Hilltop Holdings - 10-Q quarterly report FY

AFFORDABLE RESIDENTIAL COMMUNITIES INC.
CONSOLIDATED BALANCE SHEETS
AS OF SEPTEMBER 30, 2005 AND DECEMBER 31, 2004
(in thousands, except share and per share data)
(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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AFFORDABLE RESIDENTIAL COMMUNITIES INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004
(in thousands, except per share data)
(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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AFFORDABLE RESIDENTIAL COMMUNITIES INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005 and 2004
(in thousands)
(unaudited)

(continued on next page)

The accompanying notes are an integral part of these consolidated financial statements.

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AFFORDABLE RESIDENTIAL COMMUNITIES INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005 and 2004
(in thousands)
(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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AFFORDABLE RESIDENTIAL COMMUNITIES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1.   Business, Basis of Presentation and Summary of Significant Accounting Policies

Business

Affordable Residential Communities Inc. (the “Company” or “ARC”) is a Maryland corporation organized as a fully integrated, self-administered and self-managed equity real estate investment trust (“REIT”) for U. S. Federal income tax purposes and is engaged in the acquisition, renovation, repositioning and operation of primarily all-age manufactured home communities, the retail sale and financing of manufactured homes, the rental of manufactured homes and other related businesses including acting as agent in the sale of homeowners’ insurance and related products, all exclusively to residents and prospective residents of our communities. We were organized in July 1998 and operate primarily through Affordable Residential Communities LP (the “Operating Partnership” or “OP”) and its subsidiaries, of which we are the sole general partner with an ownership percentage of 95.7% as of September 30, 2005.

On February 18, 2004, we completed an initial public offering (“IPO”) of approximately 22.3 million shares of our common stock at $19.00 per share (excluding approximately 2.3 million shares sold by selling stockholders) and 5.0 million shares of our preferred stock priced at $25.00 per share. The net proceeds to the Company from our IPO of common stock and preferred stock were $517.5 million before expenses. On March 17, 2004, we issued 791,592 shares of common stock pursuant to the underwriters’ exercise of their over-allotment option generating net proceeds to the Company of $14.0 million. In conjunction with the IPO, we also completed a financing transaction consisting of $500.0 million of new mortgage debt and the repayment of certain existing indebtedness (see Note 2).

Concurrent with our IPO and the financing transaction noted above, we acquired 90 manufactured home communities from Hometown America, L.L.C. (“Hometown”). The 90 acquired communities are located in 24 states and totaled 26,406 homesites. The total purchase price for these communities and related assets was approximately $615.3 million including assumed indebtedness with a fair value of $93.1 million. See Note 2 for a discussion of the Company’s 2004 acquisitions.

In September 2005, ARC’s board of directors authorized the sale of approximately 79 communities either at auction or through various negotiated sales (see Note 10). Giving effect to these proposed sales, as of September 30, 2005, we owned and operated 237 communities consisting of 49,491 homesites (net of 13,393 homesites classified as discontinued operations) in 21 states with occupancy of 87.5%. Our five largest markets for our continuing operations are Dallas-Fort Worth, Texas, with 13.0% of our total homesites; Atlanta, Georgia, with 10.0% of our total homesites; Salt Lake City, Utah, with 7.7% of our total homesites; the Front Range of Colorado, with 6.6% of our total homesites; and Jacksonville, Florida, with 4.6% of our total homesites. We also conduct a retail home sales business.

Our common stock is traded on the New York Stock Exchange under the symbol “ARC”. Our Series A Cumulative Redeemable Preferred Stock is traded on the New York Stock Exchange under the symbol “ARC-PA”. We have no public trading history prior to February 12, 2004.

Basis of Presentation

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America and in conformity with the rules and regulations of the Securities and

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Exchange Commission requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amount of revenues and expenses during the reporting period. Actual results may differ from previously estimated amounts.

The interim consolidated financial statements presented herein reflect all adjustments that are necessary to fairly present the financial position, results of operations and cash flows of the Company, and all such adjustments are of a normal and recurring nature. The results of operations for the interim period ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ended December 31, 2005. These financial statements should be read in conjunction with the financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004.

