability could increase materially.

 

Under the Carve Out Guarantees, we and our joint venture partner have agreed to indemnify the lenders for any liabilities, obligations, losses, damages, penalties, actions, judgments, suits, costs, charges, expenses and disbursements arising out of certain matters. These matters include fraud or material misrepresentation by any of the borrowing entities, the misappropriation by the borrowing entities of certain payments, improper use of insurance proceeds, intentional misconduct or waste with respect to the collateral and failure to maintain insurance. In addition, upon the filing of a voluntary petition in bankruptcy by any of the borrowers, we and our joint venture partner would be responsible for payment of the full amount of the outstanding loans. Although the lenders have alleged losses, we have denied their allegations. For example, we are evaluating the calculations of the borrowing bases submitted to the Administrative Agent which were used to determine available credit. If a miscalculation existed, it could be deemed a misrepresentation. If it is determined that the lenders incurred losses from a miscalculation, we could be responsible for such losses. This and other matters related to these Guarantees are currently unresolved, and the extent of damages, if any, is not determinable.

 

In accordance with SFAS No. 5, Accounting for Contingencies (“SFAS 5”), we have evaluated whether any amount should be accrued in connection with the Demand Letters received related to the Guarantees discussed above. SFAS 5 requires that an estimated loss from a loss contingency shall be accrued by a charge to income if information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. Currently we are working with the lenders and financial consultants to produce a global solution for all parties involved. This process is ongoing, but is not sufficiently complete to produce the facts necessary to permit meaningful analysis of a potential solution to the situation or to determine our exposure, if any under the Guarantees. As a result, we did not recognize an accrual for loss contingency at September 30, 2006 in our statement of financial condition.

 

TECHNICAL OLYMPIC USA, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Summarized condensed combined financial information of unconsolidated entities in which we have investments that are accounted for under the equity method, excluding our Transeastern JV, is (dollars in millions):

 

 

 

TECHNICAL OLYMPIC USA, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

We enter into strategic joint ventures to acquire, develop and sell land and/or homesites, as well as to construct and sell homes, in which we have a voting ownership interest of 50% or less and do not have a controlling interest. Our partners generally are unrelated homebuilders, land sellers, financial partners or other real estate entities. Certain of these joint ventures have third party debt that is secured by the assets of the joint venture; however, we may be responsible for certain indemnity and completion obligations in the event the joint venture fails to fulfill certain of its obligations. At September 30, 2006, we had receivables of $20.3 million from these joint ventures, of which $1.0 million represented notes receivable.

 

In many instances, we are appointed as the day-to-day manager of the unconsolidated entities and receive management fees for performing this function. We received management fees from these unconsolidated entities of $7.4 million and $26.8 million for the three and nine months ended September 30, 2006, respectively. We received management fees from these unconsolidated entities of $7.8 million and $14.6 million for the three and nine months ended September 30, 2005, respectively. These fees are included in income (loss) from joint ventures in the accompanying consolidated statements of operations. In the aggregate, these joint ventures delivered (excluding the Transeastern JV) 1,458 and 746 homes for the nine months ended September 30, 2006 and 2005, respectively.

 

In March 2006, we assigned to our Sunbelt joint venture our rights under a contract to purchase approximately 539 acres of raw land. We received $18.7 million for the assignment of the purchase contract. In connection with this assignment, we realized a gain of $15.8 million, of which $2.3 million is included in cost of sales-land sales in the accompanying consolidated statements of operations. Due to our continuing involvement with this contract through our investment in the joint venture, we deferred $13.5 million of this

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

gain which is included in accounts payable and other liabilities in the accompanying consolidated statement of financial condition at September 30, 2006. This deferral will be recognized in the consolidated statements of operations as income as homes are delivered by the joint venture.

 

Certain of our unconsolidated joint venture agreements require the ventures to allocate earnings to the members using preferred return levels based on actual and expected cash flows throughout the life of the venture. Accordingly, determination of the allocation of the members’ earnings in these joint ventures can only be certain at or near the completion of the project and upon agreement of the partners. In order to allocate earnings, the members of the joint venture must make estimates based on expected cash flows throughout the life of the venture. During the three months ended September 30, 2006, two of our unconsolidated joint ventures neared completion, which allowed the joint venture to adjust the income allocation to its members based on the final cash flow projections. The reallocation of earnings resulted in the recognition of an additional $5.9 million in income from unconsolidated joint ventures during the three months ended September 30, 2006. We have evaluated these revisions in earnings allocations under SFAS No. 154, Accounting Changes and Error Corrections, a replacement of Opinion No. 20 and FASB Statement No. 3 and have appropriately accounted for this change in estimate in our September 30, 2006 financial statements.

