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Hovnanian Enterprises, Inc. (NYSE:HOV)
F3Q07 Earnings Call
September 7, 2007 11:00 am ET

Executives

Ara Hovnanian - President, Chief Executive Officer, Director
Larry Sorsby - Chief Financial Officer, Executive Vice President, Director
Brad O’Connor - Vice President, Associate Corporate Controller
Paul W. Buchanan - Senior Vice President, Corporate Controller
Kevin Hake - Senior Vice President-Finance, Treasurer
Jeff O’Keefe – IR

Analysts

Michael Rehaut – JP Morgan
Steve Kim - Citigroup
Dan Oppenheim - Banc of America Securities
Nishu Sood - Deutsche Bank
Larry Taylor - Credit Suisse
Carl Reichardt - Wachovia Securities
Joel Locker - FBN Securities
Robert Manowitz - RBS
Alex Barron - Agency Trading Group
Shankar Menkobi - JP Morgan
Rashid Dahod - Argus Research
Scott Cavanaugh - Merrill Lynch
Keith Wiley - Goldman Sachs

Presentation

Operator
Good morning and thank you for joining us today for Hovnanian Enterprises fiscal 2007 third quarter conference call. By now you should have all received a copy of the press release from this morning. However, if anyone is missing a copy and you would like one, please contact Donna Roberts at 732-383-2200. We will send you a copy of today's release and ensure that you are on the company's distribution list.

There will be a replay for today's call. This telephone replay will be available after the completion of the call and run for one week. The replay can be accessed by dialing 888-286-8010 and the passcode is 12272730. An archive of the webcast slides will be available for 12 months. This conference is being recorded for rebroadcast and all participants are currently in a lead listen-only mode.

Management will make opening remarks about the third quarter results and then open up 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 investor's page of the company's website at www.khov.com. Those listeners who would like to follow along should log onto the website at this time.

Before we begin, I would like to remind everyone that the cautionary language about forward-looking statements contained in the press release also applies to any comments made during the conference call and to the information in the slide presentation.

I would now like to turn over the conference call to Ara Hovnanian, President and Chief Executive Officer of Hovnanian Enterprises. Ara, please go ahead.

Ara Hovnanian

Good morning and thank you for participating in today's call to review the results of our third quarter ended July 31, 2007. Joining me today from the company are Larry Sorsby, Executive Vice President and CFO; Kevin Hake, Senior Vice President and Treasurer; Paul Buchanan, Senior Vice President and Corporate Controller; Brad O'Connor, VP and Associate Corporate Controller; and Jeff O’Keefe, Director of Investor Relations.

Overall, the housing market remains very challenging. If you turn to slide 1 you see performance in all key metrics for the third quarter was poor. This is all data which is clear in the release so I am not going to rehash it here, but rather spend more time on details.

If you turn to slide 2, you do see one positive factor in a difficult market, and that is that our traffic per community was only off about 10%; far less than our sales were off. That tells us that customers are out there that are interested in buying a house. That makes sense, given that the economy is still positive and that 30-year fixed rate mortgages are still near historical lows, but there are still two lingering significant problems.

First, mortgage underwriting criteria have tightened significantly; and second, there is a lot of negative psychology out in the market causing hesitancy among buyers. Customers are waiting, trying to pick the bottom of the market decline. Clearly news coverage of the collapse of the sub-prime mortgage, falling home prices, credit liquidity issues and further tightening and availability of jumbo and Alt-A mortgage programs does not help boost consumer confidence.

If you turn to slide 3, prior to August we were experiencing a positive trend in contract comparisons through each month of the third quarter. Similar to what we experienced from last October through February of this year, buyer psychology was slowly starting to turn month by month, helped in part by increasing price concessions. Net contracts were down 35% year over year in May, only down 22% in June and down 16% in July year over year. Unfortunately this improvement did not continue into August after the end of our third quarter.

Similar to what happened in March earlier this year, home buyer confidence once again declined in August. In March it fell as the sub-prime phenomenon hit; in August, the positive momentum stopped as the credit problems spread to the Alt-A market and the pricing and availability of jumbo loans. Credit markets around the world started to feel the effects of liquidity crisis, causing extra media attention. Contracts went from the minus 16% you see in the slide in July to minus 24% in August. Once again, the only positive indicator is that despite the negative views, traffic only decreased from 13.2 to 11.8. There are interested buyers there. The challenge is mortgage qualification and buyer psychology.

For the second time this year it felt like the housing market might be starting to stabilize, only to hit yet another barrage of bad news, once again shaking buyer’s confidence. There are several events that you are well aware of that may alleviate some of this pressure. Three weeks ago the Federal Reserve stepped in and lowered the discount rate and has taken additional steps to inject liquidity into the banking system and ultimately shore up the mortgage markets. And, last Friday, President Bush announced a plan to have the FHA step in to assist buyers with guarantees on certain mortgages, and the Federal Reserve has suggested additional actions that are possible if they need to help the markets further. Over the long term, steps like these are likely to increase liquidity in the mortgage market and bring stability, but it is too early to tell when and how significant the effects will be. Perhaps a drop in the Fed funds rate, if that happens, would give the necessary boost in buyer psychology and improve home buyer confidence.

Despite ongoing turmoil in the mortgage markets, however, we continue to close a significant volume of mortgages on a daily basis through our mortgage company. The quality of the mortgages that we originate on behalf of our buyers, as evidenced by the higher FICO scores and lower default rates than national averages, continues to makes the vast majority of our mortgages attractive to some of the largest and most well capitalized financial institutions that buy our paper. This includes Chase, Citi and Countrywide. These three institutions collectively purchase 95% of the mortgages that we originated in the third quarter. Larry will provide further detail on our mortgage operations in a moment.

Before turning it over to Larry, I want to talk about the efforts we're making in dealing with the ongoing slowdown, particularly in reducing our land position and generating cash flow. First, let me talk about impairments and walkaway charges. In accordance with GAAP requirements, we continue to evaluate all of our own land for potential impairments at the end of every quarter. We do this across the board in communities that are open for sale as well as those that are not yet open. We've explained previously how this discounted cash flow projection works, and I won't go into detail again now, but suffice it to say a further decline in pricing and sales pace in many locations during the third quarter led to more impairment charges. Certain communities that previously continued to show a profit fell to a net loss projection once we factored in the fall-off in pace and pricing that we experienced during the quarter. This led to a total of $87.4 million in impairments for the quarter.

If you turn to slide 4, you'll see that it displays the geographic breakdown of where those impairments occurred along with a similar breakdown for the past three quarters. As you can see, impairments over the past four quarters have been largely concentrated in two states: Florida and California. We made significant investments in Florida in 2005, primarily in Fort Myers, and we are now paying a price for the poor timing. While the coastal markets in Southern California contributed to much of the impairment in the fourth quarter of '06, the decline in sales pace and pricing swung more to the inland empire and central valley markets during the second and third quarters of '07, and that's where more of our California impairments in the third quarter were realized.

In addition to the impairment charges that we recorded in the third quarter, we incurred $21.2 million in charges related to lot option walkaways. We terminated and walked away from land contracts totaling about 4,500 lots during the quarter, which resulted in these changes. We're continuing to actively renegotiate, extend, and in some cases terminate land option takedowns. Our presidents and land acquisition managers regularly review each of our option contracts and renegotiate the lot price and the timing of the takedowns. The larger contracts and those in more challenged markets are also reviewed by me and our management team.

We use a rigorous analysis methodology, and we review the most recent comparative information on sales and pricing for our market competition to project potential absorption and pricing going toward. We only move forward in taking down additional lots when the terms have been successfully renegotiated to where they make compelling economic sense for us, even under the assumption that current sales conditions persist, or some in cases, after assuming that sales prices decline even further. If we cannot obtain the concessions needed to make further development of an option community viable, then we terminate and walk away from the contract.