The accompanying consolidated financial statements include all of our accounts, which include the results of operations of the manufactured home communities acquired only for the periods subsequent to the date of acquisition. We have eliminated all significant inter-company balances and transactions.

Summary of Significant Accounting Policies

Rental and Other Property

We carry rental property at cost, less accumulated depreciation. We capitalize significant renovations and improvements that substantially improve asset quality and/or extend the useful life of assets and depreciate them over their estimated remaining useful lives. We expense maintenance and repairs as incurred.

Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives of the various classes of rental property assets are as follows:

We evaluate the recoverability of our investment in rental property whenever events or changes in circumstances indicate that the recoverability of the net book value of the asset is questionable. Our assessment of the recoverability of rental property includes, but is not limited to, recent operating results and expected net operating cash flows from future operations. In the event that facts and circumstances indicate that the carrying amount of rental property may be impaired, we perform an evaluation of recoverability in which we compare the estimated future undiscounted cash flows associated with the asset to the asset’s carrying amount to determine if an impairment adjustment is required. If this review indicates that the asset’s carrying amount will not be fully recoverable, we will reduce the carrying value of the asset to its estimated fair value. During the three months ended September 30, 2005, the Company designated 79 communities as being held for sale and performed a comparison of their carrying amount against their recoverability. Certain of these communities have expected net proceeds that are lower than their net book value and accordingly we recorded an impairment loss of $34.8 million to write down these communities to their estimated fair value as of period-end. These communities had lower than average occupancy and operating performance. No impairment losses were recorded for the same period in 2004.

Effective January 1, 2005, we changed our estimate of the depreciable life of our rental homes from 10 years to 3 years. Homes in our rental home portfolio will now be depreciated over three years of service to an estimated salvage value of 70%. This change was made to align the depreciable lives of our rental

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homes to our intent to sell homes from our rental home portfolio after a three-year period to reduce the costs of repairs and maintenance. This change in estimate did not have a material impact on our financial positions, results of operations or cash flows.

Discontinued Operations

The Company considers a community to be a discontinued operation when: (i) management commits to a plan to sell the asset, supported by a Board resolution granting approval to proceed with the sale; (ii) the asset is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such assets; (iii) an active program to locate a buyer and other actions required to complete the plan to sell the asset have been initiated; (iv) the sale of the asset is probable, and transfer of the asset is expected to qualify for recognition as a completed sale, within one year; (v) the asset is being actively marketed for sale at a price that is reasonable in relation to its current fair value; and (vi) actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn. In accordance with the guidance provided by Statement of Financial Accounting Standards, “SFAS”, No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we measure each of our assets held for sale at the lower of its carrying amount or fair value, less cost to sell at the balance sheet date and re-cast any applicable balances and corresponding liabilities related to the communities identified in all comparable periods presented. Depreciation of the assets held for sale, if applicable, is suspended at the date of the determination of discontinuance. Interest and other expenses attributable to the liabilities of the communities classified as held for sale continues to be accrued. The results of operations of the assets sold and those classified as held for sale are reported as discontinued operations for all periods presented. We recognize any estimated losses on the sales of communities in the period in which the properties are discontinued and recognize any resulting gains on the sales of communities when realized. A description of the facts and circumstances leading to the expected disposal, the expected manner and timing of that disposal, and, if not separately presented on the face of the balance sheet, the carrying amounts of the major classes of assets and liabilities included as part of the disposal group is disclosed in the notes to the financial statements. We disclose in the notes to our financial statements (and on the face of the income statement) the gain or loss recognized in accordance with SFAS No. 144 and, if applicable, the amounts of revenue and pretax profit or loss reported in discontinued operations. We disclose, if applicable, in the notes to our financial statements the segment under which the long-lived asset is reported.

