Good morning, and thank you for joining us today for the Hovnanian Enterprises fiscal 2009 second quarter earnings conference call. By now you should have all 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 that you are on the company’s distribution list.
There will be a replay for 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 17857471. An archive of the webcast slides will be available for 12 months.
Management will make opening remarks about the second quarter results and then open the line up 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.
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 any information in the slide presentation.
I would now like to turn the presentation over to your host, Ara Hovnanian, President, and Chief Executive Officer of Hovnanian Enterprises.
Good morning and thank you all for participating in today’s call to review the results of our second quarter and six months ended April of 2009.
Joining me from the company today are Larry Sorsby, Executive Vice President and CFO; Paul Buchanan, Senior Vice President and Chief Accounting Officer; Brad O’Conner, Vice President and Corporate Controller; David Valiaveedan, Vice President Finance; and Jeff O’Keefe, Director of Investor Relations.
On slide three you’ll see a brief summary of our second quarter results. As usual we give all of this data and more in our press release which we issued yesterday. There are three points on this side that are worth highlighting. On the third line down, you see that our net contracts per community during the most recent quarter showed a 25% year over year increase for the quarter.
This is the second consecutive quarter we have achieved an increase in year over year contracts per community and its certainly encouraging considering the consistent year over year declines we saw for the past four years.
Another positive trend on the fourth line down you see that our cancellation rate decreased during the second quarter of 2009 to 24%. This is the lowest quarterly cancellation rate that we have reported since the third quarter of 2005. A cancellation rate in the mid-20’s is close to more normalized levels.
Third and third from the bottom, you see that we purchased $525 million of face value of debt for $208 million in cash. These transactions resulted in $525 million reduction in our outstanding debt and $311 million of pre-tax gain from debt extinguishment.
During the first half of fiscal 2009 we’ve reduced our debt by $620 million as a result of the debt exchange and open market repurchases of our debt resulting in the $391 million pre-tax gain.
Turning to slide four we show the progress we’ve made in reducing our active selling community count from 379 at the end of last year’s second quarter to 215 at the end of our 2009 second quarter. This represents a 43% decline in the number of storefronts we operate, an important step in lowering our capital invested in communities, and lowering our overheads.
Now let me get back to the sales trends we’re seeing in the market today. We have seen more then the typical seasonal uptick in sales throughout our second quarter. The seasonal aspect of the pickup in sales is not unusual but its noteworthy that this is the second consecutive quarter that our contracts per community were up year over year as you can see on slide number five.
Net contracts per community were up 5% in the first quarter, and increased even more, actually 25% year over year in the second quarter and that’s same season compared to the same season last year. The enhancement of the $8,000 Federal Tax Credit certainly contributed to our increased sales, but out of all of the applications our mortgage company took in the second quarter, only 32% of them were from first time homebuyers, which was not significantly more then the 29% we had in the first quarter of 2009 before the new tax credit.
This is relevant because the Federal Tax Credit is only available to first time homebuyers. Approximately two thirds of our purchasers bought without any benefit of a tax credit. Of particular note, the second quarter pace of 7.4 net contracts per community not only exceeded our 2008 second quarter results, but it exceeded our 2007 second quarter results as well.
Prior to the increased sales pace in the first quarter of 2009 we reported a year over year decrease in net contracts per community for 15 quarters in a row. While this increase in net contracts per community is certainly a positive trend that has continued now for two quarters, it is fair to point out that our net contracts in total for the second quarter were still off 29% year over year.
However we feel the most relevant number is the per community results because our community count continues to shrink as we discussed earlier similar to the retail business with 43% fewer storefronts you’d expect lower absolute year over year numbers, again lowering these storefronts is part of our overall plan of capital reduction in overhead.
Looking at net contracts on a monthly basis, slide six, you see what our monthly net contracts were since September of 2008. In February, March, and April monthly sales exceeded 500 for the first time since August of 2008. On the bottom of this slide you can see what our contracts per community were for the most recent month and for the comparable month a year ago.
The contracts per community have shown a positive comparison for six of the past seven months and the comparison has been even stronger during the two most recent months with a 25% and 33% increase in net contracts per community for March and April respectively.
When you look at the MLS data for many markets today you see two positive forces at work. First you see absolute sales numbers have picked up and second you see inventory levels have come down. In some markets you could almost make the case that the month’s supply has corrected too much. Believe it or not, by normal standards there is actually a shortage of homes based on the current sales pace in certain markets including some of the markets that were the most over supplied not long ago.
However there are a few risk factors that mitigate some of this good news, for starters, again, the expiration of the Federal Tax Credit coming up in November of this year is a concern. Second, at some point the state of California will max out on its $10,000 State Tax Credit for new homebuyers. Third, there is the potential increase in listings due to a potential rise in foreclosures as recent moratoriums on foreclosures have ended.
And finally mortgage rates while still very low by historical standards, they have tweaked up in the very recent period. The combination of these factors could clearly dampen the positive signs we’ve been seeing popping up.
Even though we are concerned with these potential risks, many markets have shown signs of improvement in terms of supply and sales pace. Not only have the conditions improved from the technical perspective but these markets feel better today and there seems to be a better psychology today.
These next couple of slides shows listings and sales trends for existing homes in some of our most difficult markets. On slide seven you see what is happening in Stockton, California. The yellow symbols are total listing outstanding each month. The maroon symbols are monthly sales and the blue line is the number of months’ supply.
This is one of the hardest hit markets in the country with respect to foreclosures resulting in dramatic price declines. However, the good news is listings have consistently declined for almost two years and over the last eight months sales have increased.
The combination has resulted in a sharp decline of months’ supply which now stands at less then two months’ supply. That’s unusually low and below normal. Similar trends can be seen for Bakersfield, California as you can see on the next slide, number eight.