On slide 5 you will see our walkaway charges for the past four quarters broken down by geographic segment. We took a large charge in the fourth quarter of 2006 in response to the plunge in the housing markets during the summer and fall of last year, and now we've taken a bit more in the most recent quarter as market conditions worsened and we walked away from more deals.

If you turn to slide 6, we ended the quarter with 46,747 option lots which is cut almost in half from the level in the April quarter last year; down about a third from the July quarter of last year. Our owned lot position was 32,576 lots at the end of July '07. This is down about 11% from the peak a year ago in July of '06, and we expect it to continue to decline as our pace of lot takedowns under option remains below our pace of deliveries. The significant number of our land option contracts are currently in the process of renegotiation this quarter. Either there will be significant changes in prices and terms or there will be additional walkaway charges booked in the fourth quarters. In either case, we will spend less cash on future option takedowns, causing a positive impact on future cash flows.

In some cases where we already own the land and development has not yet begun, we are postponing land development and the community opening along with the corresponding dollar investments until the market improves. In other locations we are redesigning the product to be more suitable to the changing market. This ability to manage our balance sheet and forego additional expenditures on land gives us the confidence in our ability to manage our way through the current downturn and generate positive cash flow, even with the poor margins and the net losses we're reporting. We will use this positive cash flow to repay debt and bring our leverage back in line with our goals.

In an effort to provide further transparency to our financial data, we've broken out the components of our inventory on slide 7. We show our investment levels separately in homes under construction which include backlog, specs and models and lots and land under development. As you can see from this chart, we have reduced our total inventory investments since July of last year by $259 million or about 77%. We've also reduced our investment in land in the past 12 months by $100 million, or about 5% as our owned lot position has come down. We expect to continue along this path but with a more significant reduction in our total inventories in the fourth quarter. Further reductions in our inventory investment will occur as we continue to deliver homes at a reduced rate but replenish our lot position at an even slower rate, and this will allow to us generate additional cash flow.

If you turn to slide 8, this shows our cash flow projection for the fourth quarter and for all of fiscal '08. In the fourth quarter of this year we expect to generate $175 million to $250 million of positive cash flow. Next year in fiscal '08 we expect to generate positive cash flow for the full year in the range of $100 million to $400 million which is in line with our prior guidance. Our ability to manage our balance sheet and forego additional expenditures on land gives us the confidence in our ability to manage our way through the current downturn and generate positive cash flow, again, even with the poor margins and lower EBITDA that we are experiencing.

In 2005 and 2006 the opposite effect was occurring. Even as we generated almost $1 billion dollars annually in EBITDA, we reported more than $1 billion of negative cash flow over those two years as a result of the significant growth we were experiencing in our business and the associated growth in our inventory investment that was occurring during those years. As you can see on slide 9, during the period from 2000 to 2006 we were growing our inventory investments rapidly, in line with the 40% annual growth in equity we were achieving. During this time, our growth in equity and earnings was among the highest in the industry; 40% compounded annual growth in equity compared to an industry growth rate of 29%.

At the same time as this growth was occurring, we brought our leverage down. From 2000 to 2005 our leverage went down from 60% debt to cap to 44.5%. Unfortunately, planning our investments in new communities requires reasonably long lead times, and we had to make decisions to reinvest our growth in equity. Hence, given our more rapid growth in equity and investment, we were not able to reduce our investment levels and generate cash flow as rapidly as we would have liked or as rapidly as some of our peers.

Given our high growth rates when we experienced such an abrupt and severe downturn, our leverage jumped from below 50% to the high 50% range. It has taken us a few quarters to slow our inventory build up and we primarily used our ability to renegotiate, extend, and terminate lot option contracts to do this. We've also dramatically scaled back our investments in tying up new land parcels while also postponing development of some owned parcels. We finally feel like we're in a position to turn from slowing our inventory growth to more meaningful reductions. As a result, we are now projecting to become cash flow positive in the fourth quarter and into '08.

We will also bring down leverage in the fourth quarter and in 2008. In the future, as our leverage comes down and the markets begin to stabilize, we are likely to set an even lower target for our debt to cap ratio, well below our current 50% target, particularly when we are experiencing rapid growth that we've now realized takes a lot longer to slow down the corresponding growth in inventory. Thus one of the lessons we learned from this downturn is that we should operate at even lower debt to cap targets than we have been, particularly during these high growth rate periods.

While we made substantial progress, our reductions in inventory have not been significant enough to date. This is about to change. As I stated earlier, we're in the midst of renegotiations with numerous option holders this quarter and we plan on taking a firm stance to reduce our inventories. We are prepared to walk from more options where we cannot obtain the terms that we seek. The fall off in our projected inventory levels on this chart is not enough, and we are working to bring inventories down even further by the end of '08 and I look forward to reporting on the progress in future calls.

We ended the third quarter with $456 million outstanding on our $1.5 billion unsecured revolving line of credit. The ratio of net recourse debt to capitalization at the end of quarter was 58.2%. The primary use of the cash that we generate will be to reduce the absolute level of debt outstanding and bring our net debt to capitalization ratio closer to our target of 50% or less. Although we expect to bring down our debt to capital ratio during the fourth quarter, reducing our debt to capital ratio to below 50% won't happen over night. However, we are very committed to bringing down the leverage under that 50% target as quickly as possible. While our leverage is higher than we would like, it is still lower than the levels we managed through prior downturns in our 48-year history and lower leverage is definitely helpful in managing through this type of slowdown. We will absolutely stay focused on reducing our debt levels until we see for sure that the market is turned and profits have recovered.

In addition to the importance of lower leverage, the importance of our geographic diversification and our product diversification has been very evident in this downturn as well, although the slowdown has impacted all of our markets and nearly every community to some degree. The slowdown has shifted geographically over the past year and the magnitude of the impact on some price points and some markets has varied significantly. As difficult as this market slowdown is, we're in a much better position to manage through it as a large, diversified builder.

I will now turn it over to Larry Sorsby to discuss our third quarter financial performance and projections in greater detail.

Larry Sorsby

Thank you, Ara. I will start out by commenting on the mortgage markets and our mortgage finance operations since that is an area that has experienced a fair amount of turmoil of late. If you turn to slide 10, our recent data indicates that our average credit quality of our mortgage customers remains higher than national averages. We continue to experience higher FICO scores in the third quarter of 2007 than we did last year and we continue to see a declining use of adjustable rate mortgages at 10% of our originations in the third quarter compared to 32% for the full fiscal year in '06. Of course the improvement in our FICO scores is linked to the fall off in sub-prime originations this year.

Turning to slide 11, we show you a breakdown of all of the various loan types we originated at our company mortgage operations during fiscal '06 compared to the third quarter of fiscal '07. Keep in mind we sell all of our loans on a whole loan basis. We identify a buyer of the loans prior to closing on that loan and would not go to the closing table with a loan that we did not have presold. Our conventional prime loan business defined as conventional loans with full documentation of income and assets with either conforming or nonconforming loan limits has increased modestly from 48.7% during fiscal '06 to 53.1% in our third quarter of '07. FHA and VA loans have held steady at 7.2% of total originations.

However, as underwriting criteria for sub-prime mortgages tightened, our level of sub-prime business continued to contract. The amount of sub-prime mortgages generated by our mortgage companies declined from 11.1% during fiscal '06 to 2% of total loan volume during the third quarter of '07. More recently there has been a lot of interest in the percentage of our business and other products as lending standards have tightened there as well. Alt-A loans were 22% of our volume in 2006 and 28% of our volume in the third quarter of 2007. Due to the more recent tightening of lending standards for this product, Alt-A approved applications in August declined to 19% of our total volume and we would expect our fourth quarter Alt-A arrange originations to return to somewhere between 15% to 20% of our total loan volume, somewhat lower than the 22% level we originated during fiscal '06.

