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Hovnanian Enterprises, Inc. (NYSE:HOV)

F4Q08 Earnings Call

December 17, 2008 11:00 am ET

Executives

Ara K. Hovnanian – President, Chief Executive Officer & Director

J. Larry Sorsby – Chief Financial Officer, Executive Vice President & Director

Paul W. Buchanan – Senior Vice President & Chief Accounting Officer

Brad O’Connor – Vice President and Corporate Controller

David Valiaveedan – Vice President of Finance

Jeffrey T. O’Keefe – Director of Investor Relations

Analysts

David Goldberg - UBS

Dan Oppenheim - Credit Suisse

Ivy Zelman - Zelman & Associates

Michael Rehaut - JP Morgan Securities, Inc.

Analyst for Nishu Sood - Deutsche Bank Securities

Megan Talbott McGrath - Barclays Capital

[Joel Locker - SBS Securities]

[Timothy Jones - Weselin & Associates]

[Alex Barron - Agency Trading Group]

James Wilson - JMP Securities

[Eva Young] - Private Investor

Operator

Thank you for joining us today for Hovnanian Enterprises fiscal 2008 year-end earnings conference call. By now you should have already received a copy of the earnings press release. However, if anyone is missing a copy and would like one, please contact Donna Roberts at 732-383-2200. We will send you a copy of the release and ensure you are on the company’s distribution list.

There will be a replay of today’s call. This telephone replay will be available after the completion of the call and run for one week. The replay can be accessed by dialing 888-286-8010, pass code 95838352. Again, the replay number is 888-286-8010, pass code 95838352. An archive of the webcast slides will be available for 12 months.

This conference is being recorded for rebroadcast and all participants are currently in a listen only mode. Management will make some opening remarks about the fourth quarter results and then open up the line for questions. The company will also be webcasting a slide presentation along with the opening comments from management. The slides are available on the investors page of the company’s website at www.KHov.com. Those listeners who would like to follow along should log on to the website at this time.

Before we begin, I would like to remind everyone that the cautionary language about the forward-looking statements contained in the press release also applies to any comments made during this conference call and to the information in the slide presentation. I would now like to turn the call over to Ara Hovnanian, President and Chief Executive Officer of Hovnanian Enterprises.

AA

Thank you for participating in today’s call to review the results of our fourth quarter and fiscal year ’08. Joining me today are Larry Sorsby, Executive Vice President and CFO, Paul Buchanan, Senior Vice President and Chief Accounting Officer, Brad O’Connor, Vice President and Corporate Controller, David Valiaveedan, Vice President of Finance and Jeff O’Keefe, Director of Investor Relations.

As you are well aware, the housing market remains challenging. Some of the obstacles we face today include rising unemployment levels, a steady stream of foreclosure, dwindling consumer confidence and continued disruptions in the credit and financial markets. This presents a very difficult backdrop for just about any industry today and makes for particularly hard times for home builders.

If you turn to Slide One, you can see the impact these factors have had on our full year results. We gave all this data and more in our press release which we issued yesterday so as we did in prior quarters I’m not going to review all of the data points but instead I’m going to focus on the key parameters driving our performance and the current market conditions as well as what we’re doing to manage through this current time.

Our results are reflective of the challenging market conditions that persist and have, in fact, deteriorated since we reported our third quarter earnings in the beginning of September. Our goal today is to maximize cash flow even at the expense of margins. We are happy in this environment to clear land off of our balance sheet as long as our cash flow is positive.

On Slide Two you can see that with that broad operating principal in mind, we generated $175 million of cash flow during the fourth quarter of 2008. Increasing and preserving our cash position is very much a focus with every decision we make today. We ended the year with $838 million in cash as you see in Slide Three. This was slightly above the guidance of about $800 million of cash that we gave on September 3rd.

The world has changed a number of times since the beginning of September but we were able to reach our cash generation targets. Looking forward, given the continued deterioration in the housing market, generating cash flow is clearly going to be more challenging. However, we will continue to move forward with projects when cash flow makes sense in order to maximize our liquidity.

Of note, we do expect to get our federal tax refund in February of ’09 for about $145 million. On Slide Four we show a breakdown of the 23,000 thousand plus lots that we have owned at the end of the year. Approximately 53% of those lots were 80% or more finished, 18% had between 30% to 80% of the improvement costs already in place, the remaining 29% were less than 30% finished.

Given the fact that more than half of the lots that we own are largely finished and our net contracts for ’08 were down 41% year-over-year we did not feel the necessity to spend a significant amount of cash on land development this year. We perform a lot recovery analysis to determine the amount of cash we can generate by building and selling a home on an owned lot. If we are unable to obtain a reasonable recovery of our land costs relative to the perceived long term value, we will mothball the community.

We will save that land until such time as the market improves and we can generate higher returns and more meaningful cash flow. So far, we have mothballed land in 54 communities. An additional 22 communities were mothballed during the fourth quarter, most of these were in California. The book value at the year-end of these communities was $550 million net of an impairment balance of $290 million.

For our option land, we continue to actively renegotiate, extend and modify land option take downs as well as walk away from others. Our operating teams regularly review each of the option contracts and renegotiate the lot price at the timing of take downs. We use a rigorous analysis and review the most current comparative information on sales and pricing for our market competition to predict potential absorption and pricing going forward.

We only move forward in taking down additional option lots when the terms have been successfully renegotiated to where the terms make a compelling economic case. In some conditions this includes assuming that the sales pace and price decline further. Before we take down a single lot it has to be personally approved by me.

Slide Five shows the declines we have seen in our owned and option lot position. As of October 31, total lots were down 67% from the peak that we reached in April, 2006. While we are currently focused on reducing our consolidated land supply, we’re cognoscente that at some point the market will hit bottom and banks will let more non-performing real estate assets and will mark the assets down to the levels that will allow them to move it off their books.

Our goal is to team up with joint venture partners to take advantage of the land prices that will inevitably become more attractive both directly and through the purchase of loans. We continue to have discussions with potential JV partners to establish ventures that would take advantage of land at the bottom of the market. Some of the names of the private equity and hedge funds that we are talking to today have changed from the ones we were talking to months ago.

