Again No Spring Savior for Housing - HOV, KBH

By Dr. Duru written for One-Twenty

June 5, 2007

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The spring selling season for housing has effectively come to a close. And for the second year in a row signs of a rebound in housing demand were almost nowhere to be found. The main difference this year is that the hopes were much more fleeting than last year when homebuilding CEOs were still extrapolating from their historic peak of activity from 2004 to 2005.

Hovnanian (HOV) provided an appropriate close to another poor season with its own bad news last Friday, June 1 when it held its earnings conference call. The market took the stock down 4.6% and another 4% today. HOV is on the verge of making fresh four (yep! FOUR!) year lows. It probably would have already happened except that buy-out rumors on KB Homes (KBH) sent the stocks of many homebuilders hurtling upward for a moment (more on that below). Hovnanian is now reporting losses, its book value is well below 1 at 0.87, and shorts are all over the stock at 49.1% of the float - which is significant because Hovnanian family members own 10 million shares of stock (total shares outstanding is currently about 62.2M). Things are looking pretty precarious, right now!

For those interested, I have pasted below a summary of Hovnanian's earnings call from (which you can also read in HOV's press release) followed by my own notes from the Q&A period. As usual, the Q&A period is very good at revealing what the executives really think about the housing market. I end this piece with a quick review of KBH.

Hovnanian Enterprises reported a third consecutive quarterly loss, and withdrew its earnings guidance for the year, citing increased uncertainty in the U.S. housing market. Shares of the Red Bank, N.J.-based homebuilder traded lower on the news, losing roughly 2% in pre-market activity.
Like many homebuilders, Hovnanian faces challenging conditions in many of its markets, as the supply of houses continues to outpace demand and recent problems in the sub-prime lending market have made it difficult for some potential buyers to qualify for a mortgage. Since the beginning of the year, the company has seen its stock tumble more than 25%, and with demand continuing to slow and inventories rising, the slump is likely to continue.
For its fiscal second quarter, Hovnanian posted a loss of $30.7 million, or ($0.49) per share, versus a year ago profit of $101 million, or $1.55 per share. Earlier in the May, the company said it expected to lose between ($0.45) and ($0.50) per share in the quarter. Analysts on average were expecting a loss of ($0.48) per share.
Revenue for the period fell 29.4% year/year to $1.11 billion, slightly below the consensus estimate of $1.13 billion, as the housing market continued to slow in many locations in terms of both sales pace and sales prices. The company delivered 3,150 homes with a sales value of $1.1 billion in the quarter, down 30.8% compared to deliveries of 4,555 homes with sales of $1.5 billion last year. Homebuilding gross margin slipped 740 basis points to 16.3%, due to lower prices and increased sales incentives to buyers to close homes.

Overall, the housing market remains very challenging. Co says on an operating basis, Q2 results are moderately better than the initial indication they gave on March 4, but the amount of land related impairment and walk away charges was a bit higher than the co had expected, the net result being about the same. Markets did not pick up as they usually do in March and April, and remained at a contract pace similar to February which, co says, is substantially below the pace in March and April last year and even further off the strong pace of a spring selling season in prior years. May sales have not shown any improvements. Co says through the end of Q2, traffic is off but not as much as net contracts for Q2. These more recent negative trends led the co to further use of incentives on new contracts signed as well as on homes that close during the qtr. They believe that the further slip age in housing demand in many locations was largely linked to the tightening of mortgage lending standards, particularly in the subprime market. They felt the impact most directly in those communities that relied on subprime buyers. On a longer term basis, they think the tighter mortgage standards will prove to be a healthy part of the correction and may limit future activity from investors, but the short-term, they say the impact has been a pull back in housing demand.

