Hovnanian Enterprises, Inc. (HOV) Q3 2018 Earnings Report, Transcript and Summary

Good morning, and thank you for joining us today for Hovnanian Enterprises fiscal 2018 third quarter earnings conference call. An archive of this webcast will be available after the completion of the call and run for 12 months. This conference is being recorded for rebroadcast and all participants are currently in a listen-only mode. Management will make some opening remarks about the third quarter results, and then open up the line for questions. The company will also be webcasting a slide presentation along with the opening comments from management. The slides are available on the Investors page of the company's website at www.khov.com. Those listeners who would like to follow along should log on to the Web site at this time. Before we begin, I would like to turn the call over to Jeff O'Keefe, Vice President, Investor Relations. Jeff, please go ahead.

Thank you, Gigi, and thank you all for participating in this morning's call to review the results for our third quarter, which ended July 31, 2018. All statements in this conference call that are not historical facts should be considered as forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such forward-looking statements include, but are not limited to, statements related to the company's goals and expectations with respect to its financial results for future financial periods. Although we believe that our plans, intentions and expectations reflected in, or suggested by, such forward-looking statements are reasonable, we can give no assurance that such plans, intentions or expectations will be achieved. By their nature, forward-looking statements speak only as of the date they are made, are not guarantees of future performance or results and are subject to risks, uncertainties and assumptions that are difficult to predict or quantify. Therefore, actual results could differ materially and adversely from those forward-looking statements as a result of a variety of factors. Such risks, uncertainties and others are described in detail in the sections entitled Risk Factors in Management's Discussion and Analysis, particularly the portion of MD&A entitled Safe Harbor statement in our annual report on Form 10-K for the fiscal year ended October 31, 2017, and subsequent filings with the Securities and Exchange Commission. Except as otherwise required by applicable security laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason. Joining me today are Ara Hovnanian, Chairman, President and CEO; Larry Sorsby, Executive Vice President and CFO; Brad O'Connor, Vice President, Chief Accounting Officer and Controller; and David Bachstetter, Vice President, Finance and Treasurer. I'll now turn the call over to Ara. Ara, go ahead.

