Disclosure: The author is long HOVNP and this position represents a significant percentage of the author's assets.
Recently, I read an article by Arbitrage Trader about his pair trade related to Hovnanian Enterprises securities (found here), which turned out fantastically well for those who followed him on that trade. While I am not a stock trader nor an arbitrageur, at least not a good one, this article did pique my interest in a security (HOVNP) that I had owned after the financial crisis (and sold after it ran up a bit). I had not paid attention to this security over the past few years and decided to update my research on the status of HOVNP and the company which has issued it, Hovnanian Enterprises (NYSE:HOV), to determine if either had become interesting for a value investor like myself, again. My thanks to Arbitrage Trader for waking me up to the valuation of HOVNP at the time of his publication.
The result of that research can be found below. At $2.75/share (pricing as I began to write the article), I had felt that these shares offered compelling value, even if they do not represent an investment whose value is backed by assets (my typical standard). The extremely low valuation of these shares, combined by what I view is a change in emphasis and strategy of the company (as discussed below) resulted in an attractive investment combining exceptional value with a unrecognized catalyst to realize this value. Specifically, an increased emphasis on repairing the balance sheet (at the expense of growth), perhaps helped by an incremental improvement in the overall housing market, may combine to enable HOV to de-lever their balance sheet, rendering HOVNP a much more attractive speculation. The bad news is that I do not expect this to happen in days or weeks, but rather in (MANY) years, so this investment is appropriate for patient investors and not for the "fast money" crowd. My rationale for recommending purchase is offered in the article below.
Of course, as I began to write this article (and as I had obtained only a portion of the position originally targeted), the shares rallied strongly, nearly doubling in value. While the rational may indeed be now less compelling to value investors, there is still substantial upside to be realized. Value investors will need to decide if they will tolerate the higher risk and lower returns caused by this currently higher price (hovering around $5 at the time of this writing) or hold off for potentially lower prices.
In my case, I experienced the very disheartening "mercaturius interruptus", being able to obtain only a portion of the position originally planned prior to this "unfortunate" runup in the price. Options around addressing this higher price, perhaps making this an uninteresting investment for some of the readers, will be discussed below.
State of the Hovnanian Balance Sheet:
The balance sheet at the end of the 2Q'16 (April 30, 2016) is as follows:
I modified the formatting to highlight the net asset position and the assets that would be "standing behind" each preferred share and each common share, as is my typical practice. In this case, there are no assets supporting the value of either the preferred or the common shares. Following my standard investing approach, this would rule out my buying these shares as a distressed investment. That is, this situation is NOT analogous to other situations about which I have recently written (Condor Hospitality (NASDAQ:CDOR), RAIT Financial Trust (NYSE:RAS) debt or Vale (NYSE:VALE) preferred), in which assets were available to back the face value of discounted securities. Investors should not be putting a disproportionate amount of their hard-earned assets into HOVNP as there is a strong possibility that they could go to zero (or remain a zombie security as it has been since 2008), not having real assets standing behind their face value and providing no security in the case of bankruptcy or liquidation.
However, I do recommend below that investors experienced in deep value or distressed investing consider these as a "speculation", but perhaps on a pull-back, depending upon the risk tolerance of the reader. I will differentiate deep value "investments" and "speculations" below, along with how I handle those two very distinctive ways in which to invest.
Recent Re-focusing that Could Create Catalyst for Value Realization:
One graph really struck me as I began to look at HOV and HOVNP; it is the chart highlighting cash flow for HOV by source (operations, investing and financing), taken from Google Finance, reflecting the four quarters prior to the 1Q report (note: the recent report was for the 2Q, but this chart has not yet been updated):
As one can clearly see, there is a distinct inflection in this graph. Operating cash flows had historically been trailing the cost of creating those cash flows in pursuit of growth. Suddenly, there appears to be a discontinuity in this trend, which would be consistent with a change of approach from growing the enterprise to a focus on profitability or at least positive overall cash flows. One swallow does not a spring make, but his chart suggests to me that the company is refocusing on margin, cash flow and profitability while de-emphasizing costly growth initiatives in pursuit of growth that just isn't there (for HOV certainly, but perhaps for other homebuilders as well). If this is indeed true, then I believe that HOV's board will have made a very wise decision.
Supporting this view is the announcement that they are abandoning the San Francisco, Minneapolis, Raleigh and Tampa markets. In two cases, their holdings are being liquidated and in the other two, it appears that they are going into a "run off" approach, simply finishing and selling off their holdings in those communities, but not initiating any new activity in those communities. This provides support for the trend demonstrated in the chart shown above; that is, this would suggest that the company is eschewing growth markets in which significant investment is needed or their market position is not the best, choosing to play in those markets which represent "home games" for Hovnanian (more existing investment to be leveraged or a better market position), even if those markets do not have the sexy growth of the more fashionable, faster-growing markets.
