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Hovnanian Enterprises, Inc (NYSE:HOV)

Q3 2014 Earnings Conference Call

September 4, 2014 11:00 AM ET

Executives

Jeff O'Keefe - VP, IR

Ara Hovnanian - Chairman, President and CEO

Larry Sorsby - EVP and CFO

Analysts

Adam Rudiger - Wells Fargo

Michael Rehaut - JP Morgan

Ivy Zelman - Zelman and Associates

Nishu Sood - Deutsche Bank

David Goldberg - UBS

Joel Locker - FBN Securities

Megan McGrath - MKM Partners

Adam Steinberg - Waveny Capital

Stephen Kim - Barclays

Operator

Good morning and thank you for joining us today for the Hovnanian Enterprises' Fiscal 2014 Third Quarter Earnings Conference Call. An archive of the web cast will be available after the completion of the call and run for 12 months. The conference is being recorded for rebroadcast and all participants are currently in a listen-only mode.

Management will make some opening remarks about the third quarter results and then open the line for questions. The Company will also be webcasting a slide presentation, along with the opening comments from management. The slides are available on the Investors page of the Company's web site at www.khov.com. Those listeners, who would like to follow along, should logon to the web site at this time.

Before we begin, I would like to turn the call over to, Jeff O'Keefe, Vice President, Investor Relations. Jeff, please go ahead.

Jeff O'Keefe

Thank you, operator, and thank you all for participating in this morning's call to review the results for our third quarter. Before we get started, I would like to quickly read through our forward-looking statements.

All statements in this conference call that are not historical facts should be considered as forward-looking statements. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Although we believe that our plans, intentions and expectations reflected in or suggested by such forward-looking statements are reasonable, we can give no assurance that such plans, intentions or expectations will be achieved.

Such risks, uncertainties and other factors include but are not limited to, changes in general and local economic, industry and business conditions and impacts of the sustained homebuilding downturn, adverse weather and other environmental conditions and natural disasters, changes in market conditions and seasonality of the Company's business, changes in home prices and sales activity in the markets where the Company builds homes, government regulation, including regulations concerning development of land, the homebuilding, sales and customer financing processes, tax laws and the environment; fluctuations in interest rates and availability of mortgage financing, shortages in and price fluctuations of raw materials and labor, the availability and cost of suitable land and improved lots, levels of competition, availability of financing to the Company; utility shortages and outages or rate fluctuations, levels of indebtedness and restrictions on the Company's operations and activities imposed by the agreements governing the Company's outstanding indebtedness, the Company's sources of liquidity, changes in credit ratings, availability of net operating loss carry-forwards, operations through joint ventures with third parties, product liability litigation, warranty claims and claims made by mortgage investors, successful identification and integration of acquisitions, significant influence of the Company's controlling stockholders, changes in tax laws affecting the after-tax costs of owning a home, geopolitical risks, terrorist acts and other acts of war, and other factors described in detail in the Company's annual report on the Form 10-K for the fiscal year ended October 31, 2013, and subsequent filings with the Securities and Exchange Commission. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason.

With that out of the way, joining me today from the Company are Ara Hovnanian, Chairman, President and CEO; Larry Sorsby, Executive Vice President and CFO; Brad O'Connor, Vice President, Chief Accounting Officer and Controller; and David Valiaveedan, Vice President of Finance and Treasurer.

I'll now turn the call over to Ara. Ara, go ahead.

Ara Hovnanian

Thanks Jeff. We are pleased to review the result of our third quarter ended July 31, 2014. I am going to start with slide number 3. Our total revenues increased 15% year-over-year from the third quarter of fiscal 2013. Our revenue growth was driven by an increase of deliveries, and an increase in average sales price from $345,000 to $367,000.

Although we have been able to increase home prices in certain communities across the country, the 6% increase in our average sales price was primarily driven by changes in geographic and product mix.

Moving to the upper right hand portion of the slide, our homebuilding gross margin increased 100 basis points year-over-year to 21.3%. Continuing clockwise, in the lower right hand quadrant, we show that the dollar value of the backlog increased 14% year-over-year. In the lower left hand quadrant, we show that our SG&A ratios increased slightly this quarter compared to last year. Larry will talk a little more about SG&A in a moment.

Lastly, we show that interest as a percentage of total revenues decreased 100 basis points compared to last year's third quarter. Going forward, we remain focused on growing our revenues even further, so that we can leverage our operating platform and drive increased profitability.

Slide 4 illustrates the operating leverage that we gained, as we grew our revenues during the first three quarters of fiscal 2014. As we sequentially increased our top line, we leveraged our fixed costs and returned to profitability during the third quarter.

Starting the upper left hand corner of the slide, you can see that sequentially our total revenues increased 24% from the first quarter to the second quarter, and then another 22% increase from the second quarter to the third quarter.

Moving to the upper right hand portion of the slide, our gross margin also increased sequentially each quarter in 2014 from 18.8% in the first quarter to 21.3% in the third quarter. In the lower left hand quadrant, we show that our total SG&A and total interest expense, as a percentage of total revenues improved sequentially each quarter during 2014. Our SG&A ratio improved 16.6% in the first quarter to 12.2% in the third quarter and our interest expense ratio improved from 9% to 6.5%.

The results of these improvements on our profitability can be seen in the lower right hand portion of the slide, where we show we swung to a $15 million pre-tax profit during the third quarter. We are convinced that as we continue to generate increases in revenues, we will show further improvements in our SG&A and expense -- interest expense ratios, and over time, return them to more normalized levels. Additionally, in the third quarter of 2014, the dollar value of our consolidated net contracts increased 5% to $517 million from $495 million last year.

At the beginning of this year, we expected to continue to see improvements in sales pace and overall housing activity, similar to what we saw in 2013. The housing market has certainly improved dramatically, compared to where it was in the trough of the market in 2009, but this year sales pace has been choppy. Slide 5 shows the dollar amount of net contracts, including unconsolidated joint ventures on a monthly basis, with most recent months shown in blue, and the same month a year ago shown in yellow. This slide illustrates the choppiness that we have recently in the market.

