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Table of Contents

UNITED STATES

 

SECURITIES AND EXCHANGE COMMISSION

 

WASHINGTON, D.C. 20549

 

FORM 10-Q

  

(Mark One)

[X ]

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended APRIL 30, 2018

OR

 

[    ]

Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

Commission file number 1-8551

 

Hovnanian Enterprises, Inc. (Exact Name of Registrant as Specified in Its Charter)

 

Delaware (State or Other Jurisdiction of Incorporation or Organization)

 

22-1851059 (I.R.S. Employer Identification No.)

 

90 Matawan Road, 5th Floor, Matawan, NJ 07747 (Address of Principal Executive Offices)

 

732-747-7800 (Registrant's Telephone Number, Including Area Code)

 

N/A (Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes [ X ]    No [   ]

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes [ X ]  No [    ]

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer [   ]  Accelerated Filer  [ X ]

Non-Accelerated Filer  [   ]  (Do not check if smaller reporting company)   Smaller Reporting Company [   ]     Emerging Growth Company [   ]

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  [   ]

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes [    ]  No [ X ]

 

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 132,643,015 shares of Class A Common Stock and 15,470,482 shares of Class B Common Stock were outstanding as of June 1, 2018.

 

 

 

HOVNANIAN ENTERPRISES, INC.  

    

FORM 10-Q  

 

 

INDEX

PAGE

NUMBER

  

  

PART I.  Financial Information

  

Item l.  Financial Statements:

  

  

  

Condensed Consolidated Balance Sheets (unaudited) as of April 30, 2018 and October 31, 2017

3

  

  

Condensed Consolidated Statements of Operations (unaudited) for the three and six months ended April 30, 2018 and 2017

4

  

  

Condensed Consolidated Statement of Equity (unaudited) for the six months ended April 30, 2018

5

  

  

Condensed Consolidated Statements of Cash Flows (unaudited) for the six months ended April 30, 2018 and 2017

6

  

  

Notes to Condensed Consolidated Financial Statements (unaudited)

8

  

  

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations

32

  

  

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

53

  

  

Item 4.  Controls and Procedures

54

  

  

PART II.  Other Information

  

Item 1.  Legal Proceedings

54

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

54

  

  

Item 6.  Exhibits

55

  

  

Signatures

56

  

 

 

HOVNANIAN ENTERPRISES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands)

 

   

April 30,

2018

   

October 31,

2017

 
   

(Unaudited)

         

ASSETS

               

Homebuilding:

               

Cash and cash equivalents

  $ 248,815     $ 463,697  

Restricted cash and cash equivalents

    13,957       2,077  

Inventories:

               

Sold and unsold homes and lots under development

    856,620       744,119  

Land and land options held for future development or sale

    104,518       140,924  

Consolidated inventory not owned

    78,907       124,784  

Total inventories

    1,040,045       1,009,827  

Investments in and advances to unconsolidated joint ventures

    88,344       115,090  

Receivables, deposits and notes, net

    70,168       58,149  

Property, plant and equipment, net

    19,944       52,919  

Prepaid expenses and other assets

    40,529       37,026  

Total homebuilding

    1,521,802       1,738,785  
                 

Financial services cash and cash equivalents

    4,960       5,623  

Financial services other assets

    115,729       156,490  

Total assets

  $ 1,642,491     $ 1,900,898  
                 

LIABILITIES AND EQUITY

               

Homebuilding:

               

Nonrecourse mortgages secured by inventory, net of debt issuance costs

  $ 70,644     $ 64,512  

Accounts payable and other liabilities

    288,120       335,057  

Customers’ deposits

    30,997       33,772  

Nonrecourse mortgages secured by operating properties

    -       13,012  

Liabilities from inventory not owned, net of debt issuance costs

    53,515       91,101  

Revolving and term loan credit facilities, net of debt issuance costs

    257,129       124,987  

Notes payable (net of discount, premium and debt issuance costs) and accrued interest

    1,340,246       1,554,687  

Total homebuilding

    2,040,651       2,217,128  
                 

Financial services

    99,914       141,914  

Income taxes payable

    1,902       2,227  

Total liabilities

    2,142,467       2,361,269  
                 

Stockholders’ equity deficit:

               

Preferred stock, $0.01 par value - authorized 100,000 shares; issued and outstanding 5,600 shares with a liquidation preference of $140,000 at April 30, 2018 and at October 31, 2017

    135,299       135,299  

Common stock, Class A, $0.01 par value – authorized 400,000,000 shares; issued 144,403,778 shares at April 30, 2018 and 144,046,073 shares at October 31, 2017

    1,444       1,440  

Common stock, Class B, $0.01 par value (convertible to Class A at time of sale) – authorized 60,000,000 shares; issued 16,162,230 shares at April 30, 2018 and 15,999,355 shares at October 31, 2017

    162       160  

Paid in capital – common stock

    707,487       706,466  

Accumulated deficit

    (1,229,008

)

    (1,188,376

)

Treasury stock – at cost – 11,760,763 shares of Class A common stock and 691,748 shares of Class B common stock at April 30, 2018 and October 31, 2017

    (115,360

)

    (115,360

)

Total stockholders’ equity deficit

    (499,976

)

    (460,371

)

Total liabilities and equity

  $ 1,642,491     $ 1,900,898  

 

See notes to condensed consolidated financial statements (unaudited).

 

 

 

HOVNANIAN ENTERPRISES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In Thousands Except Per Share Data)

(Unaudited)

 

   

Three Months Ended April 30,

   

Six Months Ended April 30,

 
   

2018

   

2017

   

2018

   

2017

 

Revenues:

                               

Homebuilding:

                               

Sale of homes

  $ 468,117     $ 567,553     $ 869,694     $ 1,098,968  

Land sales and other revenues

    21,373       3,888       26,074       11,633  

Total homebuilding

    489,490       571,441       895,768       1,110,601  

Financial services

    13,054       14,494       23,942       27,343  

Total revenues

    502,544       585,935       919,710       1,137,944  
                                 

Expenses:

                               

Homebuilding:

                               

Cost of sales, excluding interest

    393,012       475,440       722,539       920,467  

Cost of sales interest

    19,364       20,337       31,656       38,659  

Inventory impairment loss and land option write-offs

    2,673       1,953       3,087       5,137  

Total cost of sales

    415,049       497,730       757,282       964,263  

Selling, general and administrative

    45,544       45,467       88,775       89,875  

Total homebuilding expenses

    460,593       543,197       846,057       1,054,138  
                                 

Financial services

    8,798       7,360       17,139       14,215  

Corporate general and administrative

    16,144       16,071       35,279       31,727  

Other interest

    26,088       22,297       55,219       44,924  

Other operations

    402       (95

)

    792       1,492  

Total expenses

    512,025       588,830       954,486       1,146,496  

(Loss) gain on extinguishment of debt

    (1,440

)

    (242

)

    (1,440

)

    7,404  

Income (loss) from unconsolidated joint ventures

    1,343       (4,562

)

    (3,833

)

    (6,228

)

Loss before income taxes

    (9,578

)

    (7,699

)

    (40,049

)

    (7,376

)

State and federal income tax provision (benefit):

                               

State

    245       2,292       583       2,274  

Federal

    -       (3,309

)

    -       (2,825

)

Total income taxes

    245       (1,017

)

    583       (551

)

Net (loss)

  $ (9,823

)

  $ (6,682

)

  $ (40,632

)

  $ (6,825

)

                                 

Per share data:

                               

Basic:

                               

Net (loss) per common share

  $ (0.07

)

  $ (0.05

)

  $ (0.27

)

  $ (0.05

)

Weighted-average number of common shares outstanding

    148,435       147,558       148,228       147,556  

Assuming dilution:

                               

Net (loss) per common share

  $ (0.07

)

  $ (0.05

)

  $ (0.27

)

  $ (0.05

)

Weighted-average number of common shares outstanding

    148,435       147,558       148,228       147,556  

 

See notes to condensed consolidated financial statements (unaudited).

    

 

 

HOVNANIAN ENTERPRISES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF EQUITY

(In Thousands Except Share Amounts)

(Unaudited)

 

   

A Common Stock

   

B Common Stock

   

Preferred Stock

                                 
   

Shares

Issued and Outstanding

   

Amount

   

Shares

Issued and Outstanding

   

Amount

   

Shares

Issued and Outstanding

   

Amount

   

Paid-In

Capital

   

Accumulated

Deficit

   

Treasury

Stock

   

Total

 
                                                                                 

Balance,

October 31, 2017

    132,285,310     $ 1,440       15,307,607     $ 160       5,600     $ 135,299     $ 706,466     $ (1,188,376 )   $ (115,360 )   $ (460,371 )
                                                                                 

Stock options, amortization and issuances

    24,000                                               302                       302  
                                                                                 

Restricted stock amortization, issuances and forfeitures

    332,264       4       164,316       2                       719                       725  
                                                                                 

Conversion of Class B to Class A common stock

    1,441               (1,441 )                                                     -  
                                                                                 

Net (loss)

                                                            (40,632 )             (40,632 )
                                                                                 

Balance,

April 30, 2018

    132,643,015     $ 1,444       15,470,482     $ 162       5,600     $ 135,299     $ 707,487     $ (1,229,008 )   $ (115,360 )   $ (499,976 )

 

See notes to condensed consolidated financial statements (unaudited). 

 

 

 

 

HOVNANIAN ENTERPRISES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)

(Unaudited)

 

   

Six Months Ended

 
   

April 30,

 
   

2018

   

2017

 

Cash flows from operating activities:

               

Net (loss)

  $ (40,632

)

  $ (6,825

)

Adjustments to reconcile net (loss) to net cash provided by (used in) operating activities:

               

Depreciation

    1,509       2,083  

Compensation from stock options and awards

    2,075       1,500  

Amortization of bond discounts, premiums and deferred financing costs

    4,150       9,348  

Gain on sale and retirement of property and assets

    (3,592

)

    (78

)

Loss from unconsolidated joint ventures

    3,833       6,228  

Distributions of earnings from unconsolidated joint ventures

    -       203  

Loss (gain) on extinguishment of debt

    1,440       (7,404

)

Inventory impairment and land option write-offs

    3,087       5,137  

Deferred income tax benefit

    -       (1,419

)

(Increase) decrease in assets:

               

Origination of mortgage loans

    (456,828

)

    (476,845

)

Sale of mortgage loans

    501,227       553,827  

Restricted cash, receivables, prepaids, deposits and other assets

    (18,972

)

    16,672  

Inventories

    (20,267

)

    68,735  

(Decrease) increase in liabilities:

               

State income tax payable

    (325

)

    600  

Customers’ deposits

    (2,775

)

    2,892  

Accounts payable, accrued interest and other accrued liabilities

    (46,511

)

    (57,436

)

Net cash (used in) provided by operating activities

    (72,581

)

    117,218  

Cash flows from investing activities:

               

Proceeds from sale of property and assets

    38,273       86  

Purchase of property, equipment and other fixed assets and acquisitions

    (3,208

)

    (4,500

)

Decrease (increase) in restricted cash related to mortgage company

    53       (2,715

)

(Increase) decrease in restricted cash related to letters of credit and bonds

    (12,124 )     1  

Investments in and advances to unconsolidated joint ventures

    (18,879

)

    (23,368

)

Distributions of capital from unconsolidated joint ventures

    28,754       10,735  

Net cash provided by (used in) investing activities

    32,869       (19,761

)

Cash flows from financing activities:

               

Proceeds from mortgages and notes

    75,962       103,620  

Payments related to mortgages and notes

    (82,121

)

    (119,860

)

Proceeds from model sale leaseback financing programs

    746       9,113  

Payments related to model sale leaseback financing programs

    (22,741

)

    (10,931

)

Proceeds from land bank financing programs

    3,766       8,643  

Payments related to land bank financing programs

    (19,890

)

    (41,617

)

Proceeds from senior unsecured term loan facility

    132,500       -  

Payments related to senior notes and senior amortizing notes

    (215,093

)

    (33,327

)

Net payments related to mortgage warehouse lines of credit

    (43,439

)

    (75,471

)

Deferred financing costs from land bank financing programs and note issuances

    (5,523

)

    (3,605

)

Net cash used in financing activities

    (175,833

)

    (163,435

)

Net decrease in cash and cash equivalents

    (215,545

)

    (65,978

)

Cash and cash equivalents balance, beginning of period

    469,320       346,765  

Cash and cash equivalents balance, end of period

  $ 253,775     $ 280,787  

 

 

HOVNANIAN ENTERPRISES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands - Unaudited)

(Continued)

 

   

Six Months Ended

 
   

April 30,

 
   

2018

   

2017

 

Supplemental disclosure of cash flow:

               

Cash paid during the period for:

               

Interest, net of capitalized interest (see Note 3 to the Condensed Consolidated Financial Statements)

  $ 59,707     $ 47,362  

Income taxes

  $ 909     $ 267  

 

See notes to condensed consolidated financial statements (unaudited).

  

 

Supplemental disclosure of noncash investing activities:

 

In the first quarter of fiscal 2018, we acquired the remaining assets of one of our joint ventures, resulting in a $13.6 million reduction in our investment in the joint venture and a corresponding increase to inventory.

 

Supplemental disclosure of noncash financing activities:

 

In the second quarter of fiscal 2018, we completed a debt for debt exchange of existing 8.0% Senior Notes due November 1, 2019 for newly issued 13.5% Senior Notes due 2026 and 5.0% Senior Notes due 2040. See Note 11 for further information.

 

 

HOVNANIAN ENTERPRISES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - UNAUDITED

 

 

1.

Basis of Presentation

 

Hovnanian Enterprises, Inc. and Subsidiaries (the “Company”, “we”, “us” or “our”) has reportable segments consisting of six Homebuilding segments (Northeast, Mid-Atlantic, Midwest, Southeast, Southwest and West) and the Financial Services segment (see Note 16).

 

The accompanying unaudited Condensed Consolidated Financial Statements include our accounts and those of all wholly-owned subsidiaries after elimination of all significant intercompany balances and transactions. 

 

The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X and accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. These Condensed Consolidated Financial Statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended October 31, 2017. In the opinion of management, all adjustments for interim periods presented have been made, which include normal recurring accruals and deferrals necessary for a fair presentation of our condensed consolidated financial position, results of operations and cash flows. The preparation of Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates, and these differences could have a significant impact on the Condensed Consolidated Financial Statements. Results for interim periods are not necessarily indicative of the results which might be expected for a full year. 

 

Reclassifications - In the second quarter of fiscal 2018, we reclassified our Senior Secured Term Loan due 2019 on the Condensed Consolidated Balance Sheets from the line item “Notes payable (net of discount, premium and debt issuance costs) and accrued interest” to “Revolving and term loan credit facilities, net of debt issuance costs”, resulting in a reclassification of the October 31, 2017 balance of $73.0 million.

 

 

2.

Stock Compensation

 

The Company’s total stock-based compensation expense was $1.0 million and $2.1 million for the three and six months ended April 30, 2018, respectively, and $1.0 million and $1.5 million ($0.9 million and $1.4 million net of tax) for the three and six months ended April 30, 2017, respectively. Included in this total stock-based compensation expense was the vesting of stock options of $0.1 million and $0.3 million for the three and six months ended April 30, 2018, respectively, and $0.1 million and $0.2 million for the three and six months ended April 30, 2017, respectively.

 

 

3.

Interest

 

Interest costs incurred, expensed and capitalized were:

 

   

Three Months Ended

April 30,

   

Six Months Ended

April 30,

 

(In thousands)

 

2018

   

2017

   

2018

   

2017

 
                                 

Interest capitalized at beginning of period

  $ 70,793     $ 94,438     $ 71,051     $ 96,688  

Plus interest incurred (1)

    40,014       39,156       81,179       77,855  

Less cost of sales interest expensed

    19,364       20,337       31,656       38,659  

Less other interest expensed (2)(3)

    26,088       22,297       55,219       44,924  

Interest capitalized at end of period (4)

  $ 65,355     $ 90,960     $ 65,355     $ 90,960  

 

(1)

Data does not include interest incurred by our mortgage and finance subsidiaries.

(2)

Other interest expensed includes interest that does not qualify for interest capitalization because our assets that qualify for interest capitalization (inventory under development) do not exceed our debt, which amounted to $19.9 million and $16.0 million for the three months ended April 30, 2018 and 2017, respectively, and $39.5 million and $29.3 million for the six months ended April 30, 2018 and 2017, respectively. Other interest also includes interest on completed homes, land in planning and fully developed lots without homes under construction, which does not qualify for capitalization, and therefore, is expensed. This component of other interest was $6.2 million and $6.3 million for the three months ended April 30, 2018 and 2017, respectively, and $15.8 million and $15.6 million for the six months ended April 30, 2018 and 2017, respectively.

