I propose going long Hovnanian’s preferred shares (Nasdaq: HOVNP par value $25) and short the common (NYSE: HOV). After trading close to par for a long while, HOVNP precipitously declined to $10.60 over the summer, rallied back up to $14 and is now back down to 11.61. A return to 25 would be better than a double and of course you get preference in case of bankruptcy (Note: it is likely that the company will be restricted from paying a dividend on HOVNP). Anyway, the gist of the thesis is that HOV common is unlikely to double if the company survives, at least anytime soon.

 

--------- Description of HOVNP from 10-K -----------

 

“On July 12, 2005, we issued 5,600 shares of 7.625% Series A Preferred Stock, with a liquidation preference of $25,000 per share for net proceeds of $135 million. Dividends on the Series A Preferred Stock are not cumulative and are paid at an annual rate of 7.625%. The Series A Preferred Stock is not convertible into the Company’s common stock and is redeemable in whole or in part at our option at the liquidation preference of the shares beginning on the fifth anniversary of their issuance. The Series A Preferred Stock is traded as depositary shares, with each depositary share representing 1/1000th of a share of Series A Preferred Stock. The depositary shares are listed on the Nasdaq Global Market under the symbol “HOVNP”. In each of the first, second and third quarters of 2007 and 2006, we paid $2.7 million of dividends on the Series A Preferred Stock.”

 

----------- General situation faced by HOV------------

 

The large homebuilders’ business model has been one of holding land mainly as debt-financed inventory, build on it, flip it & generate a profit while servicing the debt. The HBs therefore cannot afford to let owned land sit until the market turns. They also control land via options but that’s not the focus of this write-up. Upon reflection, the land is an income-generating asset (i.e. its value is the DCF valuation of what can be done with it based on an IRR target or some other discount rate). In order to service their debt in this unexpected bear market the builders must - to an extent - either fire-sale the land to wealthy buyers or flip the lots to consumers via homebuilding. The success with which a builder can do this, as well as its specific capital structure, is what determines survival probability. The big HBs used to all be investment-grade but lately have been downgraded to junk, which changes the available financing options in case of problems.

 

----------- U.S. Housing market -------------

 

Ok so everyone knows the housing market is in deep trouble but what exactly is occurring? Let’s divide home sellers into 3 categories. (i) homeowners (ii) bank REOs (iii) HBs. When a housing bear market starts, prices are sticky on the downside because there’s no desperation (very little REOs + existing homeowners suffer from various psychological biases causing refusal to lower prices). The HBs are the professionals. While they lower prices, they control the pace as long as they respect each other in the marketplace and trail existing homeowners. Plus, they can use incentives as a substitute for price cuts. We saw such a situation in most of 2006. Remember all the talk last year about how HBs are lowering their prices yet still profiting handsomely?

 

When the market gets worse than this, this situation evolves. The credit squeeze leads to foreclosures and takes away buyers’ capacity to borrow vs. their planned home purchase (especially if we’re coming off of a credit/mortgage bubble of historic proportions). Also, people are unable to move into new homes they want because the buyer for their old home can’t get financing. So volume dries up. In other words, a housing crash is not a price crash, it is a volume crash (i.e. housing bear markets are unefficient markets). But the volume crash turns into a price crash when banks come in with their REOs and compete hard vs. the HBs. Banks don’t play games because they hate owning homes. A recent study found 25% of Las Vegas' bank-foreclosed homes suffered intentional damage, including vandalism inside the house. When REOs and HBs compete, existing homeowners become the dear in the headlight and get left behind with their high asking prices. Eventually this shocks them into panic discounting.

 

-------------Where are we now? ----------

 

We are now at the point of a severe volume decline and a small (yet notable) price decline. September '07 new home sales were the lowest September since 1995. At the end of Q3, the Census Bureau reported the seasonally adjusted Months of Supply for new homes was 8.3 months. Adjusting for cancellations, the actual months of supply was 11 months. Sales at HBs currently are typically off 30-60% from last year with cancellation rates of 30-70%. Bear Stearns sees up to 40% of existing home sales from REOs by the end of ‘08, potentially pushing prices down by 15% - 20%. Over the next couple of months, REOs are already projected to take over 50% of the San Diego existing home market. Therefore, we are at the gate of panic discounting, especially in CA, FL, AZ, NV and perhaps NC. In California, existing home sales are typically off 20-50%. Price declines of 7-10% in each of 2008 & 2009 are being predicted by Goldman, MS and others. Indymac also published some pretty bleak 2008 numbers. Anyhow, it now appears that there will be a substantial price crash for a period of 12-24 months, followed by a slower paced protracted decline for a few more years. My bet is that 2008 will be the worse year for housing because I think the most shocking credit contraction action can’t occur over too long a time period, and that it is the main factor.

