Part I

 

ITEM 1

 

BUSINESS

 

Business Overview

 

Hovnanian Enterprises, Inc. (“HEI”) conducts all of its homebuilding and financial services operations through its subsidiaries (references herein to the “Company”, “we”, “us” or “our” refer to HEI and its consolidated subsidiaries and should be understood to reflect the consolidated business of HEI’s subsidiaries). Through its subsidiaries, HEI designs, constructs, markets, and sells single-family detached homes, attached townhomes and condominiums, urban infill, and active lifestyle homes in planned residential developments and is one of the nation’s largest builders of residential homes. Founded in 1959 by Kevork Hovnanian, HEI was incorporated in New Jersey in 1967 and reincorporated in Delaware in 1983. Since the incorporation of HEI’s predecessor company, the Company combined with its unconsolidated joint ventures have delivered in excess of 342,000 homes, including 5,720 homes in fiscal 2019. The Company has two distinct operations: homebuilding and financial services. Our homebuilding operations consist of six segments: Northeast, Mid-Atlantic, Midwest, Southeast, Southwest and West. Our financial services operations provide mortgage loans and title services to the customers of our homebuilding operations.

 

We are currently, excluding unconsolidated joint ventures, offering homes for sale in 141 communities in 24 markets in 14 states throughout the United States. We market and build homes for first-time buyers, first-time and second-time move-up buyers, luxury buyers, active lifestyle buyers and empty nesters. We offer a variety of home styles at base prices ranging from $153,000 to $2,252,000 with an average sales price, including options, of $394,000 nationwide in fiscal 2019.

 

Our operations span all significant aspects of the home-buying process – from design, construction, and sale, to mortgage origination and title services.

 

The following is a summary of our growth history:

 

1959 - Founded by Kevork Hovnanian as a New Jersey homebuilder.

 

1983 - Completed initial public offering.

 

1986 - Entered the North Carolina market through the investment in New Fortis Homes.

 

1992 - Entered the greater Washington, D.C. market.

 

1994 - Entered the Coastal Southern California market.

 

1998 - Expanded in the greater Washington, D.C. market through the acquisition of P.C. Homes.

 

1999 - Entered the Dallas, Texas market through our acquisition of Goodman Homes. Further diversified and strengthened our position as New Jersey’s largest homebuilder through the acquisition of Matzel & Mumford.

 

2001 - Continued expansion in the greater Washington D.C. and North Carolina markets through the acquisition of Washington Homes. This acquisition further strengthened our operations in each of these markets.

 

2002 - Entered the Central Valley market in Northern California and Inland Empire region of Southern California through the acquisition of Forecast Homes.

 

2003 - Expanded operations in Texas and entered the Houston market through the acquisition of Parkside Homes and Brighton Homes. Entered the greater Ohio market through our acquisition of Summit Homes and entered the greater metro Phoenix market through our acquisition of Great Western Homes.

 

2004 - Entered the greater Tampa, Florida market through the acquisition of Windward Homes and started operations in the Minneapolis/St. Paul, Minnesota market.

 

2005 - Entered the Orlando, Florida market through our acquisition of Cambridge Homes and entered the greater Chicago, Illinois market and expanded our position in Florida and Minnesota through the acquisition of the operations of Town & Country Homes, which occurred concurrently with our entering into a joint venture with affiliates of Blackstone Real Estate Advisors to own and develop Town & Country Homes’ existing residential communities. We also entered the Cleveland, Ohio market through the acquisition of Oster Homes.

    

 

2006 - Entered the coastal markets of South Carolina and Georgia through the acquisition of Craftbuilt Homes.

 

During fiscal 2016, we exited the Minneapolis, Minnesota and Raleigh, North Carolina markets and sold land portfolios in those markets. During fiscal 2018, we completed a wind down of our operations in the San Francisco Bay area in Northern California and in Tampa, Florida.

 

Geographic Breakdown of Markets by Segment

 

The Company markets and builds homes that are constructed in 16 of the nation’s top 50 housing markets. We segregate our homebuilding operations geographically into the following six segments:

 

Northeast: New Jersey and Pennsylvania

 

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

 

Midwest: Illinois and Ohio

 

Southeast: Florida, Georgia and South Carolina

 

Southwest: Arizona and Texas

 

West: California

 

For financial information about our segments, see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Employees

 

We employed 1,868 full-time employees (whom we refer to as associates) as of October 31, 2019.

 

Corporate Offices and Available Information

 

Our corporate offices are located at 90 Matawan Road, Fifth Floor, Matawan, New Jersey 07747 (See Item 2-Properties). Our telephone number is 732-747-7800, and our Internet web site address is www.khov.com. Information available on or through our web site is not a part of this Form 10-K. We make available free of charge through our web site our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(d) or 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), as soon as reasonably practicable after they are filed with, or furnished to, the Securities and Exchange Commission (SEC). Copies of the Company’s Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports are available free of charge upon request. The SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC.