Inventory here has dropped from a 12 months’ supply to just over a two months’ supply. On slide nine in Phoenix, April 2009 sales were the highest monthly sales in the past seven years. Even though listings remained somewhat elevate, the months’ supplies coming down to more realistic and normal levels and is being driven by the increased sales volume.
At a five months’ supply this market looks a lot better then it did a year and a half ago when it had almost a 25 months’ supply. We really have two components to our DC market on both sides of the Potomac. The existing home market seems to be improving on both the Virginia and the Maryland side.
On slide 10 we show Virginia, which has been gradually improving since the end of 2007, Virginia is now at about a three months’ supply of existing homes. This has decreased dramatically from the peak of a 13 months’ supply. Things on the Maryland side of the DC market have been slower to improve but the last five months have shown steady improvement. You can see this on slide 11, that market is down to about a seven months’ supply.
While all of our markets have not improved to a five to seven months’ supply of homes for sale, some markets like West Palm Beach shown on slide 12 have experienced consistent improvements in the number of months’ supply. Listings dropped to about 20,000 and monthly sales increased to about 1,400 yielding a reduction from a 42 month supply to roughly a 15 month supply.
Its still very high but its definitely progress and trending in the right direction. The trends in our monthly net contracts per community plus the trends in market specific existing home sales data indicates an improving housing market despite all of the uncertainty regarding the economy.
However there is some pain associated with these improvements. Unfortunately the increased sales pace came at the expense of declining sales prices in many of these markets partly driven by foreclosure pressures.
Since we are more focused on cash flow and are sacrificing margin to achieve pace, we have lowered our prices in many communities to achieve and improved sales pace. However its safe to say that the rate of decline in home prices has recently slowed in most parts of the country and in a few locations, we’ve actually been able to raise prices without adversely impacting our sales pace.
As illustrated on slide 13 the recent quarter saw an improvement in our gross margin over the first quarter. Needless to say in spite of the improvement we are still disappointed in the absolute levels of gross margin. During the second quarter our homebuilding cost of sales was reduced by $49.3 million from the reversal of impairments.
While the absolute amount of total SG&A decreased by 33% year over year, as you can see on slide 14, total SG&A expenses as a percentage of total revenues was still in the high teens for the second quarter clearly above normal and where we’d like to see it.
The higher then normal SG&A percentage comes despite significant reductions in our staffing levels. Slide 15 illustrates a 71% reduction in staffing levels from the peak levels in the summer of 2006 through April of 2009. In fact the staffing levels have decreased 28% in the last six months alone. But it has been hard to cut SG&A as fast as our revenues and our sales pace has dropped.
The sales pace we are achieving at a community level make this very challenging. Its unlikely that we’ll be able to get back to a more normalized historical percentage of SG&A until the sale pace per community returns to more customary levels.
We have seen positive trends these past two quarters on a per community basis although we remain at very low levels. Slide 16 gives a historical perspective of the annual sales per community. Over the period of time shown on this graph we have averaged about 42 net contracts per community per year. At the current run rate we’d be at about 23 net contracts per community. While better then last year, this is still significantly below average. After steep drops in absorption the previous three years, it appears that we may be starting to see a leveling off or slight increase in pace rather then continued declines.
However its difficult to make money when the sales pace is still so low. To keep our expenses in line, we’ll continue to right size our business based on the current activity that we’re generating in each of our markets.
Cash flow remains our top priority. Once upon a time we used gross margin as the primary go, no go call on building through a community. Because our focus has shifted to cash flow, today we are less concerned with margins and more concerned with the cash we will generate by building and delivering a home.
Needless to say we will not start a home if the selling price is less then the cost of the sticks, bricks, and labor. Besides needing to recover all of the cash costs of recovering a home, we also want to recover a reasonable portion of the cash cost for a finished lot.
In some of our communities where foreclosures are nearby and where the home prices have come down so much that we no longer generate cash flow by building homes, the decision to mothball is easy. In other markets where we can still get all of our cash back for building a house, we take a closer look at the cash we are getting back on the finished lot, both raw land and land development.
In some of our more challenged markets like Bakersfield or Fresno, California, we might accept as little as $15,000 or $20,000 per lot in cash flow by building homes. Now that may not seem like a lot of money, but there are carrying costs associated with mothballing a community so it can make sense to move forward with a project even when we’re only recovering $20,000 of lot value in certain over supplied markets.
We also mothball lots where we are bullish that the recovery will show particularly good appreciation in lot values and home prices in a given location. Through the end of the second quarter we mothballed about 9,800 lots in 76 communities. Twelve communities were mothballed during the most recent quarter. On slide 17 we show the number of lots that have been mothballed broken out by our segments.
There are more mothballed lots in markets like New Jersey and California where we do a fair percentage of the land development ourselves. In many of these communities, it just doesn’t make sense to go forward spending money on land development. In other markets like Texas, very little has been mothballed. The book value at the end of the second quarter for these communities was $388 million net of an impairment balance of almost $0.50 billion which reflects nearly a 60% reduction in book value.
One hundred and one million dollars of the mothballed land was in several parcels along the Hudson River overlooking Manhattan in our northeast segment. While this is expensive land the Hudson River waterfront is a AAA location where we have successfully built homes for more then 15 years. We are confident that this market will rebound strongly in the future given its close proximity to Manhattan.
Once home prices begin to increase and we see further improvement in sales pace, we will begin to dust off these mothballed communities and open the communities up for sale. This will obviously add to our cash flow later.
With our laser like focus on cash flow, excluding the $208 million we spent on debt repurchases we reported our fifth consecutive quarter of positive cash flow as you can see on slide 18. Given the continued deterioration in the housing market generating cash flow in the future is clearly going to be more challenging then it was last year.
Our ability to generate cash is partially a reflection of our decision to not fully replenish our land as we deliver houses. Slide 19 shows how much our land position both owned and optioned has been reduced over the past several years. Our total land position is down 71% from peak levels while our optioned and owned positions are down 85% and 40% respectively from peak levels.