(3)

Cash paid for interest, net of capitalized interest, is the sum of other interest expensed, as defined above, and interest paid by our mortgage and finance subsidiaries adjusted for the change in accrued interest on notes payable, which is calculated as follows:

 

 

   

Three Months Ended

April 30,

   

Six Months Ended

April 30,

 

(In thousands)

 

2018

   

2017

   

2018

   

2017

 

Other interest expensed

  $ 26,088     $ 22,297     $ 55,219     $ 44,924  

Interest paid by our mortgage and finance subsidiaries

    585       455       1,186       1,084  

(Increase) decrease in accrued interest

    (23,448 )     591       3,302       1,354  

Cash paid for interest, net of capitalized interest

  $ 3,225     $ 23,343     $ 59,707     $ 47,362  

 

(4)

Capitalized interest amounts are shown gross before allocating any portion of impairments, if any, to capitalized interest.

 

 

4.

Reduction of Inventory to Fair Value

 

We record impairment losses on inventories related to communities under development and held for future development when events and circumstances indicate that they may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than their related carrying amounts. If the expected undiscounted cash flows are less than the carrying amount, then the community is written down to its fair value. We estimate the fair value of each impaired community by determining the present value of the estimated future cash flows at a discount rate commensurate with the risk of the respective community. For the six months ended April 30, 2018, our discount rate used for the impairments recorded ranged from 16.8% to 19.8%. For the six months ended April 30, 2017, our discount rate used for the impairments recorded ranged from 18.3% to 19.8%. Should the estimates or expectations used in determining cash flows or fair value decrease or differ from current estimates in the future, we may need to recognize additional impairments. 

 

During the six months ended April 30, 2018 and 2017 we evaluated inventories of all 377 and 381 communities under development and held for future development or sale, respectively, for impairment indicators through preparation and review of detailed budgets or other market indicators of impairment. We performed detailed impairment calculations during the six months ended April 30, 2018 and 2017 for five and nine of those communities (i.e., those with a projected operating loss or other impairment indicators), respectively, with an aggregate carrying value of $11.2 million and $66.9 million, respectively. As a result of our impairment analysis, we recorded aggregate impairment losses of $2.1 million in all five communities (which had an aggregate pre-impairment value of $11.2 million) for both the three and six months ended April 30, 2018. We also recorded aggregate impairment losses of $1.5 million and $4.2 million, in one and six communities, respectively (which had aggregate pre-impairment values of $8.5 million and $21.1 million, respectively) for the three and six months ended April 30, 2017, respectively. These impairment losses are included in the Condensed Consolidated Statements of Operations on the line entitled “Homebuilding: Inventory impairment loss and land option write-offs” and deducted from inventory. The pre-impairment value represents the carrying value, net of prior period impairments, if any, at the time of recording the impairment. Of those communities tested for impairment during the six months ended April 30, 2017, three communities with an aggregate carrying value of $45.8 million had undiscounted future cash flows that exceeded the carrying amount by less than 20%. During the six months ended April 30, 2018, none of the five communities tested for impairment had undiscounted future cash flows that exceeded the carrying amount by less than 20%.

 

The Condensed Consolidated Statements of Operations line entitled “Homebuilding: Inventory impairment loss and land option write-offs” also includes write-offs of options and approval, engineering and capitalized interest costs that we record when we redesign communities and/or abandon certain engineering costs and we do not exercise options in various locations because the communities' pro forma profitability is not projected to produce adequate returns on investment commensurate with the risk. Total aggregate write-offs related to these items were $0.6 million and $0.4 million for the three months ended April 30, 2018 and 2017, respectively, and $1.0 million and $0.9 million for the six months ended April 30, 2018 and 2017, respectively. Occasionally, these write-offs are offset by recovered deposits (sometimes through legal action) that had been written off in a prior period as walk-away costs. Historically, these recoveries have not been significant in comparison to the total costs written off. The number of lots walked away from during the three months ended April 30, 2018 and 2017 were 714 and 478, respectively, and 1,341 and 1,539 during the six months ended April 30, 2018 and 2017, respectively.

  

We decide to mothball (or stop development on) certain communities when we determine that the current performance does not justify further investment at the time. When we decide to mothball a community, the inventory is reclassified on our Condensed Consolidated Balance Sheets from “Sold and unsold homes and lots under development” to “Land and land options held for future development or sale.” During the first half of fiscal 2018, we did not mothball any additional communities, but we sold two previously mothballed communities and re-activated one previously mothballed community. As of April 30, 2018 and October 31, 2017, the net book value associated with our 19 and 22 total mothballed communities was $24.4 million and $36.7 million, respectively, which was net of impairment charges recorded in prior periods of $186.1 million and $214.1 million, respectively.

 

 

From time to time we enter into option agreements that include specific performance requirements, whereby we are required to purchase a minimum number of lots. Because of our obligation to purchase these lots, for accounting purposes in accordance with Accounting Standards Codification (“ASC”) 360-20-40-38, we are required to record this inventory on our Condensed Consolidated Balance Sheets. As of April 30, 2018 and October 31, 2017, we had no specific performance options.

 

We sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 360-20-40-38, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Condensed Consolidated Balance Sheets, at April 30, 2018 and October 31, 2017, inventory of $33.5 million and $58.5 million, respectively, was recorded to “Consolidated inventory not owned,” with a corresponding amount of $30.0 million and $51.8 million (net of debt issuance costs), respectively, recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions.

 

We have land banking arrangements, whereby we sell our land parcels to the land bankers and they provide us an option to purchase back finished lots on a predetermined schedule. Because of our options to repurchase these parcels, for accounting purposes, in accordance with ASC 360-20-40-38, these transactions are considered a financing rather than a sale. For purposes of our Condensed Consolidated Balance Sheets, at April 30, 2018 and October 31, 2017, inventory of $45.4 million and $66.3 million, respectively, was recorded as “Consolidated inventory not owned,” with a corresponding amount of $23.5 million and $39.3 million (net of debt issuance costs), respectively, recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions.

 

 

5.

Variable Interest Entities

 

The Company enters into land and lot option purchase contracts to procure land or lots for the construction of homes. Under these contracts, the Company will fund a stated deposit in consideration for the right, but not the obligation, to purchase land or lots at a future point in time with predetermined terms. Under the terms of the option purchase contracts, many of the option deposits are not refundable at the Company's discretion. Under the requirements of ASC 810, certain option purchase contracts may result in the creation of a variable interest in the entity (“VIE”) that owns the land parcel under option.

 

In compliance with ASC 810, the Company analyzes its option purchase contracts to determine whether the corresponding land sellers are VIEs and, if so, whether the Company is the primary beneficiary. Although the Company does not have legal title to the underlying land, ASC 810 requires the Company to consolidate a VIE if the Company is determined to be the primary beneficiary. In determining whether it is the primary beneficiary, the Company considers, among other things, whether it has the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Such activities would include, among other things, determining or limiting the scope or purpose of the VIE, selling or transferring property owned or controlled by the VIE, or arranging financing for the VIE. The Company also considers whether it has the obligation to absorb losses of the VIE or the right to receive benefits from the VIE. As a result of its analyses, the Company determined that as of April 30, 2018 and October 31, 2017, it was not the primary beneficiary of any VIEs from which it is purchasing land under option purchase contracts.

 

We will continue to secure land and lots using options, some of which are with VIEs. Including deposits on our unconsolidated VIEs, at April 30, 2018, we had total cash deposits amounting to $52.5 million to purchase land and lots with a total purchase price of $1.0 billion. The maximum exposure to loss with respect to our land and lot options is limited to the deposits plus any pre-development costs invested in the property, although some deposits are refundable at our request or refundable if certain conditions are not met.

 

 

6.

Warranty Costs

 

General liability insurance for homebuilding companies and their suppliers and subcontractors is very difficult to obtain. The availability of general liability insurance is limited due to a decreased number of insurance companies willing to underwrite for the industry. In addition, those few insurers willing to underwrite liability insurance have significantly increased the premium costs. To date, we have been able to obtain general liability insurance but at higher premium costs with higher deductibles. Our subcontractors and suppliers have advised us that they have also had difficulty obtaining insurance that also provides us coverage. As a result, we have an owner controlled insurance program for certain of our subcontractors whereby the subcontractors pay us an insurance premium (through a reduction of amounts we would otherwise owe such subcontractors for their work on our homes) based on the risk type of the trade. We absorb the liability associated with their work on our homes as part of our overall general liability insurance at no additional cost to us because our existing general liability and construction defect insurance policy and related reserves for amounts under our deductible covers construction defects regardless of whether we or our subcontractors are responsible for the defect. For the six months ended April 30, 2018 and 2017, we received $1.9 million and $1.8 million, respectively, from subcontractors related to the owner controlled insurance program, which we accounted for as a reduction to inventory.

   

 

We accrue for warranty costs that are covered under our existing general liability and construction defect policy as part of our general liability insurance deductible. This accrual is expensed as selling, general and administrative costs. For homes delivered in fiscal 2018 and 2017, our deductible under our general liability insurance is a $20 million aggregate for construction defect and warranty claims. For bodily injury claims, our deductible per occurrence in fiscal 2018 and 2017 is $0.25 million, up to a $5 million limit. Our aggregate retention for construction defect, warranty and bodily injury claims is $20 million for fiscal 2018 and $21 million for fiscal 2017. In addition, we establish a warranty accrual for lower cost related issues to cover home repairs, community amenities and land development infrastructure that are not covered under our general liability and construction defect policy. We accrue an estimate for these warranty costs as part of cost of sales at the time each home is closed and title and possession have been transferred to the homebuyer. Additions and charges in the warranty reserve and general liability reserve for the three and six months ended April 30, 2018 and 2017 were as follows:

 

   

Three Months Ended

April 30,

   

Six Months Ended

April 30,

 

(In thousands)

 

2018

   

2017

   

2018

   

2017

 
                                 

Balance, beginning of period

  $ 129,314     $ 118,013     $ 127,702     $ 121,144  

Additions – Selling, general and administrative

    2,169       2,856       4,338       5,764  

Additions – Cost of sales

    4,154       3,515       9,899       7,002  

Charges incurred during the period

    (19,862 )     (7,177

)

    (26,164 )     (16,703 )

Changes to pre-existing reserves

    -       -       -       -  

Balance, end of period

  $ 115,775     $ 117,207     $ 115,775     $ 117,207  

 

Warranty accruals are based upon historical experience. We engage a third-party actuary that uses our historical warranty and construction defect data to assist our management in estimating our unpaid claims, claim adjustment expenses and incurred but not reported claims reserves for the risks that we are assuming under the general liability and construction defect programs. The estimates include provisions for inflation, claims handling and legal fees. The majority of the charges incurred during the second quarter of fiscal 2018 represented a payment for construction defect reserves related to the settlement of the Grandview II litigation as discussed in Note 7.

 

Insurance claims paid by our insurance carriers, excluding insurance deductibles paid, for prior year deliveries were less than $0.1 million and $0.2 million for the three months ended April 30, 2018 and 2017, respectively, and less than $0.1 million and $0.2 million for the six months ended April 30, 2018 and 2017, respectively.

 

 

7.

Commitments and Contingent Liabilities

 

We are involved in litigation arising in the ordinary course of business, none of which is expected to have a material adverse effect on our financial position, results of operations or cash flows, and we are subject to extensive and complex laws and regulations that affect the development of land and home building, sales and customer financing processes, including zoning, density, building standards and mortgage financing. These laws and regulations often provide broad discretion to the administering governmental authorities. This can delay or increase the cost of development or homebuilding.

 

We also are subject to a variety of local, state, federal and foreign laws and regulations concerning protection of health and the environment, including those regulating the emission or discharge of materials into the environment, the management of storm water runoff at construction sites, the handling, use, storage and disposal of hazardous substances, impacts to wetlands and other sensitive environments, and the remediation of contamination at properties that we have owned or developed or currently own or are developing (“environmental laws”). The particular environmental laws that apply to a site may vary greatly according to the community site, for example, due to the community, the environmental conditions at or near the site, and the present and former uses of the site. These environmental laws may result in delays, may cause us to incur substantial compliance, remediation and/or other costs, and can prohibit or severely restrict development and homebuilding activity. In addition, noncompliance with these laws and regulations could result in fines and penalties, obligations to remediate, permit revocations or other sanctions; and contamination or other environmental conditions at or in the vicinity of our developments may result in claims against us for personal injury, property damage or other losses.

 

 

 We anticipate that increasingly stringent requirements will be imposed on developers and homebuilders in the future. For example, for a number of years, the EPA and U.S. Army Corps of Engineers have been engaged in rulemakings to clarify the scope of federally regulated wetlands, which included a June 2015 rule many affected businesses contend impermissibly expanded the scope of such wetlands that was challenged in court, stayed, and remains in litigation, a proposal in June 2017 to formally rescind the June 2015 rule and reinstate the rule scheme previously in place while the agencies initiate a new substantive rulemaking on the issue and a February 2018 rule delaying the effective date of the June 2015 rule until February 2020 (which is being challenged in federal court by a number of states). It is unclear how these and related developments, including at the state or local level, ultimately may affect the scope of regulated wetlands where we operate. Although we cannot reliably predict the extent of any effect these developments regarding wetlands, or any other requirements that may take effect may have on us, they could result in time-consuming and expensive compliance programs and in substantial expenditures, which could cause delays and increase our cost of operations. In addition, our ability to obtain or renew permits or approvals and the continued effectiveness of permits already granted or approvals already obtained is dependent upon many factors, some of which are beyond our control, such as changes in policies, rules and regulations and their interpretations and application.

 

In March 2013, we received a letter from the Environmental Protection Agency (“EPA”) requesting information about our involvement in a housing redevelopment project in Newark, New Jersey that a Company entity undertook during the 1990s. We understand that the development is in the vicinity of a former lead smelter and that tests on soil samples from properties within the development conducted by the EPA showed elevated levels of lead. We also understand that the smelter ceased operations many years before the Company entity involved acquired the properties in the area and carried out the re-development project. We responded to the EPA’s request. In August 2013, we were notified that the EPA considers us a potentially responsible party (or “PRP”) with respect to the site, that the EPA will clean up the site, and that the EPA is proposing that we fund and/or contribute towards the cleanup of the contamination at the site. We began preliminary discussions with the EPA concerning a possible resolution but do not know the scope or extent of the Company’s obligations, if any, that may arise from the site and therefore cannot provide any assurance that this matter will not have a material impact on the Company. The EPA requested additional information in April 2014 and again in March 2017 and the Company responded to the information requests. On May 2, 2018 the EPA sent a letter to the Company entity demanding reimbursement for 100% of the EPA’s costs to clean-up the site in the amount of $2.7 million. The Company has requested a 15 day extension to reply to the EPA’s demand letter which extends the time to respond until June 15, 2018. We believe that we have adequate reserves for any potential loss.

  

The Grandview at Riverwalk Port Imperial Condominium Association, Inc. (the “Grandview Plaintiff”) filed a construction defect lawsuit against Hovnanian Enterprises, Inc. and several of its affiliates, including K. Hovnanian at Port Imperial Urban Renewal II, LLC, K. Hovnanian Construction Management, Inc., K. Hovnanian Companies, LLC, K. Hovnanian Enterprises, Inc., K. Hovnanian North East, Inc. aka and/or dba K. Hovnanian Companies North East, Inc., K. Hovnanian Construction II, Inc., K. Hovnanian Cooperative, Inc., K. Hovnanian Developments of New Jersey, Inc., and K. Hovnanian Holdings NJ, LLC, as well as the project architect, the geotechnical engineers and various construction contractors for the project alleging various construction defects, design defects and geotechnical issues totaling approximately $41.3 million. The lawsuit included claims against the geotechnical engineers for differential soil settlement under the building, against the architects for failing to design the correct type of structure allowable under the New Jersey Building Code, and against the Hovnanian-affiliated developer entity (K. Hovnanian at Port Imperial Urban Renewal II, LLC ) alleging that it: (1) had knowledge of and failed to disclose the improper building classification to unit purchasers and was therefore liable for treble damages under the New Jersey Consumer Fraud Act; and (2) breached an express warranty set forth in the Public Offering Statements that the common elements at the building were fit for their intended purpose. The Grandview Plaintiff further alleged that Hovnanian Enterprises, Inc., K. Hovnanian Holdings NJ, LLC, K. Hovnanian Developments of New Jersey, Inc., and K. Hovnanian Developments of New Jersey II, Inc. were jointly liable for any damages owed by the Hovnanian development entity under a veil piercing theory.

