Hovnanian Enterprises Inc. (NYSE:HOV)
Deutsche Bank 21st Annual Leveraged Finance Conference Transcript
October 2, 2013 5:10 PM ET
David Valiaveedan - Vice President, Finance
Jeff O'Keefe - Vice President, Investor Relations
Phil Volpicelli - Deutsche Bank
Phil Volpicelli - Deutsche Bank
After that rousing music, I don’t know how anybody can not be excited about listening to Hovnanian’s presentation here. I’m Phil Volpicelli. I cover the building materials, industrial and services, and at some point, I will be picking up on the homebuilders Hovnanian and these are likely being to the first.
But it’s my pleasure to introduce David Valiaveedan and Jeff O'Keefe from Hovnanian today. They are going to give you a little update on where they are and where the market is for homebuilding. David?
Thanks. Thank you and good afternoon, everyone. Thanks for the opportunity to update on U.S. housing market and on Hovnanian Enterprises overall. U.S. housing market is recovering. It's really no surprise given the overall improvement in the U.S. economy in terms of job growth and consumer confidence the U.S. housing market is recovering.
The best place probably start is to put some perspective on U.S. housing production, lot of data here, so please bear with me. But this shows U.S. housing starts starting with 1940 in the yellow bars on the left all the way through August of this year the blue bar on the right.
We’ve circled the cyclical peaks in red and you look at the prior, the most recent peak of little over 2 million starts in 2005 and you can see when you look across to the left, it is really not much different than prior periods and that's despite a significant growth in the U.S. population, which we’ve highlighted in gray box in the bottom during that same time.
When you look at the bottom, the trough though, you can see in the blue circles here, we have circled those and you look across to the left you'll notice that the most recent downturn is both been more severe and more -- and longer in duration than any prior downturn in recent history and significantly different than the prior three downturns in the blue circles.
So while we are certainly enthusiastic at 891,000 starts, significant improvement we’ve seen in overall U.S. housing production. It's -- looking across to the left it’s still during the 19 -- early 1940s still among the worst housing markets we’ve ever seen.
So when you look again on a decade average and look at housing production in the last decades which we’ve done with the green underline bars here, you can see in the 2001 to 2010 timeframe we produced 1.4 million homes.
On the right you can see in red, Harvard's demand projections, Harvard Joint Center for Housing Studies is projecting housing demand at $1.6 million to $1.9 million -- 1.9 million units. The good news is we highlighted Harvard here but if you go to really an economist and most economic sources, most people in that range and there is very little debate there.
But when you, what’s interesting when you look at it though is that if you take the overproduction of the last cycle and layer it on to the underproduction, we’ve experienced over the couple -- last couple of years, we are significantly underperforming 1.4 million unit average of the last decade but severely underperforming 1.6 million to 1.8 million future demand estimates.
On the pricing side, here we show the Case-Shiller 10 City Composite Index and you can see from July of 2012 through July of 2013 there was a 12.2% increase in the index. We have been focused on raising prices in all of our communities. Through the first nine months of this year we’ve raised prices in about 80% of our communities, in our most successful communities in Northern California those price increases been in the upwards of 30% to 40%, but again that’s our most successful communities and many more have been more modest. But there is definitely been an emphasis on raising the prices.
Here is the graph of the Affordability Index, the higher, its red is higher the Affordability Index the better and you'll notice that the red arrow points to the dip in affordability we saw at the peak of the last cycle. This was largely driven by the increase in home prices.
You’ll notice with the green arrow as both prices decline and mortgage rates decline affordability hit all-time highs and not surprisingly with the recent run-up in prices that we’ve seen, as well as increasing mortgage rate, July's reading has come down to 157.8, July’s reading 157.8 though is still significantly better than 135 level, which was a peak in the previous cycle.
So we still have significant room for either rates or prices to go up to get back to that same affordability level of the prior peak. And the chart on the left you see that rates can go up 135 to 130 basis points to get us to the 135 level. Our home prices could go up an additional 16% to get us to the 135 level.
We have been feeling a lot of questions about the impact of rising mortgage rates on housing market. We spoke of the noticeable different -- noticeable difference in the market we saw in July and August. The -- it was widely reported is primarily driven by the rising mortgage rates.
We went back and look back in history is to more the relationship between mortgage rates and housing starts during prior housing recoveries. So, on this chart in the blue we show mortgage rates and then total U.S. housing starts in some of those years.
So back in 1983, mortgage rates were 13.24% and the country still produced 1.7 million homes. Moving across to 2002, rates were 6.5% and we still produced 1.7 home -- 1.7 million homes. So it’s hard to believe -- it’s hard for us to start on that at 4.37 rates and 896,000 starts that we don't have more room to grow with housing starts.