Given the turmoil in the capital markets, some that were interested this past summer have stepped aside but, new interest have developed from others that have stepped forward. We are not ready to buy land today given the market dynamics but getting the venture structure set up ahead of time when we do see opportunities to buy land, we can move quickly. We’ll keep you updated on the progress in completing this joint venture structure.

Besides reducing our land supply, one of the other levers that we continue to pull is managing our SG&A costs. One of the largest components of this is the dollars for salaries and benefits for our associates. If you turn to Slide Six, you see that through the end of November, we’ve reduced our staffing levels by 65% from the peak level of associates in June of 2006. As our community count, net contracts and backlog continue to shrink, we will continue to right size our business based on the current activity that we are generating in each of our markets.

While we continue to make good progress in reducing the absolute dollars spent on SG&A, on the right hand of Slide Seven, you’ll see that our total dollars were down 26% year-over-year. The biggest challenge is with respect to the SG&A percentage of total revenues. This percentage has increased again in 2008 to 13.9%. For the fourth quarter, the percentage was even higher at 15.2% but that is slightly lower than the 15.6% or the 15.3% in the second and third quarters of ’08.

If you look at the left hand side of the Slide, you’ll see that our average SG&A costs has been about 11% over this period of time so we still have more work to do in order to lower our SG&A costs down to traditional levels. It’s been hard to cut SG&A as fast as our business has slowed down particularly when you look at the absorption levels we are achieving at a community level. We will likely not be able to get back to historical levels of SG&A until the sales pace per community returns to more normalized levels.

Slide Eight shows a 14 year history of net contracts per community. In ’08 we hit a new low with 18.3 net contracts per community. The average over this span was about 42 net contracts per community so we’re significantly below normal levels. If you look at a quarterly rate, on Slide Nine, you can see that the fourth quarter was below the pace of the second and third quarter and furthermore, sales in November continued to be weak and remain at even weaker levels.

It remains a very difficult environment out there. I’ll turn it over to Larry Sorsby to discuss gross margin and the charges we took in the fourth quarter as well as some other topics in greater detail.

LL

The slow homes sales pace and lower home pricing trends have dramatically decreased our revenues and adversely impacted our gross margins. Our gross margin has been in the single digits for the past couple of quarters as you can see on Slide 10. During the fourth quarter of 2008, our home building cost of sales was reduced by $41.7 million from the reversal of land impairments taken in prior periods.

The fourth quarter gross margin of 4.7% was lower than we anticipated primarily for a few reasons. First, we continued to be more focused on cash flow than on our margins. We’ve been aggressive on lowering home prices in order to spur sales activity. Second, when we walk away from lots in a community or adjust land development budgets where we have already delivered homes and continue to deliver homes, we need to spread the common costs over a fewer number of homes overall and over the homes previously delivered during the year which negative impacts our gross margins.

We walked away from 6,233 lots in the fourth quarter of fiscal 2008. The impact was meaningful in the fourth quarter because we needed to make adjustments for increased common costs for all deliveries that took place in every one of those communities for the entire fiscal year. Another of the reasons that our gross margin is low is that we were relatively aggressive on company and land acquisitions late in the housing cycle.

So, the land that we own is at a relatively higher basis when compared to today’s home prices. The good news here is that we don’t own as much land as some of our peers do on a comparable basis. If you turn to Slide 11, you can see how our owned land position stacks up to those of our peers. It is sorted according to owned land supply based on trailing 12 month deliveries. This is what I call the race to zero.

Even at a 2.2 year supply based on trailing four quarter deliveries, we still own more land than we would like to own right now but compared to our peers we are in relatively good shape. The good news is that each quarter we work through more of our owned land and we will eventually get through all of it and we’ll be able to replenish our land supply with lower cost land at the bottom of the housing cycle which will help our gross margins increase back to normalized levels.

Turning to Slide 12, you can see our land supply by our publically reported segments. I’d like to point out that our owned land position in the west which is entirely made up of California for us actually increased by about 1,300 lots this past quarter. However, we did not buy any new lots in California. This increase in lots is a result of us consolidating a previously unconsolidated land development joint venture after our partner was unwilling to pay his share of property taxes and reengineering costs going forward.

There was no debt associated with this joint venture and no further financial obligations required for us. Of course, we will have to continue to pay property tax on the land going forward. I want to reiterate that there was no new money put in to this land. We had already invested the money in the lots via our investment in the joint venture so we could have walked away too but we would have gotten zero dollars from the land had we walked away.

We believe that we can still sell the land for something with or without a house on it. So, we now own the lots outright and they are included in our consolidated lot count. While I’m on the topic of joint ventures, at October 31, 2008 we had invested $71.1 million in seven land development and 10 home building joint ventures. This is a significant decline in our investments in joint ventures and a $61.5 million of the decline is a result of the consolidation of our land development joint venture in California I just described.

This decrease combined with the write offs we’ve taken in our joint ventures has caused the leverage at our joint ventures to increase. Turning to Slide 13, our debt to cap of all of our joint ventures in the aggregate was 57%. We financed our joint ventures solely on a [inaudible] course basis. The facts speak for themselves, we are now three years in to this downturn and we have not had any margin or capital calls on any of the debt associated with our joint ventures.

We do not have any debt arrangements or guarantees at any of our joint ventures that require us to provide equity capital beyond our initial commitment to our joint ventures in the future. Unless we determine that it would be in our best economic interest, we don’t anticipate a need for us to voluntarily invest additional cash to support our joint ventures beyond the amount that was budgeted to be invested by the partners.

In some of our joint venture agreements we do have completion guarantees. However, in our largest joint venture with Blackstone there is no completion guarantee. Most of our joint ventures that do have completion guarantees are in advanced stages of construction and therefore the risk associated with completion guarantees are [inaudible]. At this point the majority of our joint ventures are in the latter stages of development and thus the amount of budgeted equity investment has largely already been made.

