Hovnanian Enterprises, Inc. (HOV) Earnings Call Transcript & Summary

All right. Good morning, everyone. Our next presentation will be in a fireside chat format with Hovnanian Enterprises and CFO, Brad O'Connor. I'm going to kick off with a few questions and then I would highly encourage any of you to add on as you see fit. Brad, I wanted to start off with just everyone's favorite conversation topic in the space, affordability. A lot of headlines kind of back and forth between the administration and the homebuilding sector around ways to make affordability better for all stakeholders in housing. What are you hearing from your seat? And do you think there's any momentum in Washington with regards to policy reform that could help the space?

Sure. So I mean, our CEO, Ara, has been part of those conversations with some of the other CEOs in the industry. Any regulatory changes that would improve affordability and make the opportunity for people to buy homes better would be -- we would certainly support and would love to see that. Whether there is some -- I don't think, and I don't think Ara thinks there's some silver bullet out there that's going to solve this problem. There's been a few ideas floated the idea of limiting investors' ability to buy single-family rentals, for example, I don't think that's going to have a real meaningful impact. It's a relatively small portion of the market. There was the concept of rent to-own that was talked about a few weeks ago as well. Maybe that's a way to get some people in on first-time buying. So that could be possible. One of the things that I haven't heard talk about this time around, at least not as much is something that was used previously, which is first-time buyer tax credit. That did have some impact the last time that was used. So maybe there's an opportunity there. But I think, unfortunately, I don't think that there's going to be a significant way to make that change happen. I think that what happens in our cycles in this industry typically takes time for land values to adjust according to what the current market is saying homes sales happen for with current incentives, et cetera. We only underwrite brand-new land deals at today's net pricing, net of incentives, current cost, current absorption basis. And we're finding some land deals that pencil it at today's prices. And so as more and more land sellers come to that reality, there'll be more land supply at better pricing and be able to continue to sell at lower prices. It's a land supply at right price issue, I think, as much as anything, the problem is that takes time. And so unfortunately, I don't think there is a rapid change coming from government change. But anything they can do to assist would be helpful. One of the other challenges as this question has come up is that there are a lot of local costs that are driven by municipalities and local government states, development fees, specifically what I'm talking about. And in some markets, those are very expensive. There are markets that's over $100,000. The federal government, I don't think has any way to reduce that. But if there were ways to get those kind of costs down, that would also help affordability as an input cost to the home. So unfortunately, I don't have a great answer, and it remains to be seen what comes of any of these changes, but I don't foresee it being a significant impact, at least not yet.

To your point on land prices, kind of trailing home prices, net of incentives, how far away do you think we are in terms of the effects of the last year, the elevated incentives, the effective price of a home flowing through into land valuation?

Yes. So I would say, on average, for us, it's about 2 years to 3 years on average from the time we control -- initially control a lot to getting to kind of first deliveries. And so -- and we are always underwriting our land deals at whatever the current market absorption pace, costs, sales incentives, net pricing is. So if you look back over the last few years, in 2024, our average incentive level was around 8%. And we're now at around 12%, 12.5% in the most recent quarter, and it grew in between in steps. Prior to that 8% rate, we were closer -- we went from 3% to 8% in like a 1-year time frame. So for us, as we work through the land we controlled back in 2023 or earlier at those lower incentive levels with all the pressure on margin, we should, if nothing else changes, start to see improvement in our margins because we were underwriting those more recent deals with higher incentives. But even the deals in 2024, we're underwriting at 8% incentives. So that's still 400 basis points worse than -- or 400 basis points worse than that now. So it's just going to take time for our margins to get back to normal for us, which is around 20%. But what I would say is it's about 2 years on average from control to kind of first delivery.

And then sticking with the incentives. So you mentioned 400 basis points worse than 8% to 12% roughly today. Are we at a ceiling in terms of incentives and buydowns? Can yourselves and the industry collectively provide more without coming underwater? And at some point, is it just more of a price versus piece?