 

On August 30, 2006, we terminated one of our unconsolidated joint ventures that was formed to purchase land, construct and develop a condominium project in Northern Virginia. As part of the agreement, we purchased our partner’s interest in the venture for $32.6 million. After purchasing our partner’s interest, we became the sole member of the entity and began to account for the entity as a consolidated subsidiary. The purchase price was allocated to the net assets of the venture, which were comprised primarily of inventory.

 

During the three months ended September 30, 2006, we evaluated the recoverability of our investment in and receivables from an unconsolidated joint venture located in Southwest Florida, under APB 18, and have recorded an impairment of $4.8 million, which is included in loss from joint ventures in the accompanying consolidated statement of operations.

 

 

Goodwill represents the excess of the purchase price of our acquisitions over the fair value of the net assets acquired. Additional consideration paid in subsequent periods under the terms of purchase agreements is included as acquisition costs.

 

The change in goodwill for the nine months ended September 30, 2006 and 2005 is as follows (dollars in millions):

 

 

In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, we test goodwill for impairment annually or more frequently if certain impairment indicators are present. Our impairment test is based on discounted cash flows derived from internal projections. For purposes of the impairment test, we consider each division a reporting unit. During the three months ended September 30, 2006, we determined that the challenging housing market and the asset impairments taken in certain of our homebuilding divisions were indicators of impairment. We performed an interim goodwill impairment test as of September 30, 2006

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

and determined that the goodwill recorded in our Colorado division was impaired; accordingly, we wrote off $5.7 million of goodwill.

 

Our impairment test is based on discounted cash flows derived from internal projections. This process requires us to make assumptions on future revenues, costs, and timing of expected cash flows. Due to the degree of judgment required and uncertainties surrounding such estimates, actual results could differ from such estimates. To the extent additional information arises or our strategies change, it is possible that our conclusion regarding goodwill impairment could change, which could have a material adverse effect on our financial position and results of operations.

 

 

In March 2006, we entered into an $800.0 million revolving credit facility. The facility has a letter of credit subfacility of $400.0 million. Loans outstanding under the facility may be base rate loans or Eurodollar loans, at our election. Our obligations under the revolving credit facility are guaranteed by our material domestic subsidiaries, other than our mortgage and title subsidiaries. The revolving credit facility expires on March 9, 2010. In addition, we have the right to increase the size of the facility to provide up to an additional $150.0 million of revolving loans, provided we satisfy certain conditions.

 

On October 23, 2006, we amended our $800.0 million facility as a result of a material adverse change that occurred with respect to one of our wholly-owned subsidiaries that held the investment in the Transeastern JV. This material adverse change was a direct result of the $143.6 million write-off of our investment in the Transeastern JV. This amendment changes our existing unsecured revolving credit facility to a secured revolving credit facility, which permits us to borrow up to the lesser of (i) $800.0 million or (ii) our borrowing base calculated in accordance with the amendment. The amendment changes certain definitions in the credit facility, provides for mortgage requirements on the borrowing base assets, provides interim borrowing limits until the borrowing base assets have been securitized and provides limitations on future investments in or advances to the Transeastern JV.

 

As of September 30, 2006, we had no borrowings under the revolving credit facility, had issued letters of credit totaling $307.8 million and had $465.8 million in availability, all of which we could have borrowed without violating any of our debt covenants. Included in the amendment are interim limits placed on the amount of borrowings and letters of credit we could have outstanding until all liens and security interests are filed on the borrowing base assets. Upon finalizing the amendment, our availability under the interim limits was $100.0 million from the amendment date through November 6, 2006, and $150.0 million after November 6, 2006, until the liens and security interests on the borrowing base assets are filed. Our availability under the amended credit facility would have been $492.1 million on October 23, 2006, had all liens and security interests been filed. We are currently in the process of filing all liens and security interests and anticipate completing this process by December 31, 2006.