 

Our exercise is to consider how HOV fares in this environment. A significant portion of their business is in California, New Jersey, Texas, North Carolina, Virginia, Maryland, Florida and Arizona, so they are exposed to the trends in a big way.

 

 

----------- Mortgage subsidiary ---------------

 

A few words about the mortgage sub. From the 2006 10-K: “9.5% of our home buyers paid in cash and 62.9% of our non-cash home buyers obtained mortgages from one of our mortgage banking subsidiaries”. And who buys these mortgages? From the cc: “Chase, Citi and Countrywide. These three institutions collectively purchase 95% of the mortgages that we originated in the third quarter”. So we already see one risk: Citi and CFC both look like they have *some* probability of forfeiting this business, at least to an extent. We know there’s extra risk of this with HB homes due to potential building-quality issues. (By the way, this is not a focus in my write-up but various sources would testify that building quality has been shortchanged during the bubble). So we know liquidity is being hoarded in the banking sector and clearly HOV has had incentives to underwrite aggressively. Did it do so to a significant extent? We don’t know but we know what’s going on at BZH; we also know that PHM has a huge 92% capture rate and here’s an article excerpt regarding two other peers:

 

 

 

So basically, because the home seller in this case is a powerful homebuilder, there’s a chain of incentives potentially linking HB home sales to aggressive underwriting. And we know that warehouse lines of credit are still being pulled away until this day, so this isn’t over (HRB this week).

 

Also notable is that HOV still holds $163 million of mortgages held for sale despite declaring repeatedly that liquidity is the priority. So it’s fair to assume that the market for these loans is in trouble. Finally, I note that HOV still makes a few arguably risky loans, like stated income loans and 2nd homes with only 5% down. Not the end of the world but…

 

------------ Management --------------- 

 

A word about management: in the cc, Ara Hovnanian says the following regarding real estate downturns: “we have been through these before. It is not fun, but we know what we have to do and we're working hard to make that happen”. But earlier on he says “we did not see it coming”. Well, they didn’t see it. This is supported by their ramping up of land acquisitions late in the bubble, especially the Fort Myers, FL acquisition in 2005 which is discussed also in the cc. (about 7% of their lots). Management’s casual attitude only increases the chance we’ll see more liquidations which benefit creditors at the expense of shareholders.

 

------------- Land value ------------

 

What ultimately matters for homebuilders is land value. As we said before, the value is measured by how much profit you can make off of it, which in turn depends on how bad your liquidity situation is. We will get to the liquidity soon. Here’s a passage from Big Builder Magazine:

 

For the quarter ending Aug. 31, Lennar wrote off deposits and pre-acquisition costs on 15,000 home sites it no longer plans to buy. That adds up to a total of 24,000 home sites the company has abandoned in the first nine months of this year.

 

 

Of course, HOV’s land isn’t necessarily worthless. HOV’s owned lots were about flat - around a 33000 average - over the past 2 years. There was no liquidation urgency until this summer. From the CEO: “We made significant investments in Florida in 2005, primarily in Fort Myers, and we are now paying a price for the poor timing”. Land has carrying costs, even before interest. Another problem with land is that neighboring parcels purchased by vultures put you at a huge cost disadvantage.

 

Builders value land at lower-cost-or-fair-value. Recently HOV had about 3.4B of straight-owned inventory vs. 1.2B in October 2003. We know that various sources and industry observers that back-of-envelope calculations point to prices as “fairly valued” sometime in 2003. Here’s a crude calculation: the Case-Shiller composite went up about 50% since October 2003 (i.e. needed to decline 33% in real terms). From various sources, it seems a good rule of thumb is that the amplitude of land price fluctuations is at least double that of home price fluctuations. So what’s going on in the land market? Some insight from Ara Hovnanian:

 

“On a brand new deal that hasn't been sold, land prices have not come down; they have come down but not nearly enough to make new acquisition sense. That's why you haven't seen much new activity in that regard. However, if there is a community that's under development and the properties already under option and it's proceeding but prices fall, in many cases the sellers are absolutely willing to discuss price and lower their price. Obviously we're only proceeding if they are willing to lower it sufficiently to get to a price that makes a reasonable return for us. It's getting more and more challenging without a doubt as the market deteriorates, but we're sticking to the discipline”.

