Earnings Call Transcript - HOV Q3 2020

Operator, Operator

Good morning and thank you for joining us for the Hovnanian Enterprises Fiscal 2020 Third Quarter Earnings Conference Call. An archive of this webcast will be available after the completion of the call and will run for 12 months. This conference is being recorded for rebroadcast and all participants are currently in a listen-only mode. Management will make some opening remarks about the third quarter results and then open the lines for questions. The Company will also be webcasting a slide presentation along with the opening comments from management. The slides are available on the Investor's page of the Company's website at www.khov.com. Those listeners who would like to follow along should now log on to the website. I would now like to turn the call over to Jeff O'Keefe, Vice President, Investor Relations. Jeff, please go ahead.

Jeffrey O'Keefe, Vice President, Investor Relations

Thank you, Irwin. Thank you all for participating in this morning’s call to review the results for our third quarter, which ended July 31, 2020. All statements in this conference call that are not historical facts should be considered forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such forward-looking statements include, but are not limited to statements related to the company's goals and expectations with respect to its financial results for future financial periods. Although we believe that our plans, intentions and expectations reflected in or suggested by such forward-looking statements are reasonable, we can give no assurance that such plans, intentions or expectations will be achieved. By their nature, forward-looking statements speak only as of the date they are made, are not guarantees of future performance or results, and are subject to risks, uncertainties and assumptions that are difficult to predict or quantify. Therefore, actual results could differ materially and adversely from those forward-looking statements as a result of a variety of factors. Such risks and uncertainties and other factors are described in detail in the sections entitled Risk Factors in Management's Discussion and Analysis, particularly the portion of MD&A entitled Safe Harbor statement, in our Annual Report on Form 10-K for the fiscal year ended October 31, 2019, and subsequent filings with the Securities and Exchange Commission. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason. Joining me today on the call are Ara Hovnanian, Chairman, President and CEO; Larry Sorsby, Executive Vice President and CFO; and Brad O'Connor, Senior Vice President, Chief Accounting Officer and Treasurer. I'll now turn the call over to Ara. Ara, please go ahead.

Ara Hovnanian, Chairman, President and CEO

Thanks, Jeff. I hope all of you and your families remain safe and healthy during these challenging times. Here we are in September of 2020, and although COVID continues to impact all aspects of our lives, the environment for new home sales remains robust. I'm going to review our third quarter results and then address the current market environment. As usual, Larry Sorsby will follow me with more detail before the Q&A. COVID has changed the way we do almost everything. The safety and well-being of our associates, customers, and trade partners remains a huge focus at our company. We continued to successfully work through all the obstacles thrown our way by the COVID-19 pandemic. We're working hard to ensure a safe working environment. Our associates have been absolutely amazing in continuing the day-to-day efforts to keep our operations running and planning for the future in the face of these uncertain and very difficult times. We switched to a virtual environment seamlessly and actually moved into high production sales and delivery mode at the same time. Given the challenges that COVID-19 has created, we're pleased with our third quarter performance. Total revenues grew 30% to $628 million during this year’s third quarter. Our gross margin was $106 million for the third quarter compared to $84 million last year. Reacting to slower demand in the early stages of the COVID-19 crisis, we offered consumers additional incentives on spec homes that could be delivered during our third quarter. This increased the volume of deliveries and gross margin dollars, despite a reduction in our gross margin percentage from 18.4% to 17.5%. Home demand began rebounding in May. Since June, we pivoted to increasing home prices in virtually all of our markets. These home price increases should offset potential price increases and result in improvements in future gross margins beginning in the very next quarter, our fourth quarter. Our total SG&A ratio improved to 9.5%. That's 260 basis points below last year's third quarter. We were able to reduce the ratio because our total SG&A dollars only increased 2%, including a $3 million charge for severance and related expenses, while our revenues increased 30%. EBITDA increased 88% from $35 million in last year's third quarter to $66 million this year. Our pre-tax income for the third quarter increased $23 million from a $7 million loss last year to a $16 million profit this year. If you ignore the $2 million land charge and the $4 million gain on extinguishment of debt, the pre-tax adjusted income was $15 million for this year’s third quarter compared with a $5 million loss in the same quarter of last year. We began the calendar year with solid improvements in sales, up 31% in January, up 44% in February. This was before most Americans were aware of the COVID issue. Typically, the spring selling season peaks in April each year. But 2020 is a strange year that has been impacted by the COVID-19 problems. The month of May saw our sales pace rebound and has remained exceptionally strong each month since. We recognize that demand was outstripping our ability to get these homes built and delivered within a reasonable timeframe. Furthermore, lumber costs have recently increased, and we suspect that our industry may experience additional material and labor costs soon. Therefore, starting in June, we focused on raising home prices to offset potential price increases and to improve our gross margin. We understand that demand could cool down from the white-hot sales level. Nonetheless, during August, we sold 735 homes, up 65% over last year's August. Our August sales per community increased from 3.2 last year to 6.6 this year, that's a 106% year-over-year improvement. It’s certainly indicative that demand for new homes remains exceptionally strong. We plan to continue pushing home prices, recognizing that this may slow down sales pace in certain communities. We believe that trading margin and pace makes sense in this market right now. Our quarterly contracts increased 47% to 2,226 homes from 1,515 homes in last year's third quarter. The picture is even better on a per-community basis, with 19 contracts per community for the third quarter this year, compared to 11 for last year's third quarter. When you have a 73% increase in year-over-year contracts per community for the recent quarter followed by a 106% year-over-year increase for the most recent month, it’s easy to worry about approaching a market peak. But we need to take a step back and look at a broader long-term perspective. In July 2020, we're only at an annualized pace of 1.29 million starts, which isn’t a level that indicates a market peak or a bubble. We're not even close to previous decade annual averages for starts, let alone near any cyclical peak that we hit in the last 60 years. Importantly, the purchases seem to be driven by end-users today, not speculators. Given the historically low interest rate environment, which is likely to be with us for some time, it makes one even more comfortable with the current sales market. The significant uptick in the housing market caught developers and home builders by surprise. At the current sales pace, builders will be selling out of communities faster than they planned. This makes it challenging for most builders to grow their community count over the short term. There are simply not a large enough supply of lots available in the marketplace. We are having fairly good success in acquiring new land parcels across almost all of our markets that meet our return hurdles at current prices and current paces. We're feeling good for the longer term. In the shorter term, we have 100% of all the land needed to achieve meaningful growth in 2021 and 80% for 2022. We believe the current higher sales pace per community will continue over the next year or two.