Yes. I mean, so certainly, we are -- and we've stated this publicly, we continue to believe in high inventory return and maintaining sales pace as best we can. We think that's the most efficient way to run our business. And so we will, at each community, do what's necessary to try to maintain an appropriate pace for that community. What happens is if the incentives you need to make that happen become too significant, our land-light strategy allows us to potentially choose to leave that community. Now we would forfeit a deposit and there's other costs that occur with that, but we don't have to continue to operate if it's a sub margin, it doesn't make any sense to continue. And so what you will -- what I think you would see from us and potentially others is ultimately, if there was more and more pressure, you might see our walkaway costs increase as a result. Good news is that hasn't happened to date. We're still managing even at these lower margins to want to continue that it's not worth it for us to walk away. We also have not had any significant impairments of note. So we haven't gotten to the point where we're triggering land values that need to be written down. And the people we're partnering with on the land light side, whether they're developers or even land bankers are working with us on deferring takedowns and other ways to try to make sure we can work through the community and not have to walk away. But ultimately, we want to continue to drive pace. And if you can't make at least an acceptable margin and it's a lot takedown situation, you just wouldn't keep taking lots down.

So you mentioned, at least for now, the environment around developers and land bankers, you're still taking down options. How close are we to a point where you are walking away from more deals? Are we talking about, let's say, this environment persisting for another 6 to 12 months? Or can the industry absorb 6% mortgage rates for another 1.5 years to 2 years?

I mean if incentive levels stay like they are, I don't think you would see us change much of anything. The communities we're in are -- we haven't walked away to date, and these are the incentives we have. So it would take continued deterioration for that to happen. And it's hard for me to answer that question globally because every community is different. And as you can imagine, and you'll probably ask me later what markets are better, but we have some markets that are better than others. So those communities aren't anywhere near close to having an issue where there's other communities that are in some of our more challenging markets that might be closer to having an issue. And so you're looking at each of those situations individually. Every community stands on its own.

And then just maybe drilling down a little bit more on impairment testing and what it would take to start writing down land assets. I've heard in the past some builders that gross margins are an indicator if you're underwriting a deal sub-15% gross margin, unlikely that you're going to continue moving forward with that parcel. Is there a hard and fast rule around that? Or again, is it community-specific and also determined by your outlook kind of...

So it's definitely community specific and just take an accounting lesson for just a second. What happens is you look at the remaining community life on an undiscounted cash flow basis. So what are you estimating in the revenues that are going to come in against future costs? And does the net of those things cover the current inventory value on an undiscounted basis. If it does not, and that's a negative calculation, then you have an impairment at which point you actually discount the cash flows to try to come up with the fair value that you need to write the land down to. So long story short, where we are today, and we do that assessment every quarter. So we've had -- we had no impairments in the most recent quarter, very low -- relatively low level of impairments last fiscal year. So we haven't reached a point where there's -- I have a significant concern about any of these massive impairments coming. If for some reason, our margins went from 13% to 10%, we're probably going to have some inventory impairments, right? So -- but again, it's every community that we look at all along and look to see where that community stands. Makes sense.

Yes. Outside of incentives and price pressure, are there other levers you can pull on the cost side to maintain gross margins?

Well, we haven't been able to maintain them, unfortunately, but we can help them...

Mitigate...

I know what your question. There has been some help on the cost side. I mean, as when industry cycles like this, labor supply, we rebid our communities constantly to make sure that we're getting competitive pricing for all our materials and our labor. The labor side has been helpful. You've been able to claw back some costs there, just like the opposite happened during COVID, and we had to pay them a little more because the market got so hot. The same is true with materials. We are seeing some give and take on the material side. There have been some challenges with some materials with tariffs. But for the most part, we've been able to keep our materials in check. Lumber has been down a little that helps. So big picture in the last year, a year ago this time, we were at a little around about $98 a square foot for construction costs, and we're right now around $96, high $95. So we've been able to bring cost per foot down given the current environment because of the pressure that's on -- just on the suppliers and labor just like it's on us.

Now I'm going to transition into markets. So can you give us kind of the lay of the land across your footprint, what MSAs are outperforming or underperforming and where you're seeing kind of the most opportunity?