In fact, we expect to generate cash from our joint ventures as a number of them are in the wind down stage of delivering homes without significant additional development dollars needed. During the fourth quarter, we wrote down our equity investment in Hovstone, the joint venture we formed in March, 2005 with Blackstone to buy Town & Country Homes to zero. We are in the process of negotiating with the banks to restructure the Hovstone debt to allow us to build through the remaining land supply.

We report significant details on the balance sheet and profits of our unconsolidated joint ventures and our 10Qs and in our 10K so you can look there for more details. I’ll now talk about the land related charges that we took during the fourth quarter. We walked away from 6,233 lots in the fourth quarter and took a write off of $47.5 million related to these option lots. On Slide 14 it shows the geographic breakout f these charges which represent the amount invested in these options through option deposits and also any predevelopment dollars we had invested in getting this land through the approval process.

Our remaining investment and option deposits has also dropped dramatically from a peak of $466 million at the end of the second quarter fiscal 2006 to $69.9 million at October 31, 2008. $41.2 million of cash deposits and the other at $28.7 million deposits being held with letters of credit. Additionally we have another $91.8 million invested in predevelopment expenses.

The next category of pre-tax charges relates to impairments. As shown on the same Slide, we incurred impairment charges of $215.6 million related to land and communities that we own in the fourth quarter. This is significantly higher than the $80.2 million of impairment charges we took in the third quarter of 2008 and is indicative of continued downward pressure on home prices.

More than half of the impairments were on land we owned in California, a market that remains particularly difficult today. We test all of our communities at the end of each quarter for impairments whether or not the community is open for sale. If home prices continue to deteriorate, we will see additional impairments in future quarters.

Additionally, during the fourth quarter of ’08 we recorded $21.4 million for our portion of impairments, walk-aways and investments in our joint ventures. Looking at all of our communities in the aggregate including mothball communities, we have a book value of $2.2 billion net of $719 million of impairments which were recorded on 181 of our communities.

Turning to Slide 15, it shows our investment in inventory broken out in to two distinct categories: sold; and unsold homes which include homes that are in backlog started, unsold homes and model homes as well as the land underneath those homes. Secondly, land both finished lots and lots underdevelopment which are associated with all other owned lots that do not have a sales contract or vertical construction. We have reduced our total dollar investment in these two categories by 50% since our peak levels in July, 2006 and we plan to make further progress in reducing our inventories during 2009.

Turning to Slide 16, you can see that we also continue to reduce the number of started unsold homes. We ended the year with 1,275 started unsold homes which is a decline of 61% from peak levels of July, 2006. Another component of the impairments that we took during the fourth quarter was for our goodwill which was from acquisitions that we made in the Texas and New Jersey in 1999 and in Washington DC during 2001.

Each of these acquisitions had been solid profit producers through fiscal 2007. However, based on today’s environment and the accounting rules that dictate the impairment analysis for goodwill, we impaired the entire $32.7 million of remaining goodwill we had booked for these acquisitions years ago. During the fourth quarter we also impaired the remaining balance of our definite life intangibles which was only $2.7 million.

That leaves us with the last major area of charges for the quarter which is related to taxes and the FAS 109 current and deferred tax asset valuation allowance. We concluded that we should book an additional $169.5 million after tax non-cash tax asset valuation allowance during the fourth quarter. While our tax asset valuation allowance charge was non-cash in nature, it did affect our net worth by the same $169.5 million during the quarter and $625.3 million to date.

The FAS 109 charge was for GAAP purposes only and is a non-cash valuation allowance against our current deferred tax assets. If you add back the impact of this valuation allowance to our equity, our net debt to cap would have been 63.6% as of the end of the October quarter instead of 83.5% net debt to cap including the impact of deducting the valuation allowance. Looking at it without the FAS 109 allowance is a more accurate picture of our leverage compared to our peers because some builders have not yet been required to take the FAS 109 allowances.

Let me reiterate what I said on our conference call since this issue raised its head a year ago. The FAS 109 tax asset valuation allowance is for GAAP purposes only. For tax purposes our tax assets may be carried forward for 20 years and we expect to utilize those tax loss carry forwards as we generate profits in the future.

On the subject of our expectations to utilize these net operating loss carry forwards, NOLs, and built in losses, we recently approved two steps in a vote at a special meeting of shareholders two weeks ago that should decrease the likelihood that we would cause a change of control that would trigger the IRS Code 382. This has become a relevant topic with one of our peers recently commenting that they had triggered a change in control.

We have a reasonable ownership margin before we trigger an ownership change under Section 382 of the tax code and the steps that we just approved by shareholders should keep us out of harm’s way. Now, let me update you on the mortgage market and our mortgage finance operation.

If you’ll turn to Slide 17 with average FICO scores at 723, our recent data indicates that our average credit quality of mortgage customers remains higher than national averages. Turning to Slide 18, we show a breakout of all the various loan types originated by our mortgage operations during all of fiscal 2008 and compare it to all of fiscal 2007. Once again, the percentage of FHA/VA loans increased.

During the fourth quarter FHA/VA made up 50% of our volume and for the full year it was 36% of our total loan originations. Even though the availability of mortgage products has been sharply curtailed during the housing downturn, we still have more mortgage products available today than we did six or seven years ago but not as many as we did two years ago. The industry is going back to sound reasonable lending practices.

Buyers who have a decent credit history, can verify their job and have the ability to make a modest down payment will continue to have no issues obtaining approvals for loans. However, we did notice that even on loans that historically would have been approved before the advent of subprime and ALTA financing, today they must strictly adhere to all of the underwriting guidelines rather than be able to provide a compelling explanation on slight underwriting deviations and still be approved as previously was the case.

On Slide 19, you can see that our cancellation rate increased during the fourth quarter of 2008 to 42%. It had come down slightly for the first couple of quarters this year but has increased again as potential home buyers have become skittish by rising unemployment figures and the deteriorating economic environment. We ended the year with $838 million of cash and do not have any significant debt maturities coming due over the next four years.