During the second quarter our owned lot position declined by about 1,100 lots, we delivered approximately 1,400 homes and sold 200 lots without a home on them. Offsetting these reductions we took down 420 lots that were under option. As we move forward we still need to reduce our owned lot supply further.
On slide 20 we show a breakdown of the 22,000 lots that we own at the end of the second quarter. Approximately 45% of these were 80% or more finished. Fifteen percent had 30% to 80% of the improvements already in place and the remaining 40% had less then 30% of the improvement dollars spent.
We are currently focused on reducing our consolidated land supply. In the land markets we have recently seen some land deals that are starting to make sense again, finally. These deals are primarily being marketed by banks and are penciling at current sales paces and current sales prices to an unlevered IRR of between 25% and 30%-plus. So far we’ve seen about a dozen deals across the country that meet these parameters including Chicago, Virginia, Maryland, Florida, and California.
One specific example is in Florida where we’ve recently put under contract 160 lots from a bank. In this case the original cost per raw lot was approximately $170,000 and an additional $50,000 of improvements per lot was put in place for a total cost of $220,000 per lot and that’s without allocating interest or overhead.
Our contract on this project is about $25,000 per lot which is about 11% of the original cost and only about 50% of the replacement costs of improvements and that’s with a zero land valuation. Further sales in this particular geography and product niche have been reasonably solid. The fact that we have to value the raw land at zero in order to achieve a fair return on homes is a clear indication that the pendulum for land has swung too far.
We are seeing more land deals like this making their way to the surface around the country and will provide a once in a generation opportunity for us to reload and reinvest in land. I’ll now turn it over to Larry, who is going to discuss our gross margins and the charges we took in the quarter as well as some other topics.
Thanks Ara, let me start off by making a couple of points about our current land supply. If you’ll turn to slide 21, it shows our owned and optioned land supply broken out by our publically reported segments.
On a trailing 12 month basis, we own slightly more then three year’s worth of land. On a relative basis this compares well to our owned land position of our peers which can be seen on slide 22. The good news is that each quarter we worked through more of our own land and we will eventually get through all of it and be able to replenish our land supply with lower cost land at the bottom of the housing cycle.
Over time this sale of older land combined with purchasing new land at market prices will cause our gross margins to gradually increase back to normalized levels. Of course if the market improves and we can raise prices the timeframe to return to normalized margins will shorten. I will now talk about the land related charges that we took during the second quarter.
We continued to walk away from land options when they don’t make economic sense. During the second quarter we walked away from 1,187 lots and took a write-off of $9.1 million related to these optioned lots. On slide 23 it shows how these charges were broken out between our various segments.
Our remaining investment in option deposits was $43 million at April 30, 2009, with $31 million in cash deposits and the other $12 million of deposits being held by letters of credit. Additionally we have another $56.5 million invested in predevelopment expenses.
The next category of pre-tax charges relates to impairments which is also shown on the same slide. We incurred impairment charges of $301.1 million related to land in communities that we owned in the second quarter. Land impairments exceeded $100 million in both the northeast and west segments.
Impairments in the northeast are due to recent weaknesses in this market primarily in the suburbs of Manhattan which is a direct result of recent increases in unemployment in that market especially as it relates to Wall Street. Almost $90 million of the impairments was in one location on the Hudson River waterfront overlooking Manhattan. The New York City market held up much longer then other markets during this downturn but with the perils of the financial market sector that really hit home in the fall of 2008, the declines in this market have occurred rapidly.
Unlike the weakness that we’ve recently seen on the waterfront markets overlooking Manhattan we have actually been able to raise prices in a handful of communities that are located closer to key employment centers in California as these markets have shown some signs of both prices and absorption paces firming up.
However in the fringe markets in California or the west, where much of the competition comes by way of foreclosures, we continue to lower prices during the second quarter which resulted in impairments in 37 communities in the west.
We test all of our communities including communities not open for sales at the end of each quarter for impairments. If home prices continue to deteriorate we will see additional impairments in future quarters. While we have seen signs of price stability in the past six weeks or so, more foreclosures are looming over market and indices such as the Case-Shiller Index suggests that there could still be more pressure on home prices in the future.
During the second quarter of 2009 we also recorded $8.7 million of write-downs associated with our investment in joint ventures which shows up on the loss from unconsolidated joint ventures line in our income statement. This joint venture where we had a write-down is in New Jersey and is also on the Hudson River waterfront with views of Manhattan.
Looking at all our consolidated communities in the aggregate including mothballed communities, we have an inventory book value of $1.5 billion, net of $1 billion of impairments which were recorded on 251 of our communities.
Turning to slide 24, it shows our investment in inventory broken out into two distinct categories; sold and unsold homes which includes homes that are in backlog, started on sold homes and model homes, as well as the land underneath those homes.
The other category includes both finished lots and lots under development which are associated with all other owned lots that do not have sales contracts or vertical construction. We have reduced our total dollar investment in these two categories by 66% since our peak levels in July, 2006 and we plan to make further progress in reducing our inventories during the remainder of 2009.
Turning now to slide 25, you can see that we continue to reduce the number of started and unsold homes excluding models and are below the 1,000 home level for the first time since the second quarter of fiscal 2003. We ended the quarter with 892 started and unsold homes which is a decline of 73% from the peak levels at July 31, 2006.
This translates to 4.1 started unsold homes per active selling community. While the absolute number of started unsold homes may come down as our community count decreases in the future, the number of started unsold homes per community will likely stay in the range of four to five. This is consistent with the average of five started unsold homes per community we have averaged over the past dozen years or so.
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 $42.2 million after-tax noncash tax asset valuation allowance during the second quarter.
While our tax asset valuation allowance charge was noncash in nature, it did effect our net worth by the same $42.2 million during the quarter and increased our total valuation allowance to date to $797.1 million.