Focusing on the last two quarters, we have flipped back and forth between year-over-year increases and decreases each and every month. Finally in August, we bucked the trend and had two consecutive months of improvements in the dollar amount of net contracts.

On slide 6, we show net contracts per community for the most recent months in blue, compared to the same month in the previous year shown in yellow. After 20 consecutive months of year-over-year increases -- in July of 2013, we began reporting negative year-over-year comparisons. Since then, we have had only two monthly year-over-year increases; one was in March, when we had a national sales promotion, and fortunately, one was recently in the month of August. We are encouraged that the number of net contracts per community in July approach same levels as last year, and in August, exceeded last year by 9%.

Given the somewhat easier monthly comparisons going forward, we remain optimistic that we will be able to achieve year-over-year improvements in net contracts per community, and reverse the negative trend, the homebuilding industry and our company has experienced over the last year.

On slide 7, to give you complete granularity and transparency and recognizing that many in the industry are concerned about recent sales, we show week by week comparisons. You can see, that since mid-July and for seven weeks in a row, we have achieved weekly year-over-year increases in net contracts.

Based on the growth in our community count, net contracts in our average selling price, the dollar amount of our backlog has grown compared to last year. On slide 8, we show the dollar amount of our backlog increased 14% to just over $1 billion from $897 million last year. You can also see that the number of homes in backlog increased 5% year-over-year. This increase in backlog, combined with the growth in our community count, gives us the confidence that we will be able to continue to grow our top line, as we head into next year.

Slide 9 shows that we have successfully grown our consolidated community count over the past two years. Most recently, our community count increased 5% year-over-year from 186 at the end of the third quarter of last year, to 196 at the end of the third quarter this year. During the trailing 12 months, we opened 92 new communities, but closed out 82 older ones. We continue to focus on growing our community count even further. As the homebuilding industry continues its recovery, we believe that the sales pace per community will return back to more normalized levels. That growth and sales pace, combined with the growth in our community count, will prove to be a powerful driver of future increases in our profitability.

Taking a step back and looking at the bigger picture, we continue to believe that household formations will be the primary driver of long term housing demand. Future improvements in the U.S. economy, including the creation of better paying jobs, will be beneficial to household formations, which will ultimately benefit the homebuilding industry. The current low level of housing formations is not consistent with the population growth or the demographics of our country. Given the low levels of total U.S. housing starts, we are convinced that we are in the early stages of the housing industry recovery, and as such, we are laser focused on identifying new land parcels and growing our community count and our top line.

I will now turn it over to Larry Sorsby, our Executive Vice President and CFO.

Larry Sorsby

Thanks Ara. Let me start with a discussion about our gross margin trends. Slide 10 shows that we have reported year-over-year improvements in gross margins for the past 10 quarters. During the third quarter of fiscal 2014, we once again achieved gross margin percentages in excess of 20%. Although we expect a gross margin for our fourth quarter in excess of 20%, we do not expect the fourth quarter to exceed last year's fourth quarter gross margin of 22.6%.

Turning to slide 11, we show our gross margin percentage going back to fiscal 2000. If you focus on the left hand part of the slide, in fiscal 2000 and 2001, neither boom nor bust years, our gross margin was between 20% and 21%. We consider this to be a normal gross margin range for our company. Assuming no changes in current market conditions, we expect our gross margin for our full fiscal 2014 year to be similar to the 20.1% we have reported in all of fiscal 2013. This expectation takes into account the increased concessions that we offered during our big deal days, sales promotion, and the sales incentives we continue to offer across many of our markets today.

Turning to slide 12, you can see that our total SG&A as a percent of total revenues decreased 170 basis points from the second to the third quarter of fiscal 2014. We expect further reductions in this ratio in both the fourth quarter and in future years. While our SG&A ratio decreased sequentially in both our second and third quarters, our SG&A expenses and our SG&A expense ratio have increased slightly, compared to the prior year. The majority of this increase was related to our efforts to grow our community count, including higher compensation related to increased staffing, increased advertising costs and increased architectural expenses.

Additionally, as a result of fewer joint venture deliveries, we experienced a reduction in joint venture management fees, which is an offset to general and administrative expenses. The remainder of the increase was due to increases in compensation for many of our field associates that are reflective of today's competitive homebuilding environment.

On slide 13, we show our annual total SG&A expenses as a percentage of total revenues going back to fiscal 2000. We consider approximately 10% as a normalized SG&A ratio, as we continue to generate revenue growth, we expect to be able to leverage our fixed SG&A expenses further and get this ratio back to a more normalized level. Although we expect our total SG&A dollars to increase in fiscal 2014, we anticipate that our SG&A as a percentage of total revenues during 2014 will be similar to the 11.9% we have reported for all of fiscal 2013. Assuming no deterioration from current market conditions, we expect our pre-tax income for our full 2014 fiscal year to be similar to our pre-tax income for all of fiscal 2013.

Turning now to slide 14, you will see our owned and optioned land position broken out by our publicly reported market segments. At the end of the third quarter, 91% of our option lots are newly identified lots we have put under control since January 2009. Excluding mothballed lots, 83% of our total lots are newly identified lots. Our investment in land option deposits was $75 million at July 31st, 2014, with $73 million in cash deposits and $2 million of deposits being held by letters of credit. Additionally, we have another $16 million invested in predevelopment expenses.

Turning now to slide 15, we show our mothballed lots broken out by geographic segment. In total, we have about 6,000 mothballed lots within 46 communities that were mothballed as of July 31st, 2014. The book value at the end of the third quarter for these remaining mothballed lots was $104 million net of an impairment balance of $414 million. We are carrying these mothballed lots at 20% of the original value.

During the quarter, we unmothballed a community in Southern California. Since 2009, we have unmothballed approximately 4,100 lots within 67 communities. Every quarter, we review each of our mothballed communities to see if they are ready to be put back into production. As home prices continue to rise, we expect to unmothball additional communities as we move forward.

Looking at all of our consolidated communities in the aggregate, including mothballed communities, we have an inventory book value of $1.4 billion, net of $585 million of impairments. We have recorded those impairments on 75 of our communities. With the properties that have been impaired, we are carrying them at 20% of their pre-impaired value.