 

Our mortgage subsidiary has the ability to borrow up to $200.0 million under two warehouse lines of credit to fund the origination of residential mortgage loans. The primary revolving warehouse line of credit (the “Primary Warehouse Line of Credit”) provides for revolving loans of up to $150.0 million. Our mortgage subsidiary’s other warehouse line of credit (the “Secondary Warehouse Line of Credit”), which was amended on February 11, 2006, is comprised of (1) a credit facility providing for revolving loans of up to $30.0 million, subject to meeting borrowing base requirements based on the value of collateral provided, and (2) a mortgage loan purchase and sale agreement which provides for the purchase by the lender of up to $20.0 million in mortgage loans generated by our mortgage subsidiary. The Primary Warehouse Line of Credit bears interest at the 30 day LIBOR rate plus a margin of 1.125% to 3.0%, except for certain specialty mortgage loans, determined based upon the type of mortgage loans being financed. The Secondary Warehouse Line of Credit bears interest at the 30 day LIBOR rate plus a margin of 1.125%. The Primary Warehouse Line of Credit expires on December 8, 2006 and the Secondary Warehouse Line of Credit expires on February 11, 2007. We

 

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are currently negotiating with our lenders to renew our existing Primary Warehouse Line of Credit. Both warehouse lines of credit are secured by funded mortgages, which are pledged as collateral, and require our mortgage subsidiary to maintain certain financial ratios and minimums. At September 30, 2006, we had $42.5 million in borrowings under our mortgage subsidiary’s warehouse lines of credit.

 

On April 12, 2006, we issued $250.0 million of 81/4% Senior Notes due 2011. The net proceeds of $248.8 million were used to repay amounts outstanding under our revolving credit facility. These notes are guaranteed, on a joint and several basis, by the Guarantor Subsidiaries, which are all of our material domestic subsidiaries, other than our mortgage and title subsidiaries (the Non-guarantor Subsidiaries). The senior notes rank pari passu in right of payment with all of our existing and future unsecured senior debt and senior in right of payment to our senior subordinated notes and any future subordinated debt. The indenture governing the senior notes requires us to maintain a minimum consolidated net worth and places certain restrictions on our ability, among other things, to incur additional debt, pay or declare dividends or other restricted payments, sell assets, enter into transactions with affiliates, and merge or consolidate with other entities. Interest on these notes is payable semi-annually.

 

In connection with the issuance of the 81/4% senior notes, we filed within 90 days of issuance a registration statement with the SEC covering a registered offer to exchange the notes for exchange notes of ours having terms substantially identical in all material respects to the notes (except that the exchange notes will not contain terms with respect to special interest or transfer restrictions). The registration statement has not been declared effective within the required 180 days of issuance and, as a result, the notes are subject to special interest which is accruing at a rate of 0.25% per annum during the 90-day period immediately following the occurrence of such default, October 9, 2006, and shall increase by 0.25% per annum at the end of each subsequent 90-day period, up to a maximum of 1.0% per annum.

 

 

We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS No. 109”). Under SFAS No. 109, income taxes are accounted for using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

 

During the three months ended September 30, 2006, we recognized a benefit for deferred income taxes as a result of the $143.6 million impairment recognized on our investment in the Transeastern JV, $4.8 million in inventory impairments on our joint ventures, $5.7 million in goodwill impairment and $35.8 million in inventory impairments. The net deferred tax asset included in other assets in the accompanying consolidated statements of financial condition at September 30, 2006 and December 31, 2005 was $74.5 million and $5.0 million, respectively.

 

As a result of the business operations of the Transeastern joint venture, coupled with tax planning available to us and our ability to generate future taxable income, we believe that it is more likely than not that we will be able to realize the tax benefits associated with the impairments discussed above.

 

 

We are involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters, excluding the Transeastern joint venture

 

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matter discussed below and in further detail in Note 4 above, is not expected to have a material adverse effect on our consolidated financial position or results of operations.

 

  Warranty

 

We provide homebuyers with a limited warranty of workmanship and materials from the date of sale for up to two years. We generally have recourse against our subcontractors for claims relating to workmanship and materials. We also provide up to a ten-year homeowner’s warranty which covers major structural defects. We also have a homebuilder protective policy which covers warranty claims for structure and design defects related to homes sold by us during the policy period, subject to a significant self-insured retention per occurrence. Estimated warranty costs are recorded at the time of sale based on historical experience and current factors.

 

During the nine months ended September 30, 2006 and 2005, changes in our warranty accrual consisted of (dollars in millions):

 

 

  One-Time Termination Benefits

 

During the nine months ended September 30, 2006, we recorded $7.1 million of one-time termination benefits and contract termination costs which are included in selling, general and administrative expenses in the accompanying consolidated statement of operations. The termination benefits related to employees that were involuntarily terminated and are no longer providing services. The contract termination costs related to costs that will continue to be incurred under consulting contracts for their remaining terms for which we are not receiving economic benefit.