 

 

Business Strategies

 

Given the relatively low levels of total U.S. housing starts, and our belief in the long-term recovery of the homebuilding market, we remain focused on identifying new land parcels, which are critical to improving our financial performance. As discussed previously, we were limited in our ability to invest in land purchases in fiscal 2016 and 2017 due to significant debt maturities that we were unable to refinance and therefore had to pay at maturity. This reduction of investment led to a decrease in community count and revenues, which impacted our overall profitability. In the fourth quarter of fiscal 2016 and in July 2017, we were able to refinance certain of our debt maturities and again in fiscal 2018 and fiscal 2019 the Company entered into certain financing transactions which extended our debt maturities. These transactions provided us with the long term capital needed to implement our strategy to invest in land to grow the business to more significant profitability. 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 plus years (in a market such as New Jersey). For seven consecutive quarters through the third quarter of fiscal 2019, our total number of lots controlled increased as compared to the same period of the prior year. Although there was a slight decrease in total lots controlled of 3.2% as of October 31, 2019 as compared to October 31, 2018, the growth in lots controlled in previous quarters has led to the year-over-year community count growth. Our strategy has been to grow through increased open for sale communities. As our recently opened communities begin delivering homes, we believe it should lead to additional delivery and revenue growth, and in turn profitability, in future periods absent adverse market factors. We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices and sales paces 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.

 

In addition to our current focus on maintaining adequate liquidity and evaluating new investment opportunities, we intend to continue to focus on our historic key business strategies, as enumerated below. We believe that these strategies separate us from our competitors in the residential homebuilding industry and the adoption, implementation and adherence to these principles will continue to benefit our business.

    

Our goal is to become a significant builder in each of the selected markets in which we operate, which will enable us to achieve powers and economies of scale and differentiate ourselves from most of our competitors.

 

As noted above, we offer a broad product array to provide housing to a wide range of customers. Our customers consist of first-time buyers, first-time and second-time move-up buyers, luxury buyers, active lifestyle buyers and empty nesters. Our diverse product array includes single-family detached homes, attached townhomes and condominiums, urban infill and active lifestyle homes.

 

We are committed to customer satisfaction and quality in the homes that we build. We recognize that our future success rests in the ability to deliver quality homes to satisfied customers. We seek to expand our commitment to customer service through a variety of quality initiatives. In addition, our focus remains on attracting and developing quality associates. We use several leadership development and mentoring programs to identify key individuals and prepare them for positions of greater responsibility within our Company.

 

We focus on achieving high return on invested capital. Each new community is evaluated based on its ability to meet or exceed internal rate of return requirements. Our belief is that the best way to create lasting value for our shareholders is through a strong focus on return on invested capital.

 

We prefer to use a risk-averse land acquisition strategy. We attempt to acquire land with a minimum cash investment and negotiate takedown options, thereby limiting the financial exposure to the amounts invested in property and predevelopment costs. This approach significantly reduces our risk and generally allows us to obtain necessary development approvals before acquisition of the land.

 

Our strategy includes homebuilding and land development joint ventures as a means of controlling lot positions, expanding our market opportunities, establishing strategic alliances, reducing our risk profile, leveraging our capital base and enhancing our 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 home buyers. Our land development joint ventures include those 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.

 

We manage our financial services operations to better serve all of our home buyers. Our current mortgage financing and title service operations enhance our contact with customers and allow us to coordinate the home-buying experience from beginning to end.

 

 

Operating Policies and Procedures

 

We attempt to reduce the effect of certain risks inherent in the housing industry through the following policies and procedures:

 

Training - Our training is designed to provide our associates with the knowledge, attitudes, skills and habits necessary to succeed in their jobs. Our training department regularly conducts online or webinar training in sales, construction, administration and managerial skills.

  

Land Acquisition, Planning, and Development - Before entering into a contract to acquire land, we complete extensive comparative studies and analyses which assist us in evaluating the economic feasibility of such land acquisition. We generally follow a policy of acquiring options to purchase land for future community developments.

 

	●	Where possible, we acquire land for future development through the use of land options, which need not be exercised before the completion of the regulatory approval process. We attempt to structure these options with flexible takedown schedules rather than with an obligation to take down the entire parcel upon receiving regulatory approval. If we are unable to negotiate flexible takedown schedules, we will buy parcels in a single bulk purchase. Additionally, we purchase improved lots in certain markets by acquiring a small number of improved lots with an option on additional lots. This allows us to minimize the economic costs and risks of carrying a large land inventory, while maintaining our ability to commence new developments during favorable market periods.
	●	Our option and purchase agreements are typically subject to numerous conditions, including, but not limited to, our ability to obtain necessary governmental approvals for the proposed community. Generally, the deposit on the agreement will be returned to us if all approvals are not obtained, although predevelopment costs may not be recoverable. By paying an additional nonrefundable deposit, we have the right to extend a significant number of our options for varying periods of time. In most instances, we have the right to cancel any of our land option agreements by forfeiture of our deposit on the agreement. In fiscal 2019, 2018 and 2017, rather than purchase additional lots in underperforming communities, we took advantage of this right and walked away from 5,153 lots, 2,777 lots and 3,930 lots, respectively, out of 23,157 total lots, 20,387 total lots and 17,837 total lots, respectively, under option, resulting in pretax charges of $3.6 million, $1.4 million and $2.7 million, respectively.

   

Design - Our residential communities are generally located in urban and suburban areas easily accessible through public and personal transportation. Our communities are designed as neighborhoods that fit existing land characteristics. We strive to create diversity within the overall planned community by offering a mix of homes with differing architecture, textures and colors. Recreational amenities, such as swimming pools, tennis courts, clubhouses, open areas and tot lots, are frequently included.

 

Construction - We design and supervise the development and building of our communities. Our homes are constructed according to standardized prototypes, which are designed and engineered to provide innovative product design while attempting to minimize costs of construction. We generally employ subcontractors for the installation of site improvements and construction of homes. Agreements with subcontractors are generally short term and provide for a fixed price for labor and materials. We rigorously control costs through the use of computerized monitoring systems.

