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Hovnanian Enterprises, Inc. (NYSE:HOV)

Imperial Capital Global Opportunities Conference Call

September 19, 2013 11:30 ET

Executives

David Valiaveedan - Vice President, Finance and Treasurer

Jeff O’Keefe - Vice President, Investor Relations

David Valiaveedan

Okay, good morning everyone. I am David Valiaveedan from Hovnanian Enterprises. I am Vice President and Treasurer – Vice President of Finance and Treasurer there and Jeff O’Keefe here is Vice President, Investor Relations, he is joining me this morning. Thank you for the opportunity to update you on the U.S. housing market and on Hovnanian Enterprises in general. I am going to start with a general overview of the U.S. – of the housing market and then talk about our recent performance.

Okay, not surprising, in so much of the overall U.S. economy, the housing market has also entered into a period of recovery. Perhaps the best way to look at that is to think about U.S. housing production and there is a lot of data on the slide, so bear with me. But the yellow bars, essentially this is U.S. housing starts from 1940 through the present through the last bar here is July’s seasonally adjusted annual rate. If you look across the top of the yellow bars, we have circled the peaks of the previous cycles in red. You immediately notice, of course, that the peak of a little more than 2 million homes in 2005 was not that all different than previous peaks despite a significant population increase, which you see in the bottom of the slide there, the U.S. population. Similarly, we have circled the troughs in prior cycles in blue. And again if you look across, you would see that this cycle has been very different in terms of the falloff in housing that we have seen.

Even at today’s level, it’s 896,000 through July. The August number just was released the other day was 891,000 and while we are tickled with the improvement that we have seen over the absolute lows of 554,000, we got a long way to go. The green underlined bars, the green underline shows the decade starts by average over the past decades. So in the 2001 to 2010 timeframe, you can see we have produced 1.4 million starts. We have also included a Harvard’s demand projection. This is the Harvard Joint Center for Housing Studies. They are suggesting demand of 1.6 million to 1.9 million homes. There is really very little disagreement upon economists. You can go to moodys.com or anyone else and they are kind of all in this ballpark. But what’s interesting is if you take the overproduction of the last cycle and layer it on to the housing production over the last couple of years, you will see that we are not only under-producing decade average significantly, but also the long-term projections as well. So by any historical standards, we are in the very early stages of recovery here.

Here we show the Case-Shiller pricing index, you can see that we have seen an 11.9% increase in general market pricing from June 2012 to June 2013. Pricing is going up in virtually all of our markets. Through the first 9 months of 2013, we have raised prices in about 80% of our communities. In some of our strongest communities in Northern California, we’ve seen increases upwards of 30%, 40%, but that’s in our best performing communities.

Here we show a graph of the affordability index, which from 1975. Here this red is the higher the affordability index the better and you can see that on the red arrow, as in the last cycle at the peak, affordability dipped due to rising increases and then with the downturn in prices and downturn in mortgage rates peaked to historical highs. More recently in July, you see it’s come down a little bit with the increase – rapid increases in prices we have seen slight uptick in mortgage rates, but that 157.8 number is still significantly higher than the 135 number of the previous cycle. On the left, you can see that rates can still go up 130 basis points to only bring – and would only bring down affordability to the previous peak. Similarly, home prices can still go up 16% from where we are today to get back down to that 135 affordability number.

Foreclosure and delinquency rates. I mean, this was certainly a factor early on in the cycle, where foreclosure and supply was a significant competition to our new homes. You can see the foreclosure rate in grey at the bottom of the graph and delinquencies in blue at the top, not surprisingly with the overall improvement of the economy both these metrics are coming down. This is no longer a concern in most of our markets. Months supply, a measure of listings divided by close – divided by sales in the market is really back down to historical levels of really 2 months to 4 months supply in most markets, so no longer a factor.

I will now transition into Hovnanian’s business and our third quarter results. As a way of background, Hovnanian is the sixth largest publicly traded builder in the U.S. based on deliveries. We were founded by Kevork Hovnanian in 1959 and his son Ara Hovnanian is our current Chairman, President and CEO. As of our third quarter, we are active in 190 communities, in 37 markets, in 16 states. Those states are highlighted in the map below with revenue percentages by publicly reported segments. So you can see the 38% of our revenue is derived in the Southwest segment of Arizona and Texas, which is the Phoenix, Dallas and Houston markets for us.

Hovnanian is a diversified builder with a broad product array, unlike some of our peers that focus only on one or two segments. One-third of our business is first-time buyers, one-third move up, about 21% luxury and 13% active adult, which we market through our Four Seasons at K. Hovnanian brand name. Throughout the downturn, our – and today, our strategy continues to be the same. It’s all about maximizing total revenue. We grow revenues by having more communities opened for sale, selling more homes in each of those communities and increasing prices.