 

  Liquidity

 

Our Homebuilding results reflect the continued deterioration of conditions in most of our markets throughout the three months ended September 30, 2006, characterized by record levels of new and existing homes available for sale, reduced affordability and diminished buyer confidence. The slowdown in the housing market has led to increased sales incentives, increased pressure on margins, higher cancellation rates, increased advertising expenditures and broker commissions, and increased inventories. We are responding to these situations by analyzing our sales positions and product mix in each of our markets, renegotiating takedowns under homesite and land option contracts, curtailing land acquisition, working with our suppliers to reduce costs and reducing our general and administrative expenses.

 

During the three months ended September 30, 2006, we evaluated our investment in the Transeastern JV and determined our investment in the joint venture was not recoverable based on the entity’s current financial structure combined with the deteriorating market conditions. As a result, we wrote-off our entire investment of $143.6 million. The write-off of our investment resulted in a material adverse change that required us to amend our $800.0 million revolving credit facility effective October 23, 2006. The amendment requires us to have liens and security interests filed on our borrowing base assets to secure the credit facility and limited our

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

availability to $100.0 million from the amendment date through November 6, 2006, and $150.0 million after November 6, 2006, until all liens and security interests have been filed. Our availability under the amended credit facility would have been $492.1 million on October 23, 2006, had all liens and security interests been filed.

 

As previously discussed in Note 4 above, we received Demand Letters from Deutsche Bank demanding payment under the Completion and Carve Out Guarantees. The Demand Letters allege that the Transeastern JV has failed to comply with certain of its obligations pursuant to the Credit Agreements. The Demand Letters allege potential defaults and that events of default have occurred under the Guarantees that have triggered our obligations to pay all of the outstanding obligations under each of the Credit Agreements. We do not believe that our obligations pursuant to the Guarantees have been triggered and we have formally disputed these allegations. We are in discussions with the Administrative Agent and the lenders concerning this situation. If it is determined that we have significant obligations under these guarantees, this could have a material adverse effect on our consolidated financial position and results of operations.

 

We believe that our financial position and availability under our credit facility will continue to provide sufficient liquidity to fund our operations and to withstand the current difficult market conditions and any potential liabilities arising from the Completion Guarantees and Carve Out Guarantees with lender approval. Additionally, we are currently in the process of filing all liens and security interests under the amended credit facility and anticipate completing this process by December 31, 2006, which will further enhance our liquidity.

 

 

Under the Technical Olympic USA, Inc. Annual and Long-Term Incentive Plan (the “Plan”) employees, consultants and directors of ours, our subsidiaries and affiliated entities, (as defined in the Plan), are eligible to receive options to purchase shares of common stock. Each stock option expires on a date determined when the options are granted, but not more than ten years after the date of grant. Stock options granted have a vesting period ranging from immediate vesting to a graded vesting over five years. Under the Plan, subject to adjustment as defined, the maximum number of shares with respect to which awards may be granted is 8,250,000. At September 30, 2006, there were 267,561 shares available for grant.

 

Prior to January 1, 2006, we accounted for stock option awards granted under our share-based payment plan in accordance with the recognition and measurement provisions of APB 25 and related Interpretations, as permitted by SFAS 123. Share-based employee compensation expense was not recognized in our consolidated statement of operations prior to January 1, 2006, except for certain options with performance-based accelerated vesting criteria and certain outstanding common stock purchase rights, as all other stock option awards granted under the plan had an exercise price equal to or greater than the market value of the common stock on the date of the grant. Effective January 1, 2006, we adopted the provisions of SFAS 123R using the modified-prospective-transition method. Under this transition method, compensation expense recognized during the nine months ended September 30, 2006 included: (a) compensation expense for all share-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all share-based awards granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. In accordance with the modified-prospective-transition method, results for prior periods have not been restated. Additionally, in connection with the adoption of SFAS 123R we recognized a cumulative change in accounting principle of $2.0 million, net of tax, related to certain common stock purchase rights that were accounted for under the variable accounting method. The pre-tax cumulative effect of the change in accounting principle of $3.2 million was not material and therefore was included in selling, general and administrative expenses with the related tax effect of $1.2 million included in the provision for income taxes rather than displayed separately as a cumulative change in accounting principle in the consolidated statement of operations. The adoption of SFAS 123R resulted in a charge of $10.7 million and $6.8 million to income

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

before provision for income taxes and net income, respectively, for the nine months ended September 30, 2006. The impact of adopting SFAS 123R on both basic and diluted earnings was $0.11 per share.