 

Because of the risks involved in speculative building, our general policy is to construct an attached condominium or townhouse building only after signing contracts for the sale of at least 50% of the homes in that building. A majority of our single-family detached homes are constructed after the signing of a sales contract and mortgage approval has been obtained. This limits the buildup of inventory of unsold homes and the costs of maintaining and carrying that inventory.

 

Materials and Subcontractors - We attempt to maintain efficient operations by utilizing standardized materials available from a variety of sources. In addition, we generally contract with subcontractors to construct our homes. We have reduced construction and administrative costs by consolidating the number of vendors serving certain markets and by executing national purchasing contracts with select vendors. In recent years, we have experienced some construction delays due to shortage of labor in certain markets like Houston, Dallas and Northern California; and we cannot predict the extent to which shortages in necessary materials or labor may occur in these or other markets in the future.

 

Marketing and Sales - Our residential communities are sold principally through on-site sales offices. In order to respond to our customers’ needs and trends in housing design, we rely upon our internal market research group to analyze information gathered from, among other sources, buyer profiles, exit interviews at model sites, focus groups and demographic databases. We make use of our website, internet, newspaper, radio, television, magazine, billboard, video and direct mail advertising, special and promotional events, illustrated brochures and full-sized and scale model homes in our comprehensive marketing program. In addition, we have home design galleries in our Florida, Illinois, New Jersey, Ohio and Virginia markets, which offer a wide range of customer options to satisfy individual customer tastes.

 

 

Customer Service and Quality Control - In many of our markets, associates are responsible for customer service and preclosing quality control inspections as well as responding to postclosing customer needs. Prior to closing, each home is inspected and any necessary completion work is undertaken by us or our subcontractors. Our homes are enrolled in a standard limited warranty program which, in general, provides a homebuyer with a limited warranty for the home’s materials and workmanship which follows each State’s applicable statute of repose. All of the warranties contain standard exceptions, including, but not limited to, damage caused by the customer.

 

Customer Financing - We sell our homes to customers who generally finance their purchases through mortgages. Our financial services segment provides our customers with competitive financing and coordinates and expedites the loan origination transaction through the steps of loan application, loan approval, and closing and title services. We originate loans in each of the states in which we build homes. We believe that our ability to offer financing to customers on competitive terms as a part of the sales process is an important factor in completing sales.

 

During the year ended October 31, 2019, for the markets in which our mortgage subsidiaries originated loans, 11.1% of our home buyers paid in cash and 70.9% of our noncash home buyers obtained mortgages from our mortgage banking subsidiary. The loans we originated in fiscal 2019 were 65.8% prime and 29.8% Federal Housing Administration/Veterans Affairs (“FHA/VA”). The remaining 4.4% of our loan originations represent jumbo and/or USDA loans.

  

We sell virtually all of the loans and loan-servicing rights that we originate within a short period of time. Loans are sold either individually or against forward commitments to institutional investors, including banks, mortgage banking firms, and savings and loan associations.

 

Residential Development Activities

 

Our residential development activities include site planning and engineering, obtaining environmental and other regulatory approvals and constructing roads, sewer, water, and drainage facilities, recreational facilities, and other amenities and marketing and selling homes. These activities are performed by our associates, together with independent architects, consultants and contractors. Our associates also carry out long-term planning of communities. A residential development generally includes single-family detached homes and/or a number of residential buildings containing from two to 24 individual homes per building, together with amenities, such as club houses, swimming pools, tennis courts, tot lots and open areas.

  

Current base prices for our homes in contract backlog at October 31, 2019, range from $153,000 to $860,000 in the Northeast, from $217,000 to $2,252,000 in the Mid-Atlantic, from $155,000 to $622,000 in the Midwest, from $227,000 to $1,061,000 in the Southeast, from $185,000 to $575,000 in the Southwest and from $239,000 to $956,000 in the West. Closings generally occur and are typically reflected in revenues within six to nine months of when sales contracts are signed.

 

Information on homes delivered by segment for the year ended October 31, 2019, is set forth below:

 

(Housing revenue in thousands)		Housing Revenues			Homes Delivered			Average Price
Northeast		$116,889			192			$608,797
Mid-Atlantic		356,674			652			547,046
Midwest		203,734			680			299,609
Southeast		219,860			545			403,413
Southwest		627,201			1,866			336,121
West		425,324			1,011			420,696
Consolidated total		$1,949,682			4,946			$394,194
Unconsolidated joint ventures (1)		$485,324			774			$627,034

 

(1) Represents housing revenues and home deliveries for our unconsolidated homebuilding joint ventures for the period. We provide this data as a supplement to our consolidated results as an indicator of the volume managed in our unconsolidated joint ventures. See Note 20 to the Consolidated Financial Statements for a further discussion of our unconsolidated joint ventures.

 

The value of our net sales contracts, excluding unconsolidated joint ventures, increased 14.5% to $2.1 billion for the year ended October 31, 2019 from $1.8 billion for the year ended October 31, 2018. The number of homes contracted increased 14.3% to 5,340 in fiscal 2019 from 4,671 in fiscal 2018. The increase in the number of homes contracted occurred along with a 5.4% increase in the average number of open-for-sale communities from 130 for fiscal 2018 to 137 for fiscal 2019. We contracted an average of 39.0 homes per average active selling community in fiscal 2019 compared to 35.9 homes per average active selling community in fiscal 2018, an 8.6% increase in sales pace per community as our performance per community improved in fiscal 2019 as compared to fiscal 2018.