Another area of discussion for the quarter is related to our current deferred tax asset valuation allowance. At the end of the third quarter of fiscal 2014, the valuation allowance in the aggregate was $933 million. Our valuation allowance is a very significant asset, not currently reflected on our balance sheet, and we have taken numerous steps to protect it. We will not have to pay federal income taxes on approximately the next $2 billion of pre-tax earnings. We are in the process of reviewing the time and we are endorsing our valuation allowance under GAAP with our auditors.

Based on current assumptions for future periods, we expect to be able to reverse all or part of the federal valuation allowance at the end of fiscal 2014, with any remaining portion reversed in fiscal 2015. When the reversal does occur, it will be added back to our shareholders' equity, further strengthening our balance sheet/

On slide 16, we show tat we ended the third quarter with a total shareholders deficit of $443 million. To add back the total valuation allowance as we have done on this slide, then our shareholders' equity would be a positive $490 million. Over time, we believe that we can repair our balance sheet by returning to profitability and have not intentions of issuing equity anytime soon.

Now let me update you on our mortgage operations, turning to slide 17; you can see that the credit quality of our mortgage customers continues to remain strong, with average FICO scores of 745. For the third quarter of fiscal 2014, our mortgage company captured 62% of our non-cash home buying customers.

Turning to slide 18, we show a breakout of all the various loan types originated by our mortgage operations for the third quarter of fiscal 2014, compared to all of fiscal 2013. Our percentage of FHA loans was 15% in the third quarter of fiscal 2014. At the top right hand portion of this slide, we have shown that this is down from the high 38% FHA originations in fiscal 2010. The steady decline in FHA is primarily due to increases in FHA mortgage insurance costs. Borrowers have switched away from FHA loans to more affordable Fannie Mae and Freddie Mac conforming loans.

Now, turning to our debt maturity ladder, which can be found on slide 19. The red bars on this slide represent unsecured debt. We have a lot of runway in front of us, before any material levels of debt come due. We believe that we have the ability today to refinance all of our unsecured debt that matures between 2015 and 2017. However, we don't see enough benefit to paying the high costs associated with the make-hold provisions to refinance those bonds today. We are not likely to refinance or pay those bonds off, until such time, as we're closer to the maturity dates.

As seen on slide 20, even after we spent $138 million on land and land development during our third quarter, we ended the third quarter of 2014 with $232 million of liquidity, which includes about $50 million undrawn under our $75 million unsecured revolving line of credit. We ended the quarter near the upper end of our target liquidity range of $170 million to $245 million. We feel good about our liquidity position and if we find sufficient new land parcels that meet our underwriting hurdle rates, we remain comfortable, even if our liquidity was at the lower end our target range.

As you can see on slide 21, beginning in the second half of 2012, the number of net additions to our lot count have exceeded the number of deliveries by about 10,900 lots. In the third quarter, our net additions totaled 1,600 lots, which was slightly more than deliveries we had in the third quarter. The small increase was primarily due to walking away from 1,300 lots, most of which were put under option during this year's second quarter, that did not make it through the due diligence process. Our option deposits are typically fully refundable during the due diligence time period, so these walkaways resulted in only a modest $600,000 of charges, primarily consisting of investigative expenses during our third quarter.

As you can see, on the bottom of this slide, for the past nine quarters, we continued a trend, a very modest quarterly walk-away charges. The 1,300 lots we walked away from during the quarter is reflective of the discipline we exercise, when we underwrite land, based on the then current home prices and the then current home selling paces to achieve a 20% plus internal rate of return.

Our land acquisition teams are working hard across the country, so that we can continue to grow our community count this year and beyond, and reach our goal of being fully invested. I am happy to demonstrate that our land team's hard work is paying off.

Six to nine months ahead of our typical land acquisition schedule, today, we already control, including the assumptions that we have for year-over-year growth, virtually all of the lots needed for our 2015 projected deliveries. Furthermore, including additional growth expectations for 2016 deliveries controlled today as well. This puts us well ahead of our typical land acquisition schedule for both next year and the year after.

We remain focused on controlling more land, opening up more communities and drawing our top line in order to leverage our fixed costs. We believe that we are well positioned to capitalize on opportunities on what we believe is the early stages of the housing market recovery.

I will now turn it back to Ara for some brief closing remarks.

Ara Hovnanian

Thanks Larry. We are pleased with our progress thus far, and we look forward to delivering very strong fourth quarter results. While the housing market recovery has been a little lackluster and choppy, we are confident that our growth in land investments, community count and backlog are going to lead us to continued growth and improved performance in 2015. Longer term, we are convinced that we are in the early stages of the recovery.

If you turn to slide 22, you can see total housing starts by year from World War 2 through today. The trough in this most recent recovery was different from any other trough in the past seven decades.

Prior to the most recent downturn, we had not started less than 1 million homes since World War 2. Prior cyclical troughs got as low as 1 million housing starts, but only stayed there for a year or two. This year, instead of a low of 1 million housing starts, we fell to a low of 550,000 housing starts in 2009. The industry has scraped and clawed its way back to improvement, but we are still under 1 million housing starts per year. We have now been below 1 million housing starts for seven consecutive years.

Even this year, after five years of improvement that feels pretty good, we are still at the lowest level of housing production since World War 2, other than the recent trough.

The numbers on the horizontal green bars, are the decade annual average starts. For the past six decades, we've averaged about 1.5 million starts per year. So at the current level of just under 1 million starts, we are only half way back to the six decade average annual level of starts, and demographers are projecting a better decade this quarter, based on household formations, more like what our country experienced in the 1970s that you can also see this, in this chart. Looking beyond normal levels, the peaks of the past six cycles averaged 2 million starts. That's more than twice as many homes as we are currently starting.

Demographics continue to be in our favor, as the population is still growing here in the United States, the millennials are going to the point where they too will become homeowners, and there are a lot of them. At the same time, the baby boomers are looking for that move down home, since they are becoming empty nesters with different needs. With our broad product array, we have both ends of the spectrum, first time and active adult covered, as well as many segments in between. Immigration continues to add to the housing demand as well.