Larry Sorsby, Executive Vice President and CFO

Thanks, Ara. I'll start on slide 12. This was another strong quarter for our Financial Services division, driven by historically low rates and increased volumes. Financial Services third quarter pre-tax earnings increased 182% year-over-year to $11 million. At the end of the third quarter, we had a solid backlog of 3,056 homes under contract. The number of homes in backlog was up 20%, and the dollar amount was up 17%. Our sales pace caused us to sell out of communities faster than anticipated. Additionally, our consolidated community count declined by 21 communities from 138 on July 31, 2019, to 117 at the end of July this year. We had 14 community grand openings delayed primarily due to COVID-19 issues. There were significant improvements in the sales pace we've achieved, which has driven our 27% growth in revenues through the first nine months of this year. During the initial stages of COVID-19, we took measures to preserve cash. However, we returned to normal activities with respect to land purchases, land development, and building spec homes in the third quarter. We ended the quarter with 288 started unsold spec homes, compared to 790 spec homes at the end of the first quarter. Homes were selling faster than we could get them started. The demand for to-be-built homes is even stronger than for spec homes, with our contracts for to-be-built homes up 81% during the same quarter. We control 25,748 lots or a 4.4-year supply at the end of the third quarter. We added 1,700 newly controlled lots during the period. We remain disciplined through our underwriting standards using current home sales price, current home sales pace, and current construction costs. Our liquidity position was $334 million at the end of the third quarter.

Alex Barron, Analyst

Hey, guys, very strong quarter and congrats on that.

Ara Hovnanian, Chairman, President and CEO

Thank you.

Alex Barron, Analyst

I was curious about your guidance on the margins 19% to 20%, it sounds very good. But what was the reason the margins kind of took a step back this quarter or what accounts for, you know, the step back now versus the step up next quarter? Can you elaborate on that?

Ara Hovnanian, Chairman, President and CEO

Sure. This is Ara. I'll comment on that. As we mentioned, in the depths of the COVID crisis in the middle of March and April when things were looking fairly dire, sales were really off, the economy was uncertain, and basically the U.S. shut down. To be conservative, we discounted a bit and raised incentives, particularly on spec homes that could deliver soon. Those homes are the ones that delivered in the third quarter and had lower gross margins. We began raising prices in May, and every month since has been stronger. That's why you're going to see higher gross margins in the fourth quarter because we're going to see the benefits of that pivot and pricing strategy.

Alex Barron, Analyst

Okay, that sounds good. So even though you're not really giving guidance for next year, I imagine maybe we can expect a similar margin for the first quarter of next year. Okay, great. On the – the other question was on the joint ventures. So that income right now is only coming from the existing joint ventures, you're not delivering any homes in the KSA. So when do you expect the KSA will start showing some contribution?