   

 

 Information on the value of net sales contracts by segment for the years ended October 31, 2019 and 2018, is set forth below:

  

(Value of net sales contracts in thousands)		2019			2018			Percentage of Change
Northeast		$172,950			$74,730			131.4	%
Mid-Atlantic		385,862			340,963			13.2	%
Midwest		219,266			204,487			7.2	%
Southeast		233,645			225,703			3.5	%
Southwest		677,244			640,604			5.7	%
West		411,577			348,726			18.0	%
Consolidated total		$2,100,544			$1,835,213			14.5	%
Unconsolidated joint ventures(1)		$431,419			$556,745			(22.5	)%

  

(1) Represents net contract dollars for our unconsolidated homebuilding joint ventures for the period. We provide this data as a supplement to our consolidated results as an indicator of the volume managed in our unconsolidated joint ventures. See Note 20 to the Consolidated Financial Statements for a further discussion of our unconsolidated joint ventures.

 

The following table summarizes our active selling communities under development as of October 31, 2019. The contracted not delivered and remaining homes available in our active selling communities are included in the consolidated total homesites under the total residential real estate chart in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” 

   

Active Selling Communities

 

		Communities			Approved Homes			Homes Delivered			Contracted Not Delivered(1)			Remaining Homes Available(2)
Northeast		6			829			330			152			347
Mid-Atlantic		25			4,032			1,751			343			1,938
Midwest		16			2,902			1,144			450			1,308
Southeast		17			3,536			908			282			2,346
Southwest		58			8,783			4,296			663			3,824
West		19			4,407			1,942			301			2,164
Total		141			24,489			10,371			2,191			11,927

 

(1)	Includes 278 home sites under option.
(2)	Of the total remaining homes available, 843 were under construction or completed (including 80 models and sales offices), and 6,063 were under option.

 

Backlog

 

At October 31, 2019 and 2018, including unconsolidated joint ventures, we had a backlog of signed contracts for 2,652 homes and 2,192 homes, respectively, with sales values aggregating $1.1 billion and $977.3 million, respectively. The majority of our backlog at October 31, 2019 is expected to be completed and closed within the next six to nine months. At November 30, 2019 and 2018, our backlog of signed contracts, including unconsolidated joint ventures, was 2,775 homes and 2,248 homes, respectively, with sales values aggregating $1.1 billion and $1.0 billion, respectively. For information on our backlog excluding unconsolidated joint ventures, see the table on page 44 under Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations -Homebuilding.”

 

Sales of our homes typically are made pursuant to a standard sales contract that provides the customer with a statutorily mandated right of rescission for a period ranging up to 15 days after execution. This contract requires a nominal customer deposit at the time of signing. In addition, in the Northeast, and some sections of the Mid-Atlantic and Midwest, we typically obtain an additional 5% to 10% down payment due within 30 to 60 days after signing. In most markets, an additional deposit is required when a customer selects and commits to optional upgrades in the home. The contract may include a financing contingency, which permits customers to cancel their obligation in the event mortgage financing at prevailing interest rates (including financing arranged or provided by us) is unobtainable within the period specified in the contract. This contingency period typically is four to eight weeks following the date of execution of the contract. When housing values decline in certain markets, some customers cancel their contracts and forfeit their deposits. Cancellation rates are discussed further in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Sales contracts are included in backlog once the sales contract is signed by the customer, which in some cases includes contracts that are in the rescission or cancellation periods. However, revenues from sales of homes are recognized in the Consolidated Statements of Operations, when title to the home is conveyed to the buyer, adequate initial and continuing investments have been received, and there is no continued involvement.

   

 

Residential Land Inventory in Planning

 

It is our objective to control a supply of land, primarily through options, whenever possible, consistent with anticipated homebuilding requirements in each of our housing markets. Controlled land (land owned and under option) as of October 31, 2019, exclusive of communities under development described above under “Active Selling Communities” and excluding unconsolidated joint ventures, is summarized in the following table. The proposed developable home sites in communities in planning are included in the 29,633 consolidated total home sites under the total residential real estate table in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on page 37.

 

Communities in Planning

 

(Dollars in thousands)		Number of Proposed Communities			Proposed Developable Home Sites			Total Land Option Price			Book Value(1)
Northeast:
Under option		31			2,791			$218,368			$11,078
Owned		2			7						$1,870
Total		33			2,798						$12,948
Mid-Atlantic:
Under option		18			1,771			$208,359			$3,166
Owned		11			1,245						$47,496
Total		29			3,016						$50,662
Midwest:
Under option		16			1,936			$44,244			$3,620
Owned		6			204						$4,659
Total		22			2,140						$8,279
Southeast:
Under option		21			1,884			$91,148			$772
Owned		3			181						$11,975
Total		24			2,065						$12,747
Southwest:
Under option		30			2,701			$162,993			$11,465
Owned		-			-						$-
Total		30			2,701						$11,465
West:
Under option		5			580			$37,002			$3,114
Owned		14			2,215						$9,350
Total		19			2,795						$12,464
Totals:
Under option		121			11,663			$762,114			$33,215
Owned		36			3,852						$75,350
Combined total		157			15,515						$108,565

 

(1)

Properties under option also include costs incurred on properties not under option but which are under evaluation. For properties under option, as of October 31, 2019, option fees and deposits aggregated approximately $20.4 million. As of October 31, 2019, we spent an additional $12.8 million in nonrefundable predevelopment costs on such properties, including properties not under option but under evaluation.