Sure. So for us, our East, primarily Northeast segment has been the strongest, and that includes New Jersey, Delaware and Virginia and Maryland. And as you continue down the East Coast for us, the Carolina business, which is South Carolina and Georgia is kind of, I would say, in the middle in terms of strength. So a little worse than those other markets, but not our weakest. Our weakest markets are Dallas and Southeast Florida, which for us is kind of Palm Beach north towards Stuart, Port St. Lucie that way and Dallas. And then I would -- the others, Houston, Orlando, Arizona and California are kind of in the middle. They're not as strong as our Northeast segment, but they're okay. And in every one of the markets, we've actually got communities that are performing quite well. But when you roll them up, those are the more challenged markets versus the better ones.

And can we walk through kind of the differentiation in product type as well kind of what you're seeing in demand?

Yes. So we operate in and have a diverse product portfolio. We have everything from first-time, move-up, luxury and our active adult portfolio. And I would say that on the whole, the first time, maybe to no one's surprise, the first-time product has been the most challenged. It's most -- with an affordability issue that tends to be what happens. So that's been our most challenging market. And I would say the opposite, active adult has probably been our strongest in the current market, and that's -- they need less or no mortgage, and they've had the advantage of a pretty strong equity market. So that certainly helped that customer base. So from a product perspective, that's how I would say. And the market rate stuff has kind of been in between. I would -- in most cases, I would say closer to the active adult than the first time, but it really depends on where it is. I mean one of the decisions we made in the last maybe 6 months or so is it's time, we're going to start to focus less on the periphery markets where you see more of the first-time stuff and move more towards A and B locations and focus more on market rate, what I call non-first-time buyer and active adult and kind of get away from that first-time buyer product. It tends to be in markets that are more challenged in the downturn. It also has 2 of the biggest homebuilders in play in almost every one of our markets that we compete within that space, and that's challenging to do. So I think you're going to see us shift away from first time. It's going to take time for that to happen, but you're going to see that over time shift away from first-time buyer product and go more towards the normal move up kind of market rate product and active adult.

That's helpful. You mentioned Northeast is your strongest market. Was weather a factor in January, February impacting any sort of traffic?

I mean it would have had an impact. Interestingly, it had an impact on the day of or the next day. But for the most part, it really didn't. And January and February were both stronger months for us year-over-year. So the good news, at least from our perspective is that while November and December were down year-over-year, January and February both picked up and picked up as you would normally see from a spring selling season perspective, like starting to see the improvement. Traffic actually started doing that back in August. So from August through January, 5 of those 6 months traffic was up year-over-year. And then we started to see that come through in the contracts year-over-year from an absorption pace perspective in January and February. And we're hopeful that, that will continue into March and the rest of the spring selling season. But at least there was some optimism around what we saw in January and February from a sales perspective.

Do you keep stats around kind of traffic versus contract, like how kind of...

Conversion?

Conversion, yes.

We do keep conversion for traffic. And sometimes it's actually opposite of what you would think in other words. Sometimes conversion is actually higher than you might think because there's just nobody -- the only people that are showing up are people that really want to buy versus tire kickers. So you have to take conversion with a grain of salt. In the macro, I don't think our conversion has changed that significantly. And again, we look at it division by division and community by community. But -- and it tends to be, for whatever reason, a little different in different divisions or different markets.

That's helpful. Any early insights into the spring selling season outside of what you just said around January and February?

No. I mean, like I said, we're really hopeful that March continues the trend we saw in January and February. It remains to be seen what happens as a result of this weekend's events and going forward and what that does to sentiment. But hopefully, that's a short blip, and we're back on track with the improvement we've been seeing in January and February.

And has that January and February improvement been driven by any particular product or market? Has the entry-level buyer base started to slowly reemerge with headline mortgage rates at least below 6%?

I think that's helping. I think it's helping. I mean, as most of you would know, we've been offering incentives for mortgage rate buydowns well below 6% for a long time. But there's definitely, I think, you typically do see a psychological change in buyers as rates move down, you get a little bump from that. So that could be a little bit of what's helped us in January and February. But we will see. I don't -- it has been across the board. It isn't like we only saw the improvement coming from one of the product segments. And it's actually been in almost all the markets as well. I would say Southeast Florida, Dallas still -- they've actually improved, but they're still weaker compared to others. But it's been across the whole company where we've seen that improvement in January and February.