Now let me update you on our mortgage markets and our mortgage finance operation. Turning to slide 26, with our average FICO scores at 733, our recent date indicates that our average credit quality of our mortgage customers remains quite strong.
Turning to slide 27 we show a breakout of all the various loan types originated by our mortgage operations during the second quarter of fiscal 2009 and compared it to all of fiscal 2008. During the second quarter FHA/VA loans made up 43% of our volume as compared to 36% for government loan originations throughout all of fiscal 2008 and only 8% for all of fiscal 2007.
We continued to have very little exposure to jumbo mortgages which were only 0.9% and 2.5% of total loans for the second quarter of 2009 and the 2008 full year respectively. The mortgage industry continues to be risk averse and has embraced sound reasonable lending practices. There are many loan products from which to choose and interest rates remain near all time lows.
The mortgage industry has become more black and white. One either meets the underwriting guidelines or one does not meet them. The practice of using compensating factors to get the marginal loan approved has disappeared.
We continued to offer competitive mortgage rates including rate buy downs and we are leveraging our mortgage associates’ knowledge and expertise to assist our homebuyers in obtaining mortgage loans. I will now discuss our joint venture activity.
At April 30, 2009 after cumulative charges we had $42.2 million invested in eight land development and nine homebuilding joint ventures. As a result of the cumulative effect of $359.4 million of impairments and since 2006 within our joint ventures, you can see on slide 28 that our debt to cap of all our joint ventures and the aggregate increased to 71%.
We financed our joint ventures solely on a nonrecourse basis. We are now more then four years into this downturn and because the loans are nonrecourse, these are the joint venture loans that I’m speaking of, we have not had any margin, or capital calls on any of the debt associated with our joint ventures.
Considering the $525 million of debt we repurchased during the most recent quarter it should not be surprising that our cash position has decreased. We ended the quarter with $779 million of cash as you can see on slide 29. We did borrow $100 million against our credit facility during the quarter that we subsequently have repaid.
Although this borrowing may seem odd given our significant cash balances, it had some benefits to the calculation of the amount available under our restricted payment basket covenant. This $100 million short-term borrowing had no adverse effect on our net debt or any of our debt covenants.
Net of that additional borrowing our cash position would have been $679 million at quarter end. As shown on slide 30 we do not have any significant debt maturities looming due over the next few years. Our debt maturities were well structured and our first debt maturity is not until January, 2010 and as of April 30, 2009 there is only $29 million of face value outstanding on that issue.
After that nothing comes due until April, 2012 and even then, its only $159 million of original face value. During the second quarter of fiscal 2009 total debt repurchases amounted to $525 million. Excluding the $71 million face value of the 6% senior subordinated notes due in 2010 that were purchased at an average price of 92.2% the average price of the remaining debt repurchases was 31.5%.
As a result a $311.3 million gain on extinguishment of debt was recorded during the second quarter of fiscal 2009. We have not purchased any additional debt since the end of our second quarter and we have debt covenants that limit the amount of additional debt we may repurchase. So between the exchanges and our repurchases to date, we have reduced our debt by $620 million and reduced our annual cash interest by $41 million.
Our current cash position and our lack of substantial near-term maturities compares well to those of our peers. Some of our peers do have larger cash positions as of the most recent reported quarters as can be seen on slide 31. A few of those peers also have more debt maturing between now and the end of 2012 as you can see on slide 32.
When you subtract these near-term maturities from the cash positions as we’ve done on slide 33 we’re in relatively good standing compared with our peers on a net cash basis. Now I’ll turn it back over to Ara for some closing comments.
Thanks Larry, there’s a lot of talk out there about green shoots or indications that things are starting to get better in the overall economy or in specific industries. We just told you about the positive monthly trends we’ve seen in net contracts per community in six of the last seven months as well as cancellation rates returning to more normalized levels.
We also gave you some examples of MLS data in markets that are showing signs of improvement. We see evidence that the housing starts may be finding a bottom. If you look at total housing starts since the end of World War II, which is depicted on slide 34, you see that the only year where production was below a million starts, was last year in 2008 when there were just a little over 900,000 starts.
Other then that, the seasonally adjusted current rate of 458,000 homes is the lowest level since World War II. This is significantly below any level of production we’ve seen in over the 60 plus period of time shown on this graph. Most demographers agree that approximately 1.4 million households will be forming each year this decade and in the coming decade.
This translates to annual housing demand of about 1.9 million homes needed every single year this coming decade. These current levels of low production can’t last much longer against the rising tide of a growing demographic population.
Housing is a classical cyclical industry, not just here but throughout the world. Housing tends to lead countries into and then out of recessions. If you look at slide 35 you see some examples of improving conditions in housing markets in Australia, New Zealand, Spain, Ireland, China, and the UK. While these metrics which indicate that things may be getting better, are certainly more pleasant to hear about then a barrage of negative news.
I’ll say once more that there certainly are risks remaining. Once again the $8,000 Federal Tax Credit for new homebuyers expires in November. In California, the problem could be compounded as its generous tax credit could be depleted soon and that will clearly have an effect on one of the more hardest hits markets in the country. If you look at slide 36 you see that the combination of the Federal and State tax credits has caused a months’ supply in some of the California markets to correct faster then it has in some of the other tough markets across the country.
This shows that California markets have sent the most dramatic reduction in terms of the months of inventory. If the government would just realize how important housing is to the overall recovery of the economy it could take action that would bring the total tax credit similar to what worked in California. Its also important for them to consider extending the tax credit.
In the meantime we will remain very cautious. We believe the above factors plus the potential increase in listings due to a rise in foreclosures that many are concerned about and the recent uptick in mortgage rates could clearly have a negative on future sales as we’ve said several times.
We will continue to price our homes to a level that will provide the best cash flows to the company. We’ll continue to look at land deals that the banks are shopping around, but we’ll exhibit levels of discipline in our underwriting criteria such that we’ll maximize future cash flows to the company.
