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Hovnanian Enterprises, Inc. (NYSE:HOV)

JPMorgan Homebuilding and Building Products Conference Call

May 15, 2012 03:30 pm ET

Executives

Ara K. Hovnanian – Chairman, President & Chief Executive Officer

J. Larry Sorsby – Chief Financial Officer, Executive VP & Director

Analysts

Michael Rehaut – Analyst, JPMorgan Securities LLC

Michael Rehaut, Analyst, JPMorgan Securities LLC

All right. We’re going to continue with the program, if people want to find their seats. Thanks very much. We’re going to be continuing with our last couple of presentations of the day, Hovnanian Enterprises followed by MDC. We have several other homebuilders and building product companies presenting tomorrow as well. And so I encourage you to look at your programs highlighted by Lennar, Masco, some of our – still several large companies in our universe, fortune brands, not part of our universe currently, but one of the big bellwethers as well. So I encourage you to look at your presentations, we still have a great lineup for tomorrow.

With that, I’m going to turn it over to Hovnanian. We have with us Ara Hovnanian, CEO, to Ara’s left, Larry Sorsby, CFO, and to Larry’s left, Jeff O’Keefe, Vice President of Investor Relations.

Hovnanian, one of the long-time public companies in great history, particularly on the East Coast, Northeast, Mid-Atlantic, and has diversified over the years into a national homebuilder. One of the builders that has fair share of challenges, but is still coming through. On the other hand, I think has done some a very good job over the last couple years of cutting further down on costs and continuing to opportunistically restructure the balance sheet. And the cash position has been holding and cash flows, great management there to continue to navigate. And at the same time, showing some pretty powerful order growth year-to-date, so still being able to take advantage of some of the improvements.

As with our previous presentations, hopefully we’ll try and keep prepared remarks to roughly 20 minutes, so there’s plenty of time for Q&A.

And with that, I’ll turn it over to Ara.

Ara K. Hovnanian

Thanks, Michael. As I’m sure you’ve heard all day, there are lot of signs that housing market is, in fact, finally recovering. I’m just going to show three quick slides about the industry overall, and then I’ll focus most of the time on the company, and leave plenty of time for Q&A.

I think this one slide really shows the best overall perspective of what’s happening in the housing market. This slide shows housing starts by year since World War II. There is a lot of doubt here, so I’m just going to spend a moment on this. First, I’ll point out the red circled areas, that show some of the peak production years, and by the way this includes for-sale and rental housing. No surprise, we over-built in this decade at the peak of the market in 2005. What sometimes people lose perspective of it’s not very different than some of the past peaks we’ve experienced in recent decades.

This slide also shows some of the recent troughs circled in blue. Prior to this period, if you look at the recent troughs in the worst housing downturns, housing production got down to 1 million starts, twice it did it for one year and bounced right back, once it did for two years. We’ve just completed the third year of 500,000 to 590,000 starts. So take worst level of housing since World War II, cut that in half, triple the time, that’s what this industry has been going through, without a peak that was different than other peaks.

What’s also interesting is this horizontal line that shows the average production for the entire decade. The bar show year-by-year, the horizontal line show the average production for the entire decade. And what you see is this past decade, contrary to what might be intuitive, this past decade production was the same as five of the other decades, about 1.4 million per year on average. The only exception was the 1970s decade, which actually produced more housing. And obviously what’s happened is, there were peaks and valleys, and when you add it all up and come up with an average, overall production was not very different.

I will add that United States population has been growing, on the other hand, dramatically and that’s in the bottom gray bar, population since World War II has grown two and a half times. Yet right now we are at record low levels, just completed the third year, levels we haven’t seen since World War II in this country. And obviously what matters is what’s out the front of the train and that is pretty positive in terms of demographics.

Harvard’s projections, and frankly Moody’s and most of the others, Brookings Institute and others, are projecting significant growth over where our current level of housing production is. In fact, they are projecting levels of housing needs somewhere around 1.6 to 1.9, significantly over the average in the past, let alone where we are right now.