On Slide 20, you can see that our debt maturities are well structured and our first debt maturity is not until January of 2010 and that one is only $100 million issue. After that, nothing comes due until 2012 and even then it’s only $249 million. In a proactive effort to reduce our debt outstanding, we lost a debt exchange offer late in October, 2008 and closed exchanged earlier this month.

While we did not capture as big of a discount as we would have had the exchange been fully subscribed, we did reduce our outstanding debt by $42.1 million and recognized ordinary income at $42.1 million as well, both of which are first quarter 2009 events. We did not undertake this exchange as a distressed proposition. We are pleased to have reduced our total debt and recognized the corresponding increase to our equity.

We look at this as a first step. We believe there are other initiatives that we can take to reduce our debt in the future. We intend to look at a number of options that are available to us including additional exchanges. Now, I’ll turn it back over to Ara for some closing comments.

AA

Over the long term we have faith that a equilibrium balance will be restored. Home building is a cyclical industry that overbuilds for a period of time and then must under build in order to absorb the oversupply. According to the Joint Center of Housing Studies at Harvard University, the long term growth rate of the US primarily household formations supports a substantially higher levels of home building activity than we are currently seeing today.

If you turn to Slide 21, you’ll see a table that uses some of the data from the Joint Center of Housing Studies at Harvard. You can see that the components for Harvard’s projections for long term housing demand driven primarily by household formations. Average long term demand is about 1.85 million homes per year. The projections of Moodys and [inaudible] Institute are very comparable.

Actual production including mobile homes ranged from about 1 million to 2.2 million during those same 10 years. While there is a cumulative over production based on this methodology from ’03 to ’07 compared to long term demand, the sharp drop off in housing production in ’08 has actually swung us in to a housing deficit from the long term demand perspective. The situation will worsen in ’09 at the current production rate.

This creates pent up demand and perpetuates the cycles that our industry is famous for. This of course is based on long term data. In the short term, in the current economic environment, people postpone forming new households, again creating longer term pent up demand. If you turn to Slide 22, you see a significant drop from 2002 to 2006 in the affordability index. This contributed to the housing problem that we are facing today.

This occurred primarily because house prices increased significantly during that period. A positive factor for recovery however at the moment is that affordability is now at the highest level its been in decades thanks to continued low rates and dropping home prices. If you turn to Slide 23, this shows you the details that go in to the calculations and I’ll just move right over to the right hand column that shows the October data adjusted for a 5.5% mortgage and actually in the recent days its dropped even lower than that.

The median priced home in October was about $182,000 and with a 5.5% mortgage that requires a monthly P&I payment of $826. That represents 16.3% of median income with compared to 25% that’s used in qualifying for the affordable housing index. The annual median family income is $60,840. Annual qualifying income is substantially less than that $39,638. That leads to an affordability index of 153. Again, among the most affordable housing conditions we have seen in decades.

If you turn to Slide 24, we show total housing starts over the last 37 years. There are many data points on this Slide that are interesting from a historical perspective but in the interest of time I’ll just point to the last two recent additions. First, you’ll see the dramatic reduction in new home starts, a critical component to reduced inventory and prepare for a recovery. The current production is at historic low levels, 625,000 homes per year is the current annual rate.

I think that is the most reduced level of housing production since World War II. Incidentally, some have said housing production should be zero right now to reduce the excess supply and as I showed you earlier, clearly demographically that’s not the case. The real problem is the lack of demand for fear. I’ll get more in to that in a moment.

Second, you’ll note the familiar pattern of falling house production driving the economy in to a recession which officially began in the beginning of ’08. That’s characterized on this chart by that grey cross hatched area. We’ve now officially been in a recession for four quarters. If you look historically there was one period where we had a consecutive string of quarters that was longer than that back in the early 1970s.

As an industry, we feel that the housing market and economy has deteriorated so significantly that government intervention is needed. A similar situation existed over 35 years ago in the 1970s. If you turn to Slide 25, you see a chart of some of the key metrics at that time. You go to the first column, housing starts, from ’72 to ’74 you can see that housing starts feel during that period from about 2.3 million starts per year to 1.3 million starts per year.

That, as if often does, drove GDP to a negative situation in 1974. The unemployment rate began to creep up from ’73 to ’74. The Dow Jones Industrial Average declined about 40% and in fact, peak to trough dropped more than 50% and that helped contributed to Consumer Confidence Index dropping precipitously from 116 to about 43.2. In the middle of the next year following this crisis situation, housing stimulus was introduced.

It was a two pronged stimulus of both tax credits and reduced mortgage rates. Unfortunately, it came too late in the year to help the slide of housing starts, they fell to 1.1 million and real GDP continued to be negative as the recession strung on for six quarters. Unemployment shot to 8.5% however, it did change attitudes and confidence. The Dow recovered back to 850, consumer confidence shot all the way up to 94%.

The housing stimulus lasted a very brief time however, if you look at the next few years the positive effects continued on for years. Housing starts increased dramatically in ’76 to 1.5 million and then hovered around 2 million for the next couple of years, GDP went positive as the housing recovery pulled the entire economy up with it, unemployment dropped every single year for the next several years, the Dow steadied, consumer confidence steadied and interestingly existing homes sales increased dramatically.

Now, in the recent years we’ve seen a similar condition of dropping housing starts. In fact, we have to update this Slide because the most recent housing start data was 625,000 starts per year on an annualized basis based on the November data. Our GDP is negative as you know, unemployment is creeping up, the Dow has gone down in a very significantly way and consumer confidence has dropped significantly similar to the period in 1970s. And finally, existing home sales are dropping dramatically also.

A coalition was recently formed called Fix Housing First. It is composed of both home builders and suppliers as well as non-housing related groups like the National Association of Manufacturers, the Business Roundtable, various Chambers of Commerce across the company, not for profit housing agencies, although almost everybody in housing can be called not for profit today, and many others. It is a very broad constituency that understands that housing is the root cause of our economic problems today.