Co says if the weakness seen in the first few weeks of the Q3 continues, then the co may have additional impairments in future qtrs. They say if conditions worsen further or their balance sheet becomes more stretched, they can walk away from more contracts and generate more cash by reducing inventories more rapidly.Co says in some cases, where land development has not begun on land that we already own, they are considering postponing improvements and the community opening and the corresponding investments until the market improves. Next year, in fiscal 08, they expect to generate positive operating cash flow for the full year in the range of 100- $400 mln. The co has flattened out the growth in their average inventory this year to be less than 5% and for 08, they expect avg inventories to be down. Co is not out today looking to aggressively acquire new land parcels. They don't generally see enough opportunities out there that make sense. They expect to reduce debt further in 08 and to reduce their debt-to-cap ratio for full year. Co is targeting an average ratio of less than 50% for the full year 08.

Co continues to renegotiate land deals, reducing prices, delaying takes or reducing the number of lots to be taken down. They expect to have fewer communities open by the end of the year than they predicted three months ago. The co's number of spec homes picked up slightly. Co's inventory turnover and thus their interest coverage is declining in fiscal '07. During Q2, the co did not repurchase any stock, although they do believe their stock remains under valued; do not anticipate buying back shares at this time. "The levels of existing home inventories, some of which are new homes that have never been occupied is just too high. We need to see this inventory clear the market before we can expect to realize sustainable year-over-year increases in net contracts and positive momentum in home pricing. We also need a more positive buyer psyche. We thought we had seen signs of stabilization at the end of the First Quarter but our Second Quarter ended with weak trends in net contracts as the subprime issues became the focus of the market. So, it seems that we've got more work to do." Call enters into Q&A... Co would say if the market continues as seen over the first few weeks of May, then it's likely they will have additional impairments. Co wouldn't anticipate the kind of impairment levels that they had in the 4Q06. Co says the land sale market is 'just really slowed to a complete trickle with very few buyers of any type out there, and that's part of the reason why you do see many home builders resorting to selling spec homes because there's really a way of liquidating the land portfolio.'

And now my own notes from the Q&A:
  1. $3.6B in unsold inventory
  2. Had to increase incentives. Broader incentives in Southern Cali, Sacramento, Coastal didn't change (sloed down first and now starting to stabilize),
  3. Texas markets have been stronger, haven't had to resort to concessions
  4. Range of incentives is a few thousand to $50K on higher-value homes. No firesales
  5. If spec home already finished, will be agressive, depends on land investment recovery involved
  6. In southern Florida, we are better off letting the market clear
  7. Fighting the market tactically
  8. Ft Myers has no transactions - no land sellers (???)
  9. Easier to sell land when house is on it
  10. Thinks competitors are acting rationally and limiting inventory build, but they are seeing builders who are building spec as they sell homes
  11. Problem of inventory coming from used homes, and some number of that is investor-owned homes
  12. Claim that the buyer psychology had started to turn around just as the sub-prime drama unfolded
  13. "A lot of the issue is pyschological" - corrected that statement to include inventory overhang
  14. What's different is that this is not a slowdown where you hope for a recovery in employment.
  15. Problem: pscyhology and inventory from new homes and MLS
  16. Believes there is pent-up demand whenever a catalyst shows up to release it. Not talking about a run on housing. There is demand that is waiting for the right opportunity
  17. DC market not nearly as challenging as others

On Monday, rumors apparently circulated on the trading floors that KBH might be an acquisition target. The stock responded quickly on the news and settled back a bit today. I went ahead and bought in (see disclaimer here). The stock is not nearly as "cheap" as other struggling builders like HOV, but I believe this is because its business is holding up a bit better. The chart also tells me that if the stock can conquer curent levels, it very well could be off to the races. The chart below shows that KBH has been bouncing around the 200DMA right around old resistance. $47.50 served as tough resistance in the second half of 2006, but when resistance was finally broken after 6 (six) failed attempts, the stock broke upwards for almost a 20% gain. With the lows of Monday's trading serving as a natural stop, I believe we have a great risk/reward set-up here with positive news flows tipping the balance between acting on the trade and watching it.

Be careful out there!


DR. DURU®, 2007