HOVNANIAN ENTERPRISES INC quarterly report, Q3 FY2018

Business context and reporting period

Hovnanian Enterprises, Inc. filed this unaudited Form 10-Q for the quarter and nine months ended July 31, 2018. The company operates homebuilding businesses across six U.S. regions and provides mortgage and title services. Fiscal 2018 results reflect a smaller community base following reduced land investment in fiscal 2016–2017.

Financial performance and position

Revenue fell 22.9% for the quarter and 20.4% for the nine-month period versus 2017. Home deliveries declined 15.4% in both periods; lower community counts and changes in geographic and product mix also weighed on revenue. Average selling price decreased 8.8% in the quarter and 7.3% year to date, primarily due to mix.

Homebuilding gross margin improved from 12.8% to 15.4% for the quarter and from 12.9% to 14.6% year to date. Management attributed the improvement mainly to delivery mix, price increases in certain communities, particularly in the West, and lower land charges. Selling, general and administrative costs, including corporate expenses, were 11.8% of revenue for the quarter and 12.9% year to date, versus 10.3% and 10.6%, respectively, as lower revenue outweighed dollar cost reductions.

Cash and cash equivalents were $221.9 million at July 31, 2018, including $216.7 million in homebuilding and $5.2 million in financial services; restricted cash was an additional $25.3 million. Total assets were $1.668 billion, total liabilities $2.169 billion, and stockholders’ equity deficit $500.6 million. The balance sheet included $301.5 million of revolving and term loan facilities, $1.255 billion of notes payable and accrued interest, and $95.4 million of nonrecourse mortgages secured by inventory.

For the nine months, investing cash flow was positive $14.9 million and financing cash flow was negative $164.7 million. Cash decreased $247.4 million from the start of the fiscal year. The company spent $404.9 million on land purchases and development and reported $108.5 million of net debt repayments in its liquidity discussion.

Material changes and unusual items

• Fiscal 2018 homebuilding revenue declined as active selling communities fell to 123 from 141 a year earlier. Net contracts decreased 6.4% for the quarter and 10.2% for the nine months, although contracts per average active community increased to 10.0 and 27.9, respectively.
• Backlog at July 31, 2018 was 2,287 homes valued at $946.5 million, down 9.4% in value year over year. Controlled lots increased year over year for a third consecutive quarter and rose 16.7% sequentially.
• Quarterly pretax results were near break-even, compared with a $50.2 million pretax loss in 2017; nine-month net loss improved to $41.7 million from $344.0 million. The prior-year loss included a $42.3 million debt-extinguishment loss and substantial tax expense from a valuation allowance against deferred tax assets.
• Joint-venture income improved to $10.7 million for the quarter and $6.9 million year to date, compared with losses of $3.9 million and $10.1 million in the prior-year periods.
• Debt transactions included refinancing 2019 notes with a 5.0% unsecured term loan due 2027 and new notes bearing 13.5% due 2026 and 5.0% due 2040. The company recorded $5.7 million of debt-extinguishment losses year to date. The transactions extended maturities but left the company with substantial debt and high interest costs.

Outlook, risks and contingencies

Management said recent refinancing and available cash were expected to fund working-capital needs through fiscal 2018 and 2019. It expected community-count growth to begin early in fiscal 2019, with deliveries and revenue growth to follow, assuming no adverse market factors. This is management’s outlook, not a quantified earnings forecast. The company planned continued land acquisitions while emphasizing returns and liquidity.

As of July 31, 2018, the company reported covenant compliance. Its $26 million unsecured revolving facility, with $3.8 million of letters of credit outstanding, had a stated final maturity in September 2018. Debt covenants restrict additional borrowing and dividends; the company expected to remain unable to pay its noncumulative 7.625% preferred dividends for the foreseeable future. It also reported a fully reserved $659.9 million deferred-tax asset valuation allowance, citing cumulative losses and uncertainty about future taxable income.

Material risks include housing-market and home-price fluctuations, mortgage-rate increases and mortgage availability, land and construction-cost inflation, labor and material availability, leverage and covenant limits, and potential inventory impairments. The company disclosed an EPA demand for $2.7 million in cleanup-cost reimbursement relating to a Newark site; it disputed the demand and said it had adequate reserves, but could not assure the matter would not have a material impact. A separate construction-defect case asserted approximately $119.5 million in damages, potentially subject to trebling; defendants sought summary judgment, and trial was scheduled for October 2018. The Grandview matter was settled in July 2018 for less than the posted bond, with payment scheduled for September 2018. Management stated ordinary-course litigation was not expected to materially affect results, but the specific matters remain relevant contingencies.

Important facts for investors to verify

• Whether new land investment translates into community-count, delivery, backlog and revenue growth as management anticipated.
• Cash availability after restricted cash, ongoing land spending, debt service and the September 2018 revolving-facility maturity.
• Debt repayment and refinancing needs, interest burden, covenant headroom and the effect of high-coupon obligations on liquidity.
• Whether improved reported gross margins persist after accounting for delivery mix, prior-period impairments and land charges.
• Developments and potential financial exposure in the EPA and Great Notch matters, and the final payment and indemnification outcome for Grandview.
• The assumptions supporting inventory valuations, warranty and litigation reserves, and the full valuation allowance on deferred tax assets.