Description

Short Hovnanian 6.25% Sr Notes due 1/15/2015 (Oct 24, 2010; $75.00; 14.35% YTM)

I think shorting the HOV 6.25% Senior Unsecured Bonds due 1/15/2015 represents a compelling risk reward at today's prices.  The bonds are illiquid, but not impossible to find.  Moreover, there are two other HOV unsecured bond issues that mature shortly before and three other unsecured issues that mature after this bond issue.  Of course, there are also more liquid CDS, as well.  For simplicity, I will focus the writeup on the 6.25%s of 2015.

HOV is an over-leveraged public homebuilder that has been written up several times in the past.  While HOV has some breathing room in the near term owing to its current cash balance and debt maturity profile, I believe it will struggle to repay its debt in the intermediate to longer term.  In short, while HOV has liquidity today, I believe it is insolvent.  I think there is less mark to market risk in shorting these longer dated unsecureds than in shorting the common.

Here is a table laying out HOV's debt by maturity:

HOV enjoyed a sizeable windfall when the tax loss carryback provision was extended from 2 years to 4 years in 2009.  Because of this fortuitous change, HOV received a $274mm cash tax refund in Q2'10 and expects to receive another $17mm by Q1'11.  But this source of cash has now been fully tapped.  HOV has ~$747mm in remaining future DTAs that can be used to offset nearly $2B in future pretax income, but HOV will have to earn pretax income to benefit.  Suffice it to say, HOV should not have to pay taxes for many years to come, if ever.  Management likes to talk about the fact that BV would not be negative if they could reverse the valuation allowance on their DTAs, but I believe the bigger issue for HOV is whether the company will have adequate cash to pay off its bonds as they come due.

HOV has done a strong job to date in taking advantage of the debt markets to term out their debt.  Today, fully 81% of HOV's homebuilding debt doesn't mature until 2016 and 2017.  They have also done a fine job in creating equity value (roughly $500mm in recent years!) by repurchasing debt at large discounts.  However, it would seem that most of that is now behind us.  The company stated at a conference on Sept 15 that they can only spend another ~$70-75mm for debt buybacks.  Moreover, if HOV's bonds trade down materially to create a large opportunity on this front, the short should have already been profitable.  Furthermore, it is the longest dated bonds that would tend to trade down to the lowest dollar price, so HOV would get the biggest bang for its buck in reducing total debt by repurchasing those bonds that mature after the bond issue in question - siphoning out cash that could have supported repayment of the 6.25%s of 2015 to retire bonds that mature later on.

HOV has been shrinking in recent years in order to reduce debt.  Net debt has indeed come down, but inventory $ (the majority of HOV's non-cash assets) has fallen much more rapidly.  (See the table below).  The ratio of inventory to net debt has deteriorated markedly.  Note that it would have deteriorated more in the last 12 months absent the tax refund windfall.  To wit, net debt fell only $92mm in the last 12 months despite the $274mm tax refund.

If we strip out capitalized interest from the inventory balance, the situation looks a bit worse:

But even this is after giving HOV full credit for its large restricted cash balance.  (HOV was basically forced to cash collateralize its LOCs after the bank debt market largely closed to it).  More realistically, HOV will not have access to that restricted cash unless HOV were to shrink materially from here. 

The table below compares HOV to other HY homebuilders today on the basis of inventory to net debt, stripping out restricted cash:

Clearly, HOV will require dramatic improvement over time in order to cover its debt as it comes due.  From the standpoint of the 6.25% Senior Notes of 2015, the situation looks quite a bit more dire because of the $823mm of secured debt ahead of them.  A simplistic static recovery analysis, assuming no interim cash burn between now and 2015, assuming no more impairments, and assuming a restructuring just prior to these bonds' maturity in early 2015 would suggest a mere 33% recovery.  And that is with those very optimistic assumptions.  If we were to assume just a 20% haircut to inventory and just $100mm of cash burn per year, we'd be left with a $393mm deficit, as shown below.  Just last quarter alone HOV took another $49mm in impairments so a 20% haircut assumption doesn't exactly seem draconian.  Moreover, 42% of HOV's owned lots inventory $ and 44% of its owned lots by # are currently mothballed.  Mothballed communities are, by definition, currently not economical to move forward with despite the land costs to date already having been sunk.