 

The parties reached a settlement on the construction defect issues prior to trial, but attempts to settle the subsidence, building classification issue and Consumer Fraud Act claims were unsuccessful. The trial commenced on April 17, 2017 in Hudson County, New Jersey. In the third week of the trial, all of the Hovnanian defendants resolved the geotechnical claims for an amount immaterial to the Company, but the balance of the case continued to be tried before the jury. On June 1, 2017, the jury rendered a verdict against K. Hovnanian at Port Imperial Urban Renewal II, LLC on the breach of warranty and New Jersey Consumer Fraud claims in the total amount of $3 million, which resulted in a total verdict of $9 million against that entity due to statutory trebling, plus a to-be-determined portion of Grandview Plaintiff’s counsel fees, per the statute. The jury also found in favor of Grandview Plaintiff on its veil piercing theory. Certain Hovnanian-affiliated defendants filed post-trial motions on three issues: (1) a motion for a judgment notwithstanding the verdict or a new trial; (2) a motion addressing whether any of the Hovnanian-affiliated entities could be jointly liable under a veil piercing theory for the damages awarded against K. Hovnanian at Port Imperial Urban Renewal II, LLC; and (3) a motion for contractual indemnification against the project architect. On October 27, 2017, the Court addressed a number of post-trial motions. The Court denied the motion for a judgment notwithstanding the verdict or a new trial, and held that Hovnanian Enterprises, Inc. and its affiliate, K. Hovnanian Developments of New Jersey, Inc., are jointly liable for the damages awarded against K. Hovnanian at Port Imperial Urban Renewal II, LLC. On November 18, 2017, the Court awarded approximately $1.8 million in attorney fees and costs to Grandview Plaintiff out of the approximately $4.8 million it had sought. Certain Hovnanian-affiliated defendants filed a motion for reconsideration of the Court’s decision on attorney fees and costs. In an order dated December 15, 2017, the Court granted the motion for reconsideration and reduced its award of attorney fees and costs to approximately $1.4 million. Final judgement in the amount of approximately $10.4 million was entered on January 12, 2018.

 

 

On January 24, 2018, the relevant Hovnanian-affiliated defendants filed a notice of appeal of all aspects of the verdict against them and a motion seeking a stay of execution of the judgement pending appeal. On February 16, 2018, the Court entered an order staying execution of the judgement provided that the Hovnanian-affiliated defendants post a bond in the amount of approximately $11.1 million. On March 9, 2018, the Hovnanian affiliated defendants filed the Court approved bond. On May 23, 2018, the Hovnanian affiliated defendants filed their opening appellate brief. With respect to this case, depending on the outcome of all appeals, the range of loss is between $0 and $11.1 million, inclusive of attorney fees and costs. Management believes that a loss is probable and reasonably estimable and that the Company has reserved for its estimated probable loss amount in its construction defect reserves. However, our assessment of the probable loss may differ from the ultimate resolution of this matter.

 

In 2014, the condominium association of the Grandview II at Riverwalk Port Imperial condominium building (the “Grandview II Plaintiff”) filed a lawsuit in the Superior Court of New Jersey, Law Division, Hudson County (the “Court”) alleging various construction defects, design defects, and geotechnical issues relating to the building along with a claim for piercing the corporate veil as to certain defendants. The operative complaint (“Complaint”) brought claims against Hovnanian Enterprises, Inc. and several of its affiliates, including K. Hovnanian at Port Imperial Urban Renewal III, LLC, PI Investments I, LLC, K. Hovnanian Investments, LLC, K. Hovnanian Homes (not a legal entity but named as a defendant), K. Hovnanian Shore Acquisitions, LLC, K. Hovnanian Construction Management, Inc., K. Hovnanian Companies, LLC, K. Hovnanian Northeast, Inc., K. Hovnanian Enterprises, Inc., K. Hovnanian Construction III, Inc. and K. Hovnanian Cooperative, Inc. The Complaint also brought claims against various other design professionals and contractors. Grandview II Plaintiff asserted damages of approximately $69 million to $79 million, which amount was potentially subject to treble damages. On December 7, 2017, the Court issued orders adjudicating various parties’ motions for summary judgment. The Court issued an order that granted Grandview II Plaintiff’s motion for partial summary judgment on the claim seeking to pierce the corporate veil of K. Hovnanian at Port Imperial Urban Renewal III, LLC and ordered that Hovnanian Enterprises, Inc. shall be jointly and severally liable for any damages awarded against K. Hovnanian at Port Imperial Urban Renewal III, LLC, including any treble damages and attorney fees and costs. The Court also issued an order dismissing Grandview II Plaintiff’s claims for negligence and breach of implied warranties against certain Hovnanian-affiliated defendants. On December 14, 2017, the Hovnanian-affiliated defendants reached a settlement with Grandview II Plaintiff that resolved all claims in the case involving the Hovnanian-affiliated defendants. As of October 31, 2017, the Company had fully reserved for this settlement amount. On December 15, 2017, the Court issued an order dismissing the action. The settlement was paid on March 5, 2018.

  

On December 21, 2016, the members of the Company’s Board were named as defendants in a derivative and class action lawsuit filed in the Delaware Court of Chancery by Plaintiff Joseph Hong (“Plaintiff Hong”). Plaintiff Hong had previously made a demand for inspection of the books and records of the Company pursuant to Delaware law. The Company had provided certain company documents in response to Plaintiff Hong’s demand. The complaint related to the Board of Directors’ decisions to grant Ara K. Hovnanian equity awards in the form of Class B Common Stock, alleging that the defendants breached their fiduciary duties to the Company and its stockholders; that the equity awards granted in Class B Common Stock amounted to corporate waste; and that Ara. K Hovnanian was unjustly enriched by equity awards granted to him in Class B Common Stock. The complaint sought a declaration that the equity awards granted to Ara K. Hovnanian in Class B Common Stock between June 13, 2014 and June 10, 2016 were ultra vires, invalidation or rescission of those awards, injunctive relief, and unspecified damages. 

 

On December 18, 2017, the parties finalized a settlement agreement to resolve the litigation. Pursuant to the settlement agreement, the Company submitted for stockholder approval a resolution to amend the Company’s Certificate of Incorporation to affirm that in the event of a merger, consolidation, acquisition, tender offer, recapitalization, reorganization or other business combination, the same consideration will be provided for shares of Class A Common Stock and Class B Common Stock unless different treatment of the shares of each such class is approved separately by a majority of each class. The amendment was approved by the Company's shareholders at its Annual Meeting held on March 13, 2018. The Company has also agreed to implement certain operational and corporate governance measures regarding the granting of equity awards in Class B Common Stock. The Court approved the settlement on May 4, 2018 and the Company paid the Plaintiff’s attorney fees in the amount of $275,000 on May 10, 2018.

 

On January 11, 2018, Solus Alternative Asset Management LP (“Solus”) filed a complaint in the United States District Court for the Southern District of New York against GSO Capital Partners L.P., Hovnanian Enterprises, Inc. (“Hovnanian”), K. Hovnanian Enterprises, Inc. (“K. Hovnanian”), K. Hovnanian at Sunrise Trail III, LLC (“Sunrise Trail”), Ara K. Hovnanian and J. Larry Sorsby. The complaint related to K. Hovnanian’s offer to exchange up to $185.0 million aggregate principal amount of its 8.0% Senior Notes due 2019 for a combination of (i) cash, (ii) K. Hovnanian’s newly issued 13.5% Senior Notes due 2026 and (iii) K. Hovnanian’s newly issued 5.0% Senior Notes due 2040 and related transactions that were previously disclosed in Hovnanian’s Current Report on Form 8-K filed on December 28, 2017. The complaint alleged, among other things, inadequate disclosure in the exchange offer documents, improper and fraudulent structuring of the transactions to impact the credit default swap market, violations of Sections 10(b), 14(e) and 20(a) of the Securities Exchange Act of 1934, and tortious interference with prospective economic advantage. Solus sought, among other things, additional disclosures regarding the transactions, compensatory and punitive damages, and a preliminary and permanent injunction to stop the transactions from going forward. The court held a hearing on Solus’ motion for a preliminary injunction on January 25, 2018. On January 29, 2018, the court denied the motion, finding that Solus failed to show that it would be irreparably harmed in the absence of an injunction. 

 

 

Solus filed an amended complaint on February 1, 2018, against the same defendants. Like the initial complaint, the amended complaint alleges improper and fraudulent structuring of the transactions to impact the credit default swap market, violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and tortious interference with prospective economic advantage. Solus no longer asserts inadequate disclosure claims under Sections 10(b) and 14(e). In place of injunctive relief, Solus sought a declaratory judgment that Sunrise Trail III, LLC has waived its entitlement to interest payments under the indenture governing the 8.0% Senior Notes due 2019 and that the exchange offer breached this indenture. The defendants moved to dismiss the amended complaint on March 2, 2018. On May 30, 2018, the parties signed a stipulation of dismissal of all claims with prejudice.  As part of the case resolution, on May 30, 2018, K. Hovnanian paid the overdue interest on the 8.0% Senior Notes due 2019 held by Sunrise Trail that was originally due on May 1, 2018.  The case resolution does not involve any settlement payment or admission of wrongdoing by any of the Hovnanian-related parties.  On May 31, 2018, the Court so-ordered the stipulation and closed the case.

 

Hovnanian is actively seeking insurance coverage for the litigation costs related to the Solus claims.

 

 

8.

Cash and Cash Equivalents, Restricted Cash and Cash Equivalents and Customer's Deposits

 

Cash represents cash deposited in checking accounts. Cash equivalents include certificates of deposit, Treasury bills and government money–market funds with maturities of 90 days or less when purchased. Our cash balances are held at a few financial institutions and may, at times, exceed insurable amounts. We believe we help to mitigate this risk by depositing our cash in major financial institutions. At April 30, 2018 and October 31, 2017, $11.9 million and $13.3 million, respectively, of the total cash and cash equivalents was in cash equivalents, the book value of which approximates fair value.

 

Homebuilding - Restricted cash and cash equivalents on the Condensed Consolidated Balance Sheets totaled $14.0 million and $2.1 million as of April 30, 2018 and October 31, 2017, respectively, which included cash collateralizing our letter of credit agreements and facilities as discussed in Note 11. Also included in these balances were homebuilding customers’ deposits of $0.2 million and $0.4 million at April 30, 2018 and October 31, 2017, respectively, which are subject to restrictions on our use. The April 30, 2018 balance also included cash collateral of $11.1 million for a bond related to the Grandview litigation as discussed in Note 7.

 

Financial services restricted cash and cash equivalents, which are included in Financial services other assets on the Condensed Consolidated Balance Sheets, totaled $25.2 million and $22.3 million as of April 30, 2018 and October 31, 2017, respectively. Included in these balances were (1) financial services customers’ deposits of $23.2 million at April 30, 2018 and $20.0 million as of October 31, 2017, which are subject to restrictions on our use, and (2) $2.0 million at April 30, 2018 and $2.3 million at October 31, 2017, respectively, of restricted cash under the terms of our mortgage warehouse lines of credit.

 

Total Homebuilding Customers’ deposits are shown as a liability on the Condensed Consolidated Balance Sheets. These liabilities are significantly more than the applicable periods’ restricted cash balances because in some states the deposits are not restricted from use and, in other states, we are able to release the majority of these customer deposits to cash by pledging letters of credit and surety bonds.

 

 

9.

Mortgage Loans Held for Sale

 

Our wholly owned mortgage banking subsidiary, K. Hovnanian American Mortgage, LLC (“K. Hovnanian Mortgage”) originates mortgage loans, primarily from the sale of our homes. Such mortgage loans are sold in the secondary mortgage market within a short period of time of origination. Mortgage loans held for sale consist primarily of single-family residential loans collateralized by the underlying property. We have elected the fair value option to record loans held for sale and therefore these loans are recorded at fair value with the changes in the value recognized in the Condensed Consolidated Statements of Operations in “Revenues: Financial services.” We currently use forward sales of mortgage-backed securities (“MBS”), interest rate commitments from borrowers and mandatory and/or best efforts forward commitments to sell loans to third-party purchasers to protect us from interest rate fluctuations. These short-term instruments, which do not require any payments to be made to the counterparty or purchaser in connection with the execution of the commitments, are recorded at fair value. Gains and losses on changes in the fair value are recognized in the Condensed Consolidated Statements of Operations in “Revenues: Financial services.”

 

At April 30, 2018 and October 31, 2017, $72.7 million and $119.6 million, respectively, of mortgages held for sale were pledged against our mortgage warehouse lines of credit (see Note 10). We may incur losses with respect to mortgages that were previously sold that are delinquent and which had underwriting defects, but only to the extent the losses are not covered by mortgage insurance or resale value of the home. The reserves for these estimated losses are included in the “Financial services” liability balances on the Condensed Consolidated Balance Sheets. As of April 30, 2018 and 2017, we had reserves specifically for 45 and 94 identified mortgage loans, respectively, as well as reserves for an estimate for future losses on mortgages sold but not yet identified to us. In fiscal 2017, the adjustment to pre-existing provisions for losses from changes in estimates is primarily due to the settlement of a dispute for significantly less than the amount that had been previously reserved.

 

 

The activity in our loan origination reserves during the three and six months ended April 30, 2018 and 2017 was as follows:

 

   

Three Months Ended

April 30,

   

Six Months Ended

April 30,

 

(In thousands)

 

2018

   

2017

   

2018

   

2017

 
                                 

Loan origination reserves, beginning of period

  $ 3,188     $ 5,077     $ 3,158     $ 8,137  

Provisions for losses during the period

    38       45       68       79  

Adjustments to pre-existing provisions for losses from changes in estimates

    45       (1,340

)

    45       (4,434

)

Loan origination reserves, end of period

  $ 3,271     $ 3,782     $ 3,271     $ 3,782  

 

 

10.

Mortgages

 

We have nonrecourse mortgage loans for certain communities totaling $70.6 million and $64.5 million (net of debt issuance costs) at April 30, 2018 and October 31, 2017, respectively, which are secured by the related real property, including any improvements, with an aggregate book value of $179.1 million and $157.8 million, respectively. The weighted-average interest rate on these obligations was 5.5% and 5.3% at April 30, 2018 and October 31, 2017, respectively, and the mortgage loan payments on each community primarily correspond to home deliveries. We also had nonrecourse mortgage loans on our corporate headquarters totaling $13.0 million at October 31, 2017. On November 1, 2017, these loans were paid in full in connection with the sale of our corporate headquarters building.

    

K. Hovnanian Mortgage originates mortgage loans primarily from the sale of our homes. Such mortgage loans and related servicing rights are sold in the secondary mortgage market within a short period of time. In certain instances, we retain the servicing rights for a small amount of loans. K. Hovnanian Mortgage finances the origination of mortgage loans through various master repurchase agreements, which are recorded in financial services liabilities on the Condensed Consolidated Balance Sheets.

 

Our secured Master Repurchase Agreement with JPMorgan Chase Bank, N.A. (“Chase Master Repurchase Agreement”), is a short-term borrowing facility that provides up to $50.0 million through its maturity on January 31, 2019. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable monthly on outstanding advances at an adjusted LIBOR rate, which was 1.91% at April 30, 2018, plus the applicable margin of 2.5% or 2.63% based upon type of loan. As of April 30, 2018 and October 31, 2017, the aggregate principal amount of all borrowings outstanding under the Chase Master Repurchase Agreement was $29.2 million and $41.5 million, respectively.

   

K. Hovnanian Mortgage has another secured Master Repurchase Agreement with Customers Bank (“Customers Master Repurchase Agreement”), which was amended on February 16, 2018. The Customers Master Repurchase Agreement is a short-term borrowing facility that provides up to $50.0 million through its maturity on February 15, 2019. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable daily or as loans are sold to permanent investors on outstanding advances at the current LIBOR rate, plus the applicable margin ranging from 2.375% to 5.125% based on the type of loan and the number of days outstanding on the warehouse line. As of April 30, 2018 and October 31, 2017, the aggregate principal amount of all borrowings outstanding under the Customers Master Repurchase Agreement was $23.9 million and $40.7 million, respectively.

 

K. Hovnanian Mortgage also has a secured Master Repurchase Agreement with Comerica Bank (“Comerica Master Repurchase Agreement”), which is a short-term borrowing facility that provides up to $50.0 million through December 20, 2018. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable monthly at the current LIBOR rate, subject to a floor of .25%, plus the applicable margin of 2.375%. As of April 30, 2018 and October 31, 2017, the aggregate principal amount of all borrowings outstanding under the Comerica Master Repurchase Agreement was $18.0 million and $32.4 million, respectively.

