Manufactured Homes

Presented by: Andre LodharRoy FernandesDavid StoreySarah Witol

Manufactured Homes

• Founded in 1975 with 2 retail stores• By 1987 possessed a network of 120 retail

outlets, all in Southeasters U.S.• Potential customers were those who could

not afford traditional housing, or were looking for a second home

• Customers were typically in the 18 to 40 age range who earned $20K per year or less

Manufactured Homes con’t

• Mobile home ranged in price and in size, but Manufactured Homes mainly sold the lower end units

• Behind the industry average of 30% sales to higher models, only achieving 20% of their volume but did not care

• Targeted low end market : – They felt that by fulfilling an essential housing need

sales were not affected by general ecomomic conditions

– Customers to work very hard to keep their primary residence

Porter’s 5 Forces

• Buyer Power– Many sellers of mobile homes, but has

targeted the low end market, thus price sensitivity is very important

– Manufactured Homes allows as little as a 5% down payment to take possession

– No real Brand Identity in the market– Buyers are concentrated in areas (close to

trailer parks)

Porter’s 5 Forces

• Supplier Power– Discounts based on volume purchases– Products are rather standardized (especially

low end mobile homes)– Market concentration in specific states– Manufactured Homes has the ability to

manufacture homes on their own incase the market outpaces supply

Porter’s 5 Forces

• Barriers to Entry– Capital requirements, to have stock of mobile

homes on hand– Distribution areas are concentrated, so high

competition in these areas already– Manufactured homes rely on their niche

market of low end homes, any other seller could go after that market

Porter’s 5 Forces

• Threat of Substitutes– Depreciation is high on the homes, selling and

moving to a different unit is expensive– Purchasers could walk away from their mobile

home (force the company to re-claim the home) and purchase a new one

– Clients could upgrade with Manufactured Homes as they sell different models

Porter’s 5 Forces

• Rivalry– Competitive advantage for Manufactured

Homes are their niche market of low end mobile homes, availability of financing with small down payments

– Concentrated strongly in the Southeastern USA where they have a strong presence with 114 outlets in 7 states

– Other sellers are concentration on more profitable higher end units

Porter’s 5 Forces

• Rivalry con’t– Strategic stakes are high due to re-

possession of homes where people have defaulted on payments, market specific

– Low exit barriers to retail outlets, but high barriers to those that manufacture the homes as well

Industry Direction

• Southeastern USA is the fastest growing market of mobile homes, due to the weather climate, availability of land

• Shifting towards higher end mobile homes• Net sales from 1986 are 54% higher than

a year earlier, sales in 1985 were 125% higher than the preceding year

• Southwestern states starting to experience higher concentrations as well

Current accounting

Cash + Other Assets = Liabilities + REt-1 + Salest - Expensest

Net worth

Home buyer makes a down payment and signs an installment contract with Manufactured Homes (assume purchase price of $100,000)

1. + 5 + 95 + 100

Cash Installment contract Sales

Receivable Revenue

2. - 90 - 90

Inventory COGS

3. + 5 - 5

Reserve for losses Bad debt

on credit sales expenses

Current accounting

Cash + Other Assets = Liabilities + REt-1 + Salest - Expensest

Net worth

Company transfers installment contract receivables to financial institution and receives cash:

1. + 95 - 95

Cash Installment contract

(Face value of note) Receivable

2. Record present value of participation income

+ 5 + 5 + 10

Cash Finance Participation Finance Participation

Receivable Income

3. Company records an expense of the estimate of customer prepayment and defaults

+ 5 - 5

Reserve for losses Credit loss

on credit sales expense

Method #2

• The cash from the bank is treated as a loan– The company transfers installment contracts with

recourse to bank– The company records present value of interest rate

differential (spread)

• Major advantage of this method is no estimating of credit losses required

• According to the SEC this is the method that should be used if estimating ability is poor

Method #2

= Liabilities +Cash + Other Assets = Liabilities + RE(t-1) + Sales (t) - Expenses (t)

1) Company transfers installment receivables to bank with recourse

95 (cash) 95 (loan)

2) Record present value of interest rate differential(recognize revenue only when cash is recovered)

5 (cash) 5 (finance participation revenue)

Net WorthAssets

Sales Analysis

(in millions) 1986 1985 1984

Net Sales 106.1 68.7 30.5Less: COGS 86.2 56.2 24.3

80% of SG&A * 18.2 10.9 4.7Provision for losses on credit sales 3.8 0.8 0.3Contribution to net income from sales (of new homes only) -2.1 0.8 1.2

*assuming that 80% of SG&A is related to the sale of new homes

The sales of new homes is not a significant contributor to Net Income!