I think, definitely there was a pause in -- I think it was more driven by the rapid increase in the rates more than the absolute level of rates. So just the way the treasuries move so quickly early in the summer cause corresponding spike in mortgage rates that happen very short period of times -- short period of time. Mortgage rates since moderated a little bit since the peak we have seen this summer.
Foreclosure and delinquency rates, here we show the total foreclosure rate in grey on the lower bar and delinquency rate in blue on the upper line. Not surprisingly with the overall improvement in the economy and the job situation that both these metrics are coming down.
Certainly early in the downturn, the foreclosure supply was significant competition for our new home sales. There has been lots of capital raise going after the foreclosures in the single-family rental business and in most of our markets today it is no longer a factor. Most of our markets month supply which is a measure of listings divided by closings is back to normalize levels. So it's really not significant competition any more.
Now transition to Hovnanian’s business strategy and our third quarter results. By way of background, Hovnanian is the sixth largest publicly traded homebuilder 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 ended July 31st we were open for sale in 190 communities in 37 markets in 16 states. The map below here shows the states we’re active in. It’s color coded by our public reported segments with the percentage of revenues derived in each of those segments. You'll notice that 38% of our revenue is -- was derived from Southwest segment which for us includes the Phoenix market and the Dallas and Texas -- Dallas and Houston, Texas markets.
Broad -- broad product diversification. Hovnanian is known for its broad product diversification unlike some of our peers and they only focus on one or two segments of the market. 33% of our buyers are first-time buyers, 33% are move up, 21% are luxury and 13% are active adult, which we generally market under our K. Hovnanian Four Seasons branding.
Improving operating results. Throughout the downturn in our strategy today remains the same. It's all about growing top line revenues. You can see on the upper left here, we’ve made significant progress in improving our revenues, growing our revenues from $358 million in the first quarter to $478 million in the third quarter.
The result of that is our SG&A on the lower right -- lower left rather. You can see that our SG&A and interest as a percentage of revenue, those expense items are largely fixed for us. So we continue to leverage the whole operating platform with continued growth and income. So SG&A has been reduced, 200 basis points from 13.8% in the first quarter to 11.8% in the third quarter. Similarly interest is down as a percentage of revenue 210 basis points.
On the SG&A front, we are 10%, kind of -- run rate is kind of more normal for us. On the upper right, you can see that our gross margins improved steadily 330 basis point improvement from the first of the third corner -- first of the third quarter from 17% to 20.3%.
The net results of all these efforts has been that our pretax income before land and debt related charges has improved from a loss of $20 million in the first quarter to $1 million positive in the second to $11 million in the third quarter.
On a net income basis, we generated net income of $11 million in the third quarter. It brings us just about the breakeven profitability for the first nine months. As we said on our call, we’re expecting a very strong fourth quarter. And at the time of our call, we iterated our guidance that based on our homes and backlog and gross margin on those homes. And absent any catastrophes in the market, we expect to be fully profitable for fiscal year ‘13.
Here we show our third quarter net contracts, both on the dollar-value basis on the left and unit basis on the right. You can see our contracts on a year-over-year basis were up 7.9% on a dollar-value basis and 1.8% on a unit basis. Certainly as we get further into this recovery, year-over-year comparison is going to become more difficult.
As we highlighted on our call, our third quarter included the month of July which we gave data on, was July was certainly slower than we had seen in June and likewise August was as well. One of the key strategies for us is to buy land obviously and we grow our revenues by opening more communities.
So we’ve made steady progress in growing our community count. You can see here starting on our left in October of 2012, we had 172 communities. We’re up to 186 communities on the right, four joint ventures in July of ‘13, that’s an 8% growth rate. But to do that, given an increase in the market is not easy to achieve that 8% growth rate, we had to open 76 communities and we closed out 62 communities by selling old homes. So it will be like running on a treadmill. They run faster just to keep up an improving market.
Gross margin, I indicated, we finished our quarter at 20.3%. I want to -- this is our annual gross margin going all the way back to fiscal year 2000 through fiscal year 2012. And try to put that 20.3 in perspective, it’s obviously 330 basis point improvement from first quarter as I mentioned but you can see that we’re just about back to a normalized gross margin, which for us was in fiscal 2000 to 2002 time frame, kind of, net 20% to 22% range.
And that was before, kind of, we had winded our back with price increases through that ‘03 and ‘05 kind of time frame. And so we’re pleased to have come back, all the way back to this kind of more normalized level of gross margin.
The other way we grow our top line is to sell more homes in each one of our active selling communities. Here we show our annual net contracts for active selling community starting in 1997 on the left all the way through a seasonally adjusted annual number for 2013.