Thanks, Jeff. As is typical, I'm going to review the operating results for the third quarter. Larry Sorsby will follow me with little more detail on a variety of topics, including our progress in land acquisitions and our liquidity position. I have now mentioned this on the past several conference calls, but I think it's important to review a little history again to get the right perspective of our current performance. Because the high-yield market rapidly closed to all CCC issuers when we had debt coming due in fiscal 2016, we had to use $320 million of liquidity to retire debt instead of refinancing it as we had planned. Refinancing would've enabled us to use that liquidity to invest in land back then to grow our community count, increase revenues, and achieve much better performance levels today. The land we should have been controlling at that point in time would've resulted in communities that would be open and delivering today, but because we temporarily exited the land market back in 2016, our community count shrank. We reentered the land market again in the beginning of fiscal 2017, but, unfortunately, you can't just wave a magic wand and have your land position replenished instantly. As you can see on slide four, this quarter, we made meaningful progress in growing our land supply. Our total lots controlled are up 20% year-over-year or about 5,100 lots and up 17% sequentially. Just as we couldn't instantly grow our land position, it will take some time to get these newly controlled lots to the point where they’d become communities that are open for sale. So, our delivery and revenue volumes for the third quarter were still negatively impacted by our lower community count. Turning to slide five, we show consolidated revenues in gray and joint venture revenues in blue. Here, you can see that our third quarter consolidated revenues were down about 23% year-over-year. However, you can also see that our joint venture revenues grew by a similar amount. One of the steps we took when paying down the $320 million of debt was contributing wholly-owned communities to joint ventures. If you include joint venture revenues, our third-quarter revenues would've declined less than 1%. This is not an insignificant accomplishment given the lower community count. Now, turning to slide six, in the top left-hand portion of the slide, you can see that our gross margin of 18.4% for the third quarter of 2018 improved 160 basis points from last year. We've now reported year-over-year increases in gross margin in six of the last seven quarters. Although material and labor costs are still increasing, we continue to raise home prices in excess of those increases. In the upper right-hand portion of the slide, you can see that total SG&A dollars were down 12% year-over-year from $61 million last year to $54 million in this year’s third quarter. However, due to a larger percentage decline in our revenues, our total SG&A as a percentage of revenues was 11.8% in the third quarter compared to 10.3% in last year's third quarter. On the bottom of the slide, we show that our interest expense was lower on a dollar basis during the third quarter at $38 million compared to $43 million last year. Turning to slide seven, on the left-hand portion of the slide, we show that we reported adjusted pretax income before charges and impairments of $4 million. That’s compared to a loss of $4 million last year. On the right-hand side of the slide, we show pretax income of about $100,000 for the third quarter of 2018 compared to a pretax loss of $50 million last year. The large loss last year was primarily related to a $42 million loss on the extinguishment of debt due to refinancing. While our third-quarter profit is very small, the trend is definitely a step in the right direction. We plan to continue that trend in a more meaningful manner in our fourth quarter. We recognize the fact that our SG&A ratio is not where we want it to be right now, and while we can make adjustments to some variable components, we believe we have to maintain much of our SG&A in order to execute our growth plans. Once we begin to grow our revenues, we expect our SG&A ratio will improve and trend back to our normal 10% range. In our fourth quarter, you will see the positive impact higher revenues have on our SG&A ratio. Ultimately, we hope to see our SG&A ratio drop below our historic 10% normalized levels. As I said a moment ago, posting a pretax profit in the third quarter is a step in the right direction, but in order to get to sustained levels of profitability, we need to grow our community count. Community count growth should ultimately lead to increased revenues. In the more intermediate-term, even with the lower current community count, we still expect the fourth quarter of this year to be solidly profitable. Larry will discuss this in a little more detail in a moment. We’re laser focused on growing our land position. This is the first step in growing our community count and revenues. Our land acquisition teams continue to be very busy around the company. We’re not just replenishing our land position, but working hard to grow our land position. Now, I’d like to take a moment to comment briefly on our sales activity. On slide eight, we show our quarterly contracts per community. The most recent quarter is in blue and the same quarter a year ago is in gray. Our contracts per community were greater for the last four quarters, including the most recent third quarter of 2018 when our contracts per community increased 10% over the prior year. Larry will give a little more granularity on sales in a moment. If you turn to slide nine, you can see the trend in our community count since the beginning of 2016. Once again, primarily due to the steps we have to take to retire maturing debt, our community count decreased throughout 2016, 2017, and 2018. We think were close to the trough here. We continue to expect our community count to begin to improve sequentially during the first half of 2019. Needless to say, the declining community count has negatively impacted our total revenues and profitability. On a positive note, our contracts per community have been increasing over that same time period. This has partially offset the impact of the lower community count. Within the column for each quarter on this slide, we show a narrower dark column for the trailing 12-month contracts per community for the same quarters. You'll see steady improvement on this slide. And while it is steadily improving, contracts per community are still well below our normal levels. If you turn to slide 10, you can see this. On the left side, we show our annual contracts per community from 1997 to 2002, and they averaged 44 contracts per community. As we’ve discussed in the past, this is a time that was neither a bust nor a boom in the housing market. On the center portion of the slide, you can clearly see the steady growth in contracts per community each year for the past several years. This includes the most recent trailing 12 months compared to the same period a year ago that’s shown on the right-hand portion of the slide. We would anticipate that, if demand returns to normal levels, contracts per community should also return to more normal levels. Ultimately, combining rising contracts per community with growing community count should result in our company seeing solid revenue growth and performance. I’ll now turn it over to Larry Sorsby, our Executive Vice President and Chief Financial Officer.