In addition to endorsing various forms of foreclosure prevention, the coalition is calling for a two pronged stimulus similar to what worked in 1975, a combination of tax credits for home purchasers and lower mortgage rates. The specifics of the proposal are summarized on Slide 26 along with a comparison to the ineffective attempt at housing stimulus that was passed in July of this year.

The first component is a $10,000 to $22,000 tax credit based on the Fannie Mae, Freddie Mac conforming loan limits for all home buyers, first time home buyers, move up home buyers, active adult move down home buyers, etc., on any new or used home. One limiting factor is that these tax credits would only be for primary residence it would not apply for investors or second home purchasers.

The timing of this tax credit is equally important as we’d like to see the tax credit be able to be monetized simultaneous with the closing. The second component is a mortgage rate buy down. Our proposal is that if you buy a home in the first six months of the program you’d get essentially a 3%, 30 year fixed rate mortgage and if you bought a home in the second six month window you’d get essentially a 4% 30 year fixed rate mortgage.

Declining home prices are what caused much of the financial and economical turmoil that we are faced with today. There is not a bridge, road or infrastructure today, we have a housing and a housing finance crisis and if the government wants to enact a stimulus policy that will get to the root cause of the problem, they need to fix housing first.

Overall, long term demographic trends are strong but buyers are just sitting on the sidelines today given the downward spiral of home prices and the economic turmoil. We’re confident that a housing stimulus similar to what was enacted and was successful over 35 years ago can halt the falling home values and restore the housing market and confidence as well as the entire economy back to normal conditions as it did back in 1975.

More importantly, for our future success we believe Hovnanian Enterprises has the liquidity to ride through this difficult environment. By sticking to our long term strategies of offering a broad product array and maintaining a presence in many markets that will once again present opportunities as the industry rebounds, we feel that we will be very well positioned to participate in the eventually recovery.

Obviously the fact that a huge portion of the private home builders will have gone out of business during this severe cycle will help those builders that remain to participate in the inevitable recovery. That concludes my comments and I’d be please to open up the floor for questions.

Question-and-Answer Session

(Operator Instructions) Your first question comes from David Goldberg – UBS.

David Goldberg - UBS

I’m trying to get an idea given where the backlog is now as you guys look forward into fiscal ’09 the ability to generate free cash flow based on where you are on a backlog perspective now, how are you thinking about it? And I guess that includes maybe, are you going to be bringing down a level of unsold inventory further in your plans?

Ara K. Hovnanian

Larry, do you want to address that?

J. Larry Sorsby

As we said in the release, cash flow generation is going to be a little more challenging as conditions have continued to deteriorate out there in terms of pace and sales price. Having said that, our focus remains on cash flow generation even at the expense of margins and yes, as we shrink communities you’ll see our started unsold levels come down.

We think they’re at appropriate levels given the community count right now David because you’ve got to have two or three started unsold homes at a community level. Many people wait to buy a home until they’ve actually got theirs sold so they want to get into something relatively quickly. Some of the low-hanging fruit has been taken away and we won’t be able to reduce it nearly as much as we did in 2008 but we will expect to reduce started unsolds somewhat during 2009.

David Goldberg - UBS

Ara, you mentioned in your opening comments about maybe some changes in the kind of firms that were interested in looking at joint ventures or partnerships. Can you give us some more color about what kind of firms you’re talking to now, maybe what kind of return requirements they would be looking at relative to the deal that you described a couple calls ago? That seemed like it was going forward and obviously without the land opportunities maybe that stalled it. But how it differs now and maybe what your partners are looking for relative to what they had been looking for in terms of return and in the way they want to participate?

Ara K. Hovnanian

As you can imagine there was a lot of turmoil in September, October and November in the financial markets. Some firms were very affected, some were not so affected, and some had an actual improvement in their position in appetite. I think it just changed the players. It didn’t necessarily change the type of players although maybe to some extent we’re seeing a little more interest in the private equity capital versus the hedge funds. But suffice it to say we feel there are plenty of interested parties out there; enough for us to meet our needs.

We haven’t felt a huge pressure as I’ve been saying for the last couple of calls to finalize a transaction, frankly because we just don’t see the land opportunities just yet. We think they will come up in ’09 but it’s not as though we have 20 deals that we’re waiting to find a partner on. We don’t at this moment. However we’ve been around for 50 years; we’ve been through these cycles every time; we know we have to be patient.

Overall the return criteria really hasn’t changed that much. Overall they’re looking for a mid-20s kind of IRR and based on our 50-year history we think that’s very achievable particularly in buying property at the bottom of the market place.

David Goldberg - UBS

And it’s still going vertical within the JVs?

Ara K. Hovnanian

Yes, that is still the plan.

Operator

Our next question comes from Dan Oppenheim - Credit Suisse.

Dan Oppenheim - Credit Suisse

I was wondering if you can talk about regionally the way you’re looking at the impairments, the Northeast region being the most significant in terms of your asset base had a fairly low level of impairments after not having any impairments last quarter. I’m just wondering if you can describe how you’re looking at that and how much of the land in the Northeast is raw land versus developed lots?

J. Larry Sorsby

The first comment I’d make is we don’t have a different way of looking at impairments geographically. The calculations are done in an identical manner regardless of whether it’s West Coast, East Coast or Texas. There’s no difference in how the calcs are done.

Ara K. Hovnanian

Basically every time we do the exact same thing; we look at current house prices; we look at current pace; if the community is not open yet, we do it based on the best comparable sites from our competitors; and we run the analysis. The reality is the New Jersey market has not been as nearly affected as many other parts of the country including Florida or California or Phoenix. We’re not in Nevada but certainly that has been a very affected market place. So based on our calculations we just haven’t had to take as many impairments in that market place.

Operator

Our next question comes from Ivy Zelman - Zelman & Associates.

Ivy Zelman - Zelman & Associates

Obviously it’s a challenging market and you’re doing what you can to generate cash flow which is the key to understanding that strategy. At the same time your margins are going down as a result of that strategy.