 

We either option or acquire improved or unimproved home sites from land developers or other sellers. Under a typical agreement with the land developer, we purchase a minimal number of home sites. The balance of the home sites to be purchased is covered under an option agreement or a nonrecourse purchase agreement. During the declining homebuilding market, we decided to mothball (or stop development on) certain communities where we determined that current market conditions did not justify further investment at that time. When we decide to mothball a community, the inventory is reclassified on our Consolidated Balance Sheets from Sold and unsold homes and lots under development to Land and land options held for future development or sale. See Note 3 to the Consolidated Financial Statements for further discussion on mothballed communities. For additional financial information regarding our homebuilding segments, see Note 10 to the Consolidated Financial Statements.

   

 

Raw Materials

 

The homebuilding industry has from time to time experienced raw material and labor shortages. In particular, shortages and fluctuations in the price of lumber or in other important raw materials could result in delays in the start or completion of or increase the cost of developing one or more of our residential communities. We attempt to maintain efficient operations by utilizing standardized materials available from a variety of sources. In recent years, we have experienced some construction delays due to shortage of labor in certain markets like Houston, Dallas and Northern California. We cannot predict, however, the extent to which shortages in necessary raw materials or labor may occur in the future. In addition, we generally contract with subcontractors to construct our homes. We have reduced construction and administrative costs by consolidating the number of vendors serving certain markets and by executing national purchasing contracts with select vendors.

   

Seasonality

 

Our business is seasonal in nature and, historically, weather-related problems, typically in the fall, late winter and early spring, can delay starts or closings and increase costs.

 

Competition

 

Our homebuilding operations are highly competitive. We are among the top 15 homebuilders in the United States in both homebuilding revenues and home deliveries. We compete with numerous real estate developers in each of the geographic areas in which we operate. Our competition ranges from small local builders to larger regional builders to publicly owned builders and developers, some of which have greater sales and financial resources than we do. Previously owned homes and the availability of rental housing provide additional competition. We compete primarily on the basis of reputation, price, location, design, quality, service and amenities.

 

Regulation and Environmental Matters

 

We are subject to extensive and complex laws and regulations that affect the development of land and home building, sales and customer financing processes concerning zoning, building design, construction, and similar matters, including local regulations which impose restrictive zoning and density requirements in order to limit the number of homes that can eventually be built within the boundaries of a particular locality. In addition, we are subject to registration and filing requirements in connection with the construction, advertisement and sale of our communities in certain states and localities in which we operate even if all necessary government approvals have been obtained. We may also be subject to periodic delays or may be precluded entirely from developing communities due to building moratoriums that could be implemented in the future in the states in which we operate. Generally, such moratoriums relate to insufficient water or sewerage facilities or inadequate road capacity.

 

In addition, some state and local governments in markets where we operate have approved, and others may approve, slow-growth, or no-growth initiatives that could negatively affect the availability of land and building opportunities within those areas. Approval of these initiatives could adversely affect our ability to build and sell homes in the affected markets and/or could require the satisfaction of additional administrative and regulatory requirements, which could result in slowing the progress or increasing the costs of our homebuilding operations in these markets. Any such delays or costs could have a negative effect on our future revenues and earnings.

 

We are also 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 which apply to any given community vary greatly according to the community site, the site’s environmental conditions and the present and former uses of the site. See Risk Factors – “Homebuilders are subject to a number of federal, local, state, and foreign laws and regulations concerning the development of land, the homebuilding, sales, and customer financing processes and the protection of the environment, which can cause us to incur delays and costs associated with compliance and which can prohibit or restrict our activity in some regions or areas”, Item 3 “Legal Proceedings” and Note 18 to the Consolidated Financial Statements.

  

Despite our past ability to obtain necessary permits and approvals for our communities, we anticipate that increasingly stringent requirements will be imposed on developers and homebuilders in the future. Although we cannot reliably predict the extent of any effect these requirements 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 interpretation and application.

   

 

ITEM 1A

RISK FACTORS

 

You should carefully consider the following risks in addition to the other information included in this Annual Report on Form 10-K, including the Consolidated Financial Statements and the notes thereto.

   

The homebuilding industry is significantly affected by changes in general and local economic conditions, real estate markets, and weather and other environmental conditions, which could affect our ability to build homes at prices our customers are willing or able to pay, could reduce profits that may not be recaptured, could result in cancellation of sales contracts, and could affect our liquidity.

 

The homebuilding industry is cyclical, has from time to time experienced significant difficulties, and is significantly affected by changes in general and local economic conditions such as:   

 

	●	Employment levels and wage and job growth;
	●	Availability and affordability of financing for home buyers;
	●	Interest rates;
	●	Adverse changes in tax laws;
	●	Foreclosure rates;
	●	Inflation;
	●	Consumer confidence;
	●	Housing demand in general and for our particular community locations and product designs, as well as consumer interest in purchasing a home compared to other housing alternatives;
	●	Population growth; and
	●	Availability of water supply in locations in which we operate.

 

Turmoil in the financial markets could affect our liquidity. In addition, our cash balances are primarily invested in short-term government-backed instruments. The remaining cash balances are held at numerous financial institutions and may, at times, exceed insurable amounts. We seek to mitigate this risk by depositing our cash in major financial institutions and diversifying our investments. In addition, our homebuilding operations often require us to obtain letters of credit. We have certain stand-alone letter of credit facilities and agreements pursuant to which letters of credit are issued. However, we may need additional letters of credit above the amounts provided under these facilities and letters of credit may not be issued under our current senior secured revolving credit facility. If we are unable to obtain such additional letters of credit as needed to operate our business, we would be adversely affected.