In short we are mindful that there is still some pain that lies ahead and we will do everything in our power to preserve and maximize our cash position. Maintaining liquidity remains the key to navigating this incredibly challenging times. Once our country gets through this period, we’re confident that the housing industry will once again show robust growth.
That concludes my comments, and I’ll be pleased to open up the floor for questions.
(Operator Instructions) Your first question comes from the line of Ivy Zelman - Zelman & Associates
Ivy Zelman - Zelman & Associates
First question I want to ask you relates to your gross margins and backlog, realizing you said you’re focused on cash and we understand that, can you just give us some indication if the margins were substantially higher then the 8% plus that you reported for this quarter and the second question just relates to understanding again your finished lots versus undeveloped.
We’re not making any projections about gross margins, you can see the trend that has occurred sequentially from the first to the second quarter but I will say that I don’t think there’s anything in the backlog that would lead to a dramatic improvement or decrease in the gross margin from what you saw in the second quarter.
Ivy Zelman - Zelman & Associates
The second question related to better clarification on the total owned and optioned inventory, how much is developed versus undeveloped, the finished versus unfinished.
Well we break it down only on the owned, the option loss we don’t give that same breakdown. The slide number is 20 and—
Ivy Zelman - Zelman & Associates
I was a little confused by that slide, that’s why I asked you to clarify it.
Okay, well what that means is 45% of the lots that we own have at least 80% of the development costs already in place. Some are finished, some are a 100% finished and some are almost finished and have just the last 20% remaining. The middle category means they’re in process of development, they’re not 100% finished nor are they undeveloped. They’re in the middle. They average about 50% developed.
And finally the last category is, they’re something around raw land. They may have some expenditures but if its less then 30% of the total land development cost we categorize them in that last category.
Your next question comes from the line of Dan Oppenheim - Credit Suisse
Dan Oppenheim - Credit Suisse
You have certainly done a great job opportunistically retiring debt and reducing near-term obligations, but if we start to look through the downturn here and kind of focus on what’s the next step and think about your future opportunities, leverage is still quite high so how comfortable will you be redeploying the cash you’ve built up to pursue and opportunities and what are the things that you’d need to see in order to make you comfortable doing that.
Well first of all clearly we have found ourselves in a much more highly leveraged position then we ever imagined given this downturn. We have to balance our cash uses clearly going forward. As we described on prior calls although we didn’t reiterate it on this call, our primary strategy going forward with new land acquisitions is through joint venture vehicles.
We have had very solid experience in this area. We’ve done well over a dozen joint ventures with major financial institutions. They have been our partners through the vertical. I can say that some did very well. Some did not do so well, those that obviously were entered into the peak of the marketplace.
However our relationship with all of the partners has been excellent. There is a lot of interest out in the investment world to buy assets and team up with a company such as ours at what is perceived to be at or near the bottom of the cycle. That allows us to really utilize our capital very efficiently and assuming we meet anywhere near our projected pro formas, we need to get a much better then normal return on our investment, better then if we invested in our wholly owned basis.
So that’s really our key strategy for going forward. In our 50 year history we’ve obviously seem many cycles. We’ve got a lot of experience in buying distressed assets both land and distressed loans. We were active in 1991 during the RTC days. We have been looking and looking, finally literally in the last I’d say 90 to 120 days, we are starting to see some great opportunities in the marketplace.
We just entered our first contract in buying our distressed opportunities, we’ve been on many others. We never quite got them at the right price but we’ve gotten a great opportunity buying in this case actually it was the debt which is secured by property but we’re entering into a tri party agreement with a friendly foreclosure with the original developer.
We think its an excellent opportunity for us to generate some very solid profits even at today’s dismal sales pace and sales price. That’s really our key strategy going forward. Clearly we ought to maintain the liquidity that we need to pay down our debt as well and try to get our ratios over time to improve. Obviously if we have further losses and impairments, equity is going to go to or easily be low negative and that’s going to take some earnings to bring that back into line so we can start getting some positive ratios.
But we think we have a plan in place to make that happen.
Dan Oppenheim - Credit Suisse
Thanks for the color, that also addressed the follow-up question, just with the update on the joint venture partners, so I guess, what’s the type of scale that you’re looking at generally when you’re looking at these land opportunities, the 160 lots, should we expect more deals of that type of size. Is there a specific focus on scale or geography there.
No, we’re really just looking opportunity by opportunity and I can tell you they are all over the board. We just had a land committee review this morning where we are looking at a 41 lot opportunity up in northern California, its very small. Then on the other extreme we’ve seen some tightly clustered portfolios that are substantially larger then that.
And interestingly investor appetites are all over. Generally speaking there’s more interest in larger deals but there’s also interest in medium and small sized deals as well, fortunately. Different players have different appetites so, we think there’s a very receptive market out there.
The issue has not been finding investment partners, the issue has been getting the solid deals under contract. We finally just got our first opportunity under contract and actually we closed as of a day or two ago. So that’s just happened in the recent weeks. So that’s the key first step because we can talk to all the partners and potential partners in the world, they want to see specific deals and now that we have one, we’re finding good reception out there.
Your next question comes from the line of Joshua Pollard - Goldman Sachs
Joshua Pollard - Goldman Sachs
Can you walk through the capital plan over the next few years, specifically hitting a few points, number one how much debt can you repurchase under your debt covenants, and how can you actually increase the number or the amount of debt you can repurchase. Number two, how much can you actually borrow under your facility. I know you have paid back that $100 million already. Three if you could talk about what your thoughts on raising equity and four, can you help us understand why land purchases are on the table just given your current debt position.
Similar to what we told the market at the end of the first quarter, we’re not going to provide specific details on what our restricted payment basket will allow or won’t allow with respect to the buyback of bonds. All the information regarding the limitations on restricted payments can be found in the SEC filings for each of our individual debt issues. There’s several baskets that are available to us under various limitations on restricted payments.