Obviously, affordability is not an issue. In fact, it’s never been better, when you combine the low housing prices with record low mortgage rates. The affordability index has never been higher since they started it in 1975. This is one issue that certainly haunts and hangs over the industry in general, is the foreclosure and delinquency rates. The good news is they are either stabilizing or getting better. And the foreclosed homes, the REOs, are clearing the market fairly quickly, even in some of the worst markets historically, they are moving through quite quickly. On the other hand, they are still at high levels, and that’s I think the one part of the overhang that’s keeping a very, very rapid recovery.

So with that, let me just turn back to our business. Overview of our company, we’re the sixth largest homebuilder in the country. The map on the lower left shows some of our different geographies. The pie charts on the right show our revenue broken down by those geographies in our home sites by those geographies, a fairly good mix around the country.

As Michael mentioned, we’ve shown some great performance in terms of increases in net contracts. Our first quarter ended in January; for the quarter we reported net contracts up 27%. That was for the first quarter compared to last year’s first quarter. In the subsequent months, February was up 38% and March was up 57%, and I’m pleased that we’re not the only one reporting some very good numbers. The market on the whole is absolutely showing a lot of strength in home purchaser activity and in traffic in the sales offices. And I’m also happy to say that it’s fairly wide-based in terms of geography, price points, buyer profiles. It’s really been doing very nicely across the entire country.

This gives a little bit more granular view of that data. It shows month-by-month for the last two years, the yellow lines, last year, the red bars this year, and it breaks it down by contract per community. And what you see is similar to some of the other format, very positive monthly trends. But what’s also interesting is the most recent month of March we experienced 2.8 contracts per community. The last time we were at 2.8 contracts per community was in April of 2010, and that was the final month of the home buyer tax credit. It was one of the strongest periods of sales in a long time. This time we are at that same level of sales per community and there is no artificial stimulus or help. It’s just the market really picking up steam right now.

The other positive right now for our company, besides the velocity per community, is the number of communities that we have. For a long time, we and others, almost everyone in the industry, was in shrink mode as the market was going through its downturns. However, we’ve been slowly expanding the total number. And what you see here in the color codes, blue represents new communities, and we define new here by having had a contract signed after January of 2009. The red show legacy communities; those were in place before January of 2009.

So legacy has been shrinking, the new communities have been increasing both an absolute number and as a percentage, and that is having a positive effect on our margins. This slide shows margins both by year and by quarter. If you look closely, each of the last four quarters we’ve shown a little bit of a bump in margin. We expect and feel like that trend is going to continue going forward. There is definitely a more positive environment, and it’s going to be helpful on the margins.

Nonetheless, having said that, when you look from a historical perspective, we’re well below the norm. We were 25% and 26% when things were really booming. If you go back to 2000-2001, either boom or bust years, is around 20%, which is probably more normal. So even though we are making some positive momentum there, we still got ways to go, but we absolutely feel like the market is moving in the right direction.

We’re also making great strides in our SG&A. We have unfortunately, again like most builders, had to make a substantial reduction in staffing. We dropped head count by 78% from the peak. I think the public builder average was 77%, so we’re right in there right about the average. And we’re continuing to make these drops. Even in the recent period you can see our SG&A from last year both dollars and percent. We are now with our contract orders coming in place. Those homes are starting. They will shortly be delivering, and you really see the positive leverage of top line growth on SG&A as a percentage, and that will certainly help our bottom line quite a bit.

I mentioned community count growth earlier. We have been active in the land purchasing market. Since 2009 we have purchased, optioned or JV’d over 17,000 lots around the country in 274 communities, and that’s continuing right now. We do continue to see new opportunities every quarter and we’ve been active out in the marketplace.

The bad news/good news of the strengthening market; the bad news is land prices are going up. The good news is higher land prices are convincing more sellers, including banks, to finally sell some property that they had been holding back from the market, because they were dissatisfied about the pricing. And the home price escalation and the acceleration of pace has made those land purchases viable even in today’s marketplace.

I know there certainly has been a lot of concern about our liquidity in the industry. We have repeated the fact that we’re quite comfortable with our liquidity and we’ve taken a lot of steps to really solidify our cash position. The first major point is our maturity ladder. This shows both in secured debt and unsecured debt. What you see here is, before 2016 we only have $136 million of debt maturing, and that’s actually come down just a bit, because we did make some purchases last quarter. Clearly, we’ve got a large wall in 2016 of secured notes. We’re quite comfortable that between now and when those securities are due that we’ll have plenty of options to deal with that.