Thanks, Ara. I will start by continuing the discussion with respect to our sales price. On slide 11, we show our contracts per community on a monthly basis. Here we show the most recent month in blue and the same month a year ago in gray. For 10 of the past 12 months, current contracts per community were equal to or better than the same month of the prior year. A number of our peers reported choppiness in sales during the summer months, while both our May and June sales per community were up and July was flat year-over-year. For the most recent month of August, we showed contracts per community of 2.7 compared to 3 in August last year. We believe that the decline in August is partially due to a national sales event we had in July, which likely pulled some demand forward. For the last two calendar weeks, including the first nine days of September, our net contracts per community and our absolute level of net contracts both increased over the same period last year. Now, let me update you on the results from our joint ventures. On slide 12, we show that our income from joint ventures increased to $11 million in this year's third quarter compared to a loss of $4 million in last year's third quarter. Sequentially, our joint venture income increased by $10 million over the $1 million we booked in the second quarter of 2018. We would expect this trend of improving joint venture income to continue into the fourth quarter. Next, I will discuss our efforts to grow our community count. The first step is increasing our year-over-year land control position which we accomplished during each of the first three quarters of 2018. On slide 13, you can see that, for the first nine months of 2018, we added 9,216 newly controlled lots and delivered 3,571 homes and lots, resulting in an increase of 5,645 controlled lots. Further demonstrating the significance of our growing land position, year-to-date, our newly controlled lots equaled 258% of our year-to-date home deliveries. On slide 14, we show our total consolidated lots controlled at the end of the third quarter increase 17% sequentially and 20% year-over-year. We spent $120 million on land and land development during the third quarter and increased our controlled lots by about 4,400. Our option lot position increased by 32%, while our owned lot position remained virtually unchanged. Increase in our land controlled through option contracts further demonstrates our continued focus on inventory turnover as well. Throughout fiscal 2018, and especially in the most recent quarter, we’ve made good progress in rebuilding our land supply and remain disciplined through our underwriting standards of using current home sales price, sales pace and construction costs. There is a significant lag from the initial land contract to the time when the community opens for sale and ultimately when we can deliver homes. This time lag can vary from a few months in a market like Houston to three to five years in markets like California and New Jersey. While we are pleased to report an increase in our lot supply, we recognize there is still more work to do. We remain focused on increasing our land supply even further, so we can grow our community count, revenues and, most importantly, our profitability. Many investors mistakenly believe that the majority of our land options are held by land banks, which certainly is not the case. As of the end of the third quarter of fiscal 2018, we controlled 18,416 lots through option contracts. As you can see on slide 15, only 6% of our lot options are currently with land banks. Land banks land banking for us peaked at 16% of our total lot options at the end of the third quarter of fiscal 2016 and declined compared to 8% at the end of last year's third quarter. So, even at the peak, we did not have all that many lot options with land bankers. Although supply in terms of land banking transactions continue to improve, we simply have not had the liquidity needs as of late to aggressively pursue them. As we find more acquisition opportunities to invest in land, we will likely begin to land-bank some of the larger parcels going forward. Looking at all of our consolidated communities in the aggregate, including mothballed communities and the $97 million of inventory not owned, we have an inventory book value of $1.1 billion net of $268 million of impairments. We believe one of the key pure operating metrics for the homebuilding industry is EBIT to inventory. This metric neutralizes the impact of debt. On slide 16, we show the trailing 12-month EBIT to inventory for us and our peers. This ROI metric measures pure operating performance before interest expense. We remain in the top half when compared to our peers on this metric. We and the entire industry are still not at normalized ROI levels, but we believe this will improve as we get further into the housing industry's recovery. One of the ways we were able to achieve this is maintaining our focus on inventory turns. Turning to slide 17, compared to our peers, you see that we have the second-highest inventory turnover rate over the trailing 12 months. Although, we lag NVR's industry-leading turnover number, our turns are 50% higher than the next highest peer below us. High inventory turns are a key component of our overall strategy. Another area for discussion is related to our deferred tax asset valuation allowance. Our deferred tax asset is very significant and not currently reflected on our balance sheet. We've taken numerous steps to protect it. At the end of the third quarter of fiscal 2018, our valuation allowance in the aggregate was $660 million. We will not have to pay cash federal income taxes on approximately $2.1 billion of future pretax earnings. On slide 18, we show that we ended the third quarter with a total shareholders’ deficit of $501 million. If you add back our valuation allowance, as we did on this slide, then our shareholders’ equity would be a positive $159 million. Over time, we believe that we can repair our balance sheet and have no current intentions of issuing equity anytime soon. Now, let me comment on our current liquidity position. As seen on slide 19, after paying off $26 million of debt and spending $120 million on land during the quarter, we ended the third quarter with liquidity of $242 million, which is at the high-end of our liquidity targets between $170 million and $245 million. We continue to have ample sources of liquidity to further grow our land position, which ultimately should drive increases in our community count. On the top of slide 20, we show our maturity profile as it looked as of July 31, 2018. On the bottom of the page, we show how it will look upon funding of the remaining two GSO financing commitments. After the final GSO financing, we will not have any maturities of significance until fiscal 2022. Turning to slide 21, we have a commitment from GSO for a $125 million senior secured revolver/term loan, which we anticipate making the first draw later this month. we will use this to repay our $75 million super-priority secured term loan due in 2019. Additionally, the facility provides us with $50 million of incremental liquidity we can reinvest into land to grow our community counts. Furthermore, GSO has committed to providing us, in January 2019, with another $25 million of additional liquidity via tack-on purchase at then current yields to our existing 10.5% senior secured notes due 2024. Combining these two transactions will provide a total of $75 million of capital in addition to our current levels that we believe will help fuel our growth. We will continue to evaluate our capital structure and explore further ways to improve our financial position. Turning to slide 22, I would now like to discuss our expectations for a strong fiscal 2018 fourth quarter. Assuming no changes in current market conditions, we expect to report fourth-quarter results with total revenues between $600 million and $640 million, gross margins to be in the range of 17.8% to 18.4% and our SG&A as a percentage of total revenues to be between 9% and 10%. Excluding land-related charges and gains or losses on extinguishment of debt, we expect the pretax profit for our fourth quarter of fiscal 2018 to be between $20 million and $40 million. Now, I’ll turn it back to Ara for some brief closing remarks.