 

Weather conditions and man-made or natural disasters such as hurricanes, tornadoes, earthquakes, floods, droughts, fires and other environmental conditions can harm the local homebuilding business. For example, wildfires in California and hurricanes in Texas and Florida in recent years have at various times caused utility company delays, slowing of our production process, increased cost of operations and also have impacted our sales and construction activity in affected markets during the related time periods.

 

The difficulties described above could cause us to take longer and incur more costs to build our homes. In addition, our insurance may not fully cover business interruptions or losses caused by weather conditions and manmade or natural disasters and we may not be able to recapture increased costs by raising prices in many cases because we fix our prices up to 12 months in advance of delivery by signing home sales contracts. Some home buyers may also cancel or not honor their home sales contracts altogether.

  

 

A significant downturn in the homebuilding industry could materially and adversely affect our business.

 

The homebuilding industry experienced a significant and sustained downturn that began in 2007, during which the lowest volumes of housing starts were significantly below troughs in previous downturns. This downturn resulted in an industry-wide softening of demand for new homes due to a lack of consumer confidence, decreased availability of mortgage financing, and large supplies of resale and new home inventories, among other factors. In addition, an oversupply of alternatives to new homes, such as rental properties, resale homes and foreclosures, depressed prices and reduced margins for the sale of new homes. Industry conditions had a material adverse effect on our business and results of operations in fiscal years 2007 through 2011. Further, we had substantially increased our inventory through fiscal 2006, which required significant cash outlays and which increased our price and margin exposure as we worked through this inventory. Although the homebuilding market has improved in the last few years, the recovery has been slow by historical standards and the volume of housing starts is still below normal historical averages and our business, liquidity and results of operations continue to be impacted by the lasting effects of the significant and sustained downturn and it may continue to materially adverse our business and results of operations in future years. If the homebuilding industry experiences another significant or sustained downturn, it would materially adversely affect our business and results of operations in future years.

 

Several challenges, such as general U.S. economic uncertainty and the potential for more rapid inflation, extreme weather conditions, increasing cycle times due to labor shortages, increasing labor and materials costs, including because of changes in immigration laws and trends in labor migration, the restrictive mortgage lending environment and rising mortgage interest rates and regulatory changes, could further impact the housing market and, consequently, our performance. For example, if rising house construction costs substantially outpace increases in the income of potential purchasers we may be limited in our ability to raise home sales prices, which may result in lower gross margins.

 

Our high leverage may restrict our ability to operate, may prevent us from fulfilling our obligations, and may adversely affect our financial condition.

 

We have a significant amount of debt.

 

●

Our debt (excluding nonrecourse secured debt and debt of our financial subsidiaries), as of October 31, 2019, including the debt of the subsidiaries that guarantee our debt, was $1,549.1 million ($1,480.0 million net of discount and premiums and debt issuance costs). Additionally, we have a $125.0 million senior secured revolving credit facility, which was fully available for borrowing as of October 31, 2019.

  

●

Our debt service payments for the year ended October 31, 2019, were $829.8 million, which represented interest incurred and payments on the principal of our debt and do not include principal and interest on nonrecourse secured debt, debt of our financial subsidiaries and fees under our letter of credit and other credit facilities and agreements.

 

See Note 9 “Senior Notes and Credit Facilities” to our consolidated financial statements for a discussion of our recently completed financing transitions. See also Note 23 “Subsequent Events” to our consolidated financial statements for transactions related to our debt in the first quarter of fiscal 2020.

 

As of October 31, 2019, we had $19.2 million in aggregate outstanding face amount of letters of credit issued under various letter of credit and other credit facilities and agreements, certain of which were collateralized by $19.9 million of cash. Our fees for these letters of credit for the year ended October 31, 2019, which are based on both the used and unused portion of the facilities and agreements, were $0.1 million. We also had substantial contractual commitments and contingent obligations, including $202.9 million of performance bonds as of October 31, 2019. See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contractual Obligations.”

 

Our significant amount of debt could have important consequences. For example, it could:

 

	●	Limit our ability to obtain future financing for working capital, capital expenditures, acquisitions, debt service requirements, or other requirements;
	●	Require us to dedicate a substantial portion of our cash flow from operations to the payment of our debt and reduce our ability to use our cash flow for other purposes, including land investments;
	●	Require us to pay higher interest rates upon refinancing debt if interest rates rise or due to the concentration of debt maturities;
	●	Limit our flexibility in planning for, or reacting to, changes in our business;

 

 

	●	Place us at a competitive disadvantage because we have more debt than some of our competitors;
	●	Limit our ability to implement our strategies and operational actions;
	●	Require us to consider selling some of our assets or debt or equity securities, possibly on unfavorable terms, to satisfy obligations; and
	●	Make us more vulnerable to downturns in our business and general economic conditions.

   

Our ability to meet our debt service and other obligations will depend upon our future performance. We are engaged in businesses that are substantially affected by changes in economic cycles. Our revenues and earnings vary with the level of general economic activity in the markets we serve. Our businesses are also affected by customer sentiment and financial, political, business, and other factors, many of which are beyond our control. The factors that affect our ability to generate cash can also affect our ability to raise additional funds for these purposes through the sale of equity or debt securities, the refinancing of debt, or the sale of assets. Changes in prevailing interest rates may affect our ability to meet our debt service obligations to the extent we have any floating rate indebtedness. A higher interest rate on our debt service obligations could result in lower earnings or increased losses.