Our focus is to make to ensure we’ve got the land purchases and ensure we’ve got plenty of liquidity for the next few years of maturities, and then position ourselves as the market gets a little stronger, as our performance turns more positive, as we’re confidence going to that we can deal with the longer-term issue. You’ll also know by the way, we do some of our 2017 maturities as well. We have a variety of levers that are available to us to manage the liquidity, and we’ve pulled on these levers from time to time, but a lot of them still remain available to us. And we just listed some of them in no particular order, but I’ll just go through them.

If we felt a little pressure, which again, feeling quite comfortable with our cash and liquidity position now, but these are some of the levers that we have if we need to generate a little more cash than what we’ve got in our projections. Model sale leasebacks are certainly available, something we’ve done for many, many years and that could increase need be or if we wanted to strategically. We certainly have had a good record of selling excess land and we still have some opportunities, not all locations do we want to carry. In fact, hardly any locations do we want to carry five or six years supply of land. We need to be much more efficient in our use of capital. So we prefer to shorten down the time horizon of land that we own, so selling off some of the longer positions or the back-end positions are available.

We certainly have issued equity as necessary from time to time or is opportunistically intelligent from time to time for either cash or securities. We’ve done several joint ventures in the last few years, and those opportunities, I think, are increasing right now. Land banking opportunities exist. We’ve certainly been getting many, many calls about that as the market’s been turning around. And then there are several other opportunities from reducing specs to delaying land takedowns, to really managing land development spend just a touch more.

So in summary, the spring selling season is off to a very strong start. Without home buying tax credit, we’re back to levels that we haven’t seen since that artificial stimulation was in place. Demographics remain very strong and are clearly a long-term positive pull for the marketplace. One thing I didn’t mention is that, this downturn – and we’ve been around over 50 years, we’ve seen many of these cycles. This downturn probably was more devastating to a larger number of private builders than any other. That clearly is advantageous for those that are around and have access to capital and have longer-term maturities, and are not as dependent on bank capital and we’re virtually using no bank capital, it’s all long-term capital.

Line opportunity still exists out there and they do make sense and can underwrite in today’s difficult environment. Our market is cyclical, and the bad news about a cyclical market is, it can go down. The good news is when you go down, you get a recovery and we finally feel like we’re in that stage of the cycles. We have a large infrastructure network that can absorb a lot of growth around the country without adding many people, and we think that’s where our overhead efficiencies are going to come. And finally, we think we’ve got a structure that gives us liquidity and the flexibility to participate in the industry’s rebound that clearly seems like it’s upon us.

So with that, I’ll be glad to open it up for questions.

Michael Rehaut, Analyst, JPMorgan Securities LLC

Great. Thank you, Ara. I think as I’ve done with most of the presentations today, kind of taking a little bit of moderator’s prerogative and asked a couple of questions to lead it off and the questions that are maybe more front and center industry and company specific. So the first question I’ve been asking most homebuilders today is, when you think about 2012, certainly as you’ve just mentioned better than it’s been in a long time, even better than 2010 to a degree where you had some artificial stimulation. But at the same time, we’re kind of now almost looking into the back half of the year. This spring has been great, and as it typically is it improves month-to-month sequentially on an absolute basis.

But looking into the back half, would you expect the normal seasonality to continue to occur where on an absolute basis, certainly year-over-year you expect things to continue to trend positively, but sequentially on an absolute basis the typical seasonal declines as we get into the summer in the back half. Or just given where we are in the cycle that we’re coming off of such low levels and you have some positive momentum, that the absolute levels can be maintained from where they currently are?

Ara K. Hovnanian

Well, I’d say seasonality is reality. We’re not going to sell as many homes in Phoenix in August as you do in the spring time and December, Thanksgiving, New Year’s is also always going to be a slower period. That being said, it clearly feels like we’re in a very positive sales momentum environment. Traffic continues to be very strong and there is just a lot of a positive interest in the environment. But one interesting thing that I don’t think people have focused on is, right now the public builders, particularly in the last quarter, last six months, have been reporting very positive orders.