Great. I'll pause there and see if there are any questions in the audience.

You mentioned, the desire to move into more [ move-up ] buyers. Do you have -- is there a stated mix that you would like to get to? Also, can you talk about the margin differential within the 2 different buyer segments?

Yes. So from a stated mix percentage, I don't -- we don't have targets like that. What I can tell you is today, active adult 20-ish percent, Jeff, right? Definitely would like to see that grow. And the first-time buyer was 42% in terms of the product. And the reason I'm focusing on the product is it's not just first-time buyers that buy that product. In fact, we know that it's actually quite a bit of second time or third-time buyers that are actually buying our first-time product because first-time product has actually gotten that much more expensive than it used to be that first-time buyers can't afford it. But what I would expect to see is that 42% gradually goes down as we move away from that product portfolio and you see active lifestyle or active adult move into the 30s, something like that and then the market rate or move-up buyer, luxury buyer makes up the delta. But with respect to your margin question, the answer is on a -- there is a delta for us currently and has been for the last few years that's pretty meaningful in that, I would say, on average, the first-time product, our Aspire product is 600 to 700 basis points lower than what the kind of move-up in active lifestyle are. So for us, it's been meaningful. I mean the other part of the challenge for us with the Aspire product in terms of being on the periphery, it's also competing with Lennar and Horton who dominate that market. And so you're competing with them on cost and price. It's just shown to be very challenging for us.

You had some helpful comments on margin as far as material costs. You said that lumber has been down. Just on the flip of that, like what is still giving you some pricing power or some pricing challenges as far as like what's not coming down right now given the backdrop? Because most of the building products companies are struggling quite a bit right now.

Yes. I would say just -- I mean, lumber is such a significant component. It really drives a lot of our construction costs overall. So on the rest of the material side, I don't think there's anything of note either direction, frankly. There's some that are up a little and some that are down a little, but it isn't -- there's not something that sticks out as a meaningful mover one way or the other.

Other questions, I'll continue. We've seen a little bit of M&A in the space recently with the Risewell Landsea transaction last year. You guys have also done a consolidation transaction in KSA. How do you see the homebuilding -- the U.S. homebuilding industry continuing to evolve as gross margins continue to be strained and large-scale builders tend to be able to withstand that a bit more?

Yes. I mean, I guess it wouldn't surprise me if consolidation of some form continue for all the reasons you say. I mean there's definitely efficiencies potentially to be had in size. For us specifically, we believe that we need to continue to grow in the markets that we're in. We're only in the top 5 builders and maybe 2 of the 14 divisions that we have. And therefore, we would like to use our capital and find growth in those markets that would be more efficient to us. We already have the overhead. We already have the division offices and the President and the controller, et cetera. So for us, any acquisition, I think, would just -- would more likely be like a regional local builder and a way to acquire lots and get bigger in that particular market, and you get more efficient in that division by doing so. In the grander scheme, though, you could see other larger builders acquire just like what you saw with Tri Pointe, et cetera. For us specifically, I don't think that's really in the cards. We still have a way to go in terms of -- we're going to get to it probably, but we're debt to cap is 42%. Our target is 30%. I don't really want to take on significantly more debt to do any kind of acquisition. So I don't think you'll see us do anything like that. And I don't think we are really in play from being an acquirer because the Hovnanian family still controls and wants to operate the business.

What are you seeing in terms of land spend? Obviously, just given some of the uncertainty around the market right now and existing land supply, do you expect land spend to continue moderating over the course of the year?

Yes, I do unless the market changes dramatically. We definitely have -- if you look at our statistics, our land spend is down, I think what are we averaging, Jeff, like $150 million a quarter when it was about $250 million in 2024, just to give you an order of magnitude. So it's definitely down, and that's just because we're not finding land deals that underwrite that makes sense to use our capital on. And so the corollary is we now have significant liquidity. We typically have a target range around $200 million of liquidity, and we ended the first quarter at the end of January with $470 million of liquidity. We'd rather have that invested in inventory that was earning a 20% return. We're just not buying enough deals that can do that at the moment. And so we're going to wait and be disciplined in our land acquisition approach and look for deals that can hit those hurdle rates.