 

Our sources of liquidity are limited and may not be sufficient to meet our needs.

 

We are largely dependent on our current cash balance and future cash flows from operations (which may not be positive) to enable us to service our indebtedness, to cover our operating expenses, and/or to fund our other liquidity needs. Cash used in and provided from operating activities in fiscal 2019 and fiscal 2018 were $249.1 million and $66.8 million, respectively. Depending on the levels of our land purchases, we could generate negative or positive cash flow in future years. In 2016, we used a significant portion of cash to repay debt because financing was unavailable to us in the capital and loan markets. If the homebuilding industry does not experience improved conditions over the next several years, our cash flows could be insufficient to fund our obligations and support land purchases; if we cannot buy additional land we would ultimately be unable to generate future revenues from the sale of houses. In addition, we will need to refinance all or a portion of our debt on or before maturity, which we may not be able to do on favorable terms or at all. If our cash flows and capital resources are insufficient to fund our debt service obligations or we are unable to refinance our indebtedness, we may be forced to reduce or delay investments and capital expenditures, sell assets, seek additional capital, or restructure our indebtedness. These alternative measures may not be successful or, if successful, made on desirable terms and may not permit us to meet our debt service obligations. We have also entered into certain cash collateralized letters of credit agreements and facilities that require us to maintain specified amounts of cash in segregated accounts as collateral to support our letters of credit issued thereunder. If our available cash and capital resources are insufficient to meet our debt service and other obligations, we could face liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. We may not be able to consummate those dispositions or the proceeds from the dispositions may not be permitted under the terms of our debt instruments to be used to service indebtedness or may not be adequate to meet any debt service obligations then due. For additional information about capital resources and liquidity, see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Capital Resources and Liquidity.”

 

Our cash flows, liquidity and consolidated financial statements could be materially and adversely affected if we are unable to obtain letters of credit.

 

Our homebuilding operations often require us to obtain letters of credit. We have certain stand-alone letter of credit facilities and agreements pursuant to which letters of credit are issued. However, letters of credit may not be issued under our current senior secured revolving credit facility and we may need additional letters of credit above the amounts provided under these stand-alone facilities and agreements. If we are unable to obtain such additional letters of credit as needed to operate our business, we would be adversely affected.

 

We may have difficulty in obtaining the additional financing required to operate and develop our business.

 

Our operations require significant amounts of cash, and we may be required to seek additional capital, whether from sales of debt or equity securities or borrowing additional money, for the future growth and development of our business. The terms and/or availability of additional capital is uncertain. Moreover, the agreements governing our outstanding debt instruments contain provisions that restrict the debt we may incur in the future and our ability to pay dividends on equity. If we are not successful in obtaining sufficient capital, it could reduce our sales and may hinder our future growth and results of operations. In addition, pledging substantially all of our assets to support our senior secured revolving credit facility and our senior secured notes may make it more difficult to raise additional financing in the future.

 

 

Restrictive covenants in our debt instruments may restrict our and certain of our subsidiaries’ ability to operate, and if our financial performance worsens, we may not be able to undertake transactions within the restrictions of our debt instruments.

 

The indentures governing our outstanding debt securities and our credit facilities impose certain restrictions on our and certain of our subsidiaries’ operations and activities. The most significant restrictions relate to debt incurrence (including non-recourse indebtedness), creation of liens, repayment of certain indebtedness prior to its respective stated maturity, sales of assets (including in certain land banking transactions), cash distributions, (including paying dividends on common and preferred stock), capital stock repurchases, and investments by us and certain of our subsidiaries (including in joint ventures). Because of these restrictions, we are currently prohibited from paying dividends on our common and preferred stock and anticipate that we will remain prohibited for the foreseeable future.

  

The restrictions in our debt instruments could prohibit or restrict our and certain of our subsidiaries’ activities, such as undertaking capital raising or restructuring activities or entering into other transactions. In addition, if we fail to comply with these restrictions or to make timely payments on this debt and other material indebtedness, an event of default could occur and our debt under these debt instruments could become due and payable prior to maturity. Any such event of default could lead to cross defaults under certain of our other debt or negatively impact other covenants. In any of these situations, we may be unable to amend the applicable instrument or obtain a waiver without significant additional cost, or at all. In such a situation, there can be no assurance that we would be able to obtain alternative financing. Any such situation could have a material adverse effect on the solvency of the Company.

 

The terms of our debt instruments allow us to incur additional indebtedness.

 

Under the terms of our indebtedness under our indentures and credit facilities, we have the ability, subject to our debt covenants, to incur additional amounts of debt, including secured debt. The incurrence of additional indebtedness could magnify the risks described above. In addition, certain obligations, such as standby letters of credit and performance bonds issued in the ordinary course of business, including those issued under our stand-alone letter of credit agreements and facilities, are not considered indebtedness under our debt instruments (and may be secured), and therefore, are not subject to limits in our debt covenants.

 

We could be adversely affected by a negative change in our credit rating.

 

Our ability to access capital on favorable terms is a key factor in our ability to service our indebtedness to cover our operating expenses and to fund our other liquidity needs. Negative rating actions by credit agencies, including downgrades, may make it more difficult and costly for us to access capital. Therefore, any downgrade by any of the principal credit agencies may exacerbate these difficulties. There can be no assurances that our credit ratings will not be downgraded in the future, whether as a result of deteriorating general economic conditions, a more protracted downturn in the housing industry, failure to successfully implement our operating strategy, the adverse impact on our results of operations or liquidity position of any of the above, or otherwise.