 

The Chase Master Repurchase Agreement, Customers Master Repurchase Agreement and Comerica Master Repurchase Agreement (together, the “Master Repurchase Agreements”) require K. Hovnanian Mortgage to satisfy and maintain specified financial ratios and other financial condition tests. Because of the extremely short period of time mortgages are held by K. Hovnanian Mortgage before the mortgages are sold to investors (generally a period of a few weeks), the immateriality to us on a consolidated basis of the size of the Master Repurchase Agreements, the levels required by these financial covenants, our ability based on our immediately available resources to contribute sufficient capital to cure any default, were such conditions to occur, and our right to cure any conditions of default based on the terms of the applicable agreement, we do not consider any of these covenants to be substantive or material. As of April 30, 2018, we believe we were in compliance with the covenants under the Master Repurchase Agreements.

 

 

 

11.

Senior Notes and Credit Facilities

 

Senior notes and credit facilities balances as of April 30, 2018 and October 31, 2017, were as follows:

 

 

(In thousands)

 

April 30,

2018(1)(2)

   

October 31,

2017(1)(2)

 

Senior Secured Term Loan due 2019, net of debt issuance costs

  $ 73,562     $ 72,987  

Senior Secured Notes:

               

9.5% Senior Secured Notes due November 15, 2020

  $ 74,456     $ 74,350  

2.0% Senior Secured Notes due November 1, 2021 (net of discount)

    53,076       53,058  

5.0% Senior Secured Notes due November 1, 2021 (net of discount)

    134,638       133,732  

10.0% Senior Secured Notes due July 15, 2022

    434,855       434,543  

10.5% Senior Secured Notes due July 15, 2024

    394,278       394,953  

Total Senior Secured Notes, net of debt issuance costs

  $ 1,091,303     $ 1,090,636  

Senior Notes:

               

7.0% Senior Notes due January 15, 2019

  $ -     $ 131,957  

8.0% Senior Notes due November 1, 2019

    65,386       234,293  

13.5% Senior Notes due February 1, 2026 (including premium)

    101,829       -  

5.0% Senior Notes due February 1, 2040 (net of discount)

    43,193       -  

Total Senior Notes, net of debt issuance costs

  $ 210,408     $ 366,250  

11.0% Senior Amortizing Notes due December 1, 2017, net of debt issuance costs

  $ -     $ 2,045  

Senior Exchangeable Notes due December 1, 2017, net of debt issuance costs

  $ -     $ 53,919  

Senior Unsecured Term Loan Credit Facility due 2027, net of debt issuance costs

  $ 131,567     $ -  

Unsecured Revolving Credit Facility

  $ 52,000     $ 52,000  

 

(1) “Notes payable” on our Condensed Consolidated Balance Sheets as of April 30, 2018 and October 31, 2017 consists of the total senior secured, senior and senior amortizing and senior exchangeable notes shown above, as well as accrued interest of $38.5 million and $41.8 million, respectively.

 

(2) Unamortized debt issuance costs at April 30, 2018 and October 31, 2017 were $16.6 million and $16.1 million, respectively.

 

General

 

Except for K. Hovnanian, the issuer of the notes and borrower under our credit facilities, our home mortgage subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures and certain of our title insurance subsidiaries, we and each of our subsidiaries are guarantors of the Secured Term Loan Facility (as defined below), the Unsecured Term Loan Facility (as defined below), the Unsecured Revolving Credit Facility (as defined below) and the senior secured notes and senior notes outstanding at April 30, 2018 (collectively, the “Notes Guarantors”). In addition to the Notes Guarantors, the 5.0% Senior Secured Notes due 2021 (the “5.0% 2021 Notes”), the 2.0% Senior Secured Notes due 2021 (the “2.0% 2021 Notes” and together with the 5.0% 2021 Notes, the “2021 Notes”) and the 9.5% 2020 Notes (defined below) collectively with the 2021 Notes, the “JV Holdings Secured Group Notes”) are guaranteed by K. Hovnanian JV Holdings, L.L.C. and its subsidiaries, except for certain joint ventures and joint venture holding companies (collectively, the “JV Holdings Secured Group”). Members of the JV Holdings Secured Group do not guarantee K. Hovnanian's other indebtedness.

 

 

The credit agreements governing the Secured Term Loan Facility, the Unsecured Term Loan Facility, the Unsecured Revolving Credit Facility (collectively, the “credit facilities”) and the indentures governing the notes outstanding at April 30, 2018 do not contain any financial maintenance covenants, but do contain restrictive covenants that limit, among other things, the Company’s ability and that of certain of its subsidiaries, including K. Hovnanian, to incur additional indebtedness (other than nonrecourse indebtedness, certain permitted indebtedness and refinancing indebtedness (under the Secured Term Loans (as defined below) and the 9.5% 2020 Notes, any new or refinancing indebtedness may not be scheduled to mature earlier than January 15, 2021 (so long as no member of the JV Holdings Secured Group is an obligor thereon), or February 15, 2021 (if otherwise), and under the 10.0% Senior Secured Notes due 2022 (the “10.0% 2022 Notes”), any refinancing indebtedness of the 7.0% Senior Notes due 2019 (the “7.0% Notes”) (which includes the Unsecured Term Loans (as defined below)) and 8.0% Senior Notes due 2019 (the “8.0% Notes” and together with the 7.0% Notes, the “2019 Notes”) (which includes the New Notes (as defined below) and the Unsecured Term Loans) may not be scheduled to mature earlier than July 16, 2024 (such restrictive covenant in respect of the 10.5% Senior Secured Notes due 2024 (the “10.5% 2024 Notes”) was eliminated as described below under “—Fiscal 2018”)), pay dividends and make distributions on common and preferred stock, repurchase subordinated indebtedness (with respect to the credit facilities and certain of the senior secured and senior notes) and common and preferred stock, make other restricted payments, including investments, sell certain assets (including in certain land banking transactions), incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all assets, enter into certain transactions with affiliates and make cash repayments of the 2019 Notes and refinancing indebtedness in respect thereof  (with respect to the 10.0% 2022 Notes). The credit agreements governing the Secured Term Loan Facility, the Unsecured Term Loan Facility and the Unsecured Revolving Credit Facility and the indentures governing the notes also contain events of default which would permit the lenders/holders thereof to exercise remedies with respect to the collateral (as applicable), declare the loans made under the Secured Term Loan Facility (the “Secured Term Loans”), loans made under the Unsecured Term Loan Facility (the “Unsecured Term Loans”) and loans made under the Unsecured Revolving Credit Facility (the “Unsecured Loans”)/notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the Secured Term Loans, the Unsecured Term Loans or Unsecured Loans/notes or other material indebtedness, cross default to other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy and insolvency, with respect to the Secured Term Loans, the Unsecured Term Loans and the Unsecured Loans, material inaccuracy of representations and warranties and with respect to the Secured Term Loans and the Unsecured Term Loans, a change of control, and, with respect to the Secured Term Loans and senior secured notes, the failure of the documents granting security for the Secured Term Loans and senior secured notes to be in full force and effect, and the failure of the liens on any material portion of the collateral securing the Secured Term Loans and senior secured notes to be valid and perfected. As of April 30, 2018, we believe we were in compliance with the covenants of the credit facilities and the indentures governing our outstanding notes.

 

If our consolidated fixed charge coverage ratio, as defined in the agreements governing our debt instruments, is less than 2.0 to 1.0, we are restricted from making certain payments, including dividends, and from incurring indebtedness other than certain permitted indebtedness, refinancing indebtedness and nonrecourse indebtedness. As a result of this ratio restriction, we are currently restricted from paying dividends, which are not cumulative, on our 7.625% Series A Preferred Stock. We anticipate that we will continue to be restricted from paying dividends for the foreseeable future. Our inability to pay dividends is in accordance with covenant restrictions and will not result in a default under our debt instruments or otherwise affect compliance with any of the covenants contained in our debt instruments.

 

Under the terms of our debt agreements, we have the right to make certain redemptions and prepayments and, depending on market conditions and covenant restrictions, may do so from time to time. We also continue to evaluate our capital structure and may also continue to make debt purchases and/or exchanges for debt or equity from time to time through tender offers, open market purchases, private transactions, or otherwise, or seek to raise additional debt or equity capital, depending on market conditions and covenant restrictions.

 

Any liquidity-enhancing transaction will depend on identifying counterparties, negotiation of documentation and applicable closing conditions and any required approvals. Due to covenant restrictions in our debt instruments, we are currently limited in the amount of debt we can incur that does not qualify as refinancing indebtedness with certain maturity requirements as discussed above (a limitation that we expect to continue for the foreseeable future), even if market conditions would otherwise be favorable, which could also impact our ability to grow our business.

 

Fiscal 2018

 

On December 1, 2017, our 6.0% Senior Exchangeable Note Units were paid in full, which units consisted of $53.9 million principal amount of our Senior Exchangeable Notes that matured and the final installment payment of $2.1 million on our 11.0% Senior Amortizing Notes.

 

On December 28, 2017, the Company and K. Hovnanian announced that they had entered into a commitment letter (the “Commitment Letter”) in respect of certain financing transactions with GSO Capital Partners LP on its own behalf and on behalf of one or more funds managed, advised or sub-advised by GSO (collectively, the “GSO Entities”), and had commenced a private offer to exchange with respect to the 8.0% Notes (the “Exchange Offer”).

 

Pursuant to the Commitment Letter, the GSO Entities agreed to, among other things, provide the principal amount of the following: (i) a senior unsecured term loan credit facility (the “Unsecured Term Loan Facility”) to be borrowed by K. Hovnanian and guaranteed by the Company and the Notes Guarantors, pursuant to which the GSO Entities committed to lend K. Hovnanian Unsecured Term Loans consisting of $132.5 million of initial term loans (the “Initial Term Loans”) on the settlement date of the Exchange Offer for purposes of refinancing K. Hovnanian’s 7.0% Notes, and up to $80.0 million of delayed draw term loans (the “Delayed Draw Term Loans”) for purposes of refinancing certain of K. Hovnanian’s 8.0% Notes, in each case, upon the terms and subject to the conditions set forth therein, and (ii) a senior secured first lien credit facility (the “New Secured Credit Facility” and together with the Unsecured Term Loan Facility, the “New Credit Facilities”) to be borrowed by K. Hovnanian and guaranteed by the Notes Guarantors, pursuant to which the GSO Entities have committed to lend to K. Hovnanian up to $125.0 million of senior secured first priority loans (the “New Secured Loans”) to fund the repayment of K. Hovnanian’s Secured Term Loans and for general corporate purposes, upon the terms and subject to the conditions set forth therein. In addition, pursuant to the Commitment Letter, the GSO Entities have committed to purchase, and K. Hovnanian has agreed to issue and sell, on January 15, 2019 (or such later date within five business days as mutually agreed by the parties working in good faith), $25.0 million in aggregate principal amount of additional 10.5% 2024 Notes (the “Additional 10.5% 2024 Notes”) at a purchase price, for each $1,000 principal amount of Additional 10.5% 2024 Notes, that would imply a yield equal to (a) the volume weighted average yield to maturity (calculated based on the yield to maturity during the 30 calendar day period ending on one business day prior to January 15, 2019) for the 10.5% 2024 Notes, minus (b) 0.50%, upon the terms and subject to conditions set forth therein.

 

 

On January 29, 2018, K. Hovnanian, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent, and the GSO Entities entered into the Unsecured Term Loan Facility. K. Hovnanian borrowed the Initial Term Loans on February 1, 2018 to fund, together with cash on hand, the redemption on February 1, 2018 of all $132.5 million aggregate principal amount of 7.0% Notes, which resulted in a loss on extinguishment of debt of $0.5 million. The New Term Loans bear interest at a rate equal to 5.0% per annum and interest will be payable in arrears, on the last business day of each fiscal quarter. The New Term Loans will mature on February 1, 2027, which is the ninth anniversary of the first closing date of the Unsecured Term Loan Facility.

  

On January 29, 2018, K. Hovnanian, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent (the “Secured Administrative Agent”), and the GSO Entities entered into the New Secured Credit Facility. Availability under the New Secured Credit Facility will terminate on December 28, 2019 and any outstanding New Secured Loans on such date shall convert to secured term loans maturing on December 28, 2022. When available to be drawn, the New Secured Loans and the guarantees thereof will be secured by substantially all of the assets owned by K. Hovnanian and the Notes Guarantors, subject to permitted liens and certain exceptions, on a first lien basis relative to the liens securing K. Hovnanian’s 10.0% 2022 Notes and 10.5% 2024 Notes pursuant to an existing intercreditor agreement to which the collateral agent for the New Secured Credit Facility shall become a party.

 

 The Secured Loans will bear interest at a rate per annum equal to the lesser of (a) 10.0% per annum and (b) (i) the volume weighted average yield (calculated based on the yield to maturity during the 30 calendar day period ending on the business day before the closing date of the first borrowings under the New Secured Credit Facility (the “Applicable Period”)) of the 10.5% 2024 Notes, if available, or if such rate is not available for the 10.5% 2024 Notes, such rate in respect of K. Hovnanian’s secured debt securities having the largest traded volume during the Applicable Period (the “VWAY Rate”), minus (ii) 0.50%, and interest will be payable in arrears, on the last business day of each fiscal quarter. If adequate and reasonable means do not exist for ascertaining the VWAY Rate as set forth in the preceding sentence, it shall instead be the rate calculated using the average of three quotations for the 10.5% 2024 Notes provided by three brokers of recognized standing.

 

The New Secured Credit Facility contains representations and warranties, with the accuracy of certain specified representations and warranties being a condition to the funding of the New Secured Loans on each date of funding, and affirmative and restrictive covenants that limit, among other things, and in each case subject to certain exceptions, the ability of the Company and certain of its subsidiaries, including K. Hovnanian, to incur additional indebtedness, pay dividends and make distributions on common and preferred stock, repurchase subordinated indebtedness and common and preferred stock, make other restricted payments, including investments, sell certain assets, incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all of its assets and enter into certain transactions with affiliates. The New Secured Credit Facility also contains customary events of default which would permit the Secured Administrative Agent thereunder to exercise remedies with respect to the collateral securing the New Secured Loans and declare New Secured Loans to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the New Secured Loans, including any interest and fees due in connection therewith, or other material indebtedness, the failure to satisfy covenants, the material inaccuracy of representations or warranties made, cross acceleration to other material indebtedness, and specified events of bankruptcy and insolvency.

 

The terms and covenants of the New Secured Credit Facility are effective as of January 29, 2018, the date of execution of the New Secured Credit Facility. However, the obligations of the lenders thereunder to make New Secured Loans under the New Secured Credit Facility on the applicable borrowing dates are subject to the satisfaction of certain terms and conditions precedent set forth therein, including requiring K. Hovnanian to use the net cash proceeds therefrom to repay K. Hovnanian’s Secured Term Loan Facility.

 

 

On February 1, 2018, K. Hovnanian accepted all of the $170.2 million aggregate principal amount of 8.0% Notes validly tendered and not validly withdrawn in the Exchange Offer (representing 72.14% of the aggregate principal amount of 8.0% Notes outstanding prior to the Exchange Offer) and issued $90.6 million aggregate principal amount of its 13.5% Senior Notes due 2026 (the “New 2026 Notes”) and $90.1 million aggregate principal amount of its 5.0% Senior Notes due 2040 (the “New 2040 Notes” and together with the New 2026 Notes, the “New Notes”) under a new Indenture. Also, as part of the Exchange Offer, on February 1, 2018, K. Hovnanian at Sunrise Trail III, LLC, a wholly-owned subsidiary of the Company (the “Subsidiary Purchaser”), purchased for $26.5 million in cash an aggregate of $26.0 million in principal amount of the 8.0% Notes (the “Purchased 8.0% Notes”). The New Notes are issued by K. Hovnanian and guaranteed by the Notes Guarantors, except the Subsidiary Purchaser, which does not guarantee the New Notes. The New 2026 Notes bear interest at 13.5% per annum and mature on February 1, 2026. The New 2040 Notes bear interest at 5.0% per annum and mature on February 1, 2040. Interest on the New Notes is payable semi-annually on February 1 and August 1 of each year, beginning on August 1, 2018, to holders of record at the close of business on January 15 or July 15, as the case may be, immediately preceding each such interest payment date. The Exchange Offer was treated as a substantial modification of debt. The New Notes were recorded at fair value (based on management's estimate using available trades for similar debt instruments) on the date of the issuance of the New Notes, which equaled $103.0 million for the New 2026 Notes and $44.0 million for the New 2040 Notes, resulting in a premium on the New 2026 Notes and a discount on the New 2040 Notes, and a loss on extinguishment of debt of $0.9 million for the three and six months ended April 30, 2018.