Ara Hovnanian, Chairman, President and CEO

We are on the verge of delivering homes right - we're just on the verge now. I'd expect that should begin in the next quarter or two. There are reasons I'm hesitating because just as the pandemic has created lots of issues and delays in the U.S., it's done the same in Saudi Arabia as well. But all is going well. Sales are strong, production is continuing. So we're just going through the logistics steps to begin delivering homes in fairly large quantities.

Alex Barron, Analyst

Okay, great. And if I could ask one last one. So your liquidity looks pretty good here. And you guys took advantage and bought back some debt this quarter. Is there anything that constrains how much you could do that next quarter?

Larry Sorsby, Executive Vice President and CFO

Repeat the question one more time…

Alex Barron, Analyst

Yes, you expect your liquidity, I think you said was over $300 million at this point. And you bought back like $25 million of the 2022 bonds. Is there anything that constrains how much you could buy next quarter?

Larry Sorsby, Executive Vice President and CFO

Yes, we have limited capacity under various covenants to do additional repurchases of the 2022 bonds. So I would say that you should not expect a similar amount to be done next quarter.

Thomas Maguire, Analyst

Hey, guys, great job on the quarter.

Ara Hovnanian, Chairman, President and CEO

Thank you.

Thomas Maguire, Analyst

Just on the price worst-case dynamic, what - whatsoever that makes you pull that or it gets to. Ara, you talked about raising prices across virtually all communities? What drives that decision and kind of say, you know, that pace is enough or is there a return metric you're thinking about? Is it more that you don't want the backlog to get too far extended? Or just how do you think about that?

Ara Hovnanian, Chairman, President and CEO

Really, all of the above. I mean, we analyze it on a community-by-community basis. If we sold a couple of homes in a week, and that meets our budgets, we are not shy to raise prices. If we raise prices and still sell a couple of homes, we will raise prices again. And then we’ll see what happens. If a price increase in a particular community begins to dampen sales, then we'll hold back on raising prices. It's really a dynamic situation that we analyze community-by-community and market-by-market across the entire country.

Thomas Maguire, Analyst

That makes kind of sense. Got it. And then just on the community count, I know there's a ton of moving pieces and you're continuing to close out communities with a robust pace here, but how do you think about the ability to put a floor on that number and begin ramping moving forward? And, you know, I know we talked about qualitatively the revenue and with land deals coming to the committee, is there a line of sight to that number moving higher in the coming quarters? And then you know, what drove the decision to contribute the communities to the JVs?

Ara Hovnanian, Chairman, President and CEO

First, we don't anticipate at the moment contributing more communities to JVs. We are finding fairly good success in acquiring new land parcels that meet our return hurdles at current prices and current paces. We're feeling good for the longer term. In the shorter term, we have 100% of all the land we need to achieve meaningful growth in 2021 and 80% for 2022. We believe the current higher sales pace per community will continue over the next year or two. We want to fill our 2022 desires and then look for opportunities for 2023 deliveries beyond that.

Larry Sorsby, Executive Vice President and CFO

The focus for us is really on revenue growth, whether we get that by having additional communities or by having higher sales on a per-community basis. The objective is to get higher revenues and higher profitability. We suspect that we will continue at a higher sales pace per community, given the increased demand that is causing builders to sell through communities faster than they previously anticipated. But the end result will still be revenue and profit growth for us and the industry.

Thomas Maguire, Analyst

Very good. Thank you. I really appreciate it. Congrats again. And enjoy the long weekend.

Ara Hovnanian, Chairman, President and CEO

Thanks.

Alex Barron, Analyst

Yeah. Thanks, guys. So your tax rate has been fairly low these last few quarters, is there any expectation of when that goes back to normal?

Larry Sorsby, Executive Vice President and CFO

All that's in the tax line on P&L right now is state taxes. You don't see any federal taxes because of the deferred tax asset that's fully reserved. So anytime we have income, the deferred tax asset gets used, and the valuation allowance gets reduced, but there's no P&L effect. And that won't change until we are able to reverse the reserve, which is something we probably wouldn't be able to look at until we have sustained profitability at a reasonable level. So maybe this time next year, if our trends continue, we can start that conversation.

Alex Barron, Analyst

Okay. Yeah, that was going to be my next question. If it was reasonable to expect maybe towards the end of next year that you'd be qualifying for reversing the DTA?

Larry Sorsby, Executive Vice President and CFO

I think we'll be certainly looking at it around that time, yeah.

Operator, Operator

This does conclude the question-and-answer session of today's program. I'd like now to hand the program back to Ara Hovnanian for the remarks.

Ara Hovnanian, Chairman, President and CEO

Well, thank you very much, as I said at the outset, we're pleased with our results. But we're even more excited about the results to come. We look forward to giving you continued good news in the very near future. Thank you.

Operator, Operator

Thank you, ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.