Description

Hovnanian 8.875% Sr Sub Notes due 4/1/2012 (Oct 24, 2009; $79.15; 20.15% YTM)

I am recommending a long position in Hovnanian's 8.875% Senior Subordinated Notes due 4/1/2012.  While certainly illiquid with only $69mm of face value outstanding, they can be found.  TRACE shows 15 different trades on Thursday.  TRACE also shows them trading on 14 of the last 19 trading days.

Hovnanian is a top 10 public homebuilder that had been written off for dead.  The resurgence of the HY bond market has granted HOV another lease on life.  Just this month, HOV has issued $785 million of new bonds and completed tender offers to retire ~$743 million of legacy bonds.  While HOV remains overleveraged and actually sports a negative stated BV, it now has significant liquidity and has succeeded in dramatically pushing out its debt maturity profile. 

The particular bond issue I am recommending (the "2012 Subs") is near the front of the maturity profile.  The 2012 Subs are offering a 20.15% YTM through their 4/1/12 maturity less than 2.5 years from now with what I believe to be modest risk.  I believe that the HOV's position as an overlevered builder and the 2012 Subs' subordinated status have helped create this opportunity.

Pro forma for the most recent tender offers, there remains only $11.1 million of bond debt maturing before the 2012 Subs; $35.6 million of bond debt maturing on the same day as the 2012 Subs; and $21.7 million of non-recourse mortgages with various maturities that I will assume mature before the 2012 Subs for conservatism.  Including the $69 million of 2012 Subs, that totals just $137.3 million of debt maturities through and including 2012.  Yet HOV's liquidity remains substantial, with $545.6 mm of unrestricted cash at 7/31/09 and $564.4 mm of total cash pro forma for the recent bond issuance and tender offers.

When comparing the 2012 Subs to other public builders with similar maturities and relatively similar credit ratings, the 2012 Subs stand out.  The 2012 Subs have a 20.2% YTM; whereas the April 2012 BZH bonds yield 14.3%; the April 2012 SPF bonds yield 14.7%; and the April 2012 MHO bonds yield 10.2%.   Moreover, if we ignore operations over the next 2.5 years and simply look at current cash less the interim debt maturities, HOV is left with far more excess cash than the others after after the maturity of the April 2012 bonds.  The following table demonstrates this:

A premature or "strategic" bankruptcy seems highly unlikely given the Hovnanian family's huge equity stake.  The family currently owns almost 1/3 of the total common equity (~18.4% of Class A and 91.7% of Class B for ~32.3% overall).  See the following table for detail:

If anything, the family has demonstrated a willingness to dilute its ownership in order to keep its equity option alive; HOV issued 14 million shares of common in May 2008. 

HOV has had no qualms about issuing high cost debt to avoid bankruptcy.  For instance, 11.5% 2^nd lien notes due 2013 were issued in May 2008 and just retired at 106% of par in the latest tender.  And new 10.625% 1^st lien notes due 2016 were issued earlier this month in order to fund the tender.

Because of the dual class nature of HOV's common equity (Class B shares get 10 votes per share while Class A only get 1), HOV could issue an additional 80 million Class A shares and the family would still retain over 50% of the total votes.  I think, therefore, that it is entirely possible that HOV issues more equity in the future should its stock price continue to rise.  If this were to occur, it would only serve to de-risk the 2012 Subs further.

The fact that the 2012 Subs are subordinated bonds does not seem terribly concerning to me either.  While recovery would be minimal in a near term bankruptcy, it is extremely difficult to envision a near term BK in light of HOV's large liquidity and minimal near term debt maturities.  A bankruptcy more than 2.5 years out is of course irrelevant to the 2012 Subs which will have matured before then.

The $785mm of 1^st lien bonds may sound like a lot of debt to come ahead of a sub debt holder, but those 1^st lien bonds do not mature until October 2016 and are not even callable until October 2012 (again, after the 2012 Subs will have matured).  The same argument can be made for the $811.7 mm of senior unsecured notes that mature after the 2012 Subs.

I'm certainly not banking on it coming to pass, but the rumors this week of a potential extension of NOL carrybacks from 2 years to 4 years would disproportionately benefit HOV compared to other overleveraged builders SPF and BZH which have previously triggered a Section 382 change in ownership.  (HOV has put in place a poison pill to prevent the occurrence of a Section 382 change in ownership).

In the meantime, the overall marketplace for homebuilders has been improving, admittedly driven in large part by government stimulus.  And the Metro DC market, where HOV has a large presence, is currently the strongest geography in the country.

In conclusion, therefore, I find the 2012 Subs' 20.15% YTM to be very attractive and the risk of a BK prior to their maturity on 4/1/12 to be quite unlikely.

Risks

A substantial increase in volumes would require a significant investment in WIP.  But this would be a high-class "problem" to have.

While JV debt is supposedly "non-recourse," most JV debt includes "bad boy" guarantees with a prohibition against a voluntary bankruptcy filing of the relevant JV.   That said, such contingent liabilities seem manageable in the context of HOV's liquidity position and the fact that other JV partners should share responsibility.

Catalysts

Homebuilding market sustains improvement in the coming quarters.

Possibility that HOV issues some equity to further shore up the balance sheet.

Passage of time brings maturity even closer.

Maturity on 4/1/2012.

Debt Maturity Schedule Detail

Catalyst

Homebuilding market sustains improvement in the coming quarters.

Possibility that HOV issues some equity to further shore up the balance sheet.

Passage of time brings maturity even closer.

Maturity on 4/1/2012.