 

On May 30, 2018, K. Hovnanian, the Notes Guarantors and Wilmington Trust, National Association, as Trustee, executed the Second Supplemental Indenture, dated as of May 30, 2018 (the “Supplemental Indenture”), to the Indenture governing the New Notes.  The Supplemental Indenture eliminates the covenant restricting certain actions with respect to the Purchased 8.0% Notes, which covenant had included requirements that (A) K. Hovnanian and the guarantors of the New Notes would not, (i) prior to June 6, 2018, redeem, cancel or otherwise retire, purchase or acquire any Purchased 8.0% Notes or (ii) make any interest payments on the Purchased 8.0% Notes prior to their stated maturity, and (B) K. Hovnanian and the guarantors of the New Notes would not, and would not permit any of their subsidiaries to (i) sell, transfer, convey, lease or otherwise dispose of any Purchased 8.0% Notes other than to any subsidiary of the Company that is not K. Hovnanian or a guarantor of the New Notes or (ii) amend, supplement or otherwise modify the Purchased 8.0% Notes or the indenture under which they were issued with respect to the Purchased 8.0% Notes, subject to certain exceptions. In addition, the Supplemental Indenture eliminates events of default related to the eliminated covenant.  On May 30, 2018, K. Hovnanian paid the overdue interest on the Purchased 8.0% Notes that was originally due on May 1, 2018 and as a result of such payment, the “Default” under the Indenture governing the 8.0% Notes was cured.

On January 16, 2018, K. Hovnanian, Notes Guarantors and Wilmington Trust, National Association, as Trustee and Collateral Agent, executed the Second Supplemental Indenture, dated as of January 16, 2018, to the indenture governing the 10.0% 2022 Notes and 10.5% 2024 Notes, dated as of July 27, 2017 (as supplemented, amended or otherwise modified), among K. Hovnanian, the Notes Guarantors and Wilmington Trust, National Association, as Trustee and Collateral Agent, giving effect to the proposed amendments to such indenture solely with respect to the 10.5% 2024 Notes, which were obtained in a consent solicitation of the holders of the 10.5% 2024 Notes, and which eliminated the restrictions on K. Hovnanian’s ability to purchase, repurchase, redeem, acquire or retire for value the 2019 Notes and refinancing or replacement indebtedness in respect thereof.

 

Secured Obligations

 

Our $75.0 million Secured Term Loan Facility (the “Secured Term Loan Facility”) has a maturity of August 1, 2019 and bears interest at a rate equal to LIBOR plus an applicable margin of 7.0% or, at K. Hovnanian’s option, a base rate plus an applicable margin of 6.0%, payable monthly. At any time from and after September 8, 2018, K. Hovnanian may voluntarily repay outstanding Secured Term Loans, provided that voluntary prepayments of Eurodollar loans made on a date other than the last day of an interest period applicable thereto are subject to customary breakage costs and voluntary prepayments made prior to February 1, 2019 are subject to a premium equal to 1.0% of the aggregate principal amount of the Secured Term Loans so prepaid (any prepayment of the Secured Term Loans made on or after February 1, 2019 are without any prepayment premium).

 

The 10.0% 2022 Notes have a maturity of July 15, 2022 and bear interest at a rate of 10.0% per annum payable semi-annually on January 15 and July 15 of each year, to holders of record at the close of business on January 1 and July 1, as the case may be, immediately preceding such interest payment dates. The 10.0% 2022 Notes are redeemable in whole or in part at our option at any time prior to July 15, 2019 at 100.0% of their principal amount plus an applicable “Make-Whole Amount.” K. Hovnanian may also redeem some or all of the 10.0% 2022 Notes at 105.0% of principal commencing July 15, 2019, at 102.50% of principal commencing July 15, 2020 and at 100.0% of principal commencing July 15, 2021. In addition, K. Hovnanian may also redeem up to 35.0% of the aggregate principal amount of the 10.0% 2022 Notes prior to July 15, 2019 with the net cash proceeds from certain equity offerings at 110.0% of principal.

 

The 10.5% 2024 Notes have a maturity of July 15, 2024 and bear interest at a rate of 10.5% per annum payable semi-annually on January 15 and July 15 of each year, to holders of record at the close of business on January 1 and July 1, as the case may be, immediately preceding such interest payment dates. The 10.5% 2024 Notes are redeemable in whole or in part at our option at any time prior to July 15, 2020 at 100.0% of their principal amount plus an applicable “Make-Whole Amount.” K. Hovnanian may also redeem some or all of the 10.5% 2024 Notes at 105.25% of principal commencing July 15, 2020, at 102.625% of principal commencing July 15, 2021 and at 100.0% of principal commencing July 15, 2022. In addition, K. Hovnanian may also redeem up to 35.0% of the aggregate principal amount of the 10.5% 2024 Notes prior to July 15, 2020 with the net cash proceeds from certain equity offerings at 110.50% of principal.

 

All of K. Hovnanian’s obligations under the Secured Term Loan Facility are guaranteed by the Notes Guarantors. The Secured Term Loan Facility and the guarantees thereof are secured, subject to permitted liens and other exceptions, on a first lien priority basis relative to the 10.0% 2022 Notes and the 10.5% 2024 Notes (and on a first lien super priority basis relative to future first lien indebtedness). At April 30, 2018, the aggregate book value of the real property that constituted collateral securing the Secured Term Loans was $483.4 million, which does not include the impact of inventory investments, home deliveries or impairments thereafter and which may differ from the value if it were appraised. Cash and cash equivalents collateral that secured the Secured Term Loans was $164.8 million as of April 30, 2018, which included $12.8 million of restricted cash collateralizing a bond and certain letters of credit. Subsequent to such date, fluctuations as a result of cash uses include general business operations and real estate and other investments along with cash inflow primarily from deliveries. In addition, collateral securing the Secured Term Loans includes equity interest in K Hovnanian and the subsidiary Notes Guarantors.

 

All of K. Hovnanian’s obligations under the 10.0% 2022 Notes and the 10.5% 2024 Notes are guaranteed by the Notes Guarantors. In addition to pledges of the equity interests in K. Hovnanian and the subsidiary Notes Guarantors which secure the 10.0% 2022 Notes and the 10.5% 2024 Notes, the 10.0% 2022 Notes and the 10.5% 2024 Notes and the guarantees thereof are also secured in accordance with the terms of the indenture and security documents governing such Notes by pari passu liens on substantially all of the assets owned by K. Hovnanian and the Notes Guarantors, in each case subject to permitted liens and certain exceptions (the collateral securing the 10.0% 2022 Notes and the 10.5% 2024 Notes is the same as that securing the Secured Term Loans). The liens securing the 10.0% 2022 Notes and the 10.5% 2024 Notes rank junior to the liens securing the Secured Term Loans and any other future secured obligations that are senior in priority with respect to the assets securing the 10.0% 2022 Notes and the 10.5% 2024 Notes.

 

 

Our 9.5% Senior Secured Notes (the “9.5% 2020 Notes”) have a maturity of November 15, 2020, and bear interest at a rate of 9.5% per annum, payable semi-annually on February 15 and August 15 of each year, to holders of record at the close of business on February 1 and August 1, as the case may be, immediately preceding such interest payment dates. The 9.5% 2020 Notes are redeemable in whole or in part at our option at any time prior to November 15, 2018 at 100% of their principal amount plus an applicable “Make-Whole Amount.” At any time and from time to time on or after November 15, 2018, K. Hovnanian may also redeem some or all of the 9.5% 2020 Notes at a redemption price equal to 100% of their principal amount. In addition, we may also redeem up to 35% of the aggregate principal amount of the 9.5% 2020 Notes prior to November 15, 2018 with the net cash proceeds from certain equity offerings at 109.5% of principal.

 

The 5.0% 2021 Notes and the 2.0% 2021 Notes were issued as separate series under an indenture, but have substantially the same terms other than with respect to interest rate and related redemption provisions, and vote together as a single class. The 5.0% 2021 Notes bear interest at a rate of 5.0% per annum and mature on November 1, 2021 and the 2.0% 2021 Notes bear interest at a rate of 2.0% per annum and mature on November 1, 2021. Interest on the 2021 Notes is payable semi-annually on May 1 and November 1 of each year, to holders of record at the close of business on April 15 and October 15, as the case may be, immediately preceding such interest payment dates. The 2021 Notes are redeemable in whole or in part at our option at any time, at 100.0% of the principal amount plus the greater of 1% of the principal amount and an applicable “Make-Whole Amount.”

 

The 9.5% 2020 Notes and the 2021 Notes are guaranteed by the Notes Guarantors and the members of the JV Holdings Secured Group. The guarantees of the JV Holdings Secured Group with respect to the 2021 Notes and the 9.50% 2020 Notes are secured, subject to permitted liens and other exceptions, by a first-priority lien on substantially all of the assets of the members of the JV Holdings Secured Group. As of April 30, 2018, the collateral securing the guarantees included (1) $97.9 million of cash and cash equivalents, which included $1.0 million of restricted cash collateralizing certain letters of credit (subsequent to such date, fluctuations as a result of cash uses include general business operations and real estate and other investments along with cash inflow primarily from deliveries); (2) $139.3 million aggregate book value of real property of the JV Holdings Secured Group, which does not include the impact of inventory investments, home deliveries or impairments thereafter and which may differ from the value if it were appraised; and (3) equity interests owned by guarantors that are members of the JV Holdings Secured Group. Members of the JV Holdings Secured Group also own equity in joint ventures, either directly or indirectly through ownership of joint venture holding companies, with a book value of $79.2 million as of April 30, 2018; this equity is not pledged to secure, and is not collateral for, the 2021 Notes. Members of the JV Holdings Secured Group are “unrestricted subsidiaries” under K. Hovnanian's other senior secured notes and senior notes, the Unsecured Revolving Credit Facility, the Unsecured Term Loan Facility and the Secured Term Loan Facility, and thus have not guaranteed such indebtedness. 

 

Senior Notes

 

On February 1, 2018, K. Hovnanian borrowed the Initial Term Loans in the amount of $132.5 million under the Unsecured Term Loan Facility, and proceeds of such Initial Term Loans, together with cash on hand, were used to redeem all of its outstanding $132.5 million aggregate principal amount of 7.0% Notes (upon redemption, all 7.0% Notes were cancelled).  

 

K. Hovnanian’s 8.0% Notes are redeemable in whole or in part at K. Hovnanian’s option at any time prior to August 1, 2019 at a redemption price equal to 100.0% of their principal amount plus an applicable “Make-Whole Amount.” At any time and from time to time on or after August 1, 2019, K. Hovnanian may also redeem some or all of the 8.0% Notes at a redemption price equal to 100.0% of their principal amount. As discussed above, the 8.0% Notes were the subject of the Exchange Offer that closed on February 1, 2018 and, as discussed in Note 21, K. Hovnanian called for redemption on May 28, 2018, $65.7 million aggregate principal amount of the 8.0% Notes, which redemption was funded with borrowings of the Delayed Draw Term Loans under the Unsecured Term Loan Facility (upon redemption, such redeemed 8.0% Notes were cancelled). Following the redemption, the outstanding 8.0% Notes consist of the Purchased 8.0% Notes.

 

 

 

 

Unsecured Revolving Credit Facility

 

In June 2013, K. Hovnanian, as borrower, and we and certain of our subsidiaries, as guarantors, entered into a five-year, $75.0 million unsecured revolving credit facility (the “Unsecured Revolving Credit Facility”) with Citicorp USA, Inc., as administrative agent and issuing bank, and Citibank, N.A., as a lender. The Unsecured Revolving Credit Facility is available for both letters of credit and general corporate purposes. Outstanding borrowings under the Unsecured Revolving Credit Facility accrue interest at an annual rate equal to either, as selected by K. Hovnanian, (i) the alternate base rate plus the applicable spread determined on the date of such borrowing or (ii) an adjusted London Interbank Offered Rate (“LIBOR”) rate plus the applicable spread determined as of the date two business days prior to the first day of the interest period for such borrowing. As of April 30, 2018, there were $52.0 million of borrowings and $11.6 million of letters of credit outstanding under the Unsecured Revolving Credit Facility. As of October 31, 2017, there were $52.0 million of borrowings and $14.6 million of letters of credit outstanding under the Unsecured Revolving Credit Facility. As of April 30, 2018, we believe we were in compliance with the covenants under the Unsecured Revolving Credit Facility.

 

In addition to the Unsecured Revolving Credit Facility, we have certain stand–alone cash collateralized letter of credit agreements and facilities under which there was a total of $2.7 million and $1.7 million letters of credit outstanding at April 30, 2018 and October 31, 2017, respectively. These agreements and facilities require us to maintain specified amounts of cash as collateral in segregated accounts to support the letters of credit issued thereunder, which will affect the amount of cash we have available for other uses. At April 30, 2018 and October 31, 2017, the amount of cash collateral in these segregated accounts was $2.7 million and $1.7 million, respectively, which is reflected in “Restricted cash and cash equivalents” on the Condensed Consolidated Balance Sheets.

 

 

 

12.

Per Share Calculation

 

Basic earnings per share is computed by dividing net income (loss) (the “numerator”) by the weighted-average number of common shares outstanding, adjusted for nonvested shares of restricted stock (the “denominator”) for the period. Computing diluted earnings per share is similar to computing basic earnings per share, except that the denominator is increased to include the dilutive effects of options and nonvested shares of restricted stock, and, for the first half of fiscal 2017, common shares issuable upon exchange of our Senior Exchangeable Notes issued as part of our 6.0% Exchangeable Note Units. Any options that have an exercise price greater than the average market price are considered to be anti-dilutive and are excluded from the diluted earnings per share calculation.   

  

All outstanding nonvested shares that contain nonforfeitable rights to dividends or dividend equivalents that participate in undistributed earnings with common stock are considered participating securities and are included in computing earnings per share pursuant to the two-class method. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating securities according to dividends or dividend equivalents and participation rights in undistributed earnings in periods when we have net income. The Company’s restricted common stock (“nonvested shares”) are considered participating securities.

 

Incremental shares attributed to nonvested stock and outstanding options to purchase common stock of 3.3 million and 3.5 million for the three and six months ended April 30, 2018, respectively, and 4.6 million for both the three and six months ended April 30, 2017 were excluded from the computation of diluted earnings per share because we had a net loss for the periods. Also, 1.7 million shares for the six months ended April 30, 2018, 10.0 million and 10.1 million shares for the three and six months ended April 30, 2017, respectively, of common stock issuable upon the exchange of our senior exchangeable notes (which were issued in fiscal 2012) were excluded from the computation of diluted earnings per share because the Company had a net loss for the periods.

 

In addition, shares related to out-of-the money stock options that could potentially dilute basic earnings per share in the future that were not included in the computation of diluted earnings per share were 5.6 million and 4.6 million for the three and six months ended April 30, 2018, respectively, and 4.7 million for both the three and six months ended April 30, 2017 because to do so would have been anti-dilutive for the periods presented.

 

 

 

13.

Preferred Stock

 

On July 12, 2005, we issued 5,600 shares of 7.625% Series A Preferred Stock, with a liquidation preference of $25,000 per share. Dividends on the Series A Preferred Stock are not cumulative and are payable at an annual rate of 7.625%. The Series A Preferred Stock is not convertible into the Company’s common stock and is redeemable in whole or in part at our option at the liquidation preference of the shares. The Series A Preferred Stock is traded as depositary shares, with each depositary share representing 1/1000th of a share of Series A Preferred Stock. The depositary shares are listed on the NASDAQ Global Market under the symbol “HOVNP.” During the three and six months ended April 30, 2018 and 2017, we did not pay any dividends on the Series A Preferred Stock due to covenant restrictions in our debt instruments. We anticipate that we will continue to be restricted from paying dividends, which are not cumulative, for the foreseeable future.

 

 

14.

Common Stock

 

Each share of Class A Common Stock entitles its holder to one vote per share, and each share of Class B Common Stock generally entitles its holder to ten votes per share. The amount of any regular cash dividend payable on a share of Class A Common Stock will be an amount equal to 110% of the corresponding regular cash dividend payable on a share of Class B Common Stock. If a shareholder desires to sell shares of Class B Common Stock, such stock must be converted into shares of Class A Common Stock at a one to one conversion rate.