Alt-A has not dried up in its entirety. On slide 12 we show you a sampling of Alt-A products that remain available today from large firms such as Citi, Chase and Countrywide. As that chart reflects, Alt-A is still available for the purchase of both primary and second homes provided the borrower has a high enough FICO score, and in most cases, that the borrower has to be willing to put down a reasonable downpayment. The guidelines on Alt-A product have substantially tightened over the past several months, and there is no assurance that further tightening of guidelines will not continue.

Earlier this year we would have been able to approve a borrower purchasing their primary home with no money down and a credit score of 620. Today it takes a credit score of 680 for the same type of loan, and the borrower has to be willing to fully document their credit position including verifying assets and income. Additionally, earlier this year we had Alt-A programs available with no down payment for borrower purchasing either a second home or primary home where they did not have to verify assets and income with FICO scores as low as 640. We have not historically experienced a high volume of no doc loans, loan where is we do not verify income and assets, and we have recently seen further decline in this category as a percentage of total volume. For all of fiscal ’06, it was 8% of our loan volume and it was only 6% of the third quarter of 2007 loan volume.

Going forward, no doc loans, particularly those with a high loan to value will be virtually possible to originate with few, if any, sources remaining that are willing to buy those types of loans. We regularly go through our backlog of home contracts and identify which contracts may be at risk for mortgage fallout, and we certainly escalated that practice in recent months. When we suspect a buyer may no longer qualify for a loan, we are in many cases asking them to put up a larger downpayment and/or verify their income so that we will be able to qualify them under today's tighter underwriting guidelines. If they're unwilling or unable to take these steps, unfortunately it often results in a contract cancellation.

The tightening of mortgage underwriting guidelines has adversely impacted our cancellation rate as you can see on slide 13, which shows five years of quarterly cancellation rates. We reported a cancellation rate of 35% for the third quarter.

Turning to slide 14, it shows that our pre-tax earnings from financial services decreased 19% to $6.1 million in the third quarter compared to $7.5 million for the same quarter last year, while our nine-month results came in at $20.8 million, up 4% compared to last year. Since our mortgage company focuses solely on providing mortgages for our homebuyers, the decline in profits is directly linked to the fall off in our volume of home deliveries combined with a modest decline in our origination spreads year over year.

Before I finish my comments on our mortgage operations, I want to comment briefly on the resolution to the HUD audit that had been reported in our 10-K and 10-Q since January of 2006. In August 2007 HUD informed us that it has completed its audit and closed the audit report recommendation. This audit dates back to over two years ago. In our mortgage operations, we inadvertently charged some fees that were unallowable to a handful of buyers. We refunded 17 homebuyers that were charged these fees a total in the aggregate of $5,190. This was an average refund of $305 for each of those 17 homebuyers. Additionally, HUD determined that on a total of five loans, we did not strictly adhere to their underwriting standards and we agreed to indemnify HUD on those specific five loans. All five of those loans have already been paid off, so we have no exposure on our indemnity to HUD. No further payment or action by the company is required. There are no current other HUD investigations or inquiries concerning our mortgage operations going on at this time.

Now I will turn back to the performance of our homebuilding operations in the third quarter. Our contract backlog at July 31, 2007, excluding unconsolidated joint ventures, was 7,126 homes with a dollar value of about $2.5 billion. On slide 5 we show the backlog at July 31st for the prior five years and we provide a breakout of the portion of backlog associated with our Fort Myers Cape Coral operations. At the end of the third quarter of fiscal 2007 1,787 homes amounting to $496 million of backlog are associated with the Company's Fort Myers Cape Coral operations. Our operations in this market are very different from what we see throughout most of our company and we've commented that we view Fort Myers as likely to be the worst housing market in the country, so we think it is worth providing some additional clarity on the status of this sizable sales backlog, most of which is likely to close with much lower gross margins and profits than our consolidated averages.

Almost all of our home buyers in this market first buy a lot from us and then use construction financing from a third party lender to build the home. We typically receive between 75% and 90% of the purchase price from our Fort Myers customers via their construction loans. However, given that the market has deteriorated so significantly in Fort Myers, many buyers are now refusing to convert to permanent financing where we would receive the balance of our sales price. They are effectively defaulting on their construction loan. Therefore it is likely that we will not receive the balance of the purchase price on many of these homes and will make minimal, if any, margin on these homes. We do not book any revenues or profits on any of the Fort Myers homes until either our customer secures permanent financing and pays off the construction loan or when the construction lender forecloses or takes the deed in lieu back from their customer.

Additionally, we continue to work on sale in bulk of our remaining lots in this Fort Myers market which total approximately 2,500 lots with a book value of $31.6 million after impairments taken in prior quarters. One small block of lots has already sold, another larger block comprised of nearly half the remaining lots is currently under contract, and we continue to market the remaining lots in bulk.

If you turn to slide 16, it shows our updated projections for deliveries and revenues for 2007. Based on our backlog we expect total deliveries of 13,200 to 13,800 homes for the full year, excluding delivery from unconsolidated joint ventures. This would result in total revenues between $4.5 billion and $4.9 billion for the year. We have already delivered 9,595 homes through the first nine months of the year, so for the fourth quarter this implies that we expect to deliver between 3,600 and 4,200 homes with total revenues between $1.1 billion and $1.5 billion. Given the uncertainties in the housing market and volatility in the mortgage markets we remain uncomfortable providing any earnings guidance for the fourth quarter.

The incentives and price reductions we have instituted have kept our margins below normal levels for the past several quarters. Slide 17 reflects our homebuilding gross margins an annual basis for the past several years. During '03, '04, and ’05 we posted above average gross margins. On the right-hand side of the graph you can see the negative trend for the past three quarters. Home-building gross margins was 15.9% for the third quarter, below the 16.3% in the second quarter and the 18% we posted in the first quarter of 2007. These recent quarterly gross margins are historically low and reflect the continued weakening of the housing market.

Controlling our SG&A has also been challenging, but we think we're taking the steps that are needed. In our efforts to reduce overhead expenses, we continue to consolidate business units and reduce our staffing levels to meet current activity. Companywide as of the end of August, we had reduced our staffing level by approximately 30% since the peak of June 2006. Going forward, we will continue to make additional staffing adjustments based on business levels in each of our individual markets.

We have reduced our investment in unconsolidated joint ventures modestly to $205 million as of July 31, '07, compared to $217 million at the end of last year's third quarter. Several of our individual project joint ventures are further along in their life cycle of development and sellout and thus the investment levels and leverage are winding down.

Our venture with the Blackstone Group, in which we had an investment of $45 million as of July 31, has delivered 3,853 homes with 3,762 homes remaining to deliver in Illinois, Florida, and just over 100 homes in left in Minnesota. Although our pace of sales and pricing has declined in the venture to an extent similar to the fall off in our communities companywide, we have generated significant cash flow and reduced the debt from $217 million at the inception of the venture to $168 million as of July 31, '07 and are in compliance with all loan requirements.

We have continued to maintain modest leverage in our joint ventures and to finance them solely on a non-recourse basis. At quarter end our debt to cap of all of our joint ventures in the aggregate was 41% as seen on slide 18. The debt at the joint venture level is non-recourse beyond the assets of the venture. However, in some of our joint ventures Hovnanian Enterprises provides a very limited environmental indemnification and completion guarantee, and we generally provide a standard covenant preventing a voluntary bankruptcy filing as well as a warranty against fraud, misrepresentation and similar actions. We believe our strategy to use outside equity to invest in certain of our developments, together with moderate leverage and limited credit support has worked effectively in the slowdown we are experiencing. We report significant details on the balance sheet and profits of our unconsolidated joint ventures in our 10-Qs and 10-K.