Given these facts, we are very encouraged that there is more upside than downside at this point in the cycle. In 2006, with a similar geographic footprint, we delivered over 20,000 homes. That's over three times what we are delivering today. As the housing market recovery progresses, we believe we have a tremendous opportunity ahead of us, and look forward to delivering industry leading performance once again.

That concludes our formal remarks and we will be happy to open it up for questions and answers right now.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Adam Rudiger, Wells Fargo Securities. Please proceed.

Adam Rudiger - Wells Fargo

Good morning. Thanks for taking my questions. My first question was just on the July and August year-over-year improvements. How much do you think that is a better market or using comparisons? So I guess just the question is, can you just talk about what your sense is, the intra-quarter trends were and really if you have seen an improvement or is it just comps?

Ara Hovnanian

I don't have handy the data for 2013. Jeff, who is in another office might be able to track that down. But its, I am sure, a little bit of both. Clearly, the markets slowed down in July of last year, but we are feeling a renewed sense of activity and interest in our sales offices.

Adam Rudiger - Wells Fargo

Okay. And on similar topic, can you talk about what you do with incentives, and if the -- what you did post big deal days?

Ara Hovnanian

Yeah. There have been really no major changes in -- on incentives or concessions since big deal days. I mean, we kind of reverted back to normal, and we haven't done any significant changes since then.

Adam Rudiger - Wells Fargo

All right. Thanks for taking my questions.

Your next question comes from the line of Michael Rehaut, JP Morgan. Please proceed.

Michael Rehaut - JP Morgan

Thanks. Good morning everyone. First question I had was on gross margins. Appreciate the guidance there, when thinking about 4Q and the full year. I just wanted to confirm that, that essentially would imply -- you said that you expect gross margins to be down year-over-year, certainly at a very strong number in 4Q 2013. But I think you had also implied, given your outlook for the full year down sequentially, maybe about 100 bps and just wanted to get a sense if, I think you'd imply that some of the impact of that -- number one is that's correct from a mathematical point, and number two, just how much of that was due to the earlier big deal days promotion, in terms of the sequential decline?

Larry Sorsby

Let me clarify, because I think maybe I misunderstood your remarks, but on the full year we expect gross margins for 2014 to be similar to the full year gross margins for 2013. In the fourth quarter of 2014, we expect gross margins to be above 20, but not as high as the 22.6% that we achieved in last year's fourth quarter; maybe that's where you are coming up with a sequential decline. And I think all -- an indication is, that we had an extremely extraordinarily high gross margin in the fourth quarter of 2013 powered by some sales price increases that we got earlier in 2013 that actually delivered in the fourth quarter of 2013. We are very pleased with how our margins are holding up, in spite of big deal days, sales promotions and subsequent incentives, modest incentives that we have been doing, and do not expect that you should be reading anything negative into our fourth quarter gross margin, other than -- our gross margins are continuing at our normalized kind of gross margin rate, that we are pleased with.

Michael Rehaut - JP Morgan

Well, I appreciate that Larry. I guess what I am getting at is, in fiscal 2013, your gross margin was right around 20%, 20.1% and so in order for you to make a roughly similar number this year, it would point to the way the math is working, at least the way I am -- the model is working, I am pretty confident there. That the 4Q gross margin would be down versus 3Q as well, and again, just wanted to kind of understand perhaps what the driver of that would be, if it would be the, some of the higher incentives from big deal days that are -- several months ago?

Larry Sorsby

I don't think you should take my comments as literally as you're taking it to a mathematic precise number. When we say they are going to be similar for the full year, that's a range of above what it was last year, and below what it was last year. You can't calculate with precision what our real expectation is. We have given you a range and you can take from it what you want, but I have given you color that we are going to be pleased with what our fourth quarter gross margins are.

Ara Hovnanian

And Mike, just to add overall. I mean, big deal days, it was certainly helpful, but it wasn't hugely impactful to our gross margins. Frankly, most of those were -- almost all of them were started homes, and there was a promotion in March. So if it was started, we have had April, May, June and July to deliver those. So a lot of those big deal days -- homes, actually delivered in Q3. There will be some, I suppose, little leftover for Q4. But they are not hugely impactful from a margin standpoint, just a bit.

Michael Rehaut - JP Morgan

That's a great point. I appreciate that Ara. Thanks for that. Just a second question, I think later in the slides, you pointed to your land position and the fact that you continue to add lots, you have 2015 deliveries tied up and 70% of 2016. Just wanted to get a sense though from a community count perspective, and when you talk in general about the fact that you have 2015 all tied up, I assume that implies -- I guess, let me not assume. Does the expected deliveries for next year, is that -- you expect that to be higher than -- I mean, assuming that let's say sales pace stays similar. What I am really asking for is your thoughts around community count growth in particular, as your lots continue to grow, if we can see further community count growth into 2015 and that your planned deliveries, what you have now under control, would assume some growth?

Ara Hovnanian

Sure, I will take that. We are intending to grow the top line for 2015, and we do not bake in any improvements in sales per community in our projections. We always project the current environment, we usually take the last two months to three months and use that trend seasonally adjust it, and assume that pace going forward. So based on those two factors, we are counting on community growth, and when Larry mentioned the progress we are making on securing our communities for deliveries for 2015 and 2016, that took into account the community count growth that we are trying to achieve.

We are always careful, and I don't think any of our peers do community count projections, either we don't like to do it. It's just a tricky one to project. There are always little minor delays on an approval, on a community before you can start, and sometimes community and older community sells out a little faster, a little slower. So there are so many moving parts that most are hesitant to give a precise projection. But you're correct, we are planning overall for community count growth, and that's one of the ways we are going to achieve our growth.

Michael Rehaut - JP Morgan

Thanks. And just on that idea, and I will get back in queue. The community count, builders have pointed to some delays in the last three to six months, that has lowered their outlook for year-end community county versus prior guidance earlier this year. Have you seen any of those delays as well, and would that result in perhaps the entire pipeline being pushed back, or by contrast, perhaps the potential for the -- expect the community roll-outs to occur, as well as, maybe getting an additional boost from some of the delays?