Income

Two Primary sources of income:

• Sales of mobile homes

• Finance participation

Current accounting

Cash + Other Assets = Liabilities + REt-1 + Salest - Expensest

Net worth

Company transfers installment contract receivables to financial institution and receives cash:

1. + 95 - 95

Cash Installment contract

(Face value of note) Receivable

2. Record present value of participation income

+ 5 + 5 + 10

Cash Finance Participation Finance Participation

Receivable Income

3. Company records an expense of the estimate of customer prepayment and defaults

+ 5 - 5

Reserve for losses Credit loss

on credit sales expense

Red Flags• Estimates of credit losses: page 194 – 195

– Lower interest rates : • Increased refinancing• Shift in demand for Mobile homes to Conventional homes

– Increase in number of prepayments

– $2M write-off in Q4 1986 for increase in credit losses• Refusal of finance companies to refinance repossessions

– Provision for credit losses in 1986 = $3.8M (p.203 Note 7)

– Provision for losses in first 9 months = $318,539 (p.211)

– Suggest large Q4 adjustment of $3.5M

– Decrease in Finance participation income• increased cash sales• increased non-recourse sales• increased manufacturing sales• decrease in interest rate spread

Red Flags• P. 192 – Expenses appear to be misstated• P. 193 – Appears that major Q4 adjustments are being made

– company not estimating but looking back and adjusting in Q4

• P.196 – Subsidiary set up – MANH Financial Services Inc.– banks refusing to finance

– banks losing confidence in Manufactured Homes

• P. 206 Note 13 – Recognition of $180M debt which is not on the B/S• P. 208 – New item suggests that credit losses and prepayments are

a problem– selling installment contracts are becoming a problem

• P. 211 – small provision for losses in first 9 months of 1986 but large full year provision (P. 203)

Future Potential of MH

Investor Attractiveness Factors

• MH currently sells a product for which there is no clear demand

• Focused strategy targeted at profitable segment of the market

• Rapid Growth enabled via backing of large financial institutions (GE Credit, Prudential Insurance)

Future Potential of MH

However,

• Business of buying and selling homes does not appear to make money. The finance participation income is what drives the profits

• MH has a consistent operating cash flow deficit and is heavily leveraged

• Grim looking future due to limited room for error due to leverage and past accounting practices

Post-Case Highlights

• Loss of $4.5 million in the 4th quarter of 1987 resulting in a $0.8 million profit for the year.

• Loss driven by 300% increase in reserve for credit losses appears to have been forced by auditors

• Management blames on aggressive marketing program and conservative fiscal policy.

Post-Case Highlights cont..

• Upon disagreement of the auditors over 1987 interim statement credit loss estimates the company changed auditors.

• In effect, the auditor felt that MH was understating the provision for future losses on credit sales and thereby overstating earnings before income taxes.

Post Case Highlights cont…

• In 1988 the loss grows to $8.5 million for the year.

• Financial institutions were now refusing to accept the transfer of instalment notes seriously impacting the finance participation income.

• Customer defaults and pre-payments forced further increases in credit loss reserves.

• Severe cash shortage resulted from the operating losses and increases in repossessed homes inventory.

Post-Case Highlights cont…

• SEC announces investigation into MH’s accounting practices primarily focused on the apparent lack of ability to estimate credit losses and thus improperly recognize finance participation income.

• Stock price drops significantly after Barron’s publishes an article questioning MH’s accounting practices.

What Happened? (1988 figures)

Balance Sheet As Reported Restated

Current Assets 79,876$ 80,010$ Net finance participation receivable - non-current 20,131$ -$ Installment contracts receivables -$ 303,000$ Net property plant and equipment 6,748$ 6,748$ Deffered income taxes 3,534$ 3,534$ Other Assets 9,088$ 9,088$

Total Assets 119,377$ 402,380$

Current Liabilities 59,522$ 59,522$ Notes payable to finance companies -$ 303,000$ Other long-term debt 43,000$ 43,000$ Deferred finance participation income -$ 20,771$ Reserve for credit losses 12,975$ 9,063$ Stockholder's equity 3,880$ 32,976-$

Total liabilities and equity 119,377$ 402,380$

Debt Ratios (1988 figures)

As Reported Restated

Debt/Capital Ratio 86% 101%

unhealthily high value of borrowing gets worse

Debt/Equity Ratio 2642% -1230%

emphasizes the series of losses

Debt Ratios (1986 figures)

• If we include the 180 million in installment sales contracts sold with recourse mentioned in Note 13 as debt, we get a glimpse into the future:

As Reported Restated

Debt/Equity Ratio 477% 1753%

Questions ?