We remain in compliance with and expect to remain in compliance with all of our debt covenants. There’s no maintenance covenants associated with any of those bonds. Its safe to say that there are some very specific significant limits. Its complicated to make all the calcs and it does change depending on our individual situation from month to month.
With respect to our revolving line of credit it’s a $300 million facility that’s primarily set up for letters of credit but we can use up to $100 million at any time for borrowings which we did at the end of the second quarter and have subsequently repaid it and that $100 million remains available to be redrawn if we ever choose to do so.
The land one is fairly straightforward, while we’ve purchased land [given] debt our plan as I mentioned was really to leverage the opportunities of joint ventures so that while we have closed on this property we really see that as kind of a staging area until we’re prepared to close with the joint venture that would replace 80% of the capital that we have put in it.
And by the way, we’re talking about doing these joint ventures on an all equity basis initially, probably no debt. Although at some point we’ll be able to put on moderate levels of debt definitely below 50% and definitely consistent with what we’ve done in the past, always staying nonrecourse so that our exposure is very limited.
But as I mentioned earlier, we’ve been through these cycles many times. Every time finally if we stay disciplined we ultimately find land opportunities that prove to be great values in the long run and that’s going to be critical to building our equity base back up. We can’t cost low enough in this environment. We have to replenish our land supply at much lower costs.
And if we do that we can generate some sizable profits and start replenishing our equity. What we’re doing now, exact same discipline we did in the 80’s and the 90’s. We only buy, we do not buy hoping for appreciation. We buy land parcels that work today and that are sizable discounts to where they were a couple of years ago.
The benefit is if we buy them that generate a reasonable return today, when and if the market recovers and we certainly think it will at some point in the near future, then we’ll generate some very substantial returns, far better then our pro formas, and we’ll start refilling our equity basket.
In regard to the question, and you were supposed to only be allowed one question. We’re going to have to give you grief about this four-pronged sneaky approach, but we are open to looking at equity in the future however we just want the equity markets to stabilize. We want the market to get a little more comfortable with where we are and have our stock price go up a little bit more before we’d consider that.
Joshua Pollard - Goldman Sachs
Quick follow-up is any update on May, the month is over, were things equally as strong as April, a little worse, a little better. Could you give us some color on that.
Yes, I think May was similar to April is probably the way to, we don’t have the specific data to provide to you right now but I’d say May was very similar to April.
Yes, the sales environment continues to be very reasonable right now. I’d hate to use the word solid because everything is relative, but so far so good, more continuation of what we just recently experienced.
Your next question comes from the line of Michael Rehaut - JPMorgan
Michael Rehaut - JPMorgan
First question you mentioned the 23 net contracts per community in 2009, if you could just extrapolate the first half of the year, but you also mentioned that it was still difficult to make money at these levels. What type of absorption do you need to turn a profit and does that [inaudible] get back to the 40 and 50 absorption rate that you had.
It’s a combination of absorption and margin, so probably close to a level that could make sense if we were back at normalized margins, but having both absorptions be roughly half of what it was on average over the last decade and margins be well below half of normalized, it just doesn’t work.
Obviously its very different from location to location. Actually in North Carolina you could probably do okay at 24 homes per year. In most locations in California or Arizona, you need to be in the 40’s. So it depends but I’d say closer to 40 would be much, much more efficient. And part of the reason for that its pretty obvious, you still have to staff a sales office. You have to keep it clean and so forth, and you have to have a minimum amount of construction to have at least one person.
That stays whether you’re doing 20 homes or 30 homes. And then you might add some more personnel as you get to 40 or 50 but it just becomes a lot more efficient.
Michael Rehaut - JPMorgan
Then what are you modeling into your own forecast given all those kind of headwinds that you mentioned regarding the tax credits going away and the impending foreclosures coming up and the spring selling season ending over the next couple of months.
We run a lot of different scenarios in terms of longer-term forecasts to gradually get us back to normalized absorption pace and gradually get us back to normalized margin, but in terms of budgeting anything on a nearer term basis say the next 12 to 18 months, we use current pace and current price and no assumption of improvements in either.
But what we do is we stress test it in our cash flow and treasury models to make sure we are comfortable and have the liquidity we need in the downside scenarios. We’ve done that and we’re comfortable with our position. Obviously it takes us longer to build our equity base in those scenarios but we’re comfortable with our liquidity position.
Your next question comes from the line of Joel Locker – FBN Securities
Joel Locker – FBN Securities
On the land impairments, how much of the $301 million was on fully developed lots and how much was on partially developed or raw.
We just don’t have that breakout.
Joel Locker – FBN Securities
And I guess the other question is more theoretical, on the slides you see how things are post WWII, but if you go back say another 20 years where you’re facing say a deleveraging period in the 30’s, you saw housing starts drop below 400,000 or so for I think a three year period and—
Where do you have that data because we’d love to get it.
Joel Locker – FBN Securities
I’ll email it to you.
No seriously because we’ve not seen it back—
But one important thing to keep in mind the population of the United States has grown dramatically—
Joel Locker – FBN Securities
I was saying on a population adjusted basis, it was between I think 250 and 400 or so for 31, 32, and 33.
Our numbers that go back to WWII are not population adjusted so we’re down way below WWII levels and the population is dramatically higher. I don’t remember them off the top of my head but I want to say we were down around 100 million plus population at that point and we’re up around 300 million today. There’s really no comparison.
But anyway, I might have interrupted the point you were making.
Your next question comes from the line of Megan Talbott McGrath - Barclays Capital
Megan Talbott McGrath - Barclays Capital
I guess I wanted to get a little bit more regional color especially on the California market, you put up a lot of different data there, some of it positive in terms of months supply and inventory and you talk about being worried about the $10,000 tax credit going away, but in terms of your results in the western segment, you’re prices came down pretty dramatically, sales the most dramatic I think of all of your segments. So I guess my question is, is the tax credit really helping you. Is it worth it given that it looks like you’re still having to make a lot of price concessions to get the volume. And if you could give any sort of general color on what’s going on there for you in California.