And then on that topic of liquidity and being above your target, how do you think about capital allocation outside of land spend, debt buybacks, stock buybacks, other forms of investment returns?

Sure. So we recently did our refinancing in September, which was great to get done. We moved from all secured debt to unsecured other than the revolver we have today. and pushed out our maturities. So to take out that debt, it's trading above par, has significant call premiums, et cetera. So not likely to spend any money on that at the moment. And we've done some stock buybacks over the last couple of years when price seemed appropriate to do so. And we have authority to continue to do some of that, but it hasn't been anything of significance compared to some of our peers. So we're just going to keep the powder dry, so to speak, if that's what it takes and look for the land deals that pencil.

And you alluded to this earlier, debt to cap 42% going down to 30%. What could keep you away from focusing on that trajectory? Obviously, you mentioned M&A is not a priority right now in inorganic growth, but is there something out there that would keep you away from.

I mean I think it's just -- if the market continues to be challenging, it slows our profit and equity growth that -- to me, that's the one driver that would keep us from being able to continue to move in that direction or just takes longer than we currently think it will. I mean even today, we're probably, I don't know, 2 or 3 years away from being able to hit that kind of a target unless the market improves and we can get there more rapidly. And obviously, if it gets worse, it would take us a little bit longer.

Can you expand a little bit more on the land underwriting challenges? How -- can you expand a little bit more on the land underwriting challenges? How much of that is maybe you guys underwriting to a conservative future kind of housing market in terms of what you could realize on the underwrite versus maybe the inventory that you have? Like what is the benchmark that you guys are using to decide this is not penciling and how much of it is conservatism around kind of future home price growth or otherwise?

So the way that we underwrite is we don't believe we have a good crystal -- any better crystal ball than anybody else. So we underwrite using today's costs, today's absorption paces, today's net pricing, so inclusive of incentives and underwrite to basically a 20% or higher IRR. And we have a profit requirement, it has to be operating profit of 6%. So that -- those are the -- and we just -- we don't try to guess at what's going to happen in the future for all the -- you can guess one way and be wrong. So I wouldn't say we're more conservative. I'd just say we use what today is. And the way we do that, we look at our own communities if we're in that market already, but we also look at our competitor communities and what they're selling for and what their paces are, and that's how we set the underwriting and look at those projects. So if ultimately, paces end up being stronger than we thought or we get a little less incentives, we should outperform the underwriting. And obviously, the opposite occurs if it goes the other way. But that's how we do it. We don't try to guess at those future dates, future things. And by the way, I think that -- I think the other builders are mostly doing the same thing. And the reason I think that is I think many builders are seeing the same thing we are, which is reducing their lots control because they're not finding deals that pencil. And that's the kind of pressure that you need so that land sellers start to expect less on the land price.

So I asked a lot of builders this question last year in terms of magic number or crystal ball in terms of mortgage rates. Obviously, given the buydown environment that we're in, you're already effectively offering 5% or below to a lot of your homebuyers. If mortgage rates were to get to 5%, is -- does anything change? Or how does...

It's hard to -- I think so. And the reason I think so, I think there's a psychological aspect of rates and what people think is an acceptable rate. And therefore, you -- just by the nature of rate reductions, you get more people that come out. So I do think there's some benefit there. I also think -- and I think we talked about this last year that if rates come down, there are people that currently will not move from their existing home because they have a 3% rate and there may be a point where they don't have to get all the way to 3, but it is 5 enough for them to be comfortable that they want to move because they need a bigger house now or whatever the case may be, and they've been holding off. Now that obviously creates an additional supply unit, but the person that's selling has to have some where to go, and we're a choice for that. So I think what happens in that instance is you just have more activity in general and perhaps that helps us.

So you believe that activity net -- would be a net positive in terms of that supply...

I think I certainly think it's an opportunity. Yes.

Any other questions? If not, I think we'll leave it there. Thanks a lot, Brandon.

Thank you.