HOVNANIAN ENTERPRISES INC annual report, FY2019

Business context and reporting period

Hovnanian Enterprises, Inc. (NYSE: HOV) filed its Form 10-K for the fiscal year ended October 31, 2019. The company builds and sells homes through six U.S. homebuilding segments and provides mortgage and title services to its homebuyers. The filing also reports fiscal fourth-quarter results for the three months ended October 31, 2019.

Financial and operating performance

• Home sales revenue rose 2.3% to $1.950 billion; deliveries increased 2.0% to 4,946 homes, while average selling price was nearly flat at $394,194.
• Net sales contracts increased 14.3% to 5,340 homes, and contract backlog rose 18.0% in value to $880.1 million for 2,191 homes, excluding unconsolidated joint ventures. Including joint ventures, year-end backlog was 2,652 homes valued at approximately $1.1 billion.
• Gross margin fell mainly because of higher cost-of-sales interest and delivery mix. Gross margin before cost-of-sales interest and land charges was 18.1%, versus 18.4% in FY 2018.
• Cash used in investing activities was $8.3 million; financing activities provided $206.7 million. The company spent $562.8 million on land purchases and development.
• At October 31, debt excluding nonrecourse secured debt and financial-subsidiary debt was $1.549 billion face value ($1.480 billion net of discounts, premiums and issuance costs). Separately, nonrecourse mortgages secured by inventory were $203.6 million. The $125 million secured revolver was undrawn and available.
• Financial services generated $17.6 million in pretax profit. The company reported a $42.4 million loss on extinguishment of debt, contributing materially to the full-year net loss.

Fiscal fourth quarter

Fourth-quarter revenue was $713.6 million, compared with $614.8 million in the prior-year quarter. The company recorded a net loss of $1.8 million, versus net income of $46.2 million a year earlier; the 2019 quarter included the $42.4 million debt-extinguishment loss. Gross margin improved sequentially from 14.0% in Q3 to 14.5% in Q4.

Material changes versus the prior year

• Revenue increased 1.3%, while the company moved from net income to a net loss. The debt-extinguishment charge and lower homebuilding gross margin were key factors.
• Community count grew 14.6% to 141 at year-end; average active selling communities increased 5.4%. Total lots controlled were 3.2% lower year over year at October 31, despite growth in earlier quarters.
• Operating cash use increased to $249.1 million from $66.8 million, reflecting continued investment in land and development and higher inventory.
• Year-end debt was restructured through new secured notes and exchanges, extending or refinancing certain maturities. The company issued $350 million of 7.75% 1.125-lien notes, $282.3 million of 10.5% 1.25-lien notes and $103.1 million of 11.25% 1.5-lien notes. The transactions generated the $42.4 million extinguishment loss.
• Inventory impairment losses and land-option write-offs totaled $6.3 million, versus $3.5 million in FY 2018. Prior-period impairment reversals benefited gross margin by $37.7 million in FY 2019; this is an important factor when assessing underlying performance.

Outlook, risks, contingencies and unusual items

• Management said available cash, expected operating cash flows and revolver availability should be sufficient to finance working-capital requirements through fiscal 2020. Total liquidity was $275.9 million at year-end, above the stated target range of $170 million to $245 million. Management expects additional communities to support future deliveries and revenue, subject to market conditions; no specific earnings or revenue guidance was provided.
• Key risks include high leverage, substantial interest costs, restrictive debt covenants, refinancing and liquidity needs, housing-market cyclicality, mortgage availability and rates, land and labor costs, subcontractor execution, weather, and regulatory or environmental requirements. Covenants restricted common and preferred cash dividends; management expected the restriction to continue for the foreseeable future.
• A New Jersey condominium association lawsuit asserts approximately $119.5 million in remaining damages, potentially subject to treble damages. The company intends to defend the claims; trial was scheduled for April 2020. The EPA separately demanded $2.7 million for cleanup costs at a Newark-area site; settlement discussions were ongoing, and the company stated it believed reserves were adequate.
• The company had a $623.2 million valuation allowance fully reserving deferred tax assets and approximately $1.6 billion of federal net operating loss carryforwards. Use of tax attributes could be limited by an ownership change.
• After year-end, in December 2019, the company exchanged additional debt for $158.5 million of 10.0% secured 1.75-lien notes due 2025 and exchanged $163.0 million of unsecured term loans for $81.5 million of secured 1.75-lien term loans. These subsequent transactions affect the capital structure after the reporting date.
• Auditors issued an unqualified opinion on the financial statements and concluded internal control over financial reporting was effective as of October 31, 2019.

Most important facts for investors to verify

1. Whether land investment translates into higher deliveries and sustained profitability without further weakening liquidity or increasing leverage.
2. The debt schedule, cash interest burden, collateral and covenant terms, and implications of the late-2019 and subsequent debt exchanges.
3. Whether backlog converts to closings at expected prices, including cancellation trends and the effects of mortgage rates and financing availability.
4. The sustainability of gross margins after separating interest capitalization, land charges and prior impairment reversals.
5. Potential outcomes and reserve adequacy for the Great Notch lawsuit, EPA matter, warranty claims and mortgage repurchase exposure.
6. Whether the company can realize its tax attributes, given the full deferred-tax valuation allowance and Section 382 ownership-change restrictions.