And so while we’re pleased with the 32.3 contracts per community we’re generating and a 15% growth that represents over 2012 and 52% growth that represents over 2011. When you look back across, you can see we’re still a long way from a more normalized level of around 44 contracts per community. So still a long runway to go before we get back to normal in terms of annual contracts for active selling community.
Another key area of focus is reloading our land position. The land is one important need to grow our business. And on the left, you can see the lots purchased or optioned since January 2009, arguably that was at or near the bottom of the market. So you can see our lots controlled improved by 30,100 lots during the time frame with 497 communities, perhaps equally important and more important in some respect.
As of July 31, we still had 20,100 of those lots remaining. So we still have lot of holes we can deliver on land at attractive prices. And we’re working hard to grow that even further.
On the right, you can see what happened during the quarter. On the bottom right, total additions were 4,100 lots. We walked away from 200 lots during the quarter for the net of 3,900 lots positive.
200 lots that we walked away from and typically this is -- we walk away from lots in the early stages of due diligence. So we could have deposited up to get something on a contract subject to due diligence period. We walked during that period and canceled the contract and get our money back. So other than -- some minor investigative cost, we’re not really coming significantly out of pocket.
Increasing lots controlled, we were obviously pleased with the -- this shows on a more recent basis the progress we made in acquiring more lands relative to the amount we’re delivering every quarter. Starting in the third quarter of 2012, you can see the progress we made in kind of growing our additional lots controlled faster than we’re delivering them.
In the third quarter, we spent about $148 million on land and land development. That was a bit higher than $119 million average of the prior four quarters. As we continue to grow our land position, get more, get more communities open. We can continue to grow the top line and leverage a relatively fixed SG&A and interest costs.
When you add the newly acquired lots, we have acquired since kind of at the bottom of the market on top of our legacy land position. This breaks out our total land position by geographic segment. You can see that in total between our owned and option lots, we controlled about 29,700 lots.
That represents about a 3.2 year supply on trailing 12-month deliveries. If you would exclude the mothballed lots of 6,715, it’s about a 1.8 year supply of lots based on trailing 12-month deliveries. Down the bottom you can see 83% of the options are newly identified lots. So they are ones that have been bought at or near the bottom of the market and then excluding the mothballed lots, 76% of the owned and option lots are newly identified lots.
Turning to our balance sheet, throughout the downturn we want to preserve our liquidity to make sure that we had enough capital to participate in buying land at the bottom of the market. And we turn to on a solid pathway to profitability, which we are pleased to become profitable again for the first -- for all of this year.
We access the capital markets a number of times to extend our debt maturities. And you can see since 2008, we’ve also reduced our debt by more than $975 million. About a year ago, the blue bars on the right represent $797 million of secured debt. Those used to mature in 2016. Last fall, we successfully refinanced those into the tranche as you see here in 2020 and 2021 and at the same time reduced the overall interest cost on those notes.
Most recently, we clear the runway a little bit by doing in September. We extended the maturity of $37 million of unsecured notes that we’d do in 2014 and tack them on to an existing 2016 issuance.
So in total we have about $465 million of unsecured debt. That’s the red bars here. A year and half ago, that was not even, probably even sooner than that, I was trading all at significant discounts to power along the way, obviously reducing our debt we took advantage of that lot.
Today unfortunately, all that debt is trading at a premium. And so it is fully refinanceable. We can go out in the market and assure any number of banks about to sell new debt for us and persist out even further.
The issue is that it’s all subject to a make all call premium and so that call premium is pretty expensive especially on the longer dated notes. With no real -- with no maturities until 2015 and only a modest one at that at $85 million, we think the best use of our capital is to continue to deploy it into the business. And we remain comfortable that we can tackle these maturities with cash and pay them off or refinance the portion of maturity when that may call become more manageable.
On the left, you can see our current liquidity position. We have finished the quarter at $279 million of liquidity. That consisted of the $226 million -- $227 million of homebuilding cash and approximately $52 million of availability under our five-year revolving credit facility.
We remain under invested relative to our liquidity target range of $170 million to $245 million. So we certainly have the capital to take on additional land opportunities. We are sticking to our underwriting criteria and our discipline of underwriting to an unleveraged IRR of 20% to 25% based on today’s home prices and today’s pace of sales that don’t allow them to -- our divisions to assume any improvement in market conditions in terms of home price increases or improving the pace of sales.
Also on the balance sheet, another area of focus is our deferred tax asset. Throughout the downturn we have taken steps to protect this deferred tax asset. As many of you know these tax carry loss -- these tax loss carry backs are good for 20 years from when they were incurred.