Thanks, Larry. Before my closing comments, I want to welcome and acknowledge our newest board member, Bonnie Stone Sellers. Bonnie has most recently served as CEO of Christie's International Real Estate and was previously a partner with McKinsey & Company. She brings to the table extensive experience in global real estate and is a valuable addition. We’re thrilled to have her as part of our Board of Directors. Now, I’d like to comment briefly on the overall housing market. We continue to operate in a new home market that's undersupplied compared to historic standards and long-term demographic trends. Nonetheless, rising mortgage rates and falling affordability levels appear to have given homebuyers some pause in the last couple of months over the summer. However, the demographic outlook and the improving economic backdrop, not to mention the positive sales we’ve experienced in the first two weeks of September, gives us the confidence that there is still more upside to this housing recovery. We believe the industry experienced a temporary hiccup, and that's occurred for several short periods in each of the recent years. The fact that we grew our lot count so significantly during the third quarter gives us confidence that we’ll see increases in our community count in the future. We recognize that we’re more highly leveraged than our peers. The additional debt has associated interest costs that have not only hampered our overall levels of profitability, but it's also hindered our performance relative to our peers. Our plan continues to be to improve our balance sheet through increased profitability. Not having to pay federal income taxes on the next couple of billion dollars of future pretax income certainly helps. As we said earlier, repayment of our bonds when the high-yield market was closed in fiscal 2016 created a short-term hurdle to our plans for growth. Today, our maturity runway is significantly more favorable. Additionally, when and if needed to fuel further growth, we have additional capital available from land bank and JV partners, non-recourse bank debt sources, and through model sale-leaseback opportunities. We’re still on track with our plan to continue repairing our balance sheet through growth of pretax earnings over the next few years. Key elements of our plan include, one, growing our community count and sales absorptions. Over time, this should lead to increased revenues. Two, focusing on high inventory turnover which will maximize our revenues and help optimize our returns on invested capital. Three, utilizing alternative capital sources when needed. Four, improving our gross margin back toward normalized 20% levels. And five, reducing SG&A and interest ratios through anticipated growth. We believe this plan will lead to enhanced returns for our shareholders and put us on a more solid foundation. Our fourth-quarter profitability should be strong and fiscal 2019 should be a little stronger than fiscal 2018. Assuming no changes in the current market conditions, in fiscal 2020, we expect to make substantial progress toward achieving our annual key metric targets that we spoke about in our earnings call last quarter. That concludes our formal remarks and we’re happy to open it up for questions.