 

Under the provisions of SFAS 123R, the unearned compensation caption in our consolidated statement of financial condition, a contra-equity caption representing the amount of unrecognized share-based compensation costs, is no longer presented. The amount that had been previously shown as unearned compensation was reversed through the additional paid-in capital caption in our consolidated statement of financial condition.

 

In accordance with SFAS 123R, we present the tax benefits resulting from the exercise of share-based awards as financing cash flows. Prior to the adoption of SFAS 123R, we reported the tax benefits resulting from the exercise of share-based awards as operating cash flows. The effect of this change was not material to our consolidated statement of cash flows.

 

We estimate that we will record an additional $0.9 million of pre-tax expense in accordance with SFAS 123R for the remainder of the year ending December 31, 2006.

 

If the methodologies of SFAS 123R were applied to determine compensation expense for our stock options based on the fair value of our common stock at the grant dates for awards under our option plan, our net income and earnings per share for the nine months ended September 30, 2005 would have been adjusted to the pro forma amounts indicated below (dollars in millions, except per share amounts):

 

 

The fair values of options granted were estimated on the date of their grant using the Black-Scholes option pricing model based on the following assumptions for all of the years presented:

 

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Activity under the Plan for the nine months ended September 30, 2006 was as follows:

 

 

As of September 30, 2006, we had $4.6 million of total unrecognized compensation expense related to unvested stock option awards. This expense is expected to be recognized over a weighted average period of 2.2 years. The aggregate fair market value of options vested during the nine months ended September 30, 2006 was $1.1 million.

 

Our chief executive officer had the right to purchase 1% of our outstanding common stock on January 1, 2007 for $16.23 per share and an additional 1% on January 1, 2008 for $17.85 per share. On January 13, 2006, our chief executive officer’s employment agreement was amended primarily to grant him 1,323,940 options at an exercise price of $23.62 per share and provide for a special bonus award of $8.7 million in lieu of the common stock purchase rights.

 

 

Our operating segments are aggregated into reportable segments in accordance with SFAS 131 based primarily upon similar economic characteristics, product type and location. Our reportable segments consist of our four major Homebuilding geographic regions (Florida, Mid-Atlantic, Texas and the West) and our Financial Services operations.

 

We have historically aggregated our Homebuilding operations into a single reportable segment, but we have restated our segment disclosures to present four homebuilding reportable segments, described in more detail below, for the three and nine months ended September 30, 2006.

 

Through our four homebuilding regions, we design, build and market high quality detached single-family residences, town homes and condominiums in various metropolitan markets in ten states, located as follows:

 

Florida: Jacksonville, Orlando, Southeast Florida, Southwest Florida, Tampa/St. Petersburg

 

Mid-Atlantic: Baltimore/Southern Pennsylvania, Delaware, Nashville, Northern Virginia

 

Texas: Austin, Dallas/Ft. Worth, Houston, San Antonio

 

West: Colorado, Las Vegas, Phoenix

 

Evaluation of segment performance is based on the segment’s results of operations without consideration of income taxes. Results of operations for our four homebuilding segments consist of revenues generated from the sales of homes and land, earnings from unconsolidated joint ventures, and other income / expense less the cost of homes and land sold and selling, general and administrative expenses. The results of operations for our

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Financial Services segment consists of revenues generated from mortgage financing, title insurance and other ancillary services less the cost of such services and certain selling, general and administrative expenses.

 

The operational results of each of our segments are not necessarily indicative of the results that would have occurred had each segment been an independent, stand-alone entity during the periods presented. Financial information relating to our operations, presented by segment, was as follows (dollars in millions):

 

 

 

 

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Our outstanding senior notes and senior subordinated notes are fully and unconditionally guaranteed, on a joint and several basis, by the Guarantor Subsidiaries, which are all of our material domestic subsidiaries, other than our mortgage and title subsidiaries (the Non-guarantor Subsidiaries). Each of the Guarantor Subsidiaries is directly or indirectly 100% owned by us. In lieu of providing separate audited financial statements for the Guarantor Subsidiaries, consolidated condensed financial statements are presented below. Separate financial statements and other disclosures concerning the Guarantor Subsidiaries are not presented because management has determined that they are not material to investors.

 

Consolidating Statement of Financial Condition
September 30, 2006