Larry Sorsby

I would say, we didn't give any guidance, specific guidance on what community count growth would be for the fourth quarter or the full year, rather than to say we were going to have community count growth, we still believe we are going to have community count growth, certainly have had it already this year, and expect it again next year as Ara discussed. We have had the typical kind of regulatory delays that happened sporadically from one market to another. I wouldn't say that it feels like we had dramatically more than normal times, though we may have had some [indiscernible].

Michael Rehaut - JP Morgan

Great. Thanks very much guys.

Ara Hovnanian

Okay.

Operator

Your next question comes from the line of Ivy Zelman with Zelman and Associates. Please proceed.

Ivy Zelman - Zelman and Associates

Good morning. Good result guys. Very helpful. With respect to your comments Larry around the mortgage data was really helpful and talking about the decline in FHA. Maybe we can just talk prospectively about, with the development activity and your plans for the next two to three years, recognizing even in the agency, you might be getting more to that entry level buyer that today, has been a more fluent buyer, but maybe give us some color around the communities they are going to be opening, one of the big debates is a demand problem or is it a supply problem, and reminded of a movie, Kevin Costner in Field of Dreams, if you will build it, they will come. Maybe just some perspective as we think about what you guys are doing and what you're seeing any green sheets on the mortgage side of the business, with respect to liquidity being more provided, mortgage liquidity to borrowers?

Larry Sorsby

I would say that at this stage, we continue to hear some positive comments about some loosening of underwriting guidelines and taking off the credit overlays, and we are seeing some evidence of that, but I would say its really around the edges and fringe and hasn't had much significant impact on underwriting the entry level buyer at this stage anyway. We haven't recognized as any kind of significant easing. We will take any easing that we can get, and it's helpful. But in terms of our planning for communities in the future, we have always believed in a very broad product array, so that we are not over relying on any particular segment. I think our entry level product represents about 30% of our buyers today. I don't think you're going to see us make any significant shift in that. I mean, its still a very important segment to us, as we go forward a little longer term, certainly the demographics of the aging baby boomers, a very powerful force, and we are going to look for growth in our Hovnanian Four Seasons brand for active adult communities, 55 and older, as well as looking at products in some of our more traditional communities, that moved down older buyer might want to see. But I don't think we are going to reduce our focus on the entry level buyer. It's about a little less than a third of our product today, and it's roughly where it will stay going forward is my suspicion.

Ivy Zelman - Zelman and Associates

And then Ara -- thank you, that was helpful Larry, just to -- get to my follow-up question. As it relates to your views, the debate about urban versus suburban, and we are really starting to just begin to knock on the door of the millennials, that are even more significant in absolute numbers than the baby boomers, turning 30. And even in the Tristate area, there seems to be -- those young 30s are moving out to the single family lifestyle. So give me your view Ara, just with respect to how you see that urban versus suburban debate, [indiscernible] has made some pretty significant statements about his views. So I would like to know yours please.

Ara Hovnanian

Sure. Well you must be chatting with my 24 year old son, who is certainly [indiscernible]. But I think there will be no doubt, a growing role of urbanism at all types, and we do some types in many of our markets. We certainly do center city redevelopment in Houston. We do it in the Northeast, outside of New York City. We are about to start in the new 13 story mid-rise outside of New York on the Gold Coast here in New Jersey, and we do, a fair amount of -- its not urban infill, but infill in some of our markets, including markets like Chicago, and out in the Silicon Valley area, near San Jose.

I am a believer in it, and I'd say, while we are probably not going to be quickly as active as we were in 2005 in the urban area, we probably will be growing our presence a bit. I would still say that when you look at demographics, and you compare the growth in the 25 to 35 year olds versus the growth in the 65 or 55 plus, its definitely more action in the 65 plus. So while we agree there should be a focus on urban redevelopment, we are also keeping the other eye on how to meet the needs of the aging population. There is a lot of growth happening in that group in the next 10 years, and we are just trying to come up with our strategic plan on how to best serve those people.

Interestingly, some of them might want a more urban environment as well. But many will want a more typical suburban. So I think it is going to be a balance in this coming decade.

Ivy Zelman - Zelman and Associates

One of the things -- just to follow on that front Ara, is that we have seen people are living longer, and they are actually staying in their -- or choosing to stay in the same family lifestyle longer. Do you have any data, given your focus on that segment of the market, to support that notion? Not necessarily, people think they are living single family, we are going to have a lot of [ph] housing, but we are seeing -- our data that suggests otherwise. So I am wondering what your studies are showing you?

Ara Hovnanian

You know, we are seeing anecdotally, and I can't give you the exact number, but I am positive that this is happening. In our non-age restricted communities, we are seeing more demand for single story homes and master-downs than we have historically. That's always been a factor in markets like Dallas for example, but its all of a sudden in the last couple of years becoming a bit factor in markets like DC, which is surprising to us, and markets like Chicago. So I'd say, while not everyone will be cut out for an active adult community, I certainly understand that. Not everyone is going to want to live in the same four bedroom, two storey, center hall colonial that they have been living in to raise their families. It might be a single family home, it might not be an age-restricted community, but it's probably going to look different than the kind of housing and the stairs associated with it, that they grew up in.

Larry Sorsby

Unfortunately Ivy, we have some of these conversations on a personal level in the hallways here, because some of the senior executives of Hovnanian not only qualify for our 55 and older, but even beyond that, and we talk about what we want to do personally. We are not the typical buyer out there, but we have houses that we are now empty nesters, and you keep that house, and you continue to live in it, even though you don't need that much space, till you go to an active adult community, that you just have two homes that are smaller, and there is not even consensus amongst the executives at our own company.

So I think that's just not a one size fits all phenomena there, that people are going to make different choices, and whether it goes to urban, whether it goes to single storey, master bedroom down, two storey, Its just going to be over the map. But we are very interested in trying to find niches, that meet the needs of the aging baby boomer.

Ara Hovnanian

I will add one other comment, and I will give one of my peers credit, Stuart Miller at Lennar, really reinvigorated the whole concept of multi-generational living, and that is something that we have introduced in many markets as well, and we have had great success. I think that's going to be a growing factor as demographics see the older buyer and not everyone wants to have their parents in a congregated care facility or nursing home, I think that's going to be a growing factor coming this decade.

Ivy Zelman - Zelman and Associates

Thank you so much guys.

