Tuesday, 18 September 2007 05:00

Credibility is the Key to Success for a CEO – Hovnanian has Lost that Key: A letter to Mr. Hovnanian

Ara Hovnanian sponsors the "Deal of the Century" to clear overvalued inventory. Okay, strategic move that makes sense, I give him that. Then his company issues a press release with enough BS to fertilize every garden in Jersey. This draws down significantly on the credibility credit line. Then he has the nerve to call a bottoming in the residential real estate industry, when he KNOWS better - and if you read further I will prove without a doubt that he know better. This maxes out his credibility credit line. Yes, I am short his company, and for a very good reason(s). Let me count the ways:

1. If the bottom is near, why don't you hold on to your inventory and let it's valuation ride the wave back up? It's not just to generate cash. I know the answer, but will you admit it? Every property you may have sold during your "Deal of the Century" will be cheaper and have a lower interest rate in just a few months. The Fed will be dropping sooner or later, just as you asked him to on CNBC and during a personal meeting with him. Now, I know it's just business when try and call a bottom. I am short your company's stock, so it is just business and not personal. The big difference is I am being a bit less sensational and not calling a bottom in your stock.


2. Ara Hovnanian has listed his Rumson, NJ home for sale (MLS# 20738770, click thumbnail to get a larger view). Coincidentally (of course), the home was listed on the same weekend his company held the "Deal of the Century" sale to reduce inventory and move homes. He offered discounts of up to 25% in the Deal of the Century, but he is trying to sell at breakeven with his own property. Why is it that Mr. Hovnanian isn't so generous with his own home? The listing price of $7.2 million is still higher than the $6.75 million he paid in 2005, but add in transaction fees, taxes and commissions and he is at about breakeven. I actually know the answer to the question I just asked, I'm just being sarcastic. Well, the answer is that he did something that I would expect a knowledgeable CEO of a major homebuilder to know better than. He took out a 100% loan-to-value, no money down mortgage at the HEIGHT of the housing bubble to buy the house (documents to back these claims up are available upon request via the comment section). It is a very nice house with its own yacht dock, to be sure. He had to know it was a housing bubble. I mean, I knew, and I didn't even own a major homebuilder. Or did he know? If he didn't know the top, why should he be calling the bottom? Better yet, why should we not be shorting his stock??? Mr. Hovnanian, are you really sure we're "very near" the bottom in housing? Or is there something else we should know?


3. I believe Ara Hovnanian, through his company, is strapped for cash and making desperate moves with his company. That "Deal of the Century" press release was a joke. His corporate balance sheet is looking a little shoddy, and his personal balance sheet is being degraded via the same mechanisms that are plaguing much of the homeowners being hit by the housing downturn. Not only did he take out a no doc, no money down loan, he maxed out the equity on a third property with a variable rate mortgage of $6 million. No, he didn't get it from CountryWide, it was PNC Bank.

4. Now, Mr. Hovnanian's personal business is ethically off limits, at least for me, but this situation does draw attention to his business acumen in real estate asset cycles and his ability to gauge the market, which is why it is part of my analysis. His company, a major, multi-billion dollar home builder is hurting hard for cash from operations. It appears it is hurting enough to affect his judgement. Let's take a look at the business as of July 31st of this year Through a letter to Mr. Hovnanian.

Dear Mr. Hovnanian:

In going over some of the publicly available documents relating to your company, I noticed:

a. Just over $4.1 billion in inventories, nearly ALL of which is underwater in comparison to acquisition cost.

b. $205 million in investments and advances towards unconsolidated JVs, where there is a realized loss of at least $3 million. Are they cash flow positive and above water? I have a strong suspicion that the unrealized losses are significant.

c. About $95 million in goodwill and definite life intangibles, translated into English: about how much we overpaid for stuff lately.

d. $163 million of mortgages held for sale, which exceeds your mortgage warehouse credit line of $149 million by a decent margin. It appears you are overloaded with mortgages. Are you having a problem selling them? I know you deal in the "luxury" end of the market where many loans will not fit into the GSE parameters. Mr. Hovnanian, are these conforming mortgages? Because if not, they will be unusually hard to sell in the current environment. This is particularly the case when trying to see to astute investors who realized who aggressive you will be in your underwriting due to your extreme need to dump inventory by all means necessary.