Our number of spec homes and models increased slightly in the quarter on a per community basis, as you can see on slide 19. For the past ten years we averaged five started and unsold homes per community. We ended the July quarter with 6.2 started and unsold homes per community, above our average but not dramatically higher. This increase is partially a result of higher than normal cancellation rates. The number of started and unsold homes represents about a 2.7 month supply of started and completed unsold homes based on our July sales pace. Even at such a slow sales pace, this represents a manageable level of spec inventories and a substantially lower than industry average of 6.3 months supply of started and completed unsold homes.

Now I will comment further on our cash flow and liquidity. Although we're working to generate positive cash flow by reducing our inventories, the EBITDA that we've been generating has been declining in line with our profits. For the third quarter we generated adjusted EBITDA of $29 million, down from adjusted EBITDA of $178 million in last year's third quarter. Adjusted EBITDA represents earnings before interest expense, income taxes, depreciation, amortization and land charges. A reconciliation of our company's consolidated adjusted EBITDA to net income can be found as an attachment to our quarterly earnings release.

Due to the slowing velocity of deliveries in each of our open communities, our inventory turnover and thus our interest coverage is declining in fiscal '07. We are working to bring our inventory investment into alignment with our lower revenues and profits so that our interest coverage begins to improve and our ratio of debt to EBITDA returns to a healthier level.

Our revolving credit agreement includes a debt service coverage test based on adjusted EBITDA calculation. However, it only applies if our leverage ratios defined in our credit agreement is above 2.1X. We ended the July quarter below that level, and we're expecting this leverage ratio to trend lower as we generate positive cash flow and reduce debt going forward. As long as the homebuilding market does not materially deteriorate from current levels, we do not anticipate our leverage ratio exceeding the 2.1X limit.

We have received a lot of questions about our availability under our revolving credit facility, particularly since we reported our borrowing base excess as of April 30th in our last 10-Q which was $162.7 million. As of July 31st the excess was $132.1 million. I will try to clarify how this works.

First, let me be clear that we had $933 million availability under our credit facility at the end of the quarter, in the same way such availability is generally calculated and reported by other public builders. We ended the third quarter with $456 million outstanding on our $1.5 billion unsecured revolving line of credit, and we also had $111 million of letter of credits outstanding under the facility, so the net amount available to borrow of was $933 million. However, we could not have borrowed all of this amount without exceeding the leverage covenant in the agreement. We estimate we could have borrowed an additional amount of approximately $320 million before exceeding the leverage covenant.

The amount that we can borrow under our credit facility is also limited by the borrowing base and how that is applied. Let me attempt to explain. The borrowing base is a more confusing concept because it is not an absolute borrowing limit. The borrowing base grows as we invest the borrowed funds in assets that qualify to the borrowing base. Ara showed you a chart with our total inventory as of 7/31 that qualifies for our borrowing base. If you apply the various advanced rates against the various asset categories, you get a borrowing base which was $2.53 billion as of July 31, 2007 and as shown on slide 20. You then subtract all of our senior debt and letters of credit from the borrowing base total to determine our net excess of $132 million. While this may not seem like a large amount, the median amount of our borrowing base excess at quarter end has been $160 million going back to 1999 when we began our growth phase, so we are not far off our historical averages.

Most importantly, if we ended the quarter with a higher amount borrowed we would have likely had more inventory and thus a higher borrowing base. It does not mean that we could have only borrowed an additional $132 million; it is not an absolute borrowing limit. The borrowing base grows if we have invested the additional borrowed funds in assets that qualify. Assuming the additional borrowings were invested in a mix of assets similar to those in the borrowing base of $731 million and with a similar advance rate, then we could have borrowed an additional amount in excess of $400 million before we would have exceeded the borrowing base. Thus the borrowing base was less restrictive on our ability to borrow at July 31st than the leverage covenant. This is confusing to a lot of investors and a lot of analysts, but hopefully this helps clear it up a bit.

Most importantly, we believe we have hit a peak in our total senior debt including uses under our revolving credit facility near the end of the third quarter and will use the cash flow we generate in the fourth quarter to pay down debt including our revolver. Thus we project our borrowing base excess to grow to higher levels as we move ahead. We anticipate that the amount we borrowed under our credit facility, net of cash, to decline by the end of the current fourth quarter and remain very low throughout 2008 as we expect to continue to reduce inventories and generate cash.

Our 10.5% senior notes mature in October 2007. Subsequent to the end of our third quarter of '07, we repurchased about $17 million of these bonds in the open market and we have put the necessary cash in escrow with the trustees of the bonds in order to discharge the balance of the $123 million, so they now have been taken out. We have no other significant debt maturities until 2012. As long as the homebuilding markets do not weaken materially further, we do not expect to have any problem managing our cash flows and debt levels to remain in compliance with the covenants in our credit facilities. In addition to reviewing our covenants in conjunction with each of our internal budget updates three times a year, we look at various downsize scenarios in our projections against all of our covenants. We believe that even under reasonable assumptions for a further slowdown in the market, we would not be in violation of these covenants as we look out to fiscal '08. As a result, we're not currently engaged in any discussions or negotiations with our banks for relief of any covenants contained in the facility.

However, this does not mean we are approaching our need to generate cash flow in reduce leverage casually. We're focused on reducing debt and we're confident that we can do so by liquidating inventories regardless of the potential further fall off in EBITDA.

We do have one covenant in our public debt issues that may prevent us from paying dividends on our $140 million non-cumulative perpetual preferred stock issue. If our consolidated fixed charge coverage ratio as defined in our senior note and senior subordinated note indentures is less than 2:1 we will be precluded from making certain restricted payments, including preferred dividends on our preferred stock. If current market trends continue or worsen at some point in fiscal '08, we anticipate that we will be restricted from paying the preferred dividend. In no way would a restriction on making preferred dividend payments impact our compliance with any covenant contained in a revolving line of credit agreement nor will it impact any other covenant for our senior or senior subordinated notes.

During the third quarter of '07 we did not repurchase any stock although we believe our stock remains undervalued. We remain committed to bringing our debt to cap back to our stated goal of less than 50% and do not anticipate buying back shares at this time. We do not pay common stock dividends which helps pre serve our capital base.

I will now turn it back over to Ara for some closing comments.

Ara Hovnanian

Thanks, Larry. If you would turn to slide 21. When it is good, many assume it is going to be good forever. When it is bad, everyone assumes it is going to be bad forever and in reality, neither is correct. If you turn to the last slide, we have been through this before in our 48-year history. This slide showing national housing starts over the last 36 years reminds us of this. We've been through all of these corrections that this chart shows, and some even before this. Without a doubt, this is a severe and significant correction that is taking place in our industry. The gray bar shows the most recent seasonally adjusted annualized rate of housing starts based on the month of July.

The long-term viability of our industry and our company remains as strong as it has ever been. Demographics continue to march forward creating millions of new households in need of shelter. We are as well positioned as we've ever been to tackle the challenges of a difficult housing market. Our geographic product and price point diversity is great and our management talent is strong, and our most senior managers have been through these cycles many times before.

While I clearly would have preferred to have been less leveraged at this point, we are confident that our credit facilities combined with our actions are adequate to steer us through this period as we have done many times in our 48-year history. We are taking significant actions to reduce our inventory levels and bring our debt levels down.

