Although Hovnanian Enterprises' net earnings for its fiscal 1Q 2010 swung into positive territory at $236.2 million, or $2.97 a share, the company continued to wrestle with a major problem during the quarter: Profitability. In the quarter ending Jan. 31, 2010, Hovnanian's home building operations continued to bleed cash, even as a $291.3 million tax benefit offset the loss. And with tax benefits such as this set to disappear, the need to reverse the negative operational earnings trend grows more acute.
During an earnings call March 3, company executives told analysts and investors that there was a single solution to the profitability problem: Open new communities. Their reasoning was that, from a balance sheet management perspective, improving the company's bottom line could only happen by growing the top line.
As an example, Hovnanian management pointed to the builder's SG&A costs, which came in at an uncomfortable 18.5% of revenues. Executives noted they had axed a lot of dollars from overhead costs by reducing head count by 76% from peak, and further cutting would disrupt the company's infrastructure and ultimately hinder the company's ability to return to profitability. Consequently, the best way to reduce SG&A as a percentage of revenue was to goose revenues so the costs could be spread out more evenly across those dollars.
Moreover, the company had already taken the majority of its lumps in terms of asset value adjustments, assuming that the market was to hold steady, executives said. During the quarter, the company took approximately $5 million in write downs, which was well below many analysts' estimates. UBS analyst David Goldberg, for example, had forecast that the company would take $40 million in balance sheet charges for asset revaluations.
So, with Hovnanian Enterprises running as lean as management's comfort level allows, its balance sheet thoroughly scrubbed, and the market showing signs of stability, the plan to move operations back into the black centers on increasing sales volume.
During its fiscal first quarter, the Red Bank, N.J.-based company delivered 1,091 homes, 10% fewer homes than a year ago, for total revenues of $319.6 million. Net new orders came in at 912, down 5% from fiscal 1Q 2009, as units in backlog fell 4% year over year to 1,593 units.
CEO Ara Hovnanian blamed the sales falloff on the fact that the company had 27% fewer actively selling communities during the quarter than last year. As of the end of January, the company counted 179 actively selling communities in its portfolio, down from a peak of 449 communities in July 2007.
With absorptions by community having increased year-over-year to 2.1 sales per community per month in fiscal 1Q 2010 from 1.5 sales per community per month during the same period the previous year, management is confident that the company can improve on those rates by having more stores open.
One interesting side note was that management appeared to be less concerned about potential negative fallout from the expiration of the federal home buyer tax credit in April than some of the team's peers. Unlike other builders, Hovnanian there hasn't seen a radical shift in the company's buyer mix toward the first-time buyer segment (which is the group largely benefiting from the tax credit), suggesting that roughly two-thirds of the company's business is relatively stable because they are making their home purchases independent of the tax credit. Based on company analysis of mortgage applications going through the company's mortgage company, in fiscal 1Q 2010, roughly 34% of Hovnanian's buyers qualified for the tax credit. Last year, 29% of its buyers during the same quarter were first-timers.
Moreover, management indicated that there was more potential for margin upside with new communities compared to similar communities that had been previously impaired. At the close of its fiscal first quarter, the company's margins, excluding balance sheet charges, were 16%.
With the executive management team firmly committed to the opening of new communities, the company's been on an aggressive prowl for land. In terms of sourcing new land deals, Hovnanian said, "It was a productive quarter." The company spent $77 million on roughly 2,100 lots; 1,550 of those lots were new acquisitions while the remaining lots were takedowns on previously held options. All told, at the end of the quarter, the company controlled 28,433 lots; roughly 17,500 were owned.
Hovnanian said that although the company has been outbidding on some of the high-profile, large portfolio land deals--unsuccessfully as it turns out—he's seeing more opportunity with smaller lot deals; by smaller he said he meant deals that would offer on average 1.5 to 2 years of absorptions. Not only were the returns penciling out better, but they also didn't require an equity partner to take advantage of them.
The other push behind this new community strategy stems from some liquidity concerns. Although the company counts roughly $450 million in cash on its balance sheet and has a relatively well-laddered debt maturity schedule, it remains one of the most highly levered large public builders. The pressure to de-lever underscores the company's need to not only grow revenue dollars but to return to profitability to be able to retire debt sooner rather than later.
In the short term, Hovnanian said, "We feel very comfortable [with our cash position]. We need and will be generating the appropriate cash ... to achieve profitability with enough left over to retire debt—early."
However, he acknowledged that the pressure the company's debt load puts on its cash "doesn't give us the capacity to do large deals." Thus the need for joint-venture partners so that Hovnanian can join the competitive wheeling and dealing for big land portfolios.
Sarah Yaussi is executive editor of BIG BUILDER magazine.