I tried to be pretty clear on the commentary that the positive was the velocity in sales pace, the negative is what’s happened in prices everywhere but absolutely positively the tax credit has been very helpful in California, much more so then just a Federal level where, the Federal level credit was only for first time homebuyers. It was only $8,000.
In California it was $10,000 on top of the $8,000 and the $10,000 was for all price points. It clearly improved the California market from what we can see, much more then anywhere else in the rest of the country. Now generally speaking during that period it hasn’t improved it so much that its dropped the sales price, excuse me the sales price decreases, although I will note that last month we’ve and we’re just trying to verify the data, we’ve heard some positive anecdotes that sales prices just in the most recent month in California went up.
So it’s a positive impact without a doubt. In general we’re constantly looking at the two alternatives of price and pace and generally speaking we as a homebuilder are more willing to drop the price to keep the pace and velocity up, generate cash flow, burn through the old land, and create the cash [inaudible] that in future land parcels at greatly discounted rates.
Megan Talbott McGrath - Barclays Capital
And then given that a good portion of your mothballed land is in the west, any sense of what you need in terms of pricing especially given what you’re seeing in some of these new land deals, to really start building on that old mothballed land again. And just as a clarification, are the mothballed lots in your total lot count.
The mothballed lots are in our total lot count and the answer to the first part, it varies dramatically by community but we have some locations where we consider unmothballing them for a $10,000 home price increase in that marketplace if its coupled with a reasonable velocity because unmothballing is dependant on pace and price.
So in some cases $10,000 would open a community back up. If it’s a $300,000 home that’s a 3.5% increase. In other communities it may take a $20 or $30,000 price increase to make it worth our while. Its also a little different whether it’s a developed lot or an undeveloped lot that’s mothballed. But I’d say from $10,000 price increases on we’ll begin to unmothball some of those properties.
Your next question comes from the line of David Goldberg - UBS
David Goldberg - UBS
First question is actually, and you talked a little bit around this, but I was wondering if you could drill into it, on the land that you’re thinking about buying in the JVs, you are potentially looking at more foreclosures as you mentioned in the opening comments and maybe more pricing pressure, and I’m just trying to get an idea how you like about margin of safety when you go out and look at land and what kind of profitability you could maybe potentially be able to achieve in the joint ventures if prices went down further in the next few months.
It’s a good question and one we talk about. First generally speaking for land purchases we are targeting a 25% to 30% unlevered IRR and often its at a minimum of a 10% pre-tax profit after everything. So if it’s a $300,000 home then you’ve got a $30,000 safety cushion so to speak to get to break-even.
We have seen much greater stability in pricing over the last four, six, eight weeks, and much greater stability in velocities. Nonetheless its reasonable that one would be cautious but in the first transaction that we finally purchased, we are buying in what I’d consider an A minus location, land at 50% of what it cost to put the streets in.
So and we’ve got the land for free, zero. So I guess basically we’re kind of looking at that and saying, okay we might not be right at the bottom and maybe there’s a little downside risk, but generally speaking on an A location if you can buy it for zero for the land and put, buy the streets in for 50%, how wrong can you be unless we go into The Great Depression.
So that’s the gamble we’re taking and that’s part of our rationale.
David Goldberg - UBS
And the follow-up question, just about the impairments this quarter and what I’m trying to reconcile is I understand you cut prices but I would have thought that the pickup in sales pace would have had more of a benefit or had a, insulated you from the impairment charges that you took and I’m just trying to get an idea when you look at the tests, degree wise, magnitude wise, what do you think the changes in pricing more relative to the change in pace, and why didn’t the increase in sales pace and the improvement in the environment help insulate you a little bit from the size of the impairment charges.
The first thing I’d say is that you have to look at this community by community and when we took the impairments we tried to highlight in the script that there were some specific instances in the northeast, all of them were Hudson River waterfront or very close to Manhattan where we’d seen some very significant declines occur very rapidly.
We had some situations on the west coast where we actually raised prices and had better absorptions. Obviously we didn’t have impairments in those communities. On the other hand where we’ve seen markets to where we’ve had significant foreclosure action even if we’ve been able to improve pace, the amount of price decreases that occurred caused us to trigger additional impairment.
So I think that price is a more important factor, they’re not equal, when you’re looking at triggering impairments.
I think its fair to say, once you trigger then the amount of the impairments could vary by velocity and how long its out there. But in terms of whether it triggers it all, price is the more significant factor. And by the way, the price decreases, we saw a lot more pressure on prices in the fringe markets. Clearly that’s where we see more of the foreclosures and the reduced demand and we really had to adjust prices there more.
In the same market but going in closer to the employment centers or the coast, we might have actually seem some price increases. So you can’t paint for example southern California with one uniform brush. There are very different things going on in different locations.
Your next question comes from the line of Nishu Sood - Deutsche Bank
Nishu Sood - Deutsche Bank
First question I wanted to ask was about your mothballed lots, by the way thanks for all the detailed information but if I look at the 9,800 mothballed lots you have, that is close to half of your owned lots so just kind of painting a scenario here, looking a year out let’s say that the market is skidding along the bottom still or very slow recovery let’s call it, but, so that these mothballed lots are in this scenario still economically unviable. Or you can’t really monetize them effectively. You would be a year from now pretty close to running out of lots so just wanted to get your thoughts, if that’s the scenario we find ourselves in, what do you do in that situation. Are you forced in that situation then to go out and acquire a lot more lots or to sell these mothballed lots.