[Operator Instructions]. Our first question from Thomas Maguire from Zelman & Associates. Your line is now open.

Hey, guys. Nice job on the sales side and improving the absorptions for the full quarter. I know we talked about the sales event in July, and that was something you hadn't done in a while. Just any color on the decision to do that. Was it something where you feel profitability is in a better place now and we can go after pace? And how that event performed kind of relative to your expectations internally, understanding that pace ended up being flat for the month there?

Sure. Well, first of all, the event was nothing like the magnitude of the event we had many years ago that we call the deal of the century. There were certainly promotions throughout the country, but they were not significant in magnitude. We just thought we'd give a little extra kick, particularly in regard to quick delivery homes that could deliver in the fiscal year, and it more or less accomplished the results we were hoping for. I wouldn't say it was an overly strong event in that our sales pace was equal to what it was last year, but as we heard the results from our peers, many of whom reported some down results year-over-year, we feel pretty good about the overall accomplishments. It did affect what happened afterwards, I think, as part of the poorer comparisons in August, but things seem to have bounced back nicely in September.

Got it. Thanks. And then just in that vein, understanding we saw it bounce back, but just more broadly, some of the choppy trends in this summer and to date here, understanding the long-term favorable drivers are still in place, but are you more cautious at aggressively invest in land at this point because of what you’ve seen or any change in underwriting relative to maybe where we were six months ago when you got out and tied up [ph] new deals because of that?

Well, we change underwriting every month in a sense, in that we look at current sales trends for that 13-week period as we’re underwriting the deals. We look at prices then net of incentives that our peers are offering and we look at pace then. So, that’s changing constantly and we are underwriting kind of with the most current data we have then. We feel like that should give us a relatively safe horizon in underwriting standards. And even if the market were to slow a bit, we think it’s the right thing to do and there's enough cushion in our underwriting that the acquisitions would be good ones.

Next question.

Thank you. Our next question is from James Finnerty from Citi. Your line is now open.

Hi. Good morning. Congrats on the margin improvement. On the land spend side, I just want to just review what your thoughts are there. It seems like year-to-date you've spent a little bit less than you did to date as of last year. So, like last year, you spent a bit more. I think you were guiding previously that you were going to increase land spend year-over-year in 2018. So, just any thoughts there would be helpful.

Yeah. I think the important thing is that we’re dramatically increasing our number of controlled lots. We’ve been able to do it by option contract more so than ownership which we think is a net positive. We still have additional capital to increase it even further as well as capital from third-party sources, if need be, but we’re extremely pleased with our progress on growing our land position year-to-date 258% more than the number of homes and lots that we've closed on during the same period. So, we were fortunate to be able to structure the transactions primarily through options rather than ownership, which led to not having to use quite as much cash as we had earlier anticipated.

So, should we think about land spend being similar to 2017, given the success of those transactions?

I would say that we’re still out there looking at new deals. I would still anticipate that maybe the fourth quarter, we’ll have a higher spend than we did last year.