When I’m thinking about it, as you look outward and you have a likelihood with further price deflation as a strategy to generate that cash flow, clearly the risk is that you’re going to have more impairments because you do not as you say forecast future price deflation. At least that’s what you said I think in one of the prior conference calls. I guess I conclude that your current stated book value of $330 million or roughly $4.25 could actually be downward pressure of significance to the point where there’s no equity value left.

Looking at it from a long-term perspective as a shareholder or a potential shareholder where you’ve got all this leverage with eroding equity which arguably can go to zero, how should we think about the viability of the future or what value do we place on Hovnanian because the equity value in essence could go to zero?

Ara K. Hovnanian

There is no question from traditional balance sheet metrics we’re highly levered and likely if the market continues to deteriorate that we’ll be more highly levered in the next quarter if the market goes down further and we do more current impairments.

On the other hand, the good part of our balance sheet is we have a lot of cash handy and fortunately don’t have a lot of short-term maturities. We do think, and obviously as you know the equity you are quoting doesn’t take into account the FAS 109 adjustments, the good news is over the many years before our maturities come due we think it’s highly likely the market is going to correct and get back to a normal semblance of order and that we will see velocities on a per community basis improve that will have a dramatic affect on margins. Not only the velocity but obviously we think pricing will stabilize and ultimately will continue to go up which will also affect both our margins and our ability to generate cash flow.

In the meantime our plan is to do new communities and acquisitions in joint ventures that will preserve our cash yet give us access to some very good returns particularly from a return on investment standpoint. So our strategy is to preserve cash in new properties by using joint ventures, continue to generate cash and the plan is that as we get profitable obviously we’re not going to be paying taxes for a long time. When we get back to making $2 million we’ll keep all of the $2 million and keep adding to our reserves there.

We think in short order we’ll be able to restore our balance sheet to normal levels. Without a doubt, for a while however, we’ll just be operating with the excess cash that we have and from the traditional metrics of book value, we’re not going to be in as good of a position.

Ivy Zelman - Zelman & Associates

Looking at your deliveries for 2008 you had approximately 10,600 deliveries roughly and obviously down 22%; your contracts for the year running down 34% or net contracts down 41%. The cash flow you’ve generated this year, the sustainability of cash flow generation and thinking about not only the lack of investment to put in the ground so that can obviously help the cash flow by not having to put new monies in the ground, but there is a working capital need to go vertical and make payroll and continue to pay subcontractors, etc.

Can you walk us through sort of a quick back-of-the-envelope 101 model on how you in fact can continue to generate cash flow per unit if closings are going to go down considerably in sort of a similar fashion in 2009 as they did in maybe 2008, because I think clearly you’ve admitted that the SG&A as a percent of sales continues to go higher even though dollars are going potentially down and home price deflation as part of the strategy is going to be apparent?

So there’s a lot of concern that cash burn will be maybe greater than you may think so despite having over $800 million right now, you will have working capital needs, you will have a possibility that the decline in the P&L in terms of unit volume, etc. will be more significant than maybe you hope it would be. I just want to see how you guys can walk us through getting more comfortable that there won’t be this cash burn while you’re in this unfortunate tough environment.

Ara K. Hovnanian

Just for a few points, in our most recent quarter we just ended we obviously did have lower delivery rates than earlier quarters or earlier years certainly. We did generate $175 million of positive cash flow and there was not a tax refund in there. We do expect in February a significant tax refund of $145 million in that quarter. From the SG&A standpoint we continue to make very significant reductions there. It is challenging given the low velocity per community but we are taking some very significant steps.

Ivy Zelman - Zelman & Associates

Sorry to interrupt you. Is there a number per community that you can get back to where you can say the bleeding would stop and maybe gross margin deceleration or erosion would stabilize? If you got back to two houses per month per community, would that be a good number? Or is it three? Is there some kind of basis that you start to see [inaudible].

Ara K. Hovnanian

Our historical average has been 42. Right now we’re running under 18. I think if we could get to the 30s I think we could do a huge improvement in SG&A on the community level. We haven’t done a specific analysis. It’s obviously very different in each location and how many models do you have, what’s the price range and is it an advertising rich market or a broker rich market? All of those things make a big difference.

The other thing I wanted to add is as we mentioned we do have 53% of our lots largely developed. When you have 23,000 lots that somewhere in excess of 12,000 lots at the slower pace where we’re building today that means we’re not sinking a lot of land development dollars into our balance sheet. While vertical does take some cash flow, that is cash flow that turns relatively quickly compared to land development. You do expend dollars out to build a house but then as you close it 90 or 120 days later that cash flow comes back.

Having said all of that, clearly in spite of the fact that we had a very positive cash flow quarter in our most recent quarter of $175 million overall we’d expect ’09 to be a challenging environment. But we’re continuing to be bold in necessary price reductions without regard to margins at the moment to favor cash flow generation. Obviously we’d love to see the margins hold but given a choice of high margins and not having cash flow or getting cash flow, we’re erring on the side of cash flow and moving forward on that basis.

Operator

Our next question comes from Michael Rehaut - JP Morgan Securities, Inc.

Michael Rehaut - JP Morgan Securities, Inc.

Going back to the gross margins for a second, you kind of went through some of the drivers there but I was wondering with the impairments that you’ve taken and the communities where you have taken impairments, what is the margin post-impairment on average?

J. Larry Sorsby

I don’t know if there is an on average there but roughly when you do the calc you get back to kind of half the normalized margin, maybe a little less. A normalized margin for us is around 20% or 21% so 10% or a little less than that is in the ballpark though it varies on a number of factors. It’s not that clean.

Michael Rehaut - JP Morgan Securities, Inc.

When we started this process or cycle a couple of years ago, I think in general the builders were more talking about putting it back to a normalized gross margin or something a little bit less than that. Has there been a shift in your approach from an accounting perspective that has driven that reset margin so to speak.

J. Larry Sorsby

No, we haven’t shifted and you’ve never heard us say and I don’t believe other than maybe one public homebuilder do they get back to something close to normalized margin when they’re impairing based on the public data that we’ve reviewed. But we’ve not shifted our approach through the last three years on how we do impairments.

