On June 6th, Turnaround Letter Buy-rated Hovnanian Enterprises (HOV) reported second quarter 2019 results that indicate some progress toward recovery.
Hovnanian shares fell 10% in trading that day and have fallen an additional 14% since then.
Given the heightened possibility of a bankruptcy, we consider these shares to be Speculative. However, also considering that investors are treating the shares as having little prospect for improvement (essentially being treated as a call option), there is considerable upside should the company post stronger results. For perspective, the current market cap of $55 million is only 3% of the enterprise value of $1.76 billion. If the enterprise value increases by a mere 3%, the value of the equity would double. Our new $16 price target reflects a partly recovered Hovnanian.
Change from Consensus Results vs
2Q19 Results 2Q18 Estimate Consensus
Revenues $441 million -12% $441 million in-line
Adjusted EPS $(2.56) 55% worse $(1.77) large miss
Adjusted EBITDA $24.1 million -41% na na
Over the past several years, Hovnanian’s financial constraints have limited its ability to acquire land and thereby limiting its ability to build homes and produce profits.
As the company appears to be returning to growth, investors should gain more confidence in its ability to produce profits and service its debts.
Homebuilders like Hovnanian produce profits by building homes. As its financial constraints are loosening (largely due to the favorable but controversial transactions with GSO Capital Partners LP, and as the company expands its use of options), Hovnanian is now starting to increase its land positions – which is the first step toward building more homes. Its community count (essentially the number of planned neighborhoods in which it has acquired vacant lots) has increased for the second consecutive quarter, to 165, up from a low of 142 in the fourth quarter of 2018. For perspective, the community count in mid-2016 was 208. The total number of lots controlled increased 17% from a year ago, to 18,602.
With the increase in the community count and lots controlled has come an increase in the number of contracts on new homes to be build. In 2Q19, the company had 1,775 contracts, up 4% from a year ago. However, the dollar value of the contracts fell 12%, due entirely to the sharp 48% decline from its unconsolidated homebuilding joint venture contracts. Many of these joint ventures are approaching their completion.
More confidence will lead to a higher valuation multiple (below is a deep dive into useful valuation minutiae)
Most homebuilders are valued on book value. Their primary assets (land and in-process homes) are on the books at roughly market value, since they are acquired at market value and sit on the balance sheet for a relatively short amount of time. After netting out any cash and liabilities, the company’s book value approximates its liquidation value. In strong housing markets, these companies have a growing stream of profits and tend to get valued at a premium of perhaps 20%-50% above book value (or, a price/book value multiple of 1.2x to 1.5x). During weak housing markets, they will be valued at discounts of perhaps 10%-30%)
Hovnanian has a negative book value due to its large losses in prior years, leaving its P/BV multiple meaningless. The company provides a tangible book value estimate of $26.67/shares, which adds back $643 million in deferred tax assets (based on the value of their tax loss carryforwards). While this implies that HOV shares trade at about 0.3x BV, it does not provide a useful mark-to-market for the company unless it were to be acquired by a buyer who could use the tax benefits.
Without a useful P/BV metric, we value HOV shares on an EV/EBITDA basis. For a partly turned-around Hovnanian, our 6.0x multiple would produce a share price of about $16. However, given the immense financial leverage, the equity value is only about 3% of the enterprise value. So, if the enterprise value increases by 3%, the share price doubles. This essentially makes HOV shares a call option on the enterprise value.
Near-term financial results are uninspiring
Hovnanian put up uninspiring second quarter results. Revenues fell 12% from a year ago. Homebuilding gross margin, a measure of construction-related profits that excludes the costs of related land and interest, fell to 16.9% compared to 17.7% a year ago. During the quarter, Hovnanian increased its buyer incentives to match competitors.
While overhead expenses fell 2% from a year ago, they rose as a percentage of revenues. The company described how these expenses are too high, but won’t likely increase much when revenues grow, allowing for better profit metrics in future quarters and years.
Adjusted EBITDA of $24.1 million fell 41%, from a year ago. Hovnanian’s Adjusted EBITDA is not covering its interest expense of $41.4 million.
Management expects better second half and strong fourth quarter
The company guided for an overall positive-profit year led by strong profits in the fourth quarter. Wall Street analysts estimate the company will be break-even on EPS this year and will earn $1.25/share next year.
Upcoming debt refinancing requires the kindness of strangers
Hovnanian has about $75 million in debt maturities in 2021 and $635 million in debt maturities in 2022. While the company believes they will be able to refinance these debts, this will be contingent upon more home sales (dependent upon the housing market), higher profits (partly under Hovnanian’s control) and the capital markets’ willingness to extend credit (not under Hovnanian’s control).
As owners of over 20% of the shares, and being the founding/living namesake of the company, the Hovnanian family certainly has the incentive to keep the company afloat. While the company has a reasonable chance of refinancing its debts under favorable circumstances, this is by no means assured. The company’s bonds are junk-rated and trade around 80-84, implying uncertainty about their ultimate fate.
Retaining our BUY rating, yet we now consider these shares to be Speculative
We continue to rate HOV shares a BUY with an updated price target of $16.
Disclosure Note: An affiliate of the Publisher, and an employee of the Publisher, owns HOV shares.