The good news is that a cyclical industry will not remain in a downturn forever. In fact, with every major market correction in the past, 1975, 1981 and 1991 we emerged as a stronger company showing vibrant growth in revenues and earnings as we take advantage of the chaos in the industry and we grow our market share. We are confident our performance after this downturn will be no different.

With that, I conclude my comments for today and I will be please to open up the floor for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Rehaut - JP Morgan.

Michael Rehaut - JP Morgan

Thanks, good morning. A question on the cash flow guidance. I appreciate all of the comprehensive comments. No doubt, probably all of the questions have been covered in your comments. To the extent that things do continue to deteriorate as the trends have been pointing, what is your flexibility in actually even accelerating or adding to the cash flow generation growth in 4Q and in 2008 where you could even potentially, if you had any flexibility to even generate further by cutting community growth or cutting back on expenditures even further? Or, do you feel that if things get worse, net-net, there would be a downside to those cash flow goals?

Ara Hovnanian

I will try to take a crack at that. Basically we absolutely have other avenues to generate more cash flow if the market dictates. Essentially our plans still call for taking down properties that are under option, although we're taking them down at a lower rate than we're delivering them. Should the market slow down further or deteriorate further than what we've just experienced in recent weeks, then we absolutely would either renegotiate far more aggressively and postpone land takes or, if necessary, walk away from the options. Thus as we deliver homes, if you don't replenish the land, it can really start generating significant cash flow.

Michael Rehaut - JP Morgan

So based on that with the community count, it rose 3% sequentially, it is now at 449. Can you give us an idea where you expect to be at the end of '07 and '08 and if things worsen, is there an even lower number that you could arrive at?

Ara Hovnanian

Well, there is definitely a lower number. As I said, if things really continue to worsen and we're not able to get significant further concessions from our land holders, then we could absolutely drop that number. We don't have a specific number in mind. We monitor it regularly. We look at every community and every market. We look at the pricing. We look at the trends. We're constantly in touch with the land sellers and the option holders, so we just make the changes as the markets dictate and it is not dictated by the overall market as much as that particular local market, and we make those decisions a community at a time.

Larry Sorsby

Just one closing comment on that point in terms of the community count growth in this quarter, it is almost exclusively related to an increase in communities in Houston where we continue to perform pretty well.

Operator

Your next question comes from Steve Kim - Citigroup.

Steve Kim - Citigroup

Could you give us an idea of what percentage of the land you currently have owned or optioned that is fully developed?

Ara Hovnanian

We don't break that down. There are either entire parcels or portions of parcels that are not fully developed and one of the new tactics we really employed in the last three or four months is to carefully evaluate those parcels and determine whether it is worth spending the dollars today in land development or if we might be better off mothballing a few and we definitely have mothballed either any future sections or in some cases entire communities where we just didn't feel the dollars were justified in this environment.

Steve Kim - Citigroup

Another way of trying to come at what I am asking is, can you give us an idea of either how many lots or roughly what percentage of your land inventory balance you think requires minimal, let's say it that way, minimal additional capital infusion to be able to build homes on it?

Ara Hovnanian

We just don't have it handy, Steve, but I can tell you in general unlike a year ago or two years ago, we don't have a lot of major land development activities going on. We own about 32,000 lots at the moment and while we were delivering 20,000 homes in '05, that number represented about a year-and-a-half supply, and that was our typical target, but obviously as absorptions have fallen, it is starting to approach well more than a two-year supply, so we've got a fair amount of developed land in front of us. There is not a lot of big dollars going out at the moment.

Operator

Your next question comes from Dan Oppenheim - Banc of America Securities.

Dan Oppenheim - Banc of America Securities

Thanks very much. I was wondering if you can talk a bit more about what you're doing in thinking about cash flow? In August you put the numbers there for the decline in net orders into the fourth quarter here. Can you give us a sense in terms of what the cancellation rate was there in August and if those cancellations are coming on homes in the late stages of construction? Does that put at risk the cash flow expectations here for the fourth quarter?

Larry Sorsby

Our cancellations in August were roughly the same as the 35% in July. In fact, I think it actually was down 1% to 34%. We did not experience a significant change, much less an increase, in cancellations in August.

Ara Hovnanian

But we have tried to factor in, Dan, that we are getting what stage we get them and more than that, what we've done in the backlog is rather than waiting to hear from the customer, our mortgage company has been carefully going through all of our backlog, trying to determine which mortgages were at risk based on the programs and liquidity that's out there, so we have tried to factor that in to our cash flow projections, and at this point we still remain very comfortable with our cash flow projections for this quarter. Keep in mind we already have a third of it over, so we feel like we're making good progress for that.

Dan Oppenheim - Banc of America Securities

After what we saw in August in terms of the order trends and potential weakening of the economy here based on some stats out this morning what you're doing, how much more aggressive you're getting on pricing just to work through more of the inventory and generate more sales here?

Ara Hovnanian

Well, actually what we have planned as we saw the market soften a bit in August is a nationwide sale-a-thon, if you will. It happens to be coming next weekend, and it is about a 72-hour sale where we're doing some particularly strong concessions that we've built into our budgets but that we hope will really spur some activity, particularly with any homes that are ready for deliveries. So we're trying to be very, very sensitive in all locations on pricing.

Operator

Your next question comes from Nishu Sood - Deutsche Bank.

Nishu Sood - Deutsche Bank

Thanks. I just wanted to follow-up on the deal of the century promotion you were talking about. How significant are the discounts that you're planning on offering in that?

Larry Sorsby

Come out to our community and we'll make you a deal.

Ara Hovnanian

Well, if you're a customer, I say they're huge and you can't afford to not be running off the call and go and buy one of our homes. We are often doing some good strong concessions on speculative homes and I think what we're trying to do is just get that word out and be more upfront and aggressive about it. Again, we've built in this anticipated pricing into our projections and financials already.

Nishu Sood - Deutsche Bank

Obviously you did a terrific job of addressing the issue of cash flows in your commentary. I think one of the important points you have made in addressing investor concerns about that is that people should relax you're nowhere near taking the sorts of drastic actions that you could take to really shore up your cash flow position. Looking at this deal of the century promotion, should we look at that as just an ongoing normal response to what's going on obviously in the market?

Ara Hovnanian

Yes. That's the case. We've seen frankly some of our peers have some good success with that kind of national sales program. We have tended to be very decentralized in marketing, and we remain so, but there was a lot of enthusiasm throughout our business unit leaders to coordinate an all-out national effort. Again, we've seen several of our peers have great success, so that's what really drove it.

Nishu Sood - Deutsche Bank

Another kind of drastic type action you've talked about or point you've made is that you could potentially halt lot takedowns altogether and you're continuing to take down lots. I just wanted to get a sense of the magnitude of that. If we look over the last quarter or two let's say, how many millions of dollars would you have generated if you had just halted all lot takedowns, for example?

Larry Sorsby

I think the best way to think about that is if we didn't replenish a single lot, the finished lot cost under one of our houses on average is call it 24%, 25% across the country, maybe a little bit higher. You could say that for every dollar of homebuilding revenue we generated $0.25 or so of that $1 would fall to free cash flow, give or take. That's probably the way to think about it.

Nishu Sood - Deutsche Bank

I am not quite following you. I am trying to just get a sense of the discretionary component of your lot takedowns.

Larry Sorsby

If we stepped on the brake and didn't take down a single other lot, how much free cash would we generate? If we weren't replenishing the land underneath the homes that we delivered, about 25% of every homebuilding dollar in revenue falls to the cash flow.

Nishu Sood - Deutsche Bank

But that doesn't take into account the ongoing development costs of your projects that are already under development.

Larry Sorsby

Well, pretend it is all finished. It just keeps rolling. It assumes a replacement.