Ara Hovnanian

And we will see you in a couple of weeks, Ivy.

Operator

Your next question comes from the line of Nishu Sood with Deutsche Bank. Please proceed.

Nishu Sood - Deutsche Bank

Thanks. Wanted to revisit the gross margin topic. If you think back to the end of 2012 and the first part of 2013, you obviously had very-very strong pricing trends. Those pricing trends obviously changed coming into this year. You folks obviously mentioned the incentives as well, the big deal days; and most of the impact of that, as you were saying earlier, Ara, has flowed through into the results already. So with all that happening, your gross margins have still looked very solid, have outperformed each of the quarters so far this year against last year. So my question for you is, how should we frame that? I mean, has there been an overreaction to -- use of the word incentives, fears from obviously what happened a few years ago. Or is this more of a reflection of the sorts of new communities that you are rolling in, and they are just coming in at higher gross margins, giving a strong tailwind?

Larry Sorsby

I think it's really a reflection of us returning to normalized gross margins. We have been very consistent in underwriting new land deals, based on then current home prices, then current absorption rates, we have not assumed that home prices were going to go up as we underwrote those new hand deals, and in spite of a relatively stagnant home price environment over the last three or four quarters, our gross margins have been relatively stable on a year-over-year 12-month kind of rolling basis, and I think we just are back to achieving kind of normalized margins, and that's kind of what you should think about in terms of us going forward, in spite of maybe just tweaking incentives slightly. I do believe it was overblown, neither ourselves nor our peers have really given away the farm so to speak, by increasing incentives. We have tweaked them around the edges. Even when we were doing our big day sales, sales promotion in March and April, we focused it on started but unsold homes, and maybe some of the least attractive lots in the community, 1% to 3% kind of number. It wasn't huge, it was really a marketing promotion that got people off the fence, and that was enough.

So just maybe the market has overreacted, that builders are giving away the ship so to speak.

Nishu Sood - Deutsche Bank

Got it. And that's helpful. And then on the second question, the effect of mortgage rates. Clearly last year, the significant decline in rates in the first part of the year, and then the complete reversal of that contributed to the boom and bust that we had in 2013. So far this year, it's not the same magnitude, but there has been a pretty significant decline in rates through the course of 2014. So my question is, have you -- in what you are seeing on the ground, have you seen a positive effect from that, and then, obviously on the other side of that, is that demand isn't super strong right now; so are you concerned about the potential effects of a reversal of what we have seen so far this year?

Larry Sorsby

Certainly like it when it's going down, a lot more than we like it, when it starts to tick up. I mean, that's an obvious statement, but its helpful, but its not an overwhelming floodgate opening that rates have come down, but its certainly helpful and I will let Ara comment on what he sees in terms of rates, as they tick up with the impact.

Ara Hovnanian

Sure. Well just a reminder, because it's all too easy to forget. In 1982 and 1983, as we were coming out of the housing recession, we had mortgage rates up 13%, and we certainly built way more houses than we are building now, and by the way we built more houses in 1981, when rates were 18% than we are building now. So I completely agree with Larry, lower is better, but as long as we don't have a shockingly quick increase, I think the market will adjust because demographics are prevailing, we are selling primarily shelter. Somebody has got to be housed somewhere. What we have seen as an interesting phenomenon over the last couple of years, and I suspect the interest rate environment has had something to do with it, people have been selecting -- we offer a variety of model types anywhere from three per community to 12 in some cases, we have seen customers gravitate towards the largest of the models, and in many cases, add a lot of options, both structural and finished options to the house.

I suspect, if rates slowly go back up, they may not select the largest house anymore, they may go towards the middle; of if rates really go up, they may go towards the lower end of the house. But we price our homes virtually the same gross margin, whether it’s a large house or a smaller house. So while the revenue per home may go down a little bit, the gross margin should not really be affected.

So again, just to give a long winded answer in summary now, lower is better, but as long as the rates are not, don't jump up overly quickly, I am not too concerned; and given the fed right now and their focus on housing, I'd be surprised if they'd allow a rapid increase in rates that would harm the market.

Nishu Sood - Deutsche Bank

Okay. Thanks for the color.

Operator

Your next question comes from the line of David Goldberg with UBS. Please proceed.

David Goldberg - UBS

Thanks. Morning.

Ara Hovnanian

Good morning.

David Goldberg - UBS

Wanted to follow-up on a question, on Ivy's question earlier, and it’s a bit of an operational follow-up and it has to do with underwriting and easing in what's happening in the market. So what I am trying to get an idea is, on a local basis, how do your operators stay on top of available liquidity sources for clients, for buyers, how do they know that they are kind of in the right place, especially when you think about capture rates, for internal business. How do you know you're getting buyers qualifying that you're in the right kind of sweet spot, especially kind of given that on a local market basis, there can be differences in risk appetite from lenders, if we want to call risk appetite with not much risk in the market. But you can find markets where you might find lenders that are willing to take on some more -- to expand the credit box a little bit?

Larry Sorsby

Yeah David, you have probably given our operators more credit than they deserve. We have customers, traffic that comes in and we train our sales staff to do everything they can, to try to convince that traffic to sign up and buy a home and then they rely on our mortgage company to do everything in their power to get them qualified for a mortgage, and so yes, there is heated competition going on in the mortgage industry right now, because the refinance business has dried up. So the third party mortgage companies are hungry for deals, and they have been very competitive on rates, and that's causing some competition. But if our mortgage company, for whatever reason, is unable to approve a prospect, we immediately try to send it to a third party lender who may be -- will do a high or lower FICO score than our mortgage company or do something in order to attempt to qualify that customer.

But we turned over every rock and stone that we can, in order to get them qualified, and hope to do that. In terms of just kind of macro positioning at the local market level, because we have that broad product array, we are not over-reliant on a particular market segment, and what they might do there, a little longer term kind of positioning, if they see a lot of competition at the entry level, we like to zig, while everybody else is zagging. So we might do more move-up, more active adult, more something else, so that there is just kind of less competition in the niches where we are trying to serve, to the extent that we can do it. But that's more like turning a battleship than it is turning a speedboat. It takes a little time to adjust.