Great. And on the order front on slide 11, you were walking through the cadence, how it went through the quarter, and then in August. So August looks like it was down 23% year-over-year. What was the comment with regard to September and how that sort of seems to net out against August?

The comment about the first nine days of September in the last two calendar weeks is that we’re up both on a sales per community basis and on an absolute contract basis, which is quite an achievement given the decline in year-over-year communities. So, it just feels like the market has bounced back for us in the last couple of weeks after a temporary hiccup in the month of August.

Okay, great. And on the community count front, you’re sticking with the guidance of sequential growth in the first half of 2019. Thinking about that, does that mean in the first quarter of 2019 we should anticipate potential growth versus the fourth quarter of 2018 or is it more sort of just generally the first half?

We haven't given granular as to whether it’s the first quarter or the second quarter, but we’re confident that it is a very difficult number to project because you can actually sell faster than anticipated, have less communities, or you can have delays in opening a community because of certain regulatory issues. So, it's hard to give you an absolute precision on when that’s going to occur, but we’re confident it’s going to occur soon.

Thank you. [Operator Instructions]. Our next question is from Megan McGrath from MKM Partners. Your line is now open.

Good morning. Thanks. Ara, you said in your closing comments, you talked a little bit about how there was a pause in the market generally speaking, but you're feeling confident about recent trends. So, aside from the sales event that you talked about, did you see any kind of theme among both the bounce back and maybe the pause that you saw during the summer, either in terms of geography or product type?

I can’t say that we did specifically. I can tell you, in general, the same market that have exhibited strength for us remain strong. Our Texas markets are strong. Northern California has been strong. Delaware is strong. So, we haven't seen any real shift of significance geographically.

Okay, thanks. And then, just a quick follow-up on the gross margin guide. Looks like sort of flat to slightly down sequentially. Is that a mix issue or is there anything else we should aware of heading into the fourth quarter?

I would say it’s primarily mix, but I think it's safe to say that, in August, we might've increased incentives or concessions just to touch that would also have some impact on margins as well.

Okay, thanks. That’s helpful.

Thank you. Our next question is from Alex Barron from Housing Research. Your line is now open.

Yeah. Thanks, guys. And great job on the improvement here. Sorry if I missed it, I got on the call a few minutes late, but I don't know if you guys discussed like what drove the improvement in the SG&A this quarter. Compared to 40-plus-million dollars in the homebuilding side last couple of quarters, this quarter, $37 million, seemed like a really good improvement.

I think it’s primarily management fees from JVs, Alex, that did it.

So, those are like a positive offsetting the $45 million? Is that how it works? Or…

As our JVs deliver homes, we receive a management fees. And some of our JVs have – as you saw on the JV income from JVs line, our JV activity was up this quarter and, therefore, the management fees received, offsetting our overall SG&A, increased this quarter over prior quarters.

Got it. What about the improvement in the gross margin? Just was that something that you guys have done differently that you start more spec building or like…

No. I’d say, as I mentioned during the call, we’ve been raising prices in many, many committees all over the country. We’ve been doing that for a while. The problem is, at any given point in time, how do those prices compare to offsetting material and labor costs and the mix throughout the country. Part of it also dependent on what mix of new land acquisitions we have. So, when you put all that into a black box, we’ve just been trending better, and we’ve been doing it for many quarters in the last couple of years.

Okay. And did you guys give any guidance on the other income or the JV? Like, is that likely to be sustainable, this $10 million, or it’s just a one-off?

What we said was wee expected the improving trend in joint venture income to continue into the fourth quarter.

Thank you. At this time, I'm showing no further questions. I would like to turn the call back over to Ara Hovnanian for closing remarks.

Great. Thank you very much. We are pleased to report an improving quarter and a profitable one and we’ll look forward to reporting an even more solid fourth quarter. Thank you.

This concludes our conference call for today. Thank you all for participating and have a nice day. All parties may now disconnect.