Ara Hovnanian

Another way of looking at it is I will try to work backwards maybe to what you're trying to get to and I will round it for ease of discussions right now. We're delivering this year about 13,000 plus homes and somewhere let's round it up to $5 billion in revenues. If the developed lot cost is about 25% of that, that's about $1.25 billion. We already had told you we're going to be replenishing less land than we're delivering, so it is already factored to be something less than the $1.25 billion. So if I had to take a quick back of the envelope guesstimate, if we cut off land 100% in terms of purchases, it probably would reduce $1 billion of cash outflow that's already built into our numbers. That's kind of a rough guess over the next year.

Operator

Your next question comes from Larry Taylor - Credit Suisse.

Larry Taylor - Credit Suisse

Thanks very much. A couple of different questions. One is, I wonder if you can give us on a regional basis or a little more detail sort of where you're seeing the most pressure on the price front?

Ara Hovnanian

Sure. I would say we definitely see more pressure building in the Southern California inland area. That really held, as the market slowed after '05, the market pricing there really held on much longer than the coastal areas, but it seemed to move up the coast, it kind of started at San Diego, moved up the coast to Orange County and L.A. and has now started moving inland, so we're definitely feeling a lot of pricing pressure in that marketplace.

The other place I would have to say we're feeling pressure is in the Florida market in general. Fortunately we don't have a lot at all in the condominium niche there. It is a very small percent of our overall business there. But I think we actually only have perhaps one, maybe two condominium communities there, but we're seeing more pricing pressure on that product type, but in general Florida is tougher. The further south you go, the tougher it is. Fort Myers probably being the worst, the Palm Beach County market, southeast Florida, second worst. Orlando and Tampa are not nearly as affected as those prior two markets.

Larry Taylor - Credit Suisse

Thanks. That's helpful. In terms of other places that you might be able to work to generate cash flow, how much do you think you might be able to cut G&A? I know you said you could cut head count if you needed to in various markets, but given that you made some progress there already, how big is that number going forward and is there any opportunity for land sales?

Ara Hovnanian

Well, as you might imagine, the land sale market is a little dry at the moment as most home builders like ourselves are being extremely conservative on new purchases. We did mention one that we just closed -- I believe it actually closed, the Fort Myers block of lots closed after the quarter ended so it is not reflected in our numbers but will be in the fourth quarter. We have the other one under contract that's actually about half of our position there. That's supposed to close in the fourth quarter if all holds, although you never know in this market. Other than that, we don't have any significant land sale parcels other than one smaller piece in Orlando to the tune of a couple of million dollars. It is not a huge amount.

Larry Taylor - Credit Suisse

Then magnitude of the financial impact of additional headcount, potentially?

Ara Hovnanian

That's something we just look at market by market.

Larry Sorsby

I just don't think we ever want to get into a position of projecting that for obvious reasons, Larry.

Ara Hovnanian

We just have to look constantly, and if a particular division reduces its volume dramatically then they are going to try to bring their overhead, including staffing levels, down appropriately. That's about as specific as we can be.

Larry Taylor - Credit Suisse

Lastly, more of a big picture question. If you take the midpoint of your guidance for cash flow generation next year of 250 and all of us have different assumptions about what's going on happen in the housing markets in 2008. But conceivably with a weaker housing market or a weak housing market with even only modest improvements in '08, doesn't move the meter enormously in terms of some of your debt metrics or relieve some of the concerns that people may have about your balance sheet. Why not step harder on the brakes here and try and slow things down faster?

Ara Hovnanian

Well, frankly, we are trying to give a range that we feel very comfortable is doable. We are having significant renegotiations, and we'll see how the market bears out. We absolutely can take additional steps, really on a week by week basis if necessary, so we're going to monitor that closely. Obviously you don't want to choke off the land supply on good communities that are contributing, clearly many of our communities are still profitable and are contributing to our performance. So it doesn't make sense to reduce those, but suffice it to say I think you will see this quarter we'll probably be a lot more aggressive and we'll make I think a little more progress in generating the more significant cash flow.

Operator

Your next question comes from Carl Reichardt - Wachovia Securities.

Carl Reichardt - Wachovia Securities

I wanted to ask, are there any geographic regions right now, particularly ones you expanded into relatively recently, that you're considering exiting on a permanent basis or are you happy with the geographic spread you have now?

Ara Hovnanian

No, we like the geographic spread. It is interesting because the markets have switched around and it is helpful to have a diversified presence. The problem right now is not any given market, and we've been in this a long time. Markets that are slow today will probably be some of the ones that rebound the strongest and the best later, so there is not any particular market that we're considering exiting at all.

Carl Reichardt - Wachovia Securities

Great. Appreciate it. Thanks.

Operator

Your next question comes from Joel Locker - FBN Securities.

Joel Locker - FBN Securities

I just noticed that actual customer deposits as a percentage of backlog dropped from about 5.1% last year to about 3.7% this year and I was wondering if it was geographic mix where you are taking less a percentage of deposits or is it something else?

Larry Sorsby

The main reason for that drop is that in our Fort Myers market where we were getting the loan draws we talked about, we received the draws in excess of inventory costs as the construction is going on, but as the construction completes, which most of those homes are now complete, that excess goes down and that's the reason for the change. Most of the homes are now complete in our Fort Myers market where they wouldn't have been last year when you looked at that.

Ara Hovnanian

Generally speaking there hasn't been any change in the deposit amount or percentages that we take in a given market. Each market is different, interestingly enough, based on the local practices. In the Northeast 10% is common; in California, 3% is common. It is affected a little bit by your mix of backlog.

Joel Locker - FBN Securities

Just a follow-up on your option contracts to buy land. There are so many different kinds, and I was just wondering what percentage, if any of the percent were actually payment options where if you step in 3% initially you are guaranteed to have to step in up to 15% say in the next two years, no matter if you take the lot down or not?

Ara Hovnanian

No.

Larry Sorsby

Very little specific performance. In fact, it is a line item on our balance sheet, so we really don't have that issue.

Ara Hovnanian

Yes. They are pure options.

Joel Locker - FBN Securities

Pure options so you can walk away?

Larry Sorsby

$15 million on the balance sheet in July.

Ara Hovnanian

For total specific performance options or contracts, we generally shy away from that.

Operator

Your next question comes from Robert Manowitz - RBS.

Robert Manowitz - RBS

A number of the questions earlier in a roundabout way questioned your confidence regarding your original second half '07 cash flow guidance. I would like to approach that slightly differently and I think it is somewhat of a fair question to ask how the third quarter cash flow fared versus your expectations? Was it better, worse, or in line?

Larry Sorsby

I will tell you that our third quarter would have been virtually right in line with our expectation had we received our roughly $60 million tax refund which we had anticipated getting in our third quarter. Unfortunately it came I think on August 2, two days after our third quarter end, so if you add that back we were pretty much in line with our internal expectations.

Robert Manowitz - RBS

I think that's an important point so I appreciate you highlighting that. Larry, the slide that you walked through on joint ventures, if I heard you correctly, of the 386 of notes payable in aggregate at the joint ventures, 186 was at one joint venture, was that correct?

Larry Sorsby

Yes, I think that's right which was the HovStone joint venture with Blackstone. 168, not 186.

Robert Manowitz - RBS

My mistake. Would you have the equity piece of the $545.9 million of equity in total for the JVs?

Larry Sorsby

You're going to see that in the 10-Q.

Ara Hovnanian

You're asking about equity buys, specific JVs?

Robert Manowitz - RBS

Well, I am just curious on the debt to cap ratio?

Ara Hovnanian

We don't break out specifics, but none of the JVs, not one, has in excess of 50% debt to cap, so they're all pretty uniformly low leverage.