Revenue Recognition

We recognize rental income on homesites and homes when earned and due from residents. Leases entered into by homeowner tenants for the rental of a site generally are month-to-month and are renewable by mutual agreement of the resident and us or, in some cases, as provided by statute. Leases entered into by home renters are generally one year in duration and are renewable by mutual agreement between the home renter and us. We defer rent received in advance and recognize it in income when earned. On lease with option to purchase contracts, we defer revenue recognition of all down-payments, supplemental lease payments and sales commissions until the point of sale, which generally is at the end of a lease term that typically has a duration of 24 to 72 months.

We recognize revenues from manufactured home sales when we receive the down payment, the buyer arranges financing, we transfer title, possession and other attributes of ownership to the buyer, and we have no further obligations to perform significant additional activities.

Restricted Stock Grants

We have included a charge of $10.1 million in general and administrative expense for the nine months ended September 30, 2004, representing the value of 530,000 shares of common stock that were granted on

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February 18, 2004 under our 2003 equity incentive plan and vested on the date of grant. We valued the shares at $19.00 per share, the price at which we sold shares in the IPO (see Note 2). In addition, during 2004 we granted 95,000 shares of restricted common stock that vest over five years. In June 2004, 42,500 of these restricted shares were forfeited and in October 2004, an additional 37,500 shares of restricted stock were forfeited pursuant to the terms of their issuance. During the nine months ended September 30, 2005, 3,000 of these shares vested. In April 2005, the ARC board of directors approved an award of 80,000 shares of common stock to Scott D. Jackson, the Company’s former Chief Executive Officer and current Vice Chairman, under the Company’s 2003 equity incentive plan. The shares granted vest over three years with 20,000 shares vesting immediately and 20,000 shares vesting on each of the anniversary dates until April 29, 2008. Vesting is subject to Mr. Jackson’s continued employment with the Company and may be accelerated in the event of death, a change in control, or termination other than for cause. Vested shares may not be sold by Mr. Jackson until the first anniversary date of vesting without the prior written consent of the Compensation Committee. All shares, vested and unvested, are entitled to receive dividends and to vote unless forfeited.

We have recorded the unvested portion of the 72,000 outstanding restricted shares as of September 30, 2005 as unearned compensation on the balance sheet and are amortizing the balance ratably over the vesting period. We recorded compensation expense related to restricted shares of $81,000 and $407,000 during the three and nine months ended September 30, 2005, respectively, as compared to $50,000 and $185,000 during the same periods in 2004.

We consider the number of vested shares issued under our 2003 equity incentive plan as common stock outstanding and include them in the denominator of our calculation of basic earnings per share. We also consider the total number of restricted shares granted under our 2003 equity incentive plan in the denominator of our calculation of diluted earnings per share if they are dilutive. We return forfeited shares to the 2003 equity incentive plan as shares eligible for future grant and adjust any compensation expense previously recorded on such shares in the period the forfeiture occurs.

Interest and Internal Cost Capitalization

We capitalize our interest costs (using our average cost of borrowings) and internal costs (using actual time spent and related costs) on development of long-lived assets from the date we begin substantive activities through the date we place such assets into service in accordance with SFAS No. 34, Capitalization of Interest and SFAS No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects,respectively. The long-lived assets on which we capitalize interest include general construction activities in our communities, manufactured homes and, in the case of the communities acquired, the cost of the vacant homesites we acquired on which we are making improvements and placing a manufactured home for rent or sale. No interest and internal costs were capitalized during the three months ended September 30, 2005 and interest and internal costs of $0.4 million were capitalized during the nine months ended September 30, 2005, as compared to $1.0 million and $2.2 million capitalized during the respective periods in 2004.

Goodwill

We account for goodwill in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. Goodwill represents the excess of the purchase price over the fair value of tangible assets acquired and liabilities assumed in the Reorganization completed on May 2, 2002. We periodically assess and adjust the value of our goodwill. For the three and nine months ended September 30, 2005, we recorded an impairment charge of $69.8 million to write-off our remaining goodwill (see Note 13).

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Accumulated Other Comprehensive Income and Comprehensive Loss

Amounts recorded in accumulated other comprehensive income as of September 30, 2005 represent unrecognized gains on our interest rate swap, which qualifies as a cash flow hedge and will be marked to market over the life of the instrument. Including these unrecognized gains or losses, our comprehensive loss for the three and nine months ended September 30, 2005 was $127.1 million and $161.2 million, respectively, compared with a comprehensive loss of $17.7 million and $58.5 million during the same periods in 2004.