  

On August 4, 2008, our Board of Directors adopted a shareholder rights plan (the “Rights Plan”), which was amended on January 11, 2018, designed to preserve shareholder value and the value of certain tax assets primarily associated with net operating loss (NOL) carryforwards and built-in losses under Section 382 of the Internal Revenue Code. Our ability to use NOLs and built-in losses would be limited if there was an “ownership change” under Section 382. This would occur if shareholders owning (or deemed under Section 382 to own) 5% or more of our stock increase their collective ownership of the aggregate amount of our outstanding shares by more than 50 percentage points over a defined period of time. The Rights Plan was adopted to reduce the likelihood of an “ownership change” occurring as defined by Section 382. Under the Rights Plan, one right was distributed for each share of Class A Common Stock and Class B Common Stock outstanding as of the close of business on August 15, 2008. Effective August 15, 2008, if any person or group acquires 4.9% or more of the outstanding shares of Class A Common Stock without the approval of the Board of Directors, there would be a triggering event causing significant dilution in the voting power of such person or group. However, existing stockholders who owned, at the time of the Rights Plan’s initial adoption on August 4, 2008, 4.9% or more of the outstanding shares of Class A Common Stock will trigger a dilutive event only if they acquire additional shares. The approval of the Board of Directors’ decision to adopt the Rights Plan may be terminated by the Board of Directors at any time, prior to the Rights being triggered. The Rights Plan will continue in effect until August 14, 2021, unless it expires earlier in accordance with its terms. The approval of the Board of Directors’ decision to initially adopt the Rights Plan was approved by shareholders at a special meeting of stockholders held on December 5, 2008 and the amendment to the Rights Plan adopted by the Board on January 11, 2018 was approved by shareholders at the Company's annual meeting of shareholders held on March 13, 2018. Also at the special meeting on December 5, 2008, our stockholders approved an amendment to our Certificate of Incorporation to restrict certain transfers of Class A Common Stock in order to preserve the tax treatment of our NOLs and built-in losses under Section 382 of the Internal Revenue Code. Subject to certain exceptions pertaining to pre-existing 5% stockholders and Class B stockholders, the transfer restrictions in the amended Certificate of Incorporation generally restrict any direct or indirect transfer (such as transfers of our stock that result from the transfer of interests in other entities that own our stock) if the effect would be to (i) increase the direct or indirect ownership of our stock by any person (or public group) from less than 5% to 5% or more of our common stock; (ii) increase the percentage of our common stock owned directly or indirectly by a person (or public group) owning or deemed to own 5% or more of our common stock; or (iii) create a new public group. Transfers included under the transfer restrictions include sales to persons (or public groups) whose resulting percentage ownership (direct or indirect) of common stock would exceed the 5% thresholds discussed above, or to persons whose direct or indirect ownership of common stock would by attribution cause another person (or public group) to exceed such threshold.

 

On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 4 million shares of Class A Common Stock. There were no shares purchased during the three and six months ended April 30, 2018. As of April 30, 2018, the maximum number of shares of Class A Common Stock that may yet be purchased under this program is 0.5 million.

 

 

15.

Income Taxes

 

The total income tax expense of $0.3 million and $0.6 million recognized for the three and six months ended April 30, 2018, respectively, was primarily related to state tax expense from income generated that was not offset by tax benefits in states where we fully reserve the tax benefit from net operating losses.

 

 

The total income tax benefit of $1.1 million and $0.6 million for the three and six months ended April 30, 2017, respectively, was primarily due to the federal tax benefit on the pre-tax loss for the periods, partially offset by state tax expense from income generated in some states, which was not offset by tax benefits in other states that had losses for which we fully reserve the net operating losses.

 

Our federal net operating losses of $1.7 billion expire between 2028 and 2037. Our state NOLs of $2.6 billion expire between 2018 and 2037. Of the total state amount, $247.1 million will expire between 2018 through 2022; $463.1 million will expire between 2023 through 2027; $1.5 billion will expire between 2028 through 2032; and $348.7 million will expire between 2033 through 2037.

 

On December 22, 2017, the President of the United States signed into law the Tax Cuts and Jobs Act of 2017 (the “Act”). Effective January 1, 2018, the comprehensive U.S. tax reform package, among other things, lowered the corporate tax rate from 35% to 21%. Under the accounting rules, companies are required to recognize the effects of changes in tax laws and tax rates on deferred tax assets and liabilities in the period in which the new legislation is enacted. The effects of the Act on the Company include one major category which is the remeasurement of deferred taxes. Our accounting for the U.S. federal corporate tax rate is complete. Consequently, we have recorded a decrease related to deferred tax assets and liabilities of $298.5 million and $12.2 million, respectively, with a corresponding net adjustment to the valuation allowance in fiscal 2018, therefore there was no income tax expense or benefit as a result of the tax law changes. We will continue to evaluate the impact of the tax reform as additional regulatory guidance is obtained. The ultimate impact of tax reform may differ from our interpretations and assumptions due to additional regulatory guidance that may be issued.

 

Deferred federal and state income tax assets (“DTAs”) primarily represent the deferred tax benefits arising from NOL carryforwards and temporary differences between book and tax income which will be recognized in future years as an offset against future taxable income. If the combination of future years’ income (or loss) and the reversal of the timing differences results in a loss, such losses can be carried forward to future years. In accordance with ASC 740, we evaluate our DTAs quarterly to determine if valuation allowances are required. ASC 740 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a “more likely than not” standard.  

 

As of April 30, 2018, we considered all available positive and negative evidence to determine whether, based on the weight of that evidence, our valuation allowance for our DTAs was appropriate in accordance with ASC 740. Listed below, in order of the weighting of each factor, is the available positive and negative evidence that we considered in determining that it is more likely than not that all of our DTAs will not be realized. In analyzing these factors, overall the negative evidence, both objective and subjective, outweighed the positive evidence. Based on this analysis, we determined that the current valuation allowance for deferred taxes of $661.8 million as of April 30, 2018, which fully reserves for our DTAs, is appropriate.

 

 

1.

Fiscal 2017 financial results, especially the $50.2 million pre-tax loss in the third quarter of 2017 primarily from the $42.3 million loss on extinguishment of debt during the quarter, that put us in a cumulative three-year loss position as of July 31, 2017. We are still in a cumulative three-year loss position as of April 30, 2018. Per ASC 740, cumulative losses are one of the most objectively verifiable forms of negative evidence. (Negative Objective Evidence)

 

2.

In the third quarter of fiscal 2017 and second quarter of fiscal 2018, we completed debt refinancing/restructuring transactions which, by extending our debt maturities, will enable us to allocate cash to invest in new communities and grow our community count to get back to sustained profitability. (Positive Objective Evidence)

 

3.

The refinancing in the third quarter of fiscal 2017 discussed in item 2 above will increase our interest incurred in fiscal 2018 and future years (based on our longer term modeling) by $23.4 million per year. (Negative Objective Evidence)

 

4.

Recent financial results of $40.0 million pre-tax loss for the first half of 2018. (Negative Objective Evidence)

 

5.

We incurred pre-tax losses during the housing market decline and the slower than expected housing market recovery. (Negative Objective Evidence)

 

6.

We exited two geographic markets in fiscal 2016, one in fiscal 2017, and completed the wind down of operations in one other market in the second quarter of fiscal 2018, that have historically had losses. By exiting these underperforming markets, the Company will be able to redeploy capital to better performing markets, which over time should improve our profitability. (Positive Subjective Evidence)

 

7.

Evidence of a sustained recovery in the housing markets in which we operate, supported by economic data showing housing starts, homebuilding volume and prices all increasing and forecasted to continue to increase. (Positive Subjective Evidence)

 

8.

The historical cyclicality of the U.S. housing market, a more restrictive mortgage lending environment compared to before the housing downturn, the uncertainty of the overall US economy and government policies and consumer confidence, all or any of which could continue to hamper a faster, stronger recovery of the housing market. (Negative Subjective Evidence)

 

 

16.

Operating and Reporting Segments

 

Our operating segments are components of our business for which discrete financial information is available and reviewed regularly by the chief operating decision maker, our Chief Executive Officer, to evaluate performance and make operating decisions. Based on this criteria, each of our communities qualifies as an operating segment, and therefore, it is impractical to provide segment disclosures for this many segments. As such, we have aggregated the homebuilding operating segments into six reportable segments.

  

 

Our homebuilding operating segments are aggregated into reportable segments based primarily upon geographic proximity, similar regulatory environments, land acquisition characteristics and similar methods used to construct and sell homes. Our reportable segments consist of the following six homebuilding segments and a financial services segment noted below.

 

Homebuilding:

 

(1)

Northeast (New Jersey and Pennsylvania)

 

(2)

Mid-Atlantic (Delaware, Maryland, Virginia, Washington D.C. and West Virginia)

 

(3)

Midwest (Illinois and Ohio)

 

(4)

Southeast (Florida, Georgia and South Carolina)

 

(5)

Southwest (Arizona and Texas)

 

(6)

West (California)

  

Financial Services

 

Operations of the Company’s Homebuilding segments primarily include the sale and construction of single-family attached and detached homes, attached townhomes and condominiums, urban infill and active lifestyle homes in planned residential developments. In addition, from time to time, operations of the homebuilding segments include sales of land. Operations of the Company’s Financial Services segment include mortgage banking and title services provided to the homebuilding operations’ customers. We do not typically retain or service mortgages that we originate but rather sell the mortgages and related servicing rights to investors. 

 

Corporate and unallocated primarily represents operations at our headquarters in New Jersey. This includes our executive offices, information services, human resources, corporate accounting, training, treasury, process redesign, internal audit, construction services, and administration of insurance, quality and safety. It also includes interest income and interest expense resulting from interest incurred that cannot be capitalized in inventory in the Homebuilding segments, as well as the gains or losses on extinguishment of debt from any debt repurchases or exchanges.  

 

Evaluation of segment performance is based primarily on operating earnings from continuing operations before provision for income taxes (“Income (loss) before income taxes”). Income (loss) before income taxes for the Homebuilding segments consist of revenues generated from the sales of homes and land, income (loss) from unconsolidated entities, management fees and other income, less the cost of homes and land sold, selling, general and administrative expenses and interest expense. Income (loss) before income taxes for the Financial Services segment consist of revenues generated from mortgage financing, title insurance and closing services, less the cost of such services and selling, general and administrative expenses incurred by the Financial Services segment. 

 

Operational results of each segment are not necessarily indicative of the results that would have occurred had the segment been an independent stand-alone entity during the periods presented.  

 

Financial information relating to the Company’s segment operations was as follows:

 

   

Three Months Ended April 30,

   

Six Months Ended April 30,

 

(In thousands)

 

2018

   

2017

   

2018

   

2017

 
                                 

Revenues:

                               

Northeast

  $ 43,771     $ 45,950     $ 63,970     $ 104,525  

Mid-Atlantic

    104,160       100,600       175,457       200,826  

Midwest

    42,938       42,019       83,517       85,721  

Southeast

    60,901       56,635       117,569       113,219  

Southwest

    159,147       225,255       287,452       408,664  

West

    78,098       100,843       163,148       197,374  

Total homebuilding

    489,015       571,302       891,113       1,110,329  

Financial services

    13,054       14,494       23,942       27,343  

Corporate and unallocated (1)

    475       139       4,655       272  

Total revenues

  $ 502,544     $ 585,935     $ 919,710     $ 1,137,944  
                                 

Income (loss) before income taxes:

                               

Northeast

  $ 5,960     $ (2,722

)

  $ (3,741 )   $ (1,816

)

Mid-Atlantic

    6,700       918       8,652       4,800  

Midwest

    (1,110 )     (3,170

)

    (3,454 )     (2,458

)

Southeast

    (5,286 )     428       (6,947 )     134  

Southwest

    10,047       19,785       15,558       31,708  

West

    7,172       2,317       15,239       1,563  

Homebuilding income before income taxes

    23,483       17,556       25,307       33,931  

Financial services

    4,256       7,134       6,803       13,128  

Corporate and unallocated (1)

    (37,317 )     (32,389

)

    (72,159 )     (54,435

)

Loss before income taxes

  $ (9,578 )   $ (7,699

)

  $ (40,049 )   $ (7,376

)

 

 

(1)  Corporate and unallocated for the three months ended April 30, 2018 included corporate general and administrative costs of $16.2 million, interest expense of $19.9 million (a component of Other interest on our Condensed Consolidated Statements of Operations), loss on extinguishment of debt of $1.4 million and $(0.1) million of other income and expenses primarily related to interest income and gain on the sale of our corporate headquarters building. Corporate and unallocated for the six months ended April 30, 2018 included corporate general and administrative costs of $35.3 million, interest expense of $39.5 million (a component of Other interest on our Condensed Consolidated Statements of Operations), loss on extinguishment of debt of $1.4 million and $(4.0) million of other income and expenses primarily related to interest income and gain on the sale of our corporate headquarters building. Corporate and unallocated for the three months ended April 30, 2017 included corporate general and administrative costs of $16.1 million, interest expense of $16.0 million (a component of Other interest on our Condensed Consolidated Statements of Operations), loss on extinguishment of debt of $0.2 million and $0.1 million of other income and expenses primarily related to rental income. Corporate and unallocated for the six months ended April 30, 2017 included corporate general and administrative costs of $31.7 million, interest expense of $29.3 million (a component of Other interest on our Condensed Consolidated Statements of Operations), gain on extinguishment of debt of $7.4 million and $0.8 million of other income and expenses primarily related to bond amortization and rental income.  

 

(In thousands)

 

April 30, 2018

   

October 31, 2017

 
                 

Assets:

               

Northeast

  $ 168,640     $ 180,545  

Mid-Atlantic

    210,238       224,398  

Midwest

    83,412       84,960  

Southeast

    244,337       231,644  

Southwest

    328,521       294,337  

West

    189,806       175,347  

Total homebuilding

    1,224,954       1,191,231  

Financial services

    120,689       162,113  

Corporate and unallocated

    296,848       547,554  

Total assets

  $ 1,642,491     $ 1,900,898  

 

 

17.

Investments in Unconsolidated Homebuilding and Land Development Joint Ventures

 

We enter into homebuilding and land development joint ventures from time to time as a means of accessing lot positions, expanding our market opportunities, establishing strategic alliances, managing our risk profile, leveraging our capital base and enhancing returns on capital. Our homebuilding joint ventures are generally entered into with third-party investors to develop land and construct homes that are sold directly to third-party home buyers. Our land development joint ventures include those entered into with developers and other homebuilders as well as financial investors to develop finished lots for sale to the joint venture’s members or other third parties.

 

In the first quarter of fiscal 2018, we acquired the remaining assets of one of our joint ventures, resulting in a $13.6 million reduction in our investment in the joint venture and a corresponding increase to inventory.

  

During the first quarter of fiscal 2017, we transferred one community we owned and our option to buy three communities to an existing joint venture, resulting in the receipt of $11.2 million of net cash.

 

 

The tables set forth below summarize the combined financial information related to our unconsolidated homebuilding and land development joint ventures that are accounted for under the equity method.

 

(Dollars in thousands)

 

April 30, 2018

 
   

Homebuilding

   

Land

Development

   

Total

 

Assets:

                       

Cash and cash equivalents

  $ 31,166     $ 2,414     $ 33,580  

Inventories

    651,968       6,923       658,891  

Other assets

    29,695       -       29,695  

Total assets

  $ 712,829     $ 9,337     $ 722,166  
                         

Liabilities and equity:

                       

Accounts payable and accrued liabilities

  $ 96,770     $ 504     $ 97,274  

Notes payable

    371,382       -       371,382  

Total liabilities

    468,152       504       468,656  

Equity of:

                       

Hovnanian Enterprises, Inc.

    79,690       3,914       83,604  

Others

    164,987       4,919       169,906  

Total equity

    244,677       8,833       253,510  

Total liabilities and equity

  $ 712,829     $ 9,337     $ 722,166  

Debt to capitalization ratio

    60

%

    0

%

    59

%

 

(Dollars in thousands)

 

October 31, 2017

 
   

Homebuilding

   

Land

Development

   

Total

 

Assets:

                       

Cash and cash equivalents

  $ 60,580     $ 194     $ 60,774  

Inventories

    666,017       9,162       675,179  

Other assets

    36,026       -       36,026  

Total assets

  $ 762,623     $ 9,356     $ 771,979  
                         

Liabilities and equity:

                       

Accounts payable and accrued liabilities

  $ 121,646     $ 429     $ 122,075  

Notes payable

    330,642       -       330,642  

Total liabilities

    452,288       429       452,717  

Equity of:

                       

Hovnanian Enterprises, Inc.

    88,884       3,746       92,630  

Others

    221,451       5,181       226,632  

Total equity

    310,335       8,927       319,262  

Total liabilities and equity

  $ 762,623     $ 9,356     $ 771,979  

Debt to capitalization ratio

    52

%

    0

%

    51

%

 

As of April 30, 2018 and October 31, 2017, we had advances and a note receivable outstanding of $5.2 million and $22.4 million, respectively, to these unconsolidated joint ventures. These amounts were included in the “Accounts payable and accrued liabilities” balances in the tables above. On our Condensed Consolidated Balance Sheets, our “Investments in and advances to unconsolidated joint ventures” amounted to $88.3 million and $115.1 million at April 30, 2018 and October 31, 2017, respectively. In some cases our net investment in these joint ventures is less than our proportionate share of the equity reflected in the table above because of the differences between asset impairments recorded against our joint venture investments and any impairments recorded in the applicable joint venture. Impairments of joint venture investments are recorded at fair value while impairments recorded in the joint venture are recorded when undiscounted cash flows trigger the impairment. During the six months ended April 30, 2018, we did not write-down any of our joint venture investments; however, one of our joint ventures in the Northeast recorded an asset impairment. We recorded our proportionate share of this impairment charge of $0.7 million as part of our share of the net loss of the venture.