David Goldberg - UBS

That makes sense. And then I was wondering -- I think there was other question, Nishu, asking earlier, but I was just wondering about -- you kind of land positions and kind of A, B, C, D locations and Ara, you mentioned in the prepared remarks about how you were significantly bigger in a similar geographic footprint? And I am wondering that if you look out over the next couple of years and the growth that you're thinking about, do you need to be in the C locations? Do you need to be in the D locations to achieve the kind of growth you want to achieve? Or can you do enough kind of A, B development and maybe some infill and accommodation to new communities. To get to the kind of growth that you think would be sufficient for your targets, without having to expand as much?

Ara Hovnanian

It’s a good question really, and one that we are kicking around internally. We and the whole industry has really gone away from the C location generally. But as rates gradually increase and they are bound to gradually increase, and as home prices increase, I think the C locations may have some attractiveness again.

I don't think you will see us go disproportionately strong in the C locations, while we have been avoiding those kind of locations in general, I would not be surprised if you see some of them coming to our overall mix. It would be logical. Its one to be careful of, as you go farther into a normal housing production level, because it is a segment that can slow down rapidly when the market softens. But we are so far away from an average level of housing production, let alone a peak level of housing production, it's probably something that makes sense. And while we haven't kind of reached consensus with all of our division heads, its something that is a current topic of discussion.

David Goldberg - UBS

That's very helpful. Thank you for the color.

Operator

Your next question comes from the line of Joel Locker with FBN Securities. Please proceed.

Joel Locker - FBN Securities

Hi guys.

Ara Hovnanian

Hello.

Joel Locker - FBN Securities

Just a question on SG&A. It creeped up a little bit, obviously the gross margin was really nice this quarter, but just on the $3.4 million increase sequentially, was there any one timers in there?

Larry Sorsby

That was pretty much what I elaborated in my prepared remarks Joel. In terms of -- we have been focusing on community count growth, and incurred some additional expenses, as a result of the investment we have made to prepare for the community count growth. I mean, initially, you kind of have the expenses without the revenues, so the ratio gets a little bit on a whack. There was no really unusual items that I can recall in the quarter, but we are confident, that as we continue to grow the top line, and that ratio come back down to the normalized level.

Joel Locker - FBN Securities

So the last two quarters of, to call it your $3.5 million kind of increase, you think that will flatline going forward more so versus Q2?

Larry Sorsby

I think -- sitting in your chair, that's the assumption I would make.

Joel Locker - FBN Securities

Right. And the other one just on JV communities, how many did you have opened at the end of the third quarter?

Larry Sorsby

Its on slide 9, but at the end of the third quarter, we had 10 open for sale JV communities.

Joel Locker - FBN Securities

10 for sale. All right. Thanks a lot guys.

Larry Sorsby

You bet.

Operator

Your next question comes from the line of Megan McGrath of MKM Partners. Please proceed.

Megan McGrath - MKM Partners

Good afternoon. Larry, you gave a lot of guidance in a very short amount of time, so I just wanted to clarify that, on your SG&A and pre-tax income guidance, it was both fiscal 2014 being very similar to fiscal 2013?

Larry Sorsby

Sorry both fiscal 2014 and 2015, is that what you're saying?

Megan McGrath - MKM Partners

No, no, no, sorry, for SG&A and pre-tax income, your guidance was that fiscal 2014 will be similar to last year's fiscal 2013? For the full year.

Larry Sorsby

For the percent of SG&A and for gross margin, that's correct.

Megan McGrath - MKM Partners

Okay. And for pre-tax income as well?

Larry Sorsby

Yes. I said that --

Megan McGrath - MKM Partners

You did say that? Okay, I just wanted to clarify that. And then I just wanted to ask, if you could provide a little bit of color geographically on what you're seeing. It looks like a lot of the growth rates were very similar to what we are seeing. [Indiscernible], you had a great course in the Mid-Atlantic, but declined in the Northeast. So any particular regions you could call out, whether that is more driven by community count growth versus true market demand would be helpful?

Larry Sorsby

Ara, you want to tackle it?

Ara Hovnanian

Yeah, some highlights regarding community count growth. We did have a decent jump in the mid-Atlantic, and that's part of the reason why you saw some higher sales growth there; and in terms of other major changes. I am not sure I would say there were any major declines out there. The West had a decline, but they are a small number, so it’s a little misleading, it was really just a decline from a percentage standpoint.

I suppose the other one, that moves both ways, is the Midwest, we have had some increases, but you don't -- in community count, you don't quite see it in home sales, and that's because the contracts for access on community in the Midwest, and for us its Illinois, Minneapolis and Ohio; those have slowed down just a bit.

In particular, Chicago market, Illinois, it slowed down, the market is very strong for us. There is a production problem. There is -- it has been tricky to get the trades to keep up with our sales, so we are just ratcheting back our releases. But in Ohio and Minneapolis, it has just been a little slower in terms of sales per community.

Those are the only ones that kind of stick out in terms of major differences in the number of community counts versus the sales.

Megan McGrath - MKM Partners

Okay, great. And then if I could just ask one more clarification, in terms of your August numbers, would it make a significant difference in the percentage growth, if we excluded the JVs from that number?

Larry Sorsby

Probably make it better.

Ara Hovnanian

Yes. Yeah, we have been really increasing our wholly-owned more rapidly, and we have actually been shrinking our community count in --

Larry Sorsby

But I think even the performance for the JVs in terms of contracts per community is a little underperforming or consolidated. Therefore, if you excluded the JVs, I think the percentage improvement would actually grow for August, on a year-over-year basis.

Megan McGrath - MKM Partners

Okay, great. Good to know. Thank you.

Operator

Your next question comes from the line of Adam Steinberg with Waveny Capital. Please proceed.

Adam Steinberg - Waveny Capital

Yeah, hi guys. Thanks for taking the question. I was just wondering if you guys could comment a little bit. You talked about how bullish you are in recovery overall, and when you look at the capital structure, you've spoken about the bonds, but you haven't mentioned a preferred. I am just wondering, if the coupon on that gets turned on in maybe a year or so, what you're thinking about doing there, and if there is an opportunity to buy those back?