Being a little, ahem, aggressive in pushing loans through to your "gross sales" customers has already caused what could mushroom into a real problem. Yes, I know that you have already been busted, and the oversight entitiy for the GSEs are requesting that you indemnify them for losses related to "improperly underwritten loans". I know you state that you don't think the outcome will have a material effect, but I and you know that you pushed more than a mere 9 loans through with the "wink, wink" underwriting nod, if you know what I mean. What happens, when (not if) this really comes back to bite you. I think it is going to bite your competitor, Beazer Homes, very hard. Just read through their current law suit.

As a matter of fact, trying to sell this non-conforming stuff has put many a lender out of business year to date, and has rocked banks from CountryWide stateside to Northern Rock in the UK. Hey, I'm sure you have it under control, though. After all, we're nearing a bottom, right? I would hate to see your company, a homebuilder, stuck with all of these unsold mortgages on your balance sheet tying up needed assets, as they start to default at rates ranging from 2% to 30%. I will refrain from taking cheap shots, but finding out you are drawing down so much or your personal equity via credit lines and buying homes at the top of the market with no money down, no doc loans just to resell at (hopefully) breakeven during the market downturn JUST ONE YEAR LATER should be very disconcerting for shareholders and other stake holders who are not short your company's stock, knowing that the company is in such a bind. I have been in a bind in the past, and I recognize the symptoms. Is there something we should know about the health of the company that you haven't told us?

e. Does the $119 million decrease in assets represented by Mortgage Notes Receivables reflect any impairments in the value of those notes, or is that an indication of the sale of said notes. I don't see a line item that represents cash from said sale. Practically all of the major and many of the minor mortgage participants have had to record significant value impairment to their mortgage assets, and you have SEVERAL significant mortgage subsidiaries, so where are yours??? I do see where you lost $185 million in underwater options.

From the 2006 HOV annual report: "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. Mortgages originated by our mortgage banking subsidiaries are sold in the secondary market within a short period of time." (Tell that to LUM, LEND, AHM, New Century, etc. - a sampling of the 165 mortgage companies either out of business year to date, or on their way, trying to sell the same mortgage product to an audience who didn't want it in a tightening credit market - I think it's safe to say you may have a problem) Even those buyers who do not need mortgages will be hurt if they cannot sell their existing properties (to those who need mortgages) to move up to their newer purchase (this is how most pay cash for the 9.5% referenced earlier). Thus the backlog that is stated in the builder's financial statements will not, and cannot, be fully realized, and thus is overstated.

f. Last quarter's decrease in cash is almost equivalent to the cash at quarter's end, and this quarter will be rougher than last quarter. What are you going to do?

g. Your net debt to capitalization ratio was last reported at 49%, which I think is significantly increased by now. Yet, even then, you had a footnote, Debt excludes CMOs, mortgage warehouse debt and non-recourse debt and is net of cash balances.. Yes, that type is small, isn't it? Back to the point, why didn't you include warehouse credit, non-recourse debt, CMO's in your calculation? They are quite material, aren't they? Exactly how deep is your involvement in CMOs? These can be some pretty illiquid and difficult to price derivatives, especially in the current environmet. Do you have the financial engineering talent in house to price and trade these properly? Because, if you don't... I can tell you some stories... BTW, are these CMOs and their performance off balance sheet? Cause I can't find any info on them anywhere in your publicly available documents. Speaking of which, I can't find much info about the performance and holdings of those Joint Ventures either.

In regards to your "Deal of the Century", since you have a mandatory period of rescission where the customer has 15 days to change their mind for any reason and most of your contracts have mortgage contingencies, your aggressive marketing, though understandable, can backfire and cause many of the alleged "gross sales" to fall through. You know the properties must appraise, and you know that appraisers aren't playing the games they used to. Even your mortgage company dare not issue too many bad loans, since there is a good chance you may get stuck with them, as we discussed a little earlier. So what do you do when you discount a house heavily, then your competition does the same, just a little more and the house you just gross sold (click here for more on "gross sales") doesn't comp out due to free falling prices?

I would love to discuss continued compliance with your various loan covenants, since I know that is definitely going to be an issue in the upcoming quarters, but I know we can do this again some time soon.

Highlights for the Quarter Ended July 31, 2007

The Company reported an after tax loss of $80.5 million for the third quarter of fiscal 2007, or a loss of $1.27 per common share, compared with earnings of $74.4 million, or $1.15 per fully diluted common share, in the third quarter of fiscal 2006. Total revenues decreased 27.1% to $1.1 billion for the third quarter compared with the third quarter of 2006.

During the fiscal 2007 third quarter, the Company incurred $108.6 million of pretax charges related to land impairments and write-offs of predevelopment costs and land deposits.