Orders then shortly turn to housing starts; housing starts turn to deliveries. When the building environment starts building and starting 30% and 40% more homes, the effect on employment is going to be huge. There are a lot of unemployed or have been a lot of unemployed masons, roofers, electricians, carpenters out there that have not been job flexible. They can’t go and work for Merck in the pharmaceutical department, and they’re not going to go and create an app out in San Jose. They are waiting around for housing starts to get back so they can do their job again.

That I think is going to have a very positive effect on the economy, again, because these orders that you are seeing from everybody, including ourselves, are going to translate to starts and that’s a lot of jobs in the industry, and I think that really reinforces some positive momentum.

Michael Rehaut, Analyst, JPMorgan Securities LLC

Great. And I guess the second question more company specific, and Ara and Larry, you probably would both want to comment. But given the cash position and your expected cash flow generation this year, I mean, you’ve seen certainly a positive uptick in orders, which would then translate to improved cash flows in the back half of the year.

How are you thinking about your cash position, your balance sheet, in terms of over the next 12, 18 months to the extent that you’d want to support growth in the business that you have the ability to do so either by what leverage you might have to draw upon in additional cash? Or would you expect the cash flows of the improved order flow that you’ve seen to support better growth over the next 12, 24 months?

Ara K. Hovnanian

I’ll take a crack at it first, and Larry can fill in. I mean, we have obviously run a variety of cash flow models. And we feel comfortable that we can grow our deliveries, and yet put away cash for our maturities that are coming up for the several years. We don’t have excess cash flow to grow and pay off all the 2016. But we think in the ensuing years we’ve got an opportunity to refinance in a much more positive environment the 2016 maturities. Larry, you want to add to that?

J. Larry Sorsby

Yeah, generally, obviously, I get that very question, and I can assure you that we’re managing the business based on our projected cash balances. We have a targeted cash balance of between $170 million and $245 million. We’re actually comfortable at the lower end of that range, as we have reduced some of our restricted cash component that used to be tied up in NLCs and freed that up to invest in our home building operations. But we continually re-projected with a very sophisticated model, so that we can see what our projected cash balances were going to be and the governor to our ability to grow, and we do believe that we can continue to grow as what is that cash number.

A lot of people over the past year and a half or two have said that they wanted us to kind of sit on our cash and have it available to pay down debt. And I was always kind of concerned when they would say that and question the wisdom of that from the perspective of, that excess cash would be invested in treasuries and earning three or four basis points. And we thought it far wiser to take that cash, invest in our core business that we know the best at then current home prices, then current home paces to generate a 25% plus unlevered IRR and grow that cash, so that we can have more cash to reduce the debt on our balance sheet.

And if, knock on wood, this apparent recovery that we’re in continues, many of the 17,000 lots that we control since January 2009 are going to help fuel our growth and fuel the returns and grow the cash balance to be a much bigger number than it would have been had we just sat on the cash.

Ara K. Hovnanian

By the way, I’ll add that we’ve been slowly taking properties over the last few years and the last bunch of quarters, slowly switching them from mothballed lots to production lots as the market gets more positive in different neighborhoods. It’s not in our base projections, but as the market gains momentum and pricing power, I think you’ll see the transfer of more properties from mothball status to active development status, which just gives us more opportunities, and that’s with land that we’ve already invested in and written down. Our mothballed lots are on their books for somewhere about, yeah, but relative to $0.22 on the $1. So we’ve got them fairly conservatively reflected on our balance sheet.

Michael Rehaut, Analyst, JPMorgan Securities LLC

Great. I’ll open it up to questions from the audience.

Question-and-Answer Session

Michael Rehaut, Analyst, JPMorgan Securities LLC

In the back.

Unidentified Analyst

Thanks. Can you talk about how the recent equity raise and any future potential equity raises or debt-for-equity exchanges you may conduct have impacted or will impact your ability to realize the full deferred tax asset? And maybe how you balance your liquidity – I mean, your liquidity needs versus the preservation of that asset?

J. Sorsby

Yeah, the preservation of the deferred tax asset valuation allowance, we kind of look at that as our most significant major asset. So we’re doing everything in our power to ensure that we continue to protect it and plan on using it by not paying taxes for many years to come as we return to profitability.