      

   

For the Three Months Ended April 30, 2018

 

(In thousands)

 

Homebuilding

   

Land

Development

   

Total

 
                         

Revenues

  $ 96,931     $ 2,343     $ 99,274  

Cost of sales and expenses

    (102,230 )     (2,123 )     (104,353 )

Joint venture net (loss) income

  $ (5,299 )   $ 220     $ (5,079 )

Our share of net income

  $ 1,296     $ 109     $ 1,405  

 

 

   

For the Three Months Ended April 30, 2017

 

(In thousands)

 

Homebuilding

   

Land

Development

   

Total

 
                         

Revenues

  $ 86,556     $ 1,658     $ 88,214  

Cost of sales and expenses

    (87,957

)

    (1,841

)

    (89,798

)

Joint venture net loss

  $ (1,401

)

  $ (183

)

  $ (1,584

)

Our share of net loss

  $ (4,583

)

  $ (92

)

  $ (4,675

)

  

   

For the Six Months Ended April 30, 2018

 

(In thousands)

 

Homebuilding

   

Land

Development

   

Total

 
                         

Revenues

  $ 155,496     $ 3,618     $ 159,114  

Cost of sales and expenses

    (174,366 )     (3,281 )     (177,647 )

Joint venture net (loss) income

  $ (18,870 )   $ 337     $ (18,533 )

Our share of net (loss) income

  $ (3,903 )   $ 168     $ (3,735 )

 

   

For the Six Months Ended April 30, 2017

 

(In thousands)

 

Homebuilding

   

Land

Development

   

Total

 
                         

Revenues

  $ 151,493     $ 2,860     $ 154,353  

Cost of sales and expenses

    (155,183

)

    (2,823

)

    (158,006

)

Joint venture net (loss) income

  $ (3,690

)

  $ 37     $ (3,653

)

Our share of net (loss) income

  $ (6,264

)

  $ 18     $ (6,246

)

 

“Income (loss) from unconsolidated joint ventures” is reflected as a separate line in the accompanying Condensed Consolidated Statements of Operations and reflects our proportionate share of the income or loss of these unconsolidated homebuilding and land development joint ventures. The difference between our share of the income or loss from these unconsolidated joint ventures in the tables above compared to the Condensed Consolidated Statements of Operations is due primarily to the reclassification of the intercompany portion of management fee income from certain joint ventures and the deferral of income for lots purchased by us from certain joint ventures. To compensate us for the administrative services we provide as the manager of certain joint ventures we receive a management fee based on a percentage of the applicable joint venture’s revenues. These management fees, which totaled $2.9 million and $3.0 million for the three months ended April 30, 2018 and 2017, respectively, and $4.9 million and $5.1 million for the six months ended April 30, 2018 and 2017, respectively, are recorded in “Homebuilding: Selling, general and administrative” on the Condensed Consolidated Statements of Operations.

  

In determining whether or not we must consolidate joint ventures that we manage, we assess whether the other partners have specific rights to overcome the presumption of control by us as the manager of the joint venture. In most cases, the presumption is overcome because the joint venture agreements require that both partners agree on establishing the operations and capital decisions of the partnership, including budgets in the ordinary course of business.

 

Typically, our unconsolidated joint ventures obtain separate project specific mortgage financing. For some of our joint ventures, obtaining financing was challenging, therefore, some of our joint ventures are capitalized only with equity. The total debt to capitalization ratio of all our joint ventures is currently 59%. Any joint venture financing is on a nonrecourse basis, with guarantees from us limited only to performance and completion of development, environmental warranties and indemnification, standard indemnification for fraud, misrepresentation and other similar actions, including a voluntary bankruptcy filing. In some instances, the joint venture entity is considered a VIE under ASC 810-10 “Consolidation – Overall” due to the returns being capped to the equity holders; however, in these instances, we have determined that we are not the primary beneficiary, and therefore we do not consolidate these entities. 

 

 

18.

Recent Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers” (Topic 606), (“ASU 2014-09”). ASU 2014-09 requires entities to recognize revenue that represents the transfer of promised goods or services to customers in an amount equivalent to the consideration to which the entity expects to be entitled to in exchange for those goods or services. The following steps should be applied to determine this amount: (1) identify the contract(s) with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when (or as) the entity satisfies a performance obligation. ASU 2014-09 supersedes the revenue recognition requirements in ASC 605, “Revenue Recognition,” and most industry-specific guidance in the Accounting Standards Codification. In August 2015, the FASB issued ASU 2015-14 on this same topic, which defers for one year the effective date of ASU 2014-09, therefore making the guidance effective for the Company beginning November 1, 2018. Additionally, the FASB also decided to permit entities to early adopt the standard, which allows for either full retrospective or modified retrospective methods of adoption, for reporting periods beginning after December 15, 2016. We are currently evaluating the impact of adopting this guidance on our Condensed Consolidated Financial Statements, and have been involved in industry-specific discussions with the FASB on the treatment of certain items. However, due to the nature of our operations, we expect to identify similar performance obligations in our contracts under ASU 2014-09 compared with the deliverables and separate units of account we have identified under existing accounting standards. As a result, we expect the timing of our recognition of revenues to remain generally the same. Nonetheless, we are still evaluating the impact of specific parts of this ASU, and expect our revenue-related disclosures to change upon its adoption.

 

 

In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)” (“ASU 2016-02”), which provides guidance for accounting for leases. ASU 2016-02 requires lessees to classify leases as either finance or operating leases and to record a right-of-use asset and a lease liability for all leases with a term greater than 12 months regardless of the lease classification. The lease classification will determine whether the lease expense is recognized based on an effective interest rate method or on a straight line basis over the term of the lease. Accounting for lessors remains largely unchanged from current GAAP. ASU 2016-02 is effective for the Company beginning November 1, 2019. Early adoption is permitted. We are currently evaluating the impact of adopting this guidance on our Condensed Consolidated Financial Statements.

 

In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments” (“ASU 2016-15”). ASU 2016-15 provides guidance on how certain cash receipts and cash payments are to be presented and classified in the statement of cash flows. ASU 2016-15 is effective for the Company’s fiscal year beginning November 1, 2018. Early adoption is permitted. We are currently evaluating the potential impact of adopting this guidance on our Condensed Consolidated Financial Statements.

 

In November 2016, the FASB issued ASU No. 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash” (“ASU 2016-18”). ASU 2016-18 amends the classification and presentation of changes in restricted cash or restricted cash equivalents in the statement of cash flows. ASU 2016-18 is effective for the Company’s fiscal year beginning November 1, 2018. Early adoption is permitted. We are currently evaluating the potential impact of adopting this guidance on our Condensed Consolidated Financial Statements.

 

In October 2016, the FASB issued ASU No. 2016-16, “Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory” (“ASU 2016-16”). ASU 2016-16 provides guidance for the accounting of income taxes related to intra-entity transfers of assets other than inventory. ASU 2016-16 is effective for the Company’s fiscal year beginning November 1, 2018. Early adoption is permitted. We are currently evaluating the potential impact of adopting this guidance on our Condensed Consolidated Financial Statements.

 

 

19.

Fair Value of Financial Instruments

 

ASC 820, “Fair Value Measurements and Disclosures,” provides a framework for measuring fair value, expands disclosures about fair-value measurements and establishes a fair-value hierarchy which prioritizes the inputs used in measuring fair value summarized as follows:

 

 

Level 1:

Fair value determined based on quoted prices in active markets for identical assets.

 

 

Level 2:

Fair value determined using significant other observable inputs.

 

 

Level 3:

Fair value determined using significant unobservable inputs.

   

Our financial instruments measured at fair value on a recurring basis are summarized below:

 

(In thousands)

Fair Value

Hierarchy

 

Fair Value at

April 30,

2018

   

Fair Value at

October 31,

2017

 
                   

Mortgage loans held for sale (1)

Level 2

  $ 87,971     $ 132,424  

Interest rate lock commitments

Level 2

    (70 )     (14

)

Forward contracts

Level 2

    125       15  

Total

  $ 88,026     $ 132,425  

 

(1)  The aggregate unpaid principal balance was $85.6 million and $128.4 million at April 30, 2018 and October 31, 2017, respectively.

 

 

We elected the fair value option for our loans held for sale for mortgage loans originated subsequent to October 31, 2008, in accordance with ASC 825, “Financial Instruments,” which permits us to measure financial instruments at fair value on a contract-by-contract basis. Management believes that the election of the fair value option for loans held for sale improves financial reporting by mitigating volatility in reported earnings caused by measuring the fair value of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. Fair value of loans held for sale is based on independent quoted market prices, where available, or the prices for other mortgage loans with similar characteristics.

 

The Financial Services segment had a pipeline of loan applications in process of $593.5 million at April 30, 2018. Loans in process for which interest rates were committed to the borrowers totaled $50.3 million as of April 30, 2018. Substantially all of these commitments were for periods of 60 days or less. Since a portion of these commitments is expected to expire without being exercised by the borrowers, the total commitments do not necessarily represent future cash requirements.

  

The Financial Services segment uses investor commitments and forward sales of mandatory MBS to hedge its mortgage-related interest rate exposure. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk is managed by entering into MBS forward commitments, option contracts with investment banks, federally regulated bank affiliates and loan sales transactions with permanent investors meeting the segment’s credit standards. The segment’s risk, in the event of default by the purchaser, is the difference between the contract price and fair value of the MBS forward commitments and option contracts. At April 30, 2018, the segment had open commitments amounting to $21.5 million to sell MBS with varying settlement dates through June 20, 2018.

 

The assets accounted for using the fair value option are initially measured at fair value. Gains and losses from initial measurement and subsequent changes in fair value are recognized in the Condensed Consolidated Financial Statements in “Revenues: Financial services.” The fair values that are included in income are shown, by financial instrument and financial statement line item, below: 

 

   

Three Months Ended April 30, 2018

 

(In thousands)

 

Mortgage

Loans Held

For Sale

   

Interest Rate

Lock

Commitments

   

Forward

Contracts

 
                         

Fair value included in net loss all reflected in financial services revenues

  $ 127     $ 178     $ (143 )

 

 

   

Three Months Ended April 30, 2017

 

(In thousands)

 

Mortgage

Loans Held

For Sale

   

Interest Rate

Lock

Commitments

   

Forward

Contracts

 
                         

Fair value included in net loss all reflected in financial services revenues

  $ 645     $ 109     $ (422

)

 

   

Six Months Ended April 30, 2018

 

(In thousands)

 

Mortgage

Loans Held

For Sale

   

Interest Rate

Lock

Commitments

   

Forward

Contracts

 
                         

Fair value included in net loss all reflected in financial services revenues

  $ 2,541     $ (70 )   $ 125  

 

   

Six Months Ended April 30, 2017

 

(In thousands)

 

Mortgage

Loans Held

For Sale

   

Interest Rate

Lock

Commitments

   

Forward

Contracts

 
                         

Fair value included in net loss all reflected in financial services revenues

  $ 3,214     $ 99     $ (305

)

 

 

The Company's assets measured at fair value on a nonrecurring basis are those assets for which the Company has recorded valuation adjustments and write-offs during the three and six months ended April 30, 2018 and 2017. The assets measured at fair value on a nonrecurring basis are all within the Company's Homebuilding operations and are summarized below:

 

Nonfinancial Assets

 

     

Three Months Ended

 
     

April 30, 2018

 

(In thousands)

Fair

Value

Hierarchy

 

Pre-Impairment

Amount

   

Total

Losses

   

Fair Value

 
                           

Sold and unsold homes and lots under development

Level 3

  $ 11,170     $ (2,117 )   $ 9,053  

Land and land options held for future development or sale

Level 3

  $ -     $ -     $ -  

 

     

Three Months Ended

 
     

April 30, 2017

 

(In thousands)

Fair

Value

Hierarchy

 

Pre-Impairment

Amount

   

Total

Losses

   

Fair Value

 
                           

Sold and unsold homes and lots under development

Level 3

  $ 8,474     $ (1,549

)

  $ 6,925  

Land and land options held for future development or sale

Level 3

  $ -     $ -     $ -  

 

     

Six Months Ended

 
     

April 30, 2018

 

(In thousands)

Fair

Value

Hierarchy

 

Pre-Impairment

Amount

   

Total

Losses

   

Fair Value

 
                           

Sold and unsold homes and lots under development

Level 3

  $ 11,170     $ (2,117 )   $ 9,053  

Land and land options held for future development or sale

Level 3

  $ -     $ -     $ -  

 

     

Six Months Ended

 
     

April 30, 2017

 

(In thousands)

Fair

Value

Hierarchy

 

Pre-Impairment

Amount

   

Total

Losses

   

Fair Value

 
                           

Sold and unsold homes and lots under development

Level 3

  $ 14,776     $ (4,136

)

  $ 10,640  

Land and land options held for future development or sale

Level 3

  $ 6,326     $ (81

)

  $ 6,245  

  

We record impairment losses on inventories related to communities under development and held for future development when events and circumstances indicate that they may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than their related carrying amounts. If the expected undiscounted cash flows are less than the carrying amount, then the community is written down to its fair value. We estimate the fair value of each impaired community by determining the present value of its estimated future cash flows at a discount rate commensurate with the risk of the respective community. Should the estimates or expectations used in determining cash flows or fair value decrease or differ from current estimates in the future, we may be required to recognize additional impairments. We recorded inventory impairments, which are included in the Condensed Consolidated Statements of Operations as “Inventory impairment loss and land option write-offs” and deducted from inventory of $2.1 million for both the three and six months ended April 30, 2018, and $1.5 million and $4.2 million for the three and six months ended April 30, 2017, respectively. See Note 4 for further detail of the communities evaluated for impairment.

 

The fair value of our cash equivalents, restricted cash and cash equivalents and customers' deposits approximates their carrying amount, based on Level 1 inputs.

 

The fair value of our borrowings under the revolving credit and term loan facilities approximates their carrying amount based on Level 2 inputs. The fair value of each series of the senior unsecured notes (other than the 13.5% senior unsecured notes due 2026 at April 30, 2018, and the senior exchangeable notes and the senior amortizing notes outstanding at October 31, 2017) is estimated based on recent trades or quoted market prices for the same issues or based on recent trades or quoted market prices for our debt of similar security and maturity to achieve comparable yields, which are Level 2 measurements. The fair value of the senior unsecured notes (all series in the aggregate), other than the 13.5% senior notes due 2026 at April 30, 2018 and the senior exchangeable notes and senior amortizing notes outstanding at October 31, 2017, was estimated at $109.6 million and $383.7 million as of April 30, 2018 and October 31, 2017, respectively.

 

 

The fair value of each of the 13.5% senior unsecured notes due 2026 at April 30, 2018 and the senior secured notes (all series in the aggregate), and the senior amortizing notes and the senior exchangeable notes outstanding at October 31, 2017 are estimated based on third party broker quotes or management’s estimate of the fair value based on available trades for similar debt instruments, which are Level 3 measurements. The fair value of the 13.5% senior unsecured notes due 2026 and the senior secured notes (all series in the aggregate) were estimated at $91.7 million and $1.1 billion, respectively, as of April 30, 2018. As of October 31, 2017, the fair value of the senior secured notes (all series in the aggregate), the senior amortizing notes and the senior exchangeable notes were estimated at $1.2 billion, $2.1 million and $54.2 million, respectively. 

 

 

20.

Transactions with Related Parties

 

During both the three months ended April 30, 2018 and 2017, an engineering firm owned by Tavit Najarian, a relative of Ara K. Hovnanian, our Chairman of the Board of Directors and our Chief Executive Officer, provided services to the Company totaling $0.2 million. During the six months ended April 30, 2018 and 2017, the services provided by such engineering firm to the Company totaled $0.3 million and $0.4 million, respectively. Neither the Company nor Mr. Hovnanian has a financial interest in the relative’s company from whom the services were provided.

 

 

21.

Subsequent events

 

On May 29, 2018, K. Hovnanian completed the redemption of $65.7 million aggregate principal amount of the 8.0% Notes with borrowings of the Delayed Draw Term Loans under the Unsecured Term Loan Facility. See Note 11 for further information.

