Hovnanian Enterprises, Inc. — Q3 2015 Form 10-Q
Business context and reporting period. Hovnanian is a U.S. homebuilder operating through six geographic homebuilding segments and a financial services business. This unaudited quarterly report covers the three and nine months ended July 31, 2015; comparisons are with the corresponding 2014 periods unless noted. Amounts below are in U.S. dollars.
Financial performance and liquidity
| Metric | Three months ended July 31 | Nine months ended July 31 |
|---|---|---|
| Total revenue | $540.6 million, down 1.9% from $551.0 million | $1,455.3 million, up 6.6% from $1,365.0 million |
| Net income (loss) | $(7.7) million versus $17.1 million income | $(41.6) million versus $(15.3) million |
| Homebuilding gross margin, before interest and land charges | 17.8% versus 21.3% | 17.4% versus 20.2% |
| Operating cash flow | $(332.7) million for the nine months, compared with $(259.5) million |
- Third-quarter home sales revenue declined 2.2%; deliveries fell 3.8% to 1,408 homes, while average selling price rose 1.7% to about $374,000. Nine-month home sales revenue rose 6.3%, reflecting a 5.0% higher average price and 1.2% more deliveries.
- Management attributed margin compression to discounting started-unsold homes in the first half of fiscal 2015 and increased incentives on homes not yet built amid pricing pressure. On a sequential basis, the reported pre-interest, pre-land-charge margin improved from 16.1% in Q2 to 17.8% in Q3.
- Financial services pretax income improved to $6.1 million for the quarter and $14.9 million for nine months, versus $3.9 million and $8.0 million. The mortgage capture rate rose to 74.8% for the quarter and 73.1% for nine months.
- Cash and cash equivalents were $213.9 million at July 31, 2015, down from $261.9 million at October 31, 2014; restricted cash was $26.4 million. Operating cash use reflected, in particular, $275.8 million of cash invested in inventories. Financing activities provided $290.0 million, including proceeds from a $250.0 million senior-note issuance.
- Notes payable totaled $1.938 billion, compared with $1.690 billion at October 31, 2014. In addition, homebuilding nonrecourse mortgages were $149.2 million and mortgage warehouse lines were $88.6 million. Total liabilities exceeded total assets by $151.5 million, resulting in a stockholders’ equity deficit.
- The company had a $75 million unsecured revolving facility with no borrowings and $26.5 million of letters of credit outstanding. Management said available cash, operating sources and the facility were expected to cover fiscal 2015 needs.
Material changes and operating trends
- Net contracts rose 13.0% in Q3 and 9.2% over nine months; backlog at July 31 was 3,097 homes valued at $1.3 billion, up 23.3% in value from a year earlier. Active selling communities increased to 206 from 196 a year earlier.
- Results varied significantly by region. The West reported a $4.0 million Q3 pretax loss and a $15.3 million nine-month loss; the Northeast and Southeast also recorded losses. The Southwest remained the largest profitable segment, although pretax income declined year over year.
- Inventory excluding consolidated inventory not owned increased $267.7 million from October 31, 2014, primarily from land purchases and development. The company opened 74 communities and closed 69 during the nine-month period, and reactivated 14 previously mothballed communities.
- Inventory impairment losses and land-option write-offs totaled $7.6 million for nine months, versus $1.9 million. This included $4.4 million of community impairments and $3.2 million of option, approval and engineering write-offs. No inventory impairments were recorded in Q3 2015.
- The company recognized a $17.5 million income tax benefit for nine months. Management retained a $642.1 million deferred-tax valuation allowance at July 31 and concluded that a substantial portion of deferred tax assets would likely be realized, while acknowledging a three-year cumulative loss position at that date.
Outlook, risks and contingencies
- Management expected stronger Q4 fiscal 2015 results than in earlier fiscal 2015 quarters and stronger results in fiscal 2016, citing backlog, expected deliveries and planned community growth. It cautioned that anticipated Q4 pretax income would not offset the pretax losses incurred through the first nine months. These are management expectations, not a quantified earnings forecast.
- Near-term senior-note maturities included approximately $60.8 million due October 15, 2015 and $172.7 million due January 15, 2016. Management preferred refinancing but warned financing might not be available at attractive rates; alternatives cited included land banking, joint ventures, project financing and model-home sale-leasebacks.
- Management said positive operating cash flow may remain difficult until sustained profitability improves. The company cited economic uncertainty, mortgage availability and rates, weather, uncertain oil prices affecting Texas, competition, land and construction costs, regulation, and its substantial indebtedness as risks.
- The EPA had identified the company as a potentially responsible party concerning lead contamination near a former smelter and proposed that it fund or contribute to cleanup. The company said the scope of any obligation was unknown and could not assure the matter would not have a material impact.
- A dispute with insurer XL over coverage and a claimed excess of the fiscal 2006 policy’s $21 million aggregate retention was unresolved. Mediation occurred in September 2015; if no resolution was reached, arbitration was scheduled for January 2016. The company could not assure the outcome would not materially affect it.
- The D’Andrea HVAC class action settlement was paid and concluded in February 2015; a separate company indemnification action against manufacturers and subcontractors remained ongoing. Management stated ordinary-course litigation was not expected to materially affect results, subject to the specific matters disclosed.
- Debt covenants restricted cash dividends, including on the 7.625% Series A Preferred Stock; management expected the restriction to continue for the foreseeable future. The company reported compliance with applicable debt and credit-facility covenants as of July 31, 2015.
Most important facts for investors to verify
- Whether backlog converts to deliveries and revenue as expected, and whether gross margins recover without continued heavy discounts or incentives.
- How the October 2015 and January 2016 maturities were funded or refinanced, and the resulting borrowing costs, liquidity and covenant position.
- Whether land investment and inventory growth can be supported while operating cash flow remains substantially negative.
- Whether the deferred-tax-asset realization assumptions remain supportable given losses and subsequent operating results.
- Any developments in the EPA cleanup matter and the XL insurance dispute, including potential financial exposure.