Prior to our recent offering, and that offering, there’s been some confusion in some of the one-on-ones today, that offering was due to us being approached by a major holder of a chunk of our unsecured notes that was willing to sell it at a substantial discount. And we were interested in capturing that discount, but we’re unwilling to use our liquidity that we kind of allocated in our own plans to buy additional land to buy that debt back. So we couldn’t just give them shares, because it would turn them into more than a 5% holder and hamper our ability to completely use the deferred tax asset valuation allowance.

So instead of just giving them a swap of equity for their debt, we did an equity raise that had less of a negative effect on the DTA, just as an indication of how conscious we are of making sure that we protect that asset. And 100% of the proceeds of that offering were used to buy back the debt, and that was the only thing we ever intended to do with it. But after the transaction, we can issue an additional 100 million shares of HOV common without adversely impacting our ability to utilize the DTA. It’s a three-year look back kind of calculation, so that over time that 100 million shares will actually grow.

Unidentified Analyst

What’s the typical down-payment on a home you’re selling today and what do you think your orders would look like if mortgage rates were at a more typical 6%?

Ara Hovnanian

No question, in a 6% environment just the psychology of it would have a negative impact, especially if it was a rapid increase. There might be a short-term spike of people jumping in before it keeps going up, but I’d say it’s obviously at the moment better in the lower environment. Of all of the things that keep homebuilders up at night, I don’t think the biggest worry is long-term rates spiking up very quickly.

Going back to your first part of the question – now, obviously, different people may have different opinions of that, but we’re not overly worried about that imminent risk. Going back to your question on down-payments, I’m not sure if I know off the top of my head – I know roughly 45% of our customers use FHA financing. One of the reasons they use FHA financing is it has lower down-payment requirements, as you know, down as low as 3.5%. Over half of our customers use non-FHA financing, probably 10% or so down-payment. Do you have the actual number, Larry?

J. Sorsby

Yeah. The actual average loan-to-value for the first quarter, this is based on deliveries, our first quarter ending January 2012, was an 87% loan-to-value, implying a 13% down payment. But as Ara said, a huge percentage of our buyers, in the mid-40s, use FHA, and the vast majority of them are probably taking the minimum down-payment of 3.5%. On the other end of the spectrum, because we have a very broad product array, we sell a fair number of active adult age restricted 55 and older homes and communities, and many of them take no mortgage or put a large down-payment. These are only for people that got mortgages at our mortgage company then include the 100% cash buyer. So it’s really all over the spectrum, but on average it’s 13% down-payment.

Ara Hovnanian

I will point out, because I think it’s hard to remember this, but I do remember it well, in 1981 mortgage rates were 18% and the industry was in a very horrific downturn. Mortgage rates were 17% when the market was improving and recovering, and really gained a reasonable amount of speed even at 16%, 15% rate. So while 6% would be a shocking rate after being used to 4% rates from a broad historical perspective, and coupled with the pricing we have in place now, I think over time that would not be a big challenge. I think what’s critical is really looking at fundamental demand and supply that balance feels pretty good. Our population is strong, the demographics are positive.

What really counts is not just population, but households and household formations are projected to be better by almost every demographer that looks at it. Even the most conservative demographers look at better household formations in this coming decade than we’ve seen over the past few decades. And given that supply houses started, whether rental or for-sale, just housing shelter of any type is really no different this past quarter than other quarters. So you couple that, excuse me, this past decade compared to other decades. So when you balance that with the fact that we’ve been producing 500,000 or 600,000 and long-term demand is projected to be triple there, ultimately demographics will pull the market.

J. Sorsby

I would add a thought to that as well, because we’ve observed and how we think about demand drivers to housing is, and you might have heard of this, generally you can think of demand drivers there are three of them, kind of think of three legs of the stool of housing, jobs confidence and interest rates. And certainly interest rates are important. I don’t want to push them off the table. And there actually been times where you can flip-over a homebuilder chart and look at the 10-year treasury and its reflection. But I think at the same what’s important to recognize is that, what we’ve observed is two out of three of those drivers if they’re going in the same direction, they’ll trump the third even if it’s in a negative view.