 

On May 30, 2018, the parties to the Solus litigation signed a stipulation of dismissal of all claims with prejudice. As part of the case resolution, on May 30, 2018, K. Hovnanian paid the overdue interest on the 8.0% Notes held by Sunrise Trail that was originally due on May 1, 2018, and as a result of such payment, the “Default” under the Indenture governing the 8.0% Notes was cured. The case resolution does not involve any settlement payment or admission of wrongdoing by any of the Hovnanian-related parties. On May 31, 2018, the Court so-ordered the stipulation and closed the case. See Note 7 for further information.

 

 

 

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

OVERVIEW

 

As we have discussed for the past several quarters, our inability to buy land in fiscal 2016 and 2017, as a result of paying off $320 million of debt maturities from October 2015 through May 2016 has led to a reduction in community count and revenues, which impacts our overall profitability. Our total number of lots controlled increased in the quarter ended April 30, 2018, as compared to the same period of the prior year. This is the second consecutive quarter in which we have experienced a year over year quarterly increase. We believe continued growth in lots controlled should ultimately lead to community count growth and our recent refinancing transactions (discussed further below) provide much needed stability to our capital structure.

 

Our cash position during the first half of fiscal 2018 allowed us to spend $284.8 million on land purchases and land development during the period and still have $248.8 million of homebuilding cash and cash equivalents as of April 30, 2018. This cash and our recent refinancing transactions, by extending our debt maturities, will enable us to allocate additional cash to further grow our business. We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices and sales pace and plan to continue actively pursuing such land acquisitions. New land purchases at pricing that we believe will generate appropriate investment returns and drive greater operating efficiencies are needed to return to sustained profitability.

 

The factors discussed above for fiscal 2016 and 2017 led to a 9.6% decline in our community count over last year’s second quarter, and as a result, for the first half of fiscal 2018 we experienced mixed operating results compared to the prior year. Net contracts per average active selling community decreased slightly to 10.6 for the three months ended April 30, 2018 compared to 10.9 in the same period in the prior year, but increased slightly to 18.1 for the six months ended April 30, 2018 compared to 17.6 in the same period in the prior year. Active selling communities decreased from 146 at April 30, 2017 to 132 at April 30, 2018, and net contracts decreased 11.7% and 12.0%, respectively, for the three and six months ended April 30, 2018, compared to the same periods of the prior year. For the three and six months ended April 30, 2018, sale of homes revenues decreased 17.5% and 20.9%, respectively, as compared to the same periods of the prior year, as a result of a 10.5% and 15.4% decrease in deliveries, respectively, along with our decreased community count. Gross margin percentage increased from 12.6% and 13.0% for the three and six months ended April 30, 2017, respectively, to 13.8% and 14.3% for the three and six months ended April 30, 2018, respectively. Gross margin percentage, before cost of sales interest expense and land charges, increased from 16.5% and 16.8% for the three and six months ended April 30, 2017, respectively, to 17.7% and 17.8% for the three and six months ended April 30, 2018. The improvements in both gross margin percentage and gross margin percentage, before cost of sales interest expense and land charges, are primarily the result of the mix of communities delivering. The improvement in gross margin percentage for the six months ended April 30, 2018 is also due to decreased land charges compared to the same period of the prior year. Selling, general and administrative costs (including corporate general and administrative expenses) were approximately flat for the three months ended April 30, 2018 and increased $2.5 million for the six months ended April 30, 2018 as compared to the same periods of the prior year. As a percentage of total revenue, such costs increased from 10.5% for the three months ended April 30, 2017 to 12.3% for the three months ended April 30, 2018 and increased from 10.7% for the six months ended April 30, 2017 to 13.5% for the six months ended April 30, 2018. The increase in the three months ended April 30, 2018 was mainly due to the decrease in total revenues, while the increase in the six months ended April 30, 2018 was also due to legal (including litigation) fees incurred related to our recent financing transactions. We are actively seeking insurance coverage for the litigation costs. Also contributing to the increase for the six months ended April 30, 2018 were higher stock compensation costs and rent expense related to (i) the sale and leaseback of our former corporate headquarters building for the period from November 2017 to February 2018 and (ii) rent on our new headquarters building.

 

When comparing sequentially from the first quarter of fiscal 2018 to the second quarter of fiscal 2018, our gross margin percentage decreased from 14.8% to 13.8%, and our gross margin percentage, before cost of sales interest expense and land charges, decreased slightly from 17.9% to 17.7%. Our gross margin percentage decreased primarily as a result of increased land charges. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenues decreased from 14.9% to 12.3%, as compared to the first quarter of fiscal 2018 primarily due to the increase in total revenues. Additionally in the first quarter of fiscal 2018, we incurred higher legal (including litigation) fees with respect to our recent financing transactions. Improving the efficiency of our selling, general and administrative expenses will continue to be a significant area of focus.

 

We had 2,193 homes in backlog with a dollar value of $900.7 million at April 30, 2018 (a decrease of 17.6% in dollar value compared to the same period in the prior year). As discussed above, we have invested $284.8 million in land purchases and land development during first half of fiscal 2018, which along with continued land acquisitions, is expected to lead to future community count growth. However, there is typically a significant time lag from when we first control lots until the time that we open a community for sale. This timeline can vary significantly from a few months (in a market such as Houston) to three to five years (in a market such as New Jersey). Although our community count increased sequentially in the first quarter of fiscal 2018 from the fourth quarter of fiscal 2017, as expected, our community count decreased from the first quarter of fiscal 2018 to the second quarter of fiscal 2018. Given the mix of land that we currently control and the land investment we currently anticipate, we believe substantial community count growth will begin in the early part of fiscal 2019. Once our community count grows, absent adverse market factors, we expect delivery and revenue growth will follow.

 

 

CRITICAL ACCOUNTING POLICIES

  

As disclosed in our annual report on Form 10-K for the fiscal year ended October 31, 2017, our most critical accounting policies relate to income recognition from mortgage loans; inventories; unconsolidated joint ventures; post-development completion, warranty and insurance reserves; and deferred income taxes. Since October 31, 2017, there have been no significant changes to those critical accounting policies.

 

CAPITAL RESOURCES AND LIQUIDITY

 

Our operations consist primarily of residential housing development and sales in the Northeast (New Jersey and Pennsylvania), the Mid-Atlantic (Delaware, Maryland, Virginia, Washington D.C. and West Virginia), the Midwest (Illinois and Ohio), the Southeast (Florida, Georgia and South Carolina), the Southwest (Arizona and Texas) and the West (California). In addition, we provide certain financial services to our homebuilding customers.

 

We have historically funded our homebuilding and financial services operations with cash flows from operating activities, borrowings under our credit facilities, the issuance of new debt and equity securities and other financing activities. Due to covenant restrictions in our debt instruments, we are currently limited in the amount of debt we can incur that does not qualify as refinancing indebtedness with certain maturity requirements (a limitation that we expect to continue for the foreseeable future), even if market conditions would otherwise be favorable, which could also impact our ability to grow our business. 

 

Operating, Investing and Financing Activities – Overview

 

Our homebuilding cash balance at April 30, 2018 decreased $214.9 million from October 31, 2017. In addition to using $82.6 million to pay down debt during the period, we spent $284.8 million on land and land development. After considering this land and land development and all other operating activities, including revenue received from deliveries, we used $72.6 million of cash from operations. During the first half of fiscal 2018, cash provided by investing activities was $32.9 million, primarily related to the sale of our corporate headquarters building, along with distributions from a joint venture. Cash used in financing activities was $175.8 million during the first half of fiscal 2018 which included payments for debt maturities, $13.0 million to pay-off nonrecourse mortgage loans on our corporate headquarters, $42.6 million for land banking and model sale leaseback programs and a $43.4 million reduction in mortgage warehouse lines of credit. We intend to continue to use nonrecourse mortgage financings, model sale leaseback, joint ventures, and, subject to covenant restrictions in our debt instruments, land banking programs as our business needs dictate.

  

Our cash uses during the six months ended April 30, 2018 and 2017 were for operating expenses, land purchases, land deposits, land development, construction spending, debt payments, state income taxes, interest payments and investments in joint ventures. During these periods, we provided for our cash requirements from available cash on hand, housing and land sales, model sale leasebacks, land banking transactions, joint ventures, financial service revenues and other revenues. We believe that these sources of cash taken together with the refinancing transactions discussed below will be sufficient through fiscal 2018 to finance our working capital requirements.

 

Our net income (loss) historically does not approximate cash flow from operating activities. The difference between net income (loss) and cash flow from operating activities is primarily caused by changes in inventory levels together with changes in receivables, prepaid and other assets, mortgage loans held for sale, interest and other accrued liabilities, deferred income taxes, accounts payable and other liabilities, and noncash charges relating to depreciation, stock compensation awards and impairment losses for inventory. When we are expanding our operations, inventory levels, prepaids and other assets increase causing cash flow from operating activities to decrease. Certain liabilities also increase as operations expand and partially offset the negative effect on cash flow from operations caused by the increase in inventory levels, prepaids and other assets. Similarly, as our mortgage operations expand, net income from these operations increases, but for cash flow purposes net income is partially offset by the net change in mortgage assets and liabilities. The opposite is true as our investment in new land purchases and development of new communities decrease (which happened in fiscal 2016 and 2017), causing us to generate positive cash flow from operations. In fiscal 2018, we used cash from operations due to increased spending on land purchases and land development compared to the past several quarters. As we continue to increase spending on land purchases and land development, cash flow from operations will decrease. As we continue to actively seek land investment opportunities, we will also remain focused on liquidity.

  

 

Debt Transactions

 

As of April 30, 2018, we had a $75.0 million outstanding senior secured term loan facility (the “Secured Term Loan Facility”) ($73.6 million net of debt issuance costs), and $1,110.0 million of outstanding senior secured notes ($1,091.3 million, net of discount and debt issuance costs), comprised of $53.2 million 2.0% 2021 Notes (defined below), $141.8 million 5.0% 2021 Notes (defined below), $75.0 million 9.5% 2020 Notes (defined below), $440.0 million 10.0% Senior Secured Notes due 2022 and $400.0 million 10.5% Senior Secured Notes due 2024. As of April 30, 2018, we also had $246.4 million of outstanding senior notes ($210.4 million net of discount, premium and debt issuance costs), comprised of $90.1 million 5.0% Senior Notes due 2040, $90.6 million 13.5% Senior Notes due 2026 and $65.7 million 8.0% Senior Notes due 2019. In addition, as of April 30, 2018, there were $132.5 million ($131.6 million net of debt issuance costs) of borrowings on our senior unsecured term loan facility (“Unsecured Term Loan Facility”) and $52.0 million of borrowings and $11.6 million of letters of credit outstanding under our unsecured revolving credit facility (the “Unsecured Revolving Credit Facility”).

 

Except for K. Hovnanian, the issuer of the notes and borrower under our credit facilities, our home mortgage subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures and certain of our title insurance subsidiaries, we and each of our subsidiaries are guarantors of the Secured Term Loan Facility (as defined below), the Unsecured Term Loan Facility (as defined below), the Unsecured Revolving Credit Facility (as defined below) and the senior secured notes and senior notes outstanding at April 30, 2018 (collectively, the “Notes Guarantors”). In addition to the Notes Guarantors, the 5.0% Senior Secured Notes due 2021 (the “5.0% 2021 Notes”), the 2.0% Senior Secured Notes due 2021 (the “2.0% 2021 Notes” and together with the 5.0% 2021 Notes, the “2021 Notes”) and the 9.5% 2020 Notes (defined below) collectively with the 2021 Notes, the “JV Holdings Secured Group Notes”) are guaranteed by K. Hovnanian JV Holdings, L.L.C. and its subsidiaries, except for certain joint ventures and joint venture holding companies (collectively, the “JV Holdings Secured Group”). Members of the JV Holdings Secured Group do not guarantee K. Hovnanian's other indebtedness.

 

The credit agreements governing the Secured Term Loan Facility, the Unsecured Term Loan Facility, the Unsecured Revolving Credit Facility (collectively, the “credit facilities”) and the indentures governing the notes outstanding at April 30, 2018 do not contain any financial maintenance covenants, but do contain restrictive covenants that limit, among other things, the Company’s ability and that of certain of its subsidiaries, including K. Hovnanian, to incur additional indebtedness (other than nonrecourse indebtedness, certain permitted indebtedness and refinancing indebtedness (under the Secured Term Loans (as defined below) and the 9.5% 2020 Notes, any new or refinancing indebtedness may not be scheduled to mature earlier than January 15, 2021 (so long as no member of the JV Holdings Secured Group is an obligor thereon), or February 15, 2021 (if otherwise), and under the 10.0% Senior Secured Notes due 2022 (the “10.0% 2022 Notes”), any refinancing indebtedness of the 7.0% Senior Notes due 2019 (the “7.0% Notes”) (which includes the Unsecured Term Loans (as defined below)) and 8.0% Senior Notes due 2019 (the “8.0% Notes” and together with the 7.0% Notes, the “2019 Notes”) (which includes the New Notes (as defined below) and the Unsecured Term Loans) may not be scheduled to mature earlier than July 16, 2024 (such restrictive covenant in respect of the 10.5% Senior Secured Notes due 2024 (the “10.5% 2024 Notes”) was eliminated as described below), pay dividends and make distributions on common and preferred stock, repurchase subordinated indebtedness (with respect to the credit facilities and certain of the senior secured and senior notes) and common and preferred stock, make other restricted payments, including investments, sell certain assets (including in certain land banking transactions), incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all assets, enter into certain transactions with affiliates and make cash repayments of the 2019 Notes and refinancing indebtedness in respect thereof  (with respect to the 10.0% 2022 Notes). The credit agreements governing the Secured Term Loan Facility, the Unsecured Term Loan Facility and the Unsecured Revolving Credit Facility and the indentures governing the notes also contain events of default which would permit the lenders/holders thereof to exercise remedies with respect to the collateral (as applicable), declare the loans made under the Secured Term Loan Facility (the “Secured Term Loans”), loans made under the Unsecured Term Loan Facility (the “Unsecured Term Loans”) and loans made under the Unsecured Revolving Credit Facility (the “Unsecured Loans”)/notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the Secured Term Loans, the Unsecured Term Loans or Unsecured Loans/notes or other material indebtedness, cross default to other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy and insolvency, with respect to the Secured Term Loans, the Unsecured Term Loans and the Unsecured Loans, material inaccuracy of representations and warranties and with respect to the Secured Term Loans and the Unsecured Term Loans, a change of control, and, with respect to the Secured Term Loans and senior secured notes, the failure of the documents granting security for the Secured Term Loans and senior secured notes to be in full force and effect, and the failure of the liens on any material portion of the collateral securing the Secured Term Loans and senior secured notes to be valid and perfected. As of April 30, 2018, we believe we were in compliance with the covenants of the credit facilities and the indentures governing our outstanding notes.

 

If our consolidated fixed charge coverage ratio, as defined in the agreements governing our debt instruments, is less than 2.0 to 1.0, we are restricted from making certain payments, including dividends, and from incurring indebtedness other than certain permitted indebtedness, refinancing indebtedness and nonrecourse indebtedness. As a result of this ratio restriction, we are currently restricted from paying dividends, which are not cumulative, on our 7.625% Series A Preferred Stock. We anticipate that we will continue to be restricted from paying dividends for the foreseeable future. Our inability to pay dividends is in accordance with covenant restrictions and will not result in a default under our debt instruments or otherwise affect compliance with any of the covenants contained in our debt instruments.

 

Under the terms of our debt agreements, we have the right to make certain redemptions and prepayments and, depending on market conditions and covenant restrictions, may do so from time to time. We also continue to evaluate our capital structure and may also continue to make debt purchases and/or exchanges for debt or equity from time to time through tender offers, open market purchases, private transactions, or otherwise, or seek to raise additional debt or equity capital, depending on market conditions and covenant restrictions.

 

 

On January 29, 2018, K. Hovnanian, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent, and the GSO Entities entered into the Unsecured Term Loan Facility. K. Hovnanian borrowed the Initial Term Loans on February 1, 2018 to fund, together with cash on hand, the redemption on February 1, 2018 of all $132.5 million aggregate principal amount of 7.0% Notes, which resulted in a loss on extinguishment of debt of $0.5 million. The Unsecured Term Loans bear interest at a rate equal to 5.0% per annum and interest will be payable in arrears, on the last business day of each fiscal quarter. The Unsecured Term Loans will mature on February 1, 2027, which is the ninth anniversary of the first closing date of the Unsecured Term Loan Facility. K. Hovnanian called for redemption on May 28, 2018, $65.7 million aggregate principal amount of the 8.0% Notes, which redemption was funded with borrowings of the Delayed Draw Term Loans under the Unsecured Term Loan Facility (upon redemption, such redeemed 8.0% Notes were cancelled). Following the redemption, the outstanding 8.0% Notes consist of the Purchased 8.0% Notes (as defined below).