 

This means land is likely to decline 50% from current levels, at least. If HOV was a pure land company it would eliminate HOV’s equity very soon but HOV is still successfully flipping land to consumers in the form of homes. Plus we haven’t even gotten to comparing entitled & unentitled land (HOV buys mostly entitled). By the way, HOV has not conducted a material amount of land sales.

 

--------- Liquidity situation -----------

 

Hovnanian claims that its liquidity situation is more than manageable (forecasts it will be cash flow positive in 2008) and this may be right but it wouldn’t imply anything regarding residual equity value.

 

A recent street.com article discusses the z-score of big HBs.

 

As you can see, HOV’s score is pretty low. Those who have been following the sector will notice that there’s a reasonable correlation between the z-score, the stock prices, the news flow & the general situation of the builders in question. The main reason for HOV’s low score seems to be its elevated debt levels. Debt to total capitalization has been in the high 50’s for them which is among the highest in the peer group. Average is in the 40’s.

 

Would banks take big actions here? We know banks have been quiet until now but as soon as there will be a foreclosure on a big builder, other banks will notice and think twice about leniency. No one wants to be left holding the bag. This is similar to how foreclosures on wholesale lenders were first conducted only by Merrill Lynch, but later all banks did the same. Banks might also need to call in loans from speculators who bought/entitled land. The question is: what would banks actually do with the land? Plus, HOV is not violating covenants for now so it’s not the main focus.

 

---------  HB Economics, Book Value and the “Deal of the Century”  ---------

 

Keeping in mind that building homes (and in many cases spec homes) is the best way to flip the land, let’s go through some quickie calculations of what HOV’s balance sheet is up against.

 

HOV’s average home price is around 350k. Developed lot cost is 25% of that. The cost to build a home on top of the lot and otherwise conduct operations is a little under 75%, leaving HOV with 1-2% margin. Note that prior to the tough times they had low-mid teen margins. They might eventually find a way to squeeze out a few hundred basis points but they aren’t promising anything (see cc slides for margin figures). The important thing is that HOV is obligated to pay its workers, its materials suppliers, etc’. so the cost of operations is fairly constant if you believe in an unrelenting bear market.

 

Therefore, as we enter these difficult times, if HOV discounts the price of the home and loses money on it, they’re essentially losing that money on the land and not the house. Since the land value is 25%, the land exposure is leveraged 4:1 vs. the ultimate home price! A 25% haircut to the home price wipes out their investment in the land.

 

HOV’s owned lot inventory is roughly 30,000. Recently HOV conducted a nationwide fire-sale of homes called “Deal of the Century”. The discount on these homes was typically 15-20% and they generated over 2,100 gross sales (1,700 contracts and more than 400 sales deposits). So the majority of these buyers didn’t even put a deposit yet! Cancellation rates lately have been 40% and contracts without deposits should have way higher cancellations - it’s got to be above 60%. In other words, despite all the rah-rah about this huge liquidation they’re promoting, we’re talking about closing only 1-3% of their lots.

 

Based on HOV’s owned land history and what we know about land markets, I’d ballpark their average land age at 3 years. So in theory let’s say all owned land was bought in fall 2004 and booked at cost. This land was selling for about 50% more than that at the top of the bubble and now prices are coming down.

 

Up until now, HOV's average home price has been 350k and the margins net of segment SG&A have come down to 1% despite the land being expensed at its 2004 prices. If it were to conduct a fire sale on its entire inventory at prices corresponding to what consumers can really afford (i.e. fair value of houses, i.e., a 25% discount of 90k) they would wipe out all land value.

But let’s be a bit more realistic and assume “deal of century” type figures. A 14% discount (roughly 50k) on the entire inventory of 30k is 1.5B of losses (or write-downs prior to transactions; however you wish to call it) leaving them with only 10% of their current book value. No one says this will happen. As a matter of fact, they’ve got a backlog for 6000 homes and in Fort Myers they’re doing block transactions. But the point is that there’s a good reason why HOV trades at 36% of book.

 

HOV will generate 25% cash-on-cash return (and, maybe 10-15% in a really bad case) in the HB business but that represents losses on the land or break-even at best and the cash is used to service & repay debt. It isn’t accumulating into equity. In the meantime, any incremental discounts are hurting equity holders while pleasing creditors. Any panic on the part of the builders leads to this outcome as well. And by the way, back when the HBs were madly buying back stock using their FCF, they were basically returning capital to shareholders who agreed to be taken out, while giving exiting shareholders a bigger share of their illiquid book value (i.e. land minus liabilities). Although, there is definitely some earnings power there for the next boom, that is undeniable.

 

In a sentence, because HOV isn’t likely to double while HOVNP is well supported, the arbitrage is likely to work.