So on a tax basis -- on a federal tax basis, we won't be paying cash taxes on a next $2.1 billion of revenue -- profit rather that we make on a GAAP basis. We have a $941 million valuation allowance against this deferred tax asset. And we’re told that based on being profitable for the full year this year with the expectation of profitability continuing next year and being sustained beyond that.
With one stroke of a pen, we are going to reverse that DTA potentially some time next -- likely some time next year. So on a third quarter basis -- on a pro forma basis for our third quarter, that would take our $467 million stockholder equity deficit and turn it immediately into a $474 million positive. We hope that also would be catalyst for the equity markets as well.
In summary, it’s -- lot of things positive going on in the market in the code economics 101 here and it is not rocket science. There is a lot of conditions that are favoring all the builders and Hovnanian as well. Lots of suppliers diminished during the downturn, very little land is taken through the entitlement process in the most severely supply constrained markets.
It can take three to five years in places like California, New Jersey to get entitlement. The public builders including Hovnanian are clearly gaining market share as we move forward here. Many of the private builders and a few of the publics for that matter aren’t with us any more.
Many of the privates have trouble accessing capital they’re allowing on the bank market primarily they just haven’t been active yet. And as I mentioned the foreclosure supply is really not a factor any more. Also on the positive the population is projected to continue to grow. Consumer sentiment and confidence are positive although admittedly fickle.
Households are unbundling. There are lot of weighted household formation we saw during the downturn, the college kids, the boomerang kids, moving home with their parents are now fortunately getting jobs and moving out on their own and will be starting their own households.
Rents in many markets have risen significantly throughout the downturn. So they are on a rent to own equation. It is actually cheaper to own. We think all these factors are the right ingredients for a very long and healthy housing market here, one that Hovnanian is well positioned to participate in.
So with that I will open it up for questions.
How do you make a decision to buy lots more often (inaudible)?
In ideal world we would option everything. But unfortunately the land markets, the ideal scenario is to, for lack of that word, option it from the natural holder, the farmer and buy it at on a just in time basis after it’s entitled and buy it just in time basis as we sell homes.
Land market is competitive and you can’t always do that in lot of markets. And so the options, so the decision ends when you are going to own something, are you going to land bank it, a lot of it in our mind, say, goes to what’s the aggregate level of capital commitment involved in the location, because there are some other -- there are some costing doing the land banking transaction, frictional transaction cost.
And it will -- but the benefit is of course that it shifts risk, because when you take something and land bank it. We’ve reduced our exposure from the 100% ownership to really just option deposit.
So that’s really the -- it’s really in, but the benefit of, we are not making our -- we are not changing our investment criteria based on our execution strategy. So we don’t buy something and assume that we are going to land bank it. We buy it on a wholly own basis. So the additional lift we get from the leverage provided by the land bank is just accretive to our 20% to 25% IRRs. Yes.
In terms of the cost to get to a finished lots status? Yeah, I mean, I think, we’re, I’m not hearing anything. Certainly I think the cost have gone up similar we see -- where we’ve seen on the homebuilding side, some price increases on commodities and labor in particular, which was really kind of expected, because lot of those firms have been operating at below level margins for so long. But nothing outside of that we would discuss think of us unusual or significant. And the net result is, net-net when we sell the home we have been able to increase home prices more than the built-in -- than the cost we’ve -- increases we have experienced.
No. I mean, we have the 6,700 mothballed lots, throughout the downturn we’ve been, where it made economic sense we have been mothballing it, I think we have unmothballed 33 communities since the downturn. On our last call, we said that there are four communities.
… I was reverse this so, 4 communities in 500 lots that we -- were likely to be unmothballed in the up -- relatively soon.
And since January of ‘09 we have actually unmothballed 3,500 lots in 62 communities. So we’ve been doing it all long here.
Where the mothballed lots are most located?
Most of the mothballed lots are in our west segment which for us is California. I think its 4,767 of the 6,715 lots.
Well, I think, we were clear on our call that we’re not going to stand by and let pace go and let pace go far below our underwriting expectations. When we have instances where we had push prices beyond, where the market would accept -- we would take steps to reduce our net pricing to keep sales moving along. And since the quarter I think we’ve estimated we reduce prices in less than 10% of our communities. Yes.
Yeah. I wouldn’t say we, I mean, we certainly pay attention to kind of the competitive landscape and where we stack up, what’s our, builder ranking, in terms of how many deliveries we have versus our competition.
Certainly there are some clear benefits to being one of a larger builder in a market in terms of -- particularly in terms of access to land. They start calling you instead of you haven’t find them a lot. But we are not running making any real decision about where to deploy our capital or anything based on our markets share in any particular market.
We are underinvested relative to our liquidity target. So we finished the quarter with $279 million and so we remained open to get fully deploying all of our geographies that we currently participate in. Any other questions? Okay. Thank you.
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