Excluding unconsolidated joint ventures, the Company delivered 3,179 homes with an aggregate sales value of $1.1 billion in the third quarter, down 31.2% from 4,623 home deliveries with an aggregate sales value of $1.5 billion in the third quarter of fiscal 2006. During the third quarter of fiscal 2007, the Company delivered 329 homes through unconsolidated joint ventures, compared with 498 homes in last year's third quarter.

The number of net contracts for the third quarter of fiscal 2007, excluding unconsolidated joint ventures, declined 24.2% to 2,539 contracts.

Contract backlog as of July 31, 2007, excluding unconsolidated joint ventures, was 7,126 homes with a sales value of $2.5 billion, down 31.1% compared to contract backlog with a sales value of $3.6 billion at the end of last year's third quarter.

Company reported a net loss of $168.5 million for the first nine months of 2007, or $2.67 per common share, compared to net income of $256.8 million, or $3.95 per fully diluted common share, in the same period a year ago.

For the nine month period, the Company incurred a total of $184.4 million of pretax charges related to land impairments and write-offs of predevelopment costs and land deposits, and $55.1 million of charges related to the impairment of intangibles.

Homebuilding gross margin, before interest expense included in cost of sales, was 15.9% for the third quarter of fiscal 2007, compared with 23.4% in the prior year's third quarter. The Company's pretax income from Financial Services in the third quarter of fiscal 2007 declined 19.3% over the same period in 2006, to $6.1 million.

The Company had 449 active selling communities on July 31, 2007, excluding unconsolidated joint ventures, compared with 436 active communities at the end of the same period last year. The Company's contract cancellation rate, excluding unconsolidated joint ventures, for the third quarter of fiscal 2007 was 35%, compared with the rate of 33% reported in the third quarter of 2006, and a rate of 32% for the second quarter of fiscal 2007.

Comments From Management

"Conditions in most of our markets remain challenging," commented Ara K. Hovnanian, President and Chief Executive Officer of the Company. "Credit tightening in the mortgage market has reduced the number of qualified home buyers, existing home inventory levels remain persistently high in many of our markets and buyer psychology has been negatively impacted by a steady stream of news related to falling housing prices, foreclosure rates, and mortgage availability. In light of these negative influences, our sales pace fell further in many of our communities, and we reacted by offering further price concessions and incentives. This created additional downward pressure on profit margins and led to additional land-related charges in the quarter."

"Overall negative sentiment toward the purchase of a new home continues to weigh on our net contract results," Mr. Hovnanian said. "Since the end of our third quarter, the tightening of lending standards in the mortgage market has extended beyond the sub prime market and is now impacting jumbo mortgages and further tightening of Alt-A loan underwriting standards. This is leading to a further reduction in the universe of qualified buyers for our homes. However, our mortgage operation continues to close a significant volume of mortgages on a daily basis for our homebuyers, and these loans are continuing to be placed with our regular base of investors, which are some of the world's largest financial institutions."

"While the housing market is definitely in a slump, we are still selling homes," Mr. Hovnanian said. "Despite difficult conditions, we sold 2,539 homes in the quarter and delivered 3,179 quality homes with a sales value in excess of $1 billion. We remain vigilant in running the day-to-day business, while adhering to our long term strategies. However, inventory reduction and cash flow are our foremost priorities. Our objective is to generate cash and pay down our debt to levels in line with our current volume of activity in our communities," Mr. Hovnanian stated.

"As of July 31, 2007, we had 46,747 lots controlled under option contracts and an additional 32,576 lots owned. This total land position of 79,323 lots represents a 31% decline from the end of the third quarter of fiscal 2006," said J. Larry Sorsby, Executive Vice President and Chief

Financial Officer. "Our owned lot position is down 11% from the year earlier period and we expect it to continue to decline. We only move forward in taking down additional lots when the terms have been successfully renegotiated to where they make compelling economic sense for us. If markets do continue to soften further, we have additional flexibility to reduce our investment in land more rapidly and reduce additional cash expenditures, by walking away from a greater number of our lot options."

"We are extremely focused on strengthening our balance sheet during this challenging business environment," Mr. Sorsby continued. "We have already discharged our 10-1/2% notes that mature in October by putting the cash required to retire the bonds in escrow with the Trustee of the bonds. Unless market conditions deteriorate further, we project adequate room to operate under our debt covenants and thus we are not currently making any requests for modifications to our $1.5 billion unsecured revolving credit facility," Mr. Sorsby stated.

Last modified on Tuesday, 18 September 2007 05:00