First of all I think our owned lot position is a little over 22,000. If you take these out we’re approaching 13,000 of owned lots not mothballed and if you look at our recent sales pace, and you annualize that, that’s actually a couple of years supply if we didn’t purchase any new lots. In some markets, like Houston and Dallas and parts of Washington and a couple of other markets, Minneapolis, etc., we are still purchasing lots on a lot by lot basis often times and most times after we’ve actually got a sales contract.
I believe last quarter we bought about 400 on that basis. So if you add that in as well we think we’ve got a reasonable supply. Add to that what we hope to purchase on the joint ventures, we’re comfortable that we’re not going to run out of lots before we have to unmothball these.
We still have 13,000 lots that are under option and as we mentioned a lot of those are Houston, Dallas, DC and other markets to where those options remain economically viable and we’re taking them down on a flow basis. So you’ve really got to look at the optioned in combination with the owned net of the mothballed I think to get to the answer you’re looking for and that is a still very significant supply.
But we’re not overly concerned about it on an overall basis.
Nishu Sood - Deutsche Bank
On the revolver, the $100 million drawdown, I just wanted to get a sense of the rationale for drawing it down. Even if you hadn’t drawn it down you would still have close to $700 million in cash on the balance sheet so why draw it down this quarter.
Well as I tried to explain in my prepared comments, there were benefits to the calculation of what we could free up under our restricted payment baskets and our covenant. That’s the primary driver for it and there was no negative impact of drawing that money down and we have subsequently repaid it.
Your next question comes from the line of Alex Barron – Agency Trading Group
Alex Barron – Agency Trading Group
I guess I have kind of a backwards looking 30,000 foot view question and that is, your own lot position has come down relatively little over the last three years compared to the number of deliveries you have done, so I’m wondering I guess in hindsight why have you continued to exercise lot options as positions as opposed to completely walk away from all those contracts.
Well first of all, in certain markets again like Houston and Dallas and in other locations, even right now in Virginia and Maryland and Minneapolis, we have land that’s under option. Its been renegotiated and it makes sense in today’s marketplace to do that. We continue to do that now. Those are properties that generate positive contribution for us.
If you go back on Monday morning, are there some that we wish we didn’t execute or exercise our option on, sure there are. But we have to make each decision with what we know at that point in time. Obviously walking away, and we haven’t been afraid to walk away from option contracts, we’ve walked away from many but based on the information we have, at that time, we make it our best estimate decision.
Alex Barron – Agency Trading Group
My other question is, it looks like the impairments seemed pretty large this quarter at least relative to my expectations, so I think you mentioned that you didn’t expect much of an improvement in the margin next quarter so I’m wondering what, one is what was the benefit from gross margin from previous impairment to the gross margin this quarter and why wouldn’t there be a bigger benefit going forward.
Well one example would be that we took impairments on the land that still is mothballed and you’re not going to get any benefit in gross margin reversals until such time as we actually begin to sell those mothballed lots. There are other lots that we will be selling that we incurred additional impairments on and that will have an incremental benefit to margin.
I didn’t say we wouldn’t have any margin improvement, I said there wouldn’t be dramatic margin improvement in backlog.
Your next question comes from the line of Timothy Jones – Wasserman & Associates
Timothy Jones – Wasserman & Associates
First question, you stated that there was a shortage of homes in certain markets and that you raised prices in other markets, can you name the markets in both cases and how much did you raise prices on average.
First of all what I said and there was some of the specific examples I gave, by historic standards, we’re undersupplied in number of lots, number of homes, and that’s in the existing home market. Typically four to six months supply in normal healthy markets exists throughout the country. I gave several examples, Stockton, Bakersfield, where it fell below that number.
Now its healthy in terms of number of months supply, prices though have remained challenging and that’s because most of the listings and the sales in those markets have been foreclosure sales and REO sales so the velocity has been good, prices have dropped, and people are taking advantage of it and that’s working well.
Now I mentioned and you asked about price increases, I’d say that has occurred in the closer in markets, specifically in southern California and some of the San Diego suburbs and in the closest in markets to LA or Orange County and there have been increases. I’d say over the past 60 days in those locations maybe 1.5% total has been the price increase which is positive. Its nice to have a positive but putting things into perspective they’ve dropped 30% plus so 1.5% is a positive trend.
But it doesn’t nearly make up for where it was.
And you’ve been around the block long enough that what we’re really saying is is the fringe markets are going to be the last to recover. We’re beginning to see better signs of stability in the closer in markets that are better located then we are in the fringe markets that are still being adversely impacted by foreclosures.
Timothy Jones – Wasserman & Associates
Forty-one years, the second question is that $90 million project that you mothballed on the Hudson River, what stage of development was it in and did the $8 million write-off that you took on the Hudson, did that have a, was that related to this project.
No, they’re two different projects, both on the Hudson River by chance, two different cities but $8 million was our portion of the write-down. That was in a joint venture and that’s in a building that’s under construction. The other one is developed land. Its almost all developed but its for a mid rise buildings that are unstarted.
Your next question comes from the line of James Wilson - JMP Securities
James Wilson - JMP Securities
One last question would be, could you go over a little bit kind of geographic exposure on your JVs and what of the debt is recourse, nonrecourse.
None of the debt on our existing JVs have any form of recourse or maintenance guarantees to us and the best evidence of that is we’re four years into this downturn and we’ve had no capital calls or any forced injection of additional equity even though we’ve written down our investment in JVs dramatically.
We always took a low leverage philosophy with our JVs, or at least what we thought at the time was low leverage, 50% debt to cap and its increased to 70% plus only because we’ve written down the value of our investment in JVs and we’ve not had any banks require us because they are nonrecourse in nature, no maintenance guarantees, etc.
Geographically we’ve got JVs in the Washington, DC market. We’ve got some in the northeast, so that’s really, primarily in the DC and northeast markets.
There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.
Thank you very much. We were glad to give at least some glimmers of positive light. We hope that by the time of our next conference call next quarter we’ll be able to share with you some more. Thank you and we look forward to chatting and updating you again.
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