After the end of the 2nd quarter, the company announced asset sales, reflecting the impact of the announcements cited above, which would have the following estimated impact on the balance sheet:
I estimated the impact of the recently announced sales, trying to piece together what the impact on the balance sheet would be at the time of sales (and not including any operational changes other than the sales). Since I could not find any reference to gains, I assumed that the sales were made at book value, put the "increase in liquidity" in the cash assets line and reduced the corporate liabilities line by the amount of debt that had been indicated had been reduced.
These sales do not make huge changes on the overall net of assets and liabilities, partially due to the assumptions (no gains or losses) that I had made, but the "cash and equivalents" line item returns to more historical levels ($200-250,000K), ensuring typical liquidity, and the overall liabilities are reduced relative to recent levels. Both of these represent a good start in restructuring the balance sheet. In addition, as liabilities come down, the company's ability to realize the higher value that they claim becomes more likely attained and the risk of financial distress in the next downturn, whenever it comes, is reduced.
Finally, the "valuation allowance" of $635 million, which the company claims is the additional value of the company beyond what is reflected on the balance sheet, is more likely to be realized as the balance sheet is de-levered and has a greater impact on positive net assets. Even if the company were able to realize half of this value, the preferred shares would be backed dollar for dollar with assets, justifying higher values for these shares even relative to the higher market values after the recent runup in shares.
The cash flow chart provided above, the company's recent announcements, the focus on de-levering the balance sheet and a potential for realizing higher values all suggest a change in direction which would be very positive for the holders of the preferred shares. The impact of this redirection may not be evident yet, but a consistent attention to the new direction over the next couple of years should show up in a strengthened balance sheet and growing positive net assets; in turn, this would provide asset backing to the preferreds (since they have first call on those assets once liabilities are satisfied), ahead of the common.
The format employed for the balance sheet is designed to show that a growth of $287MM in assets relative to liabilities would create an asset base providing $1 of asset support for every $1 of preferred face value. In turn, this would reduce risk of these securities, supporting a much higher valuation for these securities than the 20 cents per dollar of face value.
Deep Value or Distressed Investments versus Speculations:
Before I conclude the article discussing how one can invest, it is important for me to differentiate two types of investments which appear similar but, at least for me, are very different. That is, I want to introduce two terms using my definition: distressed or deep value "investments" and "speculations".
In my investing work, I focus and seek deep value or distressed "investments"; that is, I look for investments selling at significant discounts due to real or perceived problems, but where there exist assets which back the face value of the discounted security. While an emotional marketplace may discount the security aggressively, the assets on the balance sheet suggest that, even in a liquidation, there are assets on which to secure the value for those assets. Examples of this type of investing can been seen in my historical articles on Condor Hospitality, RAIT Financial debt and the preferred shares of Vale. In each of these cases, there existed assets that completely (or largely) provided an investment backing for these securities. I am prepared to commit 30% of my assets to investments of this type.
Then there are those "fun" situations which are highly speculative. There are no or inadequate assets standing behind the securities, but one speculates that such backing can be created in the future or there are other ways for the security to recover and become reassessed by the market to much higher valuations. An example of this would be my recent article on Vanguard Natural Resources (NYSE:VNR) preferred shares (VNRBP), for which there are no assets supporting the value, but the reward-risk asymmetry provides an attractive "gamble" on recovery of oil prices and/or a successful deleveraging of the balance sheet (analogous to HOVNP). However, because these investments have a vastly higher probability of going to zero, one must moderate commitments to these "speculations" if one is to prudently manage portfolio risk. As such, I limit my commitments to speculations to 10% total and limit initial commitments to 5%. if I lose 5% of my assets, then I need about six months of dividends to recover, not the end of the world. However, losing 30% of my assets in one stroke severely impairs future value of my portfolio, with the risk just not being worth it, even if there is a 10-1 upside. The flip side of a speculation is that, at 5% of assets and an 8-1 or 10-1 upside delivers a 40-50% gain for the entire portfolio, still large enough to move the needle on portfolio returns.
Therefore, a great value investment justifies potentially larger commitments of capital with a higher maximum investment level of 30-ish%; of course, less can be invested if there are suitable alternatives. However, speculations should be limited to 5% initially and 10% ultimately. This enables the investor to manage risk appropriately while capturing the gains from the few, really great ideas that any one investor will have at any given time.
Conclusion and Recommendation:
Prior to the runup of the prices of HOVNP, I had planned to recommend purchase of these shares to patient, long-term investors who are sufficiently patient to realize the potential high returns from this investment. Consistent with how I treat a distressed speculation, I had planned to recommend a position in these shares not to exceed 10% (preferably starting at not more than 5%) as these shares are not (yet) backed by assets. The recommended price would have been $3.125/share, representing 15 cents market price on each dollar of preferred face value. Starting with a 5% position, one can add shares at future lower prices while still managing portfolio risk prudently. Indeed, some value investors can still use this as a price target.