Reclassifications

Certain prior year balances have been reclassified to conform to the current year presentation.

New Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, Share-Based Payment. SFAS 123R requires that compensation cost relating to share-based payment transactions be recognized in financial statements based on the fair value of the equity or liability instruments issued. We will be required to apply SFAS 123R as of the interim reporting period beginning January 1, 2006. SFAS 123R covers a wide range of share-based compensation arrangements, including options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. We do not expect the adoption of SFAS 123R to have a material impact upon our financial position, results of operations or cash flows.

2.   IPO and Acquisitions

IPO and Hometown Acquisition

On February 18, 2004, we completed our IPO of approximately 22.3 million shares of our common stock at $19.00 per share (excluding approximately 2.3 million shares sold by selling stockholders) and 5.0 million shares of our preferred stock priced at $25.00 per share. The net proceeds to the Company from our IPO of common stock and preferred stock were $517.5 million before expenses. On March 17, 2004, we issued 791,592 shares of common stock pursuant to the underwriters’ exercise of their over-allotment option generating net proceeds to the Company of $14.0 million. Concurrent with the IPO, we also completed the refinancing of $240.0 million of our mortgage debt and raised an additional $260.0 million of new mortgage debt. The new mortgage debt at the time of the IPO consisted of $215.3 million of ten-year fixed rate debt with an interest rate of 5.53%, $100.7 million of five-year fixed rate debt with an interest rate of 5.05% and $184.0 million of floating rate debt. Proceeds from the IPO and new debt were used to purchase the Hometown communities, repay our Rental Home Credit Facility and redeem the Preferred Interest issued by one of our subsidiaries (see Note 6 to the Company’s consolidated financial statements for the year ended December 31, 2004 as filed on Form 10-K).

On February 18, 2004 and subsequent dates thereafter, we acquired 90 manufactured home communities from Hometown. The 90 acquired communities are located in 24 states and include 26,406 homesites. The total purchase price for all the communities we acquired consisted of the following (in thousands):

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Our purchase price allocation is as follows (in thousands):

D. A. M. Portfolio Acquisition

On June 30, 2004, we acquired 36 manufactured home communities from D.A.M. MASTER ENTITY, L.P. The communities are located in 3 states and include 3,573 homesites. The total purchase price (including the costs of manufactured homes) was approximately $65.5 million, including assumed indebtedness with a fair value of $29.7 million. In addition to cash and the assumption of debt, this acquisition was funded through the issuance of Series “B”, “C” and “D” Partnership Preferred Units (“PPUs”), for proceeds totaling $33.1 million. All of the “D” series PPUs totaling $8.0 million were redeemed for cash on July 6, 2004. All of the “B” series PPUs totaling $7.5 million were redeemed on July 18, 2005 for cash of $2.5 million and notes payable of $5.0 million. See Note 3 for further discussion of the PPUs.

Our purchase price allocation is as follows (in thousands):

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We have prepared the following unaudited pro-forma income statement information as if the Hometown and D.A.M. acquisitions had occurred on January 1, 2004. The pro-forma data is not necessarily indicative of the results that actually would have occurred if we had consummated the acquisitions on January 1, 2004 (in thousands, except per share information):

Other Acquisitions

During the period from January 1, 2004 through December 31, 2004, in addition to the Hometown and D.A.M. portfolio acquisitions, we acquired six manufactured home communities from unaffiliated third parties for approximately $16.5 million in cash and $3.8 million in assumed debt. We accounted for these acquisitions utilizing the purchase method of accounting and, accordingly, have allocated the purchase price to the assets acquired and liabilities assumed based on estimated fair values at the date of their acquisition. We allocated the majority of the purchase price to the rental property and intangible assets, including customer relationships and leases intangibles. No acquisitions were made in the three and nine months ended September 30, 2005.

