HOVNANIAN ENTERPRISES INC quarterly report, Q2 FY2016

Hovnanian Enterprises, Inc. — Q2 FY2016 Form 10-Q

Reporting period: Three and six months ended April 30, 2016. The company builds and sells homes through six U.S. homebuilding segments and provides mortgage and title services. Amounts below are in U.S. dollars; financial statement amounts are converted from thousands to millions.

Financial performance and liquidity

Metric	Three months ended April 30, 2016	Six months ended April 30, 2016
Total revenue	$654.7 million, up 39.6% year over year	$1,230.3 million, up 34.5%
Net loss	$8.5 million, versus $19.6 million	$24.6 million, versus $33.9 million
Loss before income taxes	$17.6 million, versus $29.5 million	$30.8 million, versus $49.2 million
Homebuilding gross margin, before cost-of-sales interest and land charges	16.1%, unchanged	16.3%, versus 17.1%
Gross margin after cost-of-sales interest and land charges	11.1%, versus 12.5%	11.3%, versus 13.8%

Second-quarter home sales revenue rose 37.6%, reflecting 1,598 deliveries, up 30.7%, and an average selling price of approximately $392,000, versus $372,000. For the first half, deliveries increased 27.3% and average price was approximately $392,000, versus $375,000.
SG&A, including corporate G&A, was 10.5% of revenue in Q2 and 10.8% for the first half, compared with 14.7% and 14.6%, respectively, in the prior-year periods. Lower corporate costs included a reversal of previously recognized performance-based stock-option expense and an adjustment to medical self-insurance reserves.
First-half operating cash flow was negative $31.2 million, compared with negative $256.1 million a year earlier. Cash and cash equivalents totaled $129.7 million at April 30, down from $253.7 million at October 31, 2015; restricted cash was $25.4 million. Management said Q2 operating cash flow was positive $33.9 million.
Notes payable totaled $1.765 billion at April 30, versus $1.936 billion at October 31, 2015. Stockholders’ equity remained in deficit at $152.3 million. The company spent $303.3 million on land and land development in the first half.
Homebuilding cash was $120.7 million and financial-services cash was $9.0 million. The $75 million revolving facility had $50 million drawn and $22.4 million of letters of credit outstanding.

Changes versus the prior comparable period

Revenue growth and lower reported net losses were supported by higher delivery volume, higher average selling prices, increased financial-services revenue, and lower corporate G&A.
Margin performance weakened year to date: management cited higher construction costs and higher land and development costs in certain newer communities. Cost-of-sales interest also rose as a percentage of home sales.
Inventory impairment losses and land-option write-offs were $21.4 million for the first half, versus $6.5 million. This included $15.1 million of inventory impairments and $6.3 million of option, approval and engineering-cost write-offs.
Active selling communities were 196 at April 30, versus 207 a year earlier and 219 at October 31, 2015. Backlog increased 8.6% by homes and 22.1% by dollar value year over year; second-quarter net contracts increased 0.9%, and first-half net contracts increased 7.3%.
First-half inventory excluding “consolidated inventory not owned” decreased $159.0 million. That accounting category increased $190.6 million, primarily from land-bank transactions and model-home sale-leasebacks treated as financings.

Outlook, risks and unusual items

Management said backlog and community count positioned the company for stronger results as the fiscal year progressed and expected the fourth quarter to contribute significantly to annual results. It did not provide specific numerical guidance. Management also cautioned that recent performance was uneven across markets and national and company home sales remained below historical levels.
The company said it was shifting focus from growing communities and revenue toward operating efficiency, profitability and positive operating cash flow. It expected available cash sources to fund working-capital needs through FY2016, while noting that refinancing debt could be unavailable or unattractive.
On January 15, 2016, $172.7 million of 6.25% senior notes matured and was paid. After quarter-end, $86.5 million of 7.5% notes matured and was paid on May 15, 2016. A further $121.0 million of 8.625% notes is due January 15, 2017. Management preferred refinancing but said it believed operations and footprint reductions could provide liquidity for repayment; it may also reduce or delay investments or pursue land banking, joint ventures or other financing measures.
After quarter-end, land-portfolio sales in Minnesota and North Carolina and a land contribution to a new joint venture generated $75.1 million of net cash proceeds. The company also decided to wind down operations in the San Francisco Bay Area and Tampa while completing homes on existing land.
Credit ratings were downgraded: Moody’s took rating actions on April 20 and S&P on May 3, 2016. The company said the downgrades did not change debt maturities or interest rates but could make capital access more difficult or costly. Debt covenants restrict dividends, including preferred dividends, and constrain additional indebtedness; management expected these restrictions to continue.
The company recorded a $9.1 million tax benefit in Q2 and a $6.2 million benefit for the first half. It retained a $635.4 million valuation allowance on deferred tax assets and concluded a full valuation allowance was not required, citing expected long-term profitability and other positive evidence despite recent pretax losses.
The EPA has identified the company as a potentially responsible party regarding lead contamination near a former smelter and a 1990s Newark, New Jersey redevelopment project. The company said the scope of any obligation is unknown and it cannot assure the matter will not have a material impact. Other ordinary-course litigation was not expected to have a material adverse effect.
Other risks cited include housing-market weakness, mortgage availability and interest rates, land and construction costs, regulatory and environmental requirements, warranty and construction-defect claims, and the ability to meet debt obligations. Inventory impairment estimates depend on projected cash flows and fair values and may require further write-downs.

Important facts for investors to verify

Progress toward covering the January 2017 $121.0 million note maturity, including refinancing access, operating cash generation and completion of planned liquidity measures.
Whether backlog growth converts to deliveries and cash, and whether cancellations, community count and regional results support management’s outlook.
Whether gross margins stabilize as land and construction costs, interest expense and inventory impairments evolve.
The terms, availability and cash-flow implications of land-bank and model-home financing, including the rise in inventory and liabilities classified as not owned.
Any developments in the EPA matter, warranty and construction-defect exposures, and the company’s assumptions supporting its deferred-tax-asset valuation.