A reasonable expectation is that these preferred shares will return to face value or near face value in 8 years (my standard expected elapsed time to revert to the mean); in turn, at the target price of $3.125/share, this would deliver annual returns of nearly 30% per year. The key change delivering this value is the perception that the company leadership is changing focus, perhaps de-emphasizing growth and emphasizing a strengthening of the balance sheet. In turn, this creates a number of opportunities for value creation that are just not plausible, given the very weak state of the company's finances. To "fix" the common (in which the Hovnanian family holds a significant portion of their wealth), the balance sheet must be restored to a point where there is at least $1 of assets standing behind each $1 of preferred face value. On the other hand, failure to do that will cut off any profitable "exits" or value creation paths that might be considered by the common holders.
My expectation is that 100% of the return on these shares will need to be based upon a recovery of the value nearer to their face value. I do not expect these shares to pay a dividend ever again. Quite honestly, it appears to me that HOV has become spoiled in having $135MM in free financing over a period of years and would like to retain that privilege. Return to higher prices or face value would be prompted by efforts to secure value for the common shareholders (for example, merger or sale of the company), which will require a restoration of value for the preferred shareholders as a necessary precondition. While readers may be skeptical of a price recovery of the preferred, appearing as a zombie to them, recovery of value for corporate insiders holding common shares requires that the preferreds get fixed. Having been a losing proposition for owners since the financial crisis, stakeholders will step in at some point to intervene if the value does not increase within a reasonable period of time.
It is worth noting that $119MM would buy a controlling interest in this company (greater than 50% of stock outstanding), which is not a large acquisition in this day. The company claims $635MM in additional value above what the balance sheet reflects, but there is currently a $287MM "asset hole" that would need to be filled before the first $1 begins to support the common shares. There remains $348MM in value of potential additional value beyond claims senior to the common that can be secured for that $119MM ($238MM to buy up all the common). This depends upon the $635MM representing realistic upside, but clearly, there is some value available in HOVNP and HOV. It is this value that could put HOV into play, which will mean that the preferred shares will be made money good at some point.
In my portfolio, I had secured a partial position with an average value of $2.75/share (as I began to write this article), prior to the recent runup in prices. My current approach is to hold that position, waiting for a pullback in the value of the shares to continue adding to the position. If they continue to run higher, then I remain a holder of my current position and look elsewhere for new investment. I feel that it is more likely that the prices will drop back to lower levels rather than running up to post-crisis highs; however, "predictions are very difficult, especially about the future" (Robert Storm/Niels Bohr/Mark Twain/Yogi Berra attributed) and I have no idea which way prices will move in the short term. As I stated before, I am not a trader, at least not a good one.
As for new buyers, buying these shares at $5/share would still deliver a 22% annual gain if they achieve face value in eight years. The logic for purchase remains the same, but the case is less compelling as one is taking higher risk (higher price per share) and a lower potential return (by purchasing at higher prices, reducing gain to reach face value). One option is to wait for a drop in prices which may, or may not come. Another option is simply to purchase HOVNP and be satisfied with a lower (but still attractive) gain. A third option, and one that I would employ if I were starting with current pricing around $5/share, is that I would obtain a smaller initial purchase, securing some upside if the prices run up, but having additional capacity to buy more and average down if they decline back to their recent lows.
The preferred shares of Hovnanian Enterprises (HOVNP) have languished over the past eight years following the financial crisis of 2008. Investors have adjusted their expectations (better to say, their lack of expectations) for HOVNP, assuming that it will be "dead money" out to the horizon. Apparent and perceived changes in approach combined with a judgment that this cannot continue forever suggests to me that steps will be taken to enhance the value of the common shares; in turn, this will lead inevitably to enhanced value for the preferreds, driving them towards their face value. My expectation is that this will occur in the next eight years or less, which is more than enough time to revert to the mean value. Patient purchasers who can potentially buy shares at the lower prices recently experienced can make large, outsized returns if the preferred shares return to face value. However, even purchases of HOVNP at current prices will deliver attractive returns if these shares return to face value, a condition for the common shares securing any significant recovery.
Disclosure: The author is long HOVNP and this position represents a significant percentage of the author's assets.
Disclaimer: No guarantees or representations are made. The Owl is not a registered investment advisor and does not provide specific investment advice. You should always consult with an investment advisor before buying or selling securities.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As stated in the article, I am long HOVNP and it represents a significant percentage of my assets. The ticker HOVNP wa not picked up by the disclosure system; thus, this additional disclosure about my holdings is required.