So what we’ve seen is, as everyone knows the last five years rates have come down, which would in a vacuum be a positive, but we’ve gone through a horrible economic recession. And jobs and confidence going down and turning negative trump that positive third stool. I wouldn’t expect it to be that much different in the reverse as we’re coming out of this, and to the extent that rates are not moving up in a vacuum and you would have positive macro trends supporting the market, that typically is a pretty powerful, at minimum partial offset if not a full offset, depending on the rate of increase in the rate market. So something to think about, something that we’ve observed over time.

Ara Hovnanian

And I’ll emphasize this one point again, because I do think it’s something that gets overlooked. And I apologize for playing economist, because I am not an economist. But we do, as a company, employ a lot of construction people either directly or indirectly, and I can tell you across the nation there are going to be a lot more construction people employed in the coming months than we’ve had employed for a long, long time in this country, and there’s going to be a lot of growth. The unemployment rate has been a stubborn drag on the economy and certainly on the psychology, which mentions one of the factors that Michael was talking about. I think that will help the positive momentum go forward.

Michael Rehaut, Analyst, JPMorgan Securities LLC

Any other questions?

Unidentified Analyst

You obviously have one of the more diverse customer bases amongst the homebuilders. I wonder if you could just speak to over the last few months obviously there’s been a broad-based recovery. But are any particular markets, whether it’d be first move up, second move or back to [adult], it’s been a notable source of improvement. And then second question just on costs, and we’ve talked a little about labor availability. Most builders, I think, have sort of characterized product and materials inflation as being offset by continued deflation on the wage side; labor is still plentiful. Do you have any feel for where housing starts would have to get to for wage inflation to return to the market, i.e., how much excess capacity exists on the labor side?

Ara Hovnanian

Okay. There are two questions, so let me try and address the first one first, and that’s which segments have seen more resilience. It has been fairly broad based, as I mentioned earlier. Geographically and by niche, even markets that were pretty downtrodden like Ohio are amazingly strong right now, perhaps because autos are doing better. But that has been a surprisingly good market for us.

But in terms of buyer segmentation, this part has been a little counterintuitive than I’m about to discuss, and I’m sure you’ve heard it before. Many builders, including ourselves, started to question our broad product strategy saying, move up the segment might be slower, because they’ve got a home to sell and they’re the ones that have had equity that has been lost. So perhaps we should, in our case, increase our mix of first-time homebuyers.

In fact, that hasn’t been the case, and luckily we didn’t make a big strategic shift, although we discussed it a lot. The first-time home buying niche has been a little more stubborn, and I think it’s primarily tied to financing. The credit qualification standards have just continued to crank down and make it very, very difficult for the first-time homebuyers. So I’d say a lot of the resiliency has been not primarily in that niche. Having said that, in general, the tide has been rising and most of the segments are feeling some positive increases.

Regarding material and wage costs, that is one of the things we think about. Clearly construction costs have been coming down both from materials and wages. Materials are broken down into two categories. One is brand-focused: carpeting, cabinets, appliances, et cetera. The other is commodities-focused: lumber and concrete. On the branded materials, most public builders are in reasonably good shape, because we have national contracts that lock in a price, and it’s typically locking in a price for two to three years. So that is not much exposure. On the commodity front, lumber, concrete, steel, we do have more exposure, all of us.

Michael Rehaut, Analyst, JPMorgan Securities LLC

Wallboard

Ara Hovnanian

Wallboard, insulation, and clearly that component of cost is at risk. It’s one we keep an eye on all the time. Hopefully, as those costs increase, it’s because the market is, on the housing consumer side is increasing and we can more than offset that with home prices. Same with the wage rates; we have been fortunate to be able to bring wage rates down, and the subcontractors have become more and more efficient, and we’ve been value engineering our products more and more.

That being said, 30% increases in orders are going to translate to 30% increases in starts, and we’re going to start feeling pressure without a doubt on wage rates as well. And once again, hopefully part of the pricing that we’re going to start to feel and beginning to see around the country will be used to offset some of those costs.

Michael Rehaut, Analyst, JPMorgan Securities LLC

I think we’ve run out of time. Actually we’re going to have to move on to the next presentation. So thank you very much Ara, Larry, Jeff. And we’re going to be moving ahead with MDC in just a couple of moments.

Ara K. Hovnanian

Thanks, Mike.

Michael Rehaut, Analyst, JPMorgan Securities LLC

Thank you.

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