You can see the progression we have made in this fiscal year growing revenues in each of our first three quarters. Our community count is up 8% since the end of fiscal 2012. On the bottom left, you can see with the increasing revenues, we continue to leverage our relatively fixed SG&A and interest costs. Since the first quarter, SG&A and interest have decreased by 200 and 210 basis points respectively. We are quickly approaching 10% on SG&A, which is really a normal measure for us. On the upper right, you can see our gross margin has also improved each quarter. Our 20.3% we delivered in the third quarter puts us back to almost normalized margins, which for us in either in a more normalized term, not excluding the peak of 2005-2006 was really in the 20% and 21% range. So we are really back to normal there.

All of this – on the bottom right I skipped over that. On the bottom right, you can see we generated $11 million of pre-tax income excluding debt-related charges and land-related charges, which brings us almost to break, and for the first – I apologize, on the net income basis we generated $11 million of net income – $8 million of net income sorry. This is second consecutive quarter of net income. And based on our homes and backlog and the margins on those homes, we reiterated again on our third quarter call that we expect to be profitable for the first – for the full year assuming no changes in the market conditions here.

Our sales performance in the third quarter, we were able to grow the dollar value of net contract 7.9% year-over-year and the number of contracts increased 1.8%. Our July quarter does include the month of – our third quarter does include the month of July. And July was clearly slower on a sales perspective than June. Had we had a June quarter end similar to some of our peers these numbers would have looked more like 17% on the contract dollars and 10% on the units. We have been putting together – we have been posting significant year-over-year increases. As we get further into the cycle, it’s going to be harder to keep that up. Nonetheless, the July and August as we clearly said were slower than the previous months.

Going back to another component of how we increased total revenues, it’s the pace of sales. As you can see on the right, here we show the active annual contracts per selling community for the last 16 years going back to 1997. Annualized year-to-date we are at 32.3%. And while that’s a 15% improvement over 2012 and a 52% improvement over 2011, you can see we got a long way to go before we get back to the average of 44 contracts per community.

Another significant area of focus is our land position. You can see that on the left hand side here since January of 2009 when we started buying land again, we have increased our lots control by 30,100 lots in 497 communities. And then as of the end of the third quarter, we still had approximately 20,100 of these lots, which are owned at attractive land values for our future deliveries. On the right hand side, we show the total additions during the quarter were 4,100 lots and then we walked away from 200 newly identified lots. These walkaways typically occur during the early stages of due diligence. We usually get our deposit back. The net results for the quarter, was that our lot position control since 2009 increased by about 3,900 lots in the third quarter.

So on a more recent basis, you can see that the growth we actually had in terms of replacing our lands over the past 5 quarters, our net additions have exceeded our deliveries and we outpaced it significantly in the third quarter delivering – acquiring 3,900 lots and additional lots in delivering 1,502 homes. During the third quarter, we spent about $148 million on land and land development, which was higher than the average of $119 million we spent during the prior four quarters. We certainly have the liquidity to keep buying land, but we are staying disciplined to our underwriting criteria, which assumed to current sales pace in the market with no assumed price increases.

Turning to our balance sheet. Here we have our debt maturity profile and our current liquidity position. Since October of 2008, we have reduced debt by more than $975 million. And most recently, we extended you can see in September ‘11, we extended – we did extended debt maturities of $37 million of 2014 notes and tapped it on to our 2016 notes further clearing the runway. All-in-all, we have about $465 million of unsecured debt maturing through 2017 with the first maturity of $85 million in 2015. All of our – it’s hard to believe a year ago all of our unsecured debt was trading at significant discounts. It’s all trading at above par today and it’s all subject to a make-whole. Because of the significant premium on the make-whole, we are not anxious to tackle the refinancing today. We feel comfortable that we will be able to tackle those maturities as they come due or refinancing into the future.

On the liquidity side on the left, you see we ended the quarter at $279 million of liquidity, which includes $227 million of homebuilding cash and approximately $52 million available under our five-year revolving credit facility. Our stated liquidity target range is $170 million to $245 million. So we remain above that range. If we can find suitable land, we have said we will be comfortable operating at the lower end of that range.

Also with regard to the balance sheet as we return to sustained profitability, we have $941 million deferred tax asset on our balance sheet assuming we are profitable this year and next. And with the expectation of continued profitability, we are told we would expect to reverse that for GAAP purposes on to our balance sheet. As of the third quarter that wouldn’t mean our negative $467 million of equity – of negative equity return to a positive $474 million with the stroke of a pen for GAAP purposes. For tax purposes, of course, the carry loss-forwards are good for 20 years and we won’t be a cash taxpayer on the next $2.1 billion of future tax profits. And that’s all I had, open it up for questions.