It would not be unprecedented for these HOV unsecureds to ultimately recover close to $0.  Look no further than the minimal recoveries to unsecured creditors (and incomplete recoveries to secured creditors) in other homebuilder bankruptcies such as WCI, TOUSA, LEV, OHB, DHOM, etc.

While the above analysis assumes HOV can reduce its cash burn to $100mm annually, HOV actually appears to be burning cash at a much higher rate and has basically acknowledged they don't know what other overhead it would still make sense to cut.  Below is a simplistic annualized cash burn analysis that compares HOV with other HY homebuilders.  It seems clear that the status quo is unsustainable for HOV.  Even before impairments, HOV's EBIT minus interest expense is running at nearly $175mm per year, or roughly 12% of revenues.  HOV's SG&A rate no longer appears out of line, but its interest expense burden remains crushing.

Note that the above cash burn analysis implicitly assumes a steady state size of operations.  In reality, HOV is counting on a substantial market recovery to drive margins higher and enable the company to begin to earn its way out of the large hole it is in.  However, homebuilding is an incredibly capital intensive business.  HOV should require significant incremental capital (primarily in WIP and land investment) to be in a position to operate at a much higher run rate of revenues.

Clearly HOV will have to raise additional capital over time in order to survive.  Preferred equity is off the table as dividends are prohibited under the different bond indentures.  Unsecured bonds could theoretically be issued to refinance unsecured bonds as they come due, but the cost would appear to close to prohibitive and it is not obvious that the market would even be open to HOV.  I believe that the opportunity to raise secured debt has been essentially fully tapped.  While HOV has shrunk operations in recent years to "release" capital, it appears clear that HOV will not be able to shrink its way to prosperity given the large overhead burden it carries. 

That leaves common equity.  Management has acknowledged the need to raise equity in the future.  On its most recent quarterly earnings call, the CFO stated: "our expectation to do that [raise common equity] would be back when we're solidly profitable, and get a multiple of earnings, rather than some kind of option valuation on our equity. So, we haven't returned to profitability yet. So it's some ways off in the future."  This is the main risk to the short.  But I believe it is a risk worth taking.

HOV has 63.1mm Class A shares outstanding and 14.6mm Class B shares outstanding.  Its total market cap is $286.6mm (including the Class B shares which don't really trade).  Its float is only $232.9mm (Class A shares only.  While certainly a possibility, it takes some imagination to envision the scenario where HOV can feasibly issue enough common equity to really make a difference.

Management seems to be implicitly assuming HOV common will trade to a reasonable P/BV multiple after the huge valuation allowance gets reversed (assuming it actually ever does get reversed).  As the CEO stated at a recent conference on 9/29/10:  "As we do return to, to profitability, what will happen is we have a $750 million deferred tax asset valuation allowance that will come back in the form of equity on our balance sheet after we're profitable for a couple of years, and then at that point in time, hopefully our stock is up in value and trading at a multiple to earnings. We will then, in all likelihood, do a stock issuance." 

But the present value of that valuation allowance will be tremendously lower than the gross amount as it will take many, many years for HOV to ever earn enough pretax income to utilize the NOLs, if ever.  Moreover, HOV is likely to trip Sec 382 and precipitate a change in ownership for tax purposes if it manages to raise enough common equity to make a difference in deleveraging.  That would further restrict the PV of the NOLs dramatically.

Trading at 75 cents on the dollar today, the 6.25% Sr Notes due 1/15/2015 are yielding 14.35% to maturity if all goes well for HOV in a blue sky scenario.  The current cash cost of carrying the short is the relatively modest 8.3% current yield.  While HOV's maturity profile in the very near term is limited and it has cash on the balance sheet today, I would expect these bonds to trade down as time passes and as a seemingly inevitable restructuring draws nearer. 

Note that it was less than 2 years ago that they traded down to the low 20s.  While the macro picture at that time seemed much bleaker in that we were in the throes of the credit crisis, it was also a time when HOV enjoyed a much more encouraging ratio of inventory excluding capitalized interest to net debt of 1.20x vs 0.75x today.

Risks

HOV manages to raise enough common equity (and unsecured debt) on attractive enough terms to avoid restructuring.

Market recovers dramatically enough that HOV can both "earn" its way out of trouble and raise the necessary capital to do so.

Catalyst