We have not presented pro-forma results of operations for the three or nine months ended September 30, 2004 as if these other acquisitions were made on the first day of 2004, as the effects of these other acquisitions are not material to our financial position, results of operations or cash flows for this period.

The table below summarizes all of our manufactured home community acquisitions for the period January 1, 2004 through September 30, 2005:

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3.   Common Stock, Preferred Stock and Minority Interest Related Transactions

On March 16, 2005, we declared a quarterly dividend of $0.3125 per share of common stock. We paid the total common stock dividend of $12.8 million on April 15, 2005, to shareholders of record on March 31, 2005. Also on March 16, 2005, we declared a dividend of $0.5156 on each share of our Series A Cumulative Redeemable Preferred Stock. We paid the total preferred stock dividend of $2.6 million on April 29, 2005, to shareholders of record on April 15, 2005.

On May 23, 2005, we declared a quarterly dividend of $0.1875 per share of common stock. We paid the total common stock dividend of $7.7 million on July 15, 2005, to shareholders of record on June 30, 2005. Also on May 23, 2005, we declared a dividend of $0.5156 on each share of our Series A Cumulative Redeemable Preferred Stock. We paid the total preferred stock dividend of $2.6 million on July 29, 2005, to shareholders of record on July 15, 2005.

On September 21, 2005, we elected to eliminate the dividend on our common stock for the quarter ended September 30, 2005. Also on September 21, 2005, we declared a quarterly dividend of $0.5156 on each share of our Series A Cumulative Redeemable Preferred Stock. We paid the total preferred stock dividend of $2.6 million on October 30, 2005 to shareholders of record on October 15, 2005.

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At September 30, 2005, minority interest consisted of 1,842,055 OP Units that were issued to various limited partners and 705,688 Series “C” PPUs issued on June 30, 2004, as part of the D.A.M. portfolio acquisition. Each OP Unit outstanding is paired with 1.9268 shares of our special voting stock (each a “Paired Equity Unit”) that allows each holder to vote an OP Unit on matters as if it were a common share of our stock. Each OP Unit is redeemable for cash, or at our election, one share of our common stock. During the three and nine months ended September 30, 2005, the Company redeemed for cash approximately 359,000 and 501,000 OP Units totaling approximately $4.6 million and $6.4 million, respectively. The Company also exchanged approximately 60,000 OP Units for shares of ARC common stock during the three and nine months ended September 30, 2005 for a total value of $0.6 million.

As of June 30, 2005, 300,000 Series “B” PPUs were outstanding. According to the terms of the Series “B” PPUs, in July 2005 the Series “B” PPU holders requested redemption of their units, and the Operating Partnership elected to repurchase them for approximately $2.5 million in cash and notes payable totaling approximately $5.0 million.

The Series “C” PPUs carry a liquidation preference of $25 per unit and earn cash distributions at the rate of 6.25% per annum, payable quarterly. The Series “C” PPUs can be redeemed at the option of the Operating Partnership for cash after the fifth anniversary of their issuance. Series “C” PPU holders can request redemption of their units after the two and a half year anniversary of issuance, at which time the Operating Partnership must redeem the PPUs or repurchase them with common stock, cash and/or a note payable, at the Operating Partnership’s option. As of September 30, 2005, we had accrued $183,773 of the Series “C” PPU preferred distribution, representing the portion of the preferred distribution earned by Series “C” preferred unitholders through that date.

We have recorded an equity transfer adjustment between additional paid-in capital and the minority interest in our consolidated balance sheet as of September 30, 2005 to account for changes in the respective ownership in the underlying equity of the Operating Partnership.

The following summarizes the activity of the minority interest in the Operating Partnership (in thousands):

4.   Rental and Other Property, Net

The following summarizes rental and other property (in thousands):

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We have capitalized interest and internal costs of zero and $0.4 million in the cost of land and building improvements and rental homes and improvements for the three and nine months ended September 30, 2005, respectively, as compared to $1.0 million and $2.2 million capitalized during the same periods in 2004.

5.   Notes Payable

The following table sets forth certain information regarding our notes payable (in thousands):