Robert Manowitz - RBS

Perfect. That's what I was looking for.

Ara Hovnanian

It is important to note that ironically, while some joint companies have their joint venture entities more highly leveraged than their main entity, in our cases it's lower leverage, just above 40% debt to cap.

Operator

Your next question comes from Alex Barron - Agency Trading Group.

Alex Barron - Agency Trading Group

You have talked a lot about renegotiating the options which is a good thing. I just wanted to understand how many of your options are in active selling communities versus in communities that haven't even started selling? When you renegotiate those, to what profit level do you do it or is it just to break even, or how does that work?

Larry Sorsby

I am going to take the second part of your question first and the guys here are seeing whether we have the answer to your first part easily at hand. But the second part, when we renegotiate an option we renegotiate it such that ignoring the sunk costs, the sunk costs being any deposit dollars we have put up or any predevelopment costs spent to date, the new cash we have to invest in that community based on today's current very low sales pace and today's current low sales price has to generate in excess of a 30% unlevered IRR for us to move forward on that option.

Unidentified Corporate Participant

The first part of the question is of the 46,000 lots under option it is about half and half that are in active communities and in to be opened.

Ara Hovnanian

Just so you know, the to be opened communities, some of those have option expirations that are some years out. Those will more typically happen in the Northeast where we option a piece of property and take it through a long and lengthy regulatory process. Many of those are fairly early in the process.

Alex Barron - Agency Trading Group

I guess I am just trying to understand have you guys walked or are you willing to walk from communities that you can't renegotiate?

Larry Sorsby

Absolutely.

Ara Hovnanian

Absolutely. We're walking from active communities. We did it last quarter. So we just build out what we have remaining and walk away from the balance.

Alex Barron - Agency Trading Group

I was just wondering why you hadn't walked away from some more. I have a hard time. Maybe you can help me, in what markets are options still making sense?

Larry Sorsby

Let me answer the question this way. If we can generate on a go-forward basis in excess of a 30% unlevered IRR using today's lower than normal sales pace and low sales prices we think those communities make sense and there is a hell of a lot more upside than downside so we haven't walked away from them. As the market tightens further, if we need to walk away we will, but right now we think those are still solid deals and if we can renegotiate in excess of a 30% go-forward IRR, at a depression kind of level sales pace and price we just think it is a valid investment to make.

Alex Barron - Agency Trading Group

Just real quickly, how many communities were impaired this quarter?

Larry Sorsby

How many communities? Hold on.

Alex Barron - Agency Trading Group

While you're at it, what are your best markets that you're still generating positive operating margins?

Ara Hovnanian

Houston, Dallas, Maryland are probably doing the best, and just below those would probably be North Carolina and parts of northern New Jersey they're doing well. Just behind that maybe northern Virginia and frankly, I think we're one of the exceptions there. I think many of our peers are having a tougher time there. We're not doing phenomenally well in returns, but we're generating some returns in that marketplace.

Larry Sorsby

The answer is that we had 24 communities impaired in the third quarter. Of that 24, 19 were communities we had not previously impaired. Five were communities we had previously impaired.

Operator

Your next question comes from Shankar Menkobi of JP Morgan.

Shankar Menkobi - JP Morgan

First of all, can you just help us with cancellation rates by market, both in this last quarter as well as what you talked about in August?

Larry Sorsby

We're pretty good at providing lots of transparency and detail, but we've just never gotten to that granularity and I don't think I want to at this point. Historically good times, bad times, indifferent times, California has a higher cancellation rate; that holds true today. Partially due to the reason I mentioned earlier is they have low deposits, and we have less high cancellation rates in the Northeast where our deposits are higher. That's true good times, bad times, indifferent times.

Shankar Menkobi - JP Morgan

How about Florida?

Larry Sorsby

Well, Fort Myers we've talked a lot about, and probably the highest cancellation rate this year for anywhere in the country for us is Florida, primarily because of Fort Myers to where we've had significant cancellations.

Shankar Menkobi - JP Morgan

Anything recent?

Larry Sorsby

In terms of what?

Shankar Menkobi - JP Morgan

In terms of is there a spike in cancellation rates down there?

Ara Hovnanian

I can't say we've seen really any dramatic change in terms of the geographic mix of cancellations. Cancellations for the quarter were 35%, for the month of August were 34%, and we haven't seen a lot of change in any particular market in cans. Now, in terms of new contracts, as I mentioned, its gotten a little weaker in the inland market and Florida and Southern California, and Florida has really been remained pretty weak, so no big changes there.

Shankar Menkobi - JP Morgan

You talked about Florida and the inland obviously as being relatively weak. You talked about it basically being a price issue. Do you think that if we saw prices decline that wouldn't be as weak, meaning could volume pick up on price declines or there just is a buyer strike?

Ara Hovnanian

Well, it is a little bit of both. At the moment there is clearly, for the last few weeks has been a little more hesitancy as the media has really picked up steam on covering the slowdown in housing, but generally throughout the year we've seen pretty good price elasticity, so as we respond and adjust prices, the market typically responds and our sales pick up. That has generally been the case all year long.

Operator

Your next question comes from Rashid Dahod - Argus Research.

Rashid Dahod - Argus Research

I had a question regarding the different types of buyers that you cater to -- the first time, the move up, et cetera -- are you seeing any signs of particular strength or weakness in terms of traffic or orders?

Ara Hovnanian

The first time buyers that clearly depended on more loose lending standards, those markets have been affected a little bit more. We saw a little bit of that in one or two communities in Bakersfield, and a couple of locations even in Houston which is generally a strong market; but it a market that really depended on typical sub-prime financing, that's been hit perhaps a bit harder. But generally speaking, it really is not price point specific what we're seeing. It is situationally specific. What are the competitors doing in pricing? What's that local supply in that micro market? That's really been more of the issues than any kind of generic comment I can make about price point.

Rashid Dahod - Argus Research

I would think that the first time buyers are in somewhat of a favorable position in that they aren't burdened with selling a home but conversely as you mentioned, they might also be prone to stricter lending standards. How about in terms of cancellations? Have you seen any type of greater concentration in one type of buyer as opposed to the other?

Ara Hovnanian

No. I can't say we have with the exception just in the last quarter of buyers that had been approved for a sub-prime and then found that source evaporated which is generally, although not always, is often associated with a first time home buyer, but that's not always the case. But we did see more cancellations in that category during that quarter. Now, we don't anticipate that going forward frankly, because we're not originating much in terms of new sub-prime mortgage approvals.

Larry Sorsby

I think the same comment holds true with respect to the tightening of Alt-A which could be conforming loan limits or jumbo loan limits, people that had strong credit and could even verify their income but wanted 100% loan to value, they are finding it more and more challenging to do that and we've had some cancellations as reflected by the tightening in Alt-A as well.

Operator

Your next question comes from Scott Cavanaugh - Merrill Lynch .

Scott Cavanaugh - Merrill Lynch

Under your bank facility you have a minimum consolidated tangible net worth covenant. What is that current minimum and what is your headroom as of quarter end?

Larry Sorsby

Again, I don't think we publicly disclose that. The more restrictive covenants we have already talked about we think we have sufficient room for a lot more impairments and a lot more operating losses than we've taken recently and we would still be okay.

Ara Hovnanian

Just one other thing just keep in mind, we don't anticipate having a lot drawn by year end under our revolving line of credit. If we're generating the cash flow we've got planned, it is very possible that we'll have nothing outstanding on the line regardless at some point in '08.

Scott Cavanaugh - Merrill Lynch

On your credit facility, can you breakdown the percentage that you've used to pay down October maturity? Just trying to get a sense of how much cash you're used?