Question-and-Answer Session

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

It’s really in all the markets that we are in. So we are open for – since we are underinvested relative to our liquidity target, we remained open for investment in all of our markets. So our teams are all of them are pursuing land deals that meet our underwriting criteria 20% to 25% IRRs.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

We certainly have the liquidity to buy land exclusively with cash. We previously announced a land banking relationship last year with GSO, so that provides $250 million of additional land and land development capital, which we are deploying on our larger projects. And we are also seeking non-recourse bank financing were available, but the banks aren’t really active players yet. But to fuel our growth, we are looking to bring on that additional leverage as prudent.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

We hear complaints. I am in the corporate office and I hear complaints from our division guys that everybody else is assuming price increases in their underwriting and are losing deals, yet we don’t see that, we don’t consistently lose to the same guy nationally or in any market. And we still believe that most of us are underwriting rationally. We have said though in certain markets where those extenuating circumstances we may lower our hurdle rate a little bit bring that down at 25 to a 20, but we are still not assuming a faster pace for any price increases in that analysis. So I just think it just comes down to the community specific nuances of what product they are planning, how they are planning their community, what amenities they are offerings, any differences between us and other builders in bidding on land.

With regard to the second part of the question of partially developed or undeveloped lots, most of the partially developed and finished lot opportunities are behind us now. That was really the first low – that was really the low hanging fruit that was picked up first. From our perspective, we underwrite to an IRR so we take into account the additional capital commitment necessary to bring the lot to a finished lot status. So we are really agnostic as to what condition it’s in.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

I mean, commodity pricing fluctuates greatly. Lumber is the largest component – largest commodity that goes into the homes. And while that was up early in the year, it still to come down. For certain branded products, we have national contracts that give us discounts for our volume. And so we are more price takers on that stuff. With regard to labor, labor is definitely creeping up a little bit, which we have been expecting with the volume increases we had. Throughout the downturn, we really pushed our labor pricing down to really breakeven and made it up on volume with a lot of the subcontractors, not surprisingly with the increase in prices. The first one is out with their hands looking for price increases.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

It’s hard to put a number on it. It varies so much, but by and large – but overall, we have been able to increase home prices more than the labor increase as you can see by our increasing gross margin, which is going up. So that’s really net-net, the effect has been overshot by the price increases we have been able to implement and that’s historically been the case.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

We don’t – no, I haven’t seen any impact or heard any even anecdotally of people positioning themselves for the implementation of the healthcare act. Other than people are taking full-time employees are here and anecdotally in the market and making them part-time, but I haven’t heard that specific point raised with regard to our labor forces that we are deploying.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

No, I mean, I think traffic has remained steady even in the slight pause in the summer here that we saw in the markets. In general, it feels buyers are pretty committed. We have existed in this more document intense sort of mortgage environment for sometime now. So I think people have been either through it on the refinance basis and are kind of familiar with the changing process. So I don’t see any real changes in that regard. And the way back.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

Sure. All the markets really were – have been performing well and exceeding our expectations. Throughout the downturn and even today, our Texas markets are probably our strongest. In terms of consistency, we have seen probably the greatest price increases in our California markets in Northern and Southern California markets. And then we have seen more moderate pickup in kind of all our other markets for various reasons, including even Ohio for the resurgence in the auto industry and fracking in Florida as well in the Northeast. So it’s been pretty uniform and some big outliers in particular in the Northern California market.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

I don’t think we – our mix varies considerably. And so I wouldn’t say I have seen any discernable shift. With our broad product array, we really have a home type or every piece of land out there, so we have that benefit. It fairly depends on what the land is entitled for and what you are capable of building.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

Yes. I mean, I think well, in total, we have about little over 6,700 mothball lots, the bulk of them are in the west as we said 4,700 of them. We constantly are evaluating the mothballed communities to bring them back into production. And we have had a history of doing that already. To-date, we have brought back 51 communities, I am sorry, 3,500 lots in 52 communities. And I think on the last call, we said there are about four communities totaling 500 lots that we would expect to bring back in the shorter term, but it’s a market-by-market decision. We think those are good stable source of land when they are economically viable, again, because we don’t have to compete against anybody to buy them.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

Yes, I don’t think we are seeing any noticeable change in buyer preferences. In general, I would say that because mortgage rates are attractive, people are generally opting for the larger home sizes and generally selecting a lot of options to maximize their buying power. So I am not really seeing any noticeable – I am not hearing of any noticeable trends between the different buyer groups.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

I mean, I think we have slightly over $100 million thereabout of performance bonds outstanding. That’s the face amount that we kind of evaluated based on the amount of work. So we put up performance bonds to secure the performance of certain improvements in communities generally infrastructure improvement. We know how much would that work if we have done at any one time. So we think our remaining work to be completed is much less than that. I think it’s about slightly half of that in terms of real work to be done. The unknown is really when that’s accepted by the ultimate municipality who has to opine that the work has been done satisfactorily. And usually it just takes time, but once we get the work in, it’s released. So it’s just an ordinary course of business type thing that we are just bonding for those improvements.

Unidentified Analyst

(Question Inaudible)

David Valiaveedan

Not necessarily, it depends on jurisdiction, most of that is just surety bond providers, so it’s an insurance product. Some of it is held in LCs, though, depending on the requirements of the municipality.

Unidentified Analyst

I think we are done.

David Valiaveedan

Okay, thank you.

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