Michael Rehaut - JP Morgan Securities, Inc.

Then just the difference between those communities where you’ve taken the impairment and you’re getting for argument’s sake a 10% gross margin, the difference between that and the number that you put out in the fourth quarter, if you could just try to give us an order of magnitude of what drove that this quarter in terms of the specs that you’re working through and some of the other maybe timing of certain communities and directionally speaking over the next quarter or two, do you expect it to stay sub-5% or maybe get closer back to where you were in the first half of ’08?

Brad O’Connor

One of the things to keep in mind when you talk about the margins for the quarter and the communities that previously have been impaired, they were impaired and they would have generated those prices the margins that Larry was talking about; 10% or 11% or 12%, whatever it might be; but prices have continued to fall as we’ve talked about throughout this quarter which then until they fall enough in those particular communities to re-impair, those communities have lower margins.

That’s why you’re not seeing us trending at double-digit margins. Even though we’ve taken these large impairments, there’ve still be further price declines on those communities. They have not re-impaired yet.

The other thing that happened in the fourth quarter is with the walk-aways as Larry described in his script earlier, there are adjustments that are made just in the fourth quarter at the time that we walk away from communities we have fewer homes to write off common costs over and there were some significant adjustments in certain communities where we took walk-aways in this quarter that also caused an adjustment in the fourth quarter.

So I wouldn’t expect it to be sub-5% in the first quarter necessarily unless prices continue to decline. But it’s hard to say where they’ll be given the uncertainty in the market.

Operator

Our next question comes from Analyst for Nishu Sood - Deutsche Bank Securities.

Analyst for Nishu Sood - Deutsche Bank Securities

You mentioned in the past that your maintenance covenants are pretty much substantially eliminated, you’ve got significant cash on the balance sheet, your larger debt maturities aren’t till 2013 so it seems like you could probably get by without doing a debt-for-equity exchange or something like that. I just wanted to see what else is going on here in terms of if your leverage ratio worsens significantly, is that going to trip some other covenant?

J. Larry Sorsby

There’s no covenant that gets tripped because your debt-to-equity ratio increases.

Analyst for Nishu Sood - Deutsche Bank Securities

Is it possible for you to give us some color around how much debt you’d be looking to retire or things like that?

J. Larry Sorsby

Eventually all of it.

Analyst for Nishu Sood - Deutsche Bank Securities

With the exchange.

J. Larry Sorsby

I think we’re not going to be able to give you much more color than we put in the release and in the conference call script. We’re exploring various alternatives including additional exchanges going forward and as we actually decide to pursue one strategy to the other and have success, we’ll certainly let you know.

Operator

Our next question comes from Megan Talbott McGrath - Barclays Capital.

Megan Talbott McGrath - Barclays Capital

I wanted to follow up on your comments around mothballing land and get maybe some practical details of your decision to do that. Could you share with us what the carrying costs are that you continue to have on that mothballed land and therefore the decision to maybe sell that land or keep it on the books? Secondly, I’m just curious if most of that mothballed land is in formerly active communities that are now mothballed or communities that had never gone active?

Ara K. Hovnanian

I’d say most of it is in formerly active communities. We stated it’s about $500 million of book value so you can apply our average cost of capital to figure out what the interest cost and carrying cost is of that.

J. Larry Sorsby

Plus property taxes obviously.

Megan Talbott McGrath - Barclays Capital

Just a follow-up question on the gross margin. Do you have a number for the impact of that true-up in the quarter from those adjustments for common costs?

J. Larry Sorsby

I do not.

Operator

Our next question comes from [Joel Locker - SBS Securities].

[Joel Locker - SBS Securities]

On the minimum attainable net covenants, do you guys have any for senior bonds that could force early redemptions?

J. Larry Sorsby

No.

[Joel Locker - SBS Securities]

So there’s none outstanding at all?

J. Larry Sorsby

Right.

[Joel Locker - SBS Securities]

On the interest payments, obviously the interest expense was $18.7 million, up $8 million or so from the third quarter. I just wanted to know what a good rate was for modeling going forward.

J. Larry Sorsby

We probably modeled the incurred. I’m not so sure you have a shot at modeling the expense.

Brad O’Connor

Just to explain the expense. Interest expense is in two line items on our income statement. One of them is in cost of sales interest and the other is in that other interest line item. The other interest line item is growing because we cannot capitalize as much of the interest that we’re incurring as our assets. As our inventory goes down you can only capitalize on qualifying assets and inventory is declining. So that’s why we’re expensing directly more of the interest. That’s what’s happening. You could assume that as our inventory continues to go down that other interest line item is going to continue to go up.

[Joel Locker - SBS Securities]

Is there a certain percent or is there any kind of guideline you could give us to try to model it?

J. Larry Sorsby

Not really on the expense side. Obviously you have a pretty good shot at modeling the incurred side but I can’t give you a percent that’s going to work from a rule of thumb perspective on the expense side for precisely the reasons Brad just enumerated.

[Joel Locker - SBS Securities]

The accrued interest went up around $29 million year-over-year on the balance sheet. I was just wondering if you could give a little color on that.

J. Larry Sorsby

It’s the timing of the payments for the $600 million notes that were issued in May. The first payments are due in November. We didn’t have that last year so when you compare the two years, that’s the primary difference.

Operator

Our next question comes from [Timothy Jones - Weselin & Associates].

[Timothy Jones - Weselin & Associates]

Can you give me the specs that you had last year compared to the 1,275 you had this year?

J. Larry Sorsby

I think in the graph we put it there.

[Timothy Jones - Weselin & Associates]

I’m listening on the phone so I didn’t have the graph on.

J. Larry Sorsby

2,390 and then there’s another year’s back further than that if you want too.

[Timothy Jones - Weselin & Associates]

I’ve been listening to what you’ve done on the graphs and I commend you. I think that’s very important.