Larry Sorsby

Well, you're assuming we used our revolver to do that. We told you that we've been generating cash flow in the fourth quarter and cash is kind of fungible, and you also had a $60 million tax refund. I don't know that we could answer that question other than to say that at quarter end, had we not bought back the 10.5, obviously the balance on the revolver would be less. But to make the conclusion we just used the revolver to do it, cash is fungible, I don't know that that's an accurate assumption for you to make.

Scott Cavanaugh - Merrill Lynch

So at quarter end the balance on the credit facility reflects your?

Larry Sorsby

Quarter end of fourth quarter. It just happened, that the buying back of the 10.5 and the remainder of the 10.5 is a fourth quarter event, not a third quarter event.

Scott Cavanaugh - Merrill Lynch

What you're telling me -- and correct me if I'm wrong -- is that the $6 million benefit from the tax and the cash flow from operations you didn't have to use your credit facility to help pay down this debt?

Ara Hovnanian

Again, it is not like a dollar goes from one location specifically to another. All sources of cash go into one pool and outflows of cash go into another pool. There are many sources. We will be generating significant cash flow and that's already begun in our fourth quarter that will be more than enough.

Larry Sorsby

We have paid off in its entirely the $150 million of 10.5.

Ara Hovnanian

And still pay down our credit facility.

Larry Sorsby

Yes.

Ara Hovnanian

Hopefully that answers it for you.

Operator

Your next question comes from Keith Wiley - Goldman Sachs.

Keith Wiley - Goldman Sachs

You mentioned about the construction loans that you made that some are defaulting.

Larry Sorsby

No, we didn't make any construction loans, not one construction loan did we make.

Keith Wiley - Goldman Sachs

Could you clarify what you said there?

Larry Sorsby

I said that our home buyers in Fort Myers got loans from third party construction lenders.

Keith Wiley - Goldman Sachs

Excellent. Okay. Then second, your forecast next year for cash flow is $100 million to $400 million, if I am interpreting your comments right, the $100 million would be more if you are able to renegotiate your options down a whole bunch and therefore you end up buying/replacing more land. And if you're unsuccessful at negotiating those options down you would come in at the higher level, 300 or 400?

Larry Sorsby

That's not how we think about it. But if it makes you feel good, go ahead.

Ara Hovnanian

Frankly, Keith, we're just trying to factor in a lot of moving parts. Part of cash flow generation is what's happening in sales, what's happening in cancellation rates, what's happening in mortgage availability as well as our new purchases of land and renegotiations. We try to factor all of that in, and what we're saying is net/net of all of those factors that's the range we're very comfortable with at this stage.

Keith Wiley - Goldman Sachs

Lastly, I am trying to figure out if 30% IRR is really enough given that your earnings are negative this year and your returns on negative this year. How much have you increased your IRR for new purchases relative to what you were doing in prior years?

Ara Hovnanian

Well in prior, 30% has been a pretty consistent IRR hurdle rate. What happened for many years is we purchased based on an IRR of 30% but then the market appreciated and instead of 30% the investments yielded returns of 40% or 50% or more; then on some of the newer purchases what we thought was at a 30% IRR turned out to be an IRR of 20% or 10%, as the market deteriorated our IRR went down. As we are renegotiating what we are doing is taking the lowest pricing that's offered as of the last few weeks in a location net of every concession out there and taking the most recent sales pace, not the pace over the last year but we're looking back over the last four to eight weeks and then we're projecting that pace and working backwards to generate a 30% IRR.

Even if we're wrong, in the overwhelming majority of the cases we are not putting additional deposit dollars up so we would be in no worse a shape than we were. I would love to renegotiate to a higher than a 30% IRR. It is just not very easy to do or realistic to do. What's happened, just so you know the mathematics, if a developed lot is 25% or 30% of the sales price, if the house price goes down 10%, the land price has to go down 30% to make the economics work. If the house price goes down 15%, the land may have to go down almost in half, so there are challenges in getting even higher IRRs.

I can assure you I would be thrilled if we can take every parcel and translate it to a 30% IRR. That would translate to something much greater than a 20% ROE.

Keith Wiley - Goldman Sachs

Well I guess that's my point, is that the stuff that you bought earlier hasn't panned out this year from an earnings perspective or return on equity perspective, so I would have guessed that you would have raised your hurdle rates and then what I am hearing from the home builders is that people aren't cutting land prices, so if land prices have to come down by 30% for every 10% drop in home prices, but the home builders are saying loan prices really aren't coming down, then why buy any land? Why replace any land?

Ara Hovnanian

On a brand new deal that hasn't been sold, land prices have not come down; they have come down but not nearly enough to make new acquisition sense. That's why you haven't seen much new activity in that regard. However, if there is a community that's under development and the properties already under option and it's proceeding but prices fall, in many cases the sellers are absolutely willing to discuss price and lower their price. Obviously we're only proceeding if they are willing to lower it sufficiently to get to a price that makes a reasonable return for us. It's getting more and more challenging without a doubt as the market deteriorates, but we're sticking to the discipline.

Larry Sorsby

If they don't, we walk away.

Ara Hovnanian

As I said, this quarter coming up, our fourth quarter happens to have a lot of properties that are in negotiation where the options are due for takes and where we feel the price and terms don't make sense, so we're in active renegotiation, and if we can't get to prices and pace that makes sense, we'll be walking.

Operator

Your next question comes from Michael Rehaut – JP Morgan.

Michael Rehaut - JP Morgan

On the cost side, to shift gears a little bit, you've been able to keep SG&A right around 135 give or take 1 million on a base of about 1.1 billion of revenues. Also, the gross margins have been coming down obviously more with the incentives but all else equal, you've mentioned that you continue to do a lot on the cost side. If things just stay where they are, can you give us an idea what you're looking at in terms of incremental savings on the SG&A or the COGS side as you're still slightly negative on an EPS before charges?

Larry Sorsby

I think probably the way for you to look at that is, although we're pedaling fast trying to cut costs, it has been difficult to cut them as fast as our volumes have slipped. So we're going to be looking business unit by business unit as Ara mentioned, that if their volumes that they're projecting for '08 decline we'll have to take appropriate action at those business units, but for your model purposes, you probably better off just projecting the numbers that you just mentioned.

Michael Rehaut - JP Morgan

Well to further clarify, certainly if volume falls further you can potentially have even worse leverage on the SG&A, but are there any specific numbers that you have in terms of goals as you continue to work with your different divisions in right sizing today? Not just on the SG&A side but on a suppliers side or is it that maybe all else equal, the SG&A, for example, which is in the 135 per quarter range might get to 125 or 115?

Larry Sorsby

Nothing that we can make public at this point. We've already worked hard with our subcontractors, and they have shared the pain with us, and we're going to ask them to share the pain going forward as the pain increases, but it is very hard to quantify a $5 million benefit per quarter or $55 million benefit per quarter. Just rest assured that we're taking every step that we possibly can to lower our cost structure on a continuous basis.

Ara Hovnanian

Let's say this. We certainly would not want our SG&A as a percentage of sales to go up if sales and revenues continue to drop. We're going to work hard to not let it worsen. It is already a higher percentage, so it is kind of a benchmark we'll be looking at.

Operator

At this time we have no further questions in queue. I'd like to turn the call back over to our speakers for any closing remarks they may have.

Ara Hovnanian

Thank you very much. As I made the comment in my closing comments earlier, we have been through these before. It is not fun, but we know what we have to do and we're working hard to make that happen. There is a particular focus on the cash flow right now and we will look forward to reporting some good progress in that regard in our next call. Thank you very much.

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Source: Hovnanian Enterprises F3Q07 (Qtr End 7/31/07) Earnings Call Transcript

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