Larry Sorsby

It has not been something we have really focused on -- to us, the preferred equity and kind of put away, as we get out fixed charge coverage ratio back up, [indiscernible]. The Board's decision to turn back on the preferred payment, which I think is likely, but we haven't even discussed it with the Board, as we haven't approached the two time fixed charge coverage ratio yet. But I think, we are going to focus our capital at this point in the cycle, continuing to grow community count, grow the top line. I think that would be a better investment than trying to buy those preferreds back. We haven't even discussed it, so I don't know whether you have a different opinion.

Ara Hovnanian

I don't know. I think that accurately reflects where we are.

Adam Steinberg - Waveny Capital

Okay. Thanks.

Operator

Your next question comes from the line of Stephen Kim of Barclays. Please proceed.

Stephen Kim - Barclays

Hey guys. How are you?

Ara Hovnanian

Hey. Good.

Stephen Kim - Barclays

Couple of questions for you; one, first a theoretical question. One thing we have observed is, on this relatively depressed level of overall housing starts which you pointed out, it seems to us that a lot of the public builders have broadened the price points which they are competing in, and particularly have moved up, would be probably the fairest way to say it. There has been this migration. I guess I was curious as to whether you think that's a temporary phenomenon, that as the market comes back, you will once again see builders focusing a little bit more on a particular price point to specialize in, and one of the thoughts is that, maybe right now, when the private builder is having such a difficult time, getting going that maybe there has been a better opportunity set for public builders to target a broader range of price points more effectively than maybe the case when we have normalized. Do you have any thoughts on that?

Ara Hovnanian

I am not sure, if it was a strategic move on the part of homebuilders, as much as having the flexibility to take advantage of the improved lots that are out there, and deciding they wanted to be flexible with the improved lots. But I am not sure if I could give anymore insight on that.

Larry Sorsby

I mean our strategy, as you probably recall for a long time, has been a product array, and we have done that for 20 years. So we really haven't changed our strategy. We did notice kind of early on in the downturn and trough, that a lot of builders focused more on entry level, and we actually, in a number of markets did the exact opposite and kind of reduced entry level, because there is just so much competition at that entry level. So my guess is, is that some of those same builders that increased their focus on entry level, because those buyers didn't have a house to sell and other reasons that maybe made sense near the trough, have said -- ratchet that back a little bit at this point in time and return to some of the stuff that we have done before, as well as the argument that it’s a little harder to qualify the entry-level buyer than it has been in prior cycles.

But whether that's a permanent change or temporary change, time will tell.

Stephen Kim - Barclays

Okay. And sort of a related question is, you made a comment I think that your margin profile across higher end and somewhat lower end or a higher price point houses and lower price point houses is pretty similar. I think you made that comment with respect to the potential for rates to rise, and maybe customers going after perhaps somewhat cheaper home. That seems -- that idea that margins are fairly constant or similar across price points. Its interesting, because generally, I think the presumption is that higher price point homes are generally located in places where the land -- the whole entitlement process and the whole business about setting up and selling out of the community takes longer, and so therefore, in order to have a similar IRR, you are going to have to have a higher margin.

So I was curious if you could elaborate a little bit more on that? Is this a particular point in time in which we are seeing this margin similarity?

Ara Hovnanian

Just the discussion and maybe I wasn't perfectly clear, was around margins of different model types at a particular location, and the point being, that if we offered five homes, one that's at 2,500 square feet and one that's at 3,500 square feet on the high end, and customers can select any one of the five, our gross margin percentage is typically pretty similar at that community, among the different product lines, and that's gross margin percentage, not gross margin dollars, since obviously the higher average price multiplied by the same percentage gives you more dollars.

So that's the clarity, and maybe that was confusing. Your assumption is on point that generally speaking, our average -- the gross margins on our higher priced communities tend to be higher, although its really more affected by the way we buy the land. If we buy land on a rolling lot option basis, those tend to have lower gross margins, the ones where we buy bulk land or developed land, those tend to be higher gross margins and where you combine that with more expensive land, they are even more higher; and the reason is that we solve to an IRR. So you can achieve IRR with a high gross margin and a low churn, or you can achieve it with a lower gross margin and a high churn, and we are pretty much indifferent.

Stephen Kim - Barclays

Great. Now that is helpful. That is a helpful clarification.

Larry Sorsby

Steve, let me just add a point. I mean, in a market like Texas, where we offer higher priced homes and lower priced homes, the margin is comparable. I think the bigger factor is the last factor that Ara mentioned, that's how we buy the land. If you are buying in bulk or it's very expensive in California, and you're behind in bulk, you got to have a very high margin. But it's more a factor of how you're buying the land. I don't think there is a truth to -- you get higher margins for higher priced homes and Texas is a great example, where a community where we have the most expensive homes we offer, have similar gross margins to a community in Texas where we have some of our lower priced homes.

Stephen Kim - Barclays

Okay, that's interesting. Last question, it was your price point, which -- the growth in the price. Can you give us a sense for -- how much you think of that -- do you think may have been mix versus more sort of price point increase or price increases or lot option premiums or things like that?

Larry Sorsby

Heavily weighted to product and geographic mix, rather than our ability to raise prices. I talked about this in my prepared remarks and gave some specifics, and that was for delivery. The increase in the average price of home deliveries. But if you look at our average price of contracts during the quarter compared to last year, it's even more dramatic. They went from 348,000 last year's third quarter to 381,000 this year, and again -- although we do have some communities where we have been able to raise prices, the vast majority of that increase is product and geographic mix.

Stephen Kim - Barclays

Okay, that's very helpful. Thanks and great job guys.

Ara Hovnanian

Thank you.

Operator

That concludes our Q&A. I will now turn the call back over to Mr. Ara Hovnanian. Please proceed.

Ara Hovnanian

Great. Thanks very much. We are pleased with the progress and our third quarter results and we look forward to delivering an even better fourth quarter, and certainly, continued improved performance beyond that in 2015. Thank you and we will talk to you next quarter.

Operator

This concludes our conference call for today. Thank you for participating and have a nice day. All parties may now disconnect.

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Source: Hovnanian Enterprises' (HOV) CEO Ara Hovnanian on Q3 2014 Results - Earnings Call Transcript
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