The other question is you take out the dollar value of your backlog to the homes under construction; in other words, subtract the backlog from the homes under construction on the balance sheet. I know there are timing differences but the differential stays around $580 million last year and $540 million this year so it’s gone from roughly about 80% to 60%. What I’m wondering is that a function of how the houses are being completed or what’s going on there that your homes in backlog are declining as opposed to your inventory of homes under construction?

J. Larry Sorsby

I haven’t done the analysis that you just went through but a big change is Fort Myers year-over-year. If you’ll recall, we spent a good deal of time talking about this on prior conference calls but we had a proposition in Fort Myers to where we had a lot of homes in backlog that couldn’t close even though technically the customer had title to them until we had no ongoing involvement. I think it was in our January quarter of 2008 we closed 1,300 of those. So that would have been in the fourth quarter of ’07.

If you take out those 1,300 and then do the calc that you’re describing, perhaps it’s closer or something. I’ve just not done the calc that you have but that’s what comes to mind. I think it may be Fort Myers. Nothing else has really changed.

Operator

Our next question comes from [Alex Barron - Agency Trading Group].

[Alex Barron - Agency Trading Group]

As far as your margins, I realize they’ve been pretty low and as I compare them to other builders, I’m just trying to understand. Is there a difference in impairments or do you think it’s more a function of the business model of taking down more option lots?

J. Larry Sorsby

I think it’s a combination of things. Again I think perhaps we’re a little more focused on cash flow. We’ve been more aggressive on lowering home prices perhaps faster than some of our peers has had an impact. I think it’s also that where we’re more aggressive in buying land at the absolute peak of the market and buying companies at the absolute peak of the market has an impact on that.

Obviously this fourth quarter impact to where we walked away from options and had to incur costs over the other homes that were delivered during the entire fiscal year just during our fourth quarter kind of skews the number and because we were heavier users of options I don’t think our peers have that same kind of impact that we would have had in that quarter.

There might be one or two of our peers that are more aggressive in their calculations of impairments than we are but we think we’re right in the middle of the pack on how we actually do the impairments. I don’t think that has as much of an impact but it could have some impact.

Then I think we have a disproportionate percentage of our assets in some of the markets that have been harmed the most during this cyclical downturn; California, Arizona, Florida have had huge hits. If you look at our percentage of assets in those markets starting out this downturn compared to some of our peers’ percentage of assets, I think that might be a big part of the explanation.

[Alex Barron - Agency Trading Group]

I was also wondering if you have the number of what the benefit was to gross margins this quarter from previous impairments?

J. Larry Sorsby

I think I said it. $41.7 million.

Operator

Our next question comes from James Wilson - JMP Securities.

James Wilson - JMP Securities

I just have one follow-up question on the margin topic. Larry, was there any material difference or either change or absolute level differentiated by region? I know you obviously just highlighted that you’ve been impacted almost everywhere but anything stand out where the margins are a lot different or the change has been a lot different in the last few months?

Ara K. Hovnanian

In general the margins in Florida and California have been particularly lousy.

James Wilson - JMP Securities

I guess if you could sum it up, that’s just gotten that much worse then the last few months? Is that a fair statement?

Ara K. Hovnanian

I think that may be fair.

James Wilson - JMP Securities

Since you’re in Texas and other places, any places that have held up better including the Northeast over the last few months?

Ara K. Hovnanian

In general on the margin front Houston has held up better but on the volume front in recent months Houston is definitely feeling the effect of the national slowdown as well. Up until that point that had been our strongest market.

Operator

Our next question comes from [Eva Young] - Private Investor.

[Eva Young] - Private Investor

Did you or are you giving any specific guidance as to where you think cash might be at the end of the coming quarter January 31 and any kind of range where cash might be next October 31?

J. Larry Sorsby

No, we’ve not publicly made a projection on either of those at this point.

[Eva Young] - Private Investor

In general should we expect it to be down? Is that what I should get from the various comments you’ve made?

J. Larry Sorsby

We just haven’t made a public projection about it. I don’t think we’ve said anything that gave you a clear picture whether we expect to be up or expect to be down. I will say on a historical basis that the first quarter is typically a quarter in which we are the weakest in terms of cash flow and if you want to use history to predict the future, that’s a decision you can make in your own modeling. But we’ve given no guidance.

Ara K. Hovnanian

And I think that’s pretty consistent with all the public homebuilders right now. In this environment it’s just too difficult to make longer-term projections.

[Eva Young] - Private Investor

Could you just indicate what community count was at the end of the quarter and any sense you have of what it might look like next year?

J. Larry Sorsby

284 is where it was at the end of October 2008. Again we’ve not made a public projection about community count for the end of ’09 but I think it would be safe for you to assume that the trend of having less communities will continue in ’09.

Operator

Our next question comes from David Goldberg - UBS.

David Goldberg - UBS

I believe in the opening statements you were talking about looking at acceptable recoverability of finished lots in terms of cash flow. Is that right?

Ara K. Hovnanian

Yes.

David Goldberg - UBS

Can you kind of walk me through some more color? Just get a little more granular on what that means in terms of how much of a finished lot costs you need to recoup in the building process to make it worthwhile for you to continue to build, if I’m understanding it correctly?

Ara K. Hovnanian

It completely depends. If it’s in a low-cost area like Fresno, we may be happy to take $15,000 a lot. If it’s in a prime location in Washington, D.C., we wouldn’t accept something as low as that. It completely depends and it’s situational. It also depends on what our outlook is for land in that market. If we think there’s plenty of excess supply, then we’ll be more aggressive. If we think land is a scarce commodity, then we’ll be a little stingier with our land and the lot recovery analysis.

David Goldberg - UBS

I understand that it absolutely varies on a dollar basis based on how high cost of land is. Have you thought about a range in terms of percentages?

Ara K. Hovnanian

No, we don’t. We just look at dollars now.

Operator

This concludes our conference call for today. Thank you for your participation. Have a nice day. All parties may now disconnect.

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Source: Hovnanian Enterprises, Inc. F4Q08 (Quarter End 11/30/08) Earnings Call Transcript
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