Description
I believe the Hovnanian 7.625% Preferreds (ticker “HOVNP”) are a logical short. (Note that a pair trade idea of long HOVNP and short HOV common was posted on 11-9-07; my idea is an outright short of HOVNP). This idea is quite simple, albeit extremely illiquid. The preferreds closed at $12.18 and are trading at 48.7% of their $25 liquidation preference. The yield is listed as nearly 16%, but by my math it’s 0%, since the dividend cannot be paid at present.
The preferred dividend presently cannot be paid because of restrictions in both the Senior Note Indentures and Senior Sub Note Indentures. The restricted payments covenant requires HOV to be on the right side of its incurrence covenant, which requires 2.0x Fixed Charge Coverage (roughly defined at EBITDA / consolidated interest incurred). At present, however, and for the foreseeable future, HOV cannot meet 2.0x fixed charge coverage.
The 10-K shows FY07 interest incurred excluding Fin Svcs debt was $195mm, which would imply required EBITDA of at least $390mm. FY07 EBITDA margin was negative (even before impairments), but even if we assume HOV can achieve a 10% EBITDA margin at some point in the future, this would imply necessary revenues of $3.9B. Note that revenues never exceeded $3.2B prior to 2004. I don’t have the buildup to the $195mm of interest incurred stated in the 10-K for FY07, but if I simply multiply coupon rate by face value of HOV’s bonds outstanding and the amount drawn on its homebuilding revolver (so I’m excluding LOCs, Fin Svcs debt, etc), I get to FY08 interest incurred of over $150mm. That would imply required EBITDA of at least $300mm. By the above math, this still seems like quite a stretch. All in all, it is hard to imagine how HOV will be permitted to pay the preferred dividend even if it wanted to.
HOV is presently negotiating with its banks to amend its credit agreement. So it remains to be seen what the restricted payments covenant will look like, but it is entirely possible that the banks decide on a restricted payments covenant even more stringent than the bonds have.
HOV filed an 8-k on 7-13-05 that lays out the legal rights, etc, of the preferred. I’m not a lawyer, but I believe the rights are rather minimal. First of all, the preferred is NOT cumulative. So once the dividend is not paid in a particular quarter, that quarter’s dividend is gone for good. Second, neither a merger nor a sale of substantially all assets count as a liquidation, so it’s not clear the liquidation preference has any value. In the case of a bankruptcy, I would be shocked to see the preferred have any value. The liquidation preference of $140mm is a tiny sliver in the context of the overall capital structure. Meanwhile, the Sub notes appear to be trading only in the 50s (after a large short squeeze in the common equity drove the Subs up from the low 40s). Even the Senior Notes only trade in the 70s. Nor do the preferreds have any real voting rights. They do have the ability to nominate 2 “Advisory Directors” after 6 quarters of non-payment, but these folks are explicitly NOT directors of the company and appear to be largely powerless.
By my estimation, the only real “stick” that the preferreds have is twofold. First, a common dividend cannot be paid in a given quarter if the preferred dividend has not been paid that quarter. But that doesn’t seem like much of a stick considering that HOV is in no position to pay a common dividend, nor has it ever done so in its history as a public company. The second “stick” is that the preferred dividend must be paid in a quarter when the dividends of Parity Preferred Stock are being paid. At present, there is not other preferred stock. But in theory, if HOV were to raise some Parity Preferred Stock and pay dividends on it in a given quarter, then the HOVNP dividends that quarter would also have to be paid.
I think these preferreds are logically inferior even to the HOV common. (Note they are NOT convertible into common.) Even if HOV were able to pay the preferred dividend, I don’t see why they would ever want to. The preferred never matures. It is not puttable. There does not appear to be a change of control put. It is non-cumulative. The only reason I can think of to ever pay the dividend would be if HOV raises new Parity Preferred Stock. In theory this is a possibility, but with the lowest yielding Subs yielding over 22% after a recent runup, I certainly don’t expect it.
I cannot imagine a circumstance where it would make sense for HOV to call the preferreds, even if they ever began paying the dividend again. So the only way the preferreds have any intrinsic value (outside of potential nuisance value in a hypothetical bankruptcy) is if HOV starts paying the dividend again in the future. And I’ve already discussed why this seems unlikely to happen ever, let alone any time soon.
If HOV files for bankruptcy, I wouldn’t expect these preferreds to recover anything. Meanwhile, I don’t expect to see them pay a dividend.
Risks
Mark to market risk. The preferred has risen from $4.88 to $12.18 in less than a month, largely in sync with the HOV common. Given that the preferred seems logically inferior to the common and is not convertible, this doesn’t appear to be driven by the fundamentals.
Legalese. It is possible that I have misunderstood or misinterpreted something in the docs as I am not a lawyer. Nothing in this post should be construed as legal advice.
Significant upturn in housing cycle ultimately enables HOV to raise common equity and increase EBITDA to levels where preferred dividend could theoretically be paid, and management decides to do so despite there not being a logical reason to.
Catalyts
More quarters pass without dividend being paid.
More impairments add to HOV’s leverage levels.
More quarters pass without EBITDA returning to levels that would enable dividend to be paid.
If housing cycle continues to deteriorate, more homebuilder bankruptcies should be expected, and HOV, being one of the most highly leveraged names, could become a casualty.
Catalyst
More quarters pass without dividend being paid.
More impairments add to HOV’s leverage levels.
More quarters pass without EBITDA returning to levels that would enable dividend to be paid.
If housing cycle continues to deteriorate, more homebuilder bankruptcies should be expected, and HOV, being one of the most highly leveraged names, could become a casualty.