 

Our business is seasonal in nature and our quarterly operating results fluctuate.

 

Our quarterly operating results generally fluctuate by season. The construction of a customer’s home typically begins after signing the agreement of sale and can take six to nine months or more to complete. Weather-related problems, typically in the fall, winter and early spring, can delay starts or closings and increase costs and thus reduce profitability. In addition, delays in opening communities could have an adverse effect on our sales and revenues. Due to these factors, our quarterly operating results will likely continue to fluctuate.

 

Our success depends on the availability of suitable undeveloped land and improved lots at acceptable prices and our having sufficient liquidity to fund such investments.

 

Our success in developing land and in building and selling homes depends in part upon the continued availability of suitable undeveloped land and improved lots at acceptable prices. The homebuilding industry is highly competitive for land that is suitable for residential development and the availability of undeveloped land and improved lots for purchase at favorable prices depends on a number of factors outside of our control, including the risk of competitive overbidding on land and lots, geographical or topographical constraints and restrictive governmental regulation. Should suitable land opportunities become less available, our ability to implement our strategies and operational actions would be limited and the number of homes we may be able to build and sell would be reduced, which would reduce revenue and profits. In addition, our ability to make land purchases will depend upon us having sufficient liquidity to fund such purchases. We may be at a disadvantage in competing for land compared to others who have more substantial cash resources.

 

 

Raw material and labor shortages and price fluctuations could delay or increase the cost of home construction and adversely affect our operating results.

 

The homebuilding industry is vulnerable to raw material and labor shortages and has from time to time experienced such shortages. In particular, shortages and fluctuations in the price of lumber or in other important raw materials could result in delays in the start or completion of, or increase the cost of, developing one or more of our residential communities. For example, manufacturers increased the price of drywall in 2013 by approximately 20% as compared to the prior year. Pricing for labor and raw materials can be affected by various national, regional, local, economic and political factors. For example, although the tariffs recently imposed on products from China and elsewhere have not had a material impact on our financial results to date, future government-imposed tariffs and trade regulations on imported building supplies could have significant impacts on the cost to construct our homes or on our customer's budgets and may therefore have a more significant impact on our business in the future. Delays or cost increases caused by raw material and labor shortages and price fluctuations, including as a result of inflation or wage increases, could also harm our operating results, the impact of which may be further affected depending on our ability to raise sales prices to offset increased costs. We have experienced some labor shortages and increased labor costs over the past few years. The cost of labor may be adversely affected by changes in immigration laws and trends in labor migration. If rising labor and house construction costs substantially outpace increases in the income of potential purchasers we may be limited in our ability to raise home sale prices, which may result in lower gross margins.  

  

We rely on subcontractors to construct our homes and may incur costs or losses if these subcontractors fail to properly construct our homes or manage and pay their employees.

 

We engage subcontractors to perform the actual construction of our homes and, in some cases, to select and obtain building materials. Therefore, the timing and quality of our construction depends on the availability, skill, and cost of our subcontractors. Despite our quality control efforts, we may discover that our subcontractors failed to properly construct our homes or may use defective materials. The occurrence of such events could require us to repair the homes in accordance with our standards and as required by law. The cost of satisfying our legal obligations in these instances may be significant, and we may be unable to recover the cost of repair from subcontractors and insurers.

 

We also can suffer damage to our reputation, and may be exposed to possible liability, if subcontractors fail to comply with applicable laws. When we learn about possibly improper practices by subcontractors, we attempt to cause the subcontractors to discontinue them and may terminate the use of such subcontractors. However, attempts at mitigation may not avoid claims against us relating to actions of or matters relating to our subcontractors that are out of our control. For example, although we do not have the ability to control what these independent subcontractors pay their own employees, or their own subcontractors, or the work rules they impose on such personnel, federal and state governmental agencies, including the U.S. National Labor Relations Board, have sought, and may in the future seek, to hold contracting parties like us responsible for subcontractors’ violations of wage and hour laws, or workers’ compensation, collective bargaining and/or other employment-related obligations related to subcontractors’ workforces. Governmental agency determinations or attempts by others to make us responsible for subcontractors’ labor practices or obligations, could create substantial adverse exposure for us in these types of situations even though not within our control.

 

We also can suffer damage to our reputation, and may be exposed to possible liability, if subcontractors fail to comply with applicable laws, including laws involving actions or matters that are not within our control.

 

When we learn about possibly improper practices by subcontractors, we attempt to cause the subcontractors to discontinue them and may terminate the use of such subcontractors. However, attempts at mitigation may not avoid claims against us relating to actions of or matters relating to our subcontractors.

 

Products supplied to us and work done by subcontractors can expose us to risks that could adversely affect our business.

 

We rely on subcontractors to perform the actual construction of our homes, and, in some cases, to select and obtain building materials. Despite our detailed specifications and quality control procedures, in some cases, subcontractors may use improper construction processes or defective materials. Defective products widely used by the homebuilding industry can result in the need to perform extensive repairs to large numbers of homes. The cost of complying with our warranty obligations may be significant if we are unable to recover the cost of repairs from subcontractors, materials suppliers and insurers.

 

 

Changes in economic and market conditions could result in the sale of homes at a loss or holding land in inventory longer than planned, the cost of which can be significant.

 

Land inventory risk can be substantial for homebuilders. We must continuously seek and make acquisitions of land for expansion into new markets and for replacement and expansion of land inventory within our current markets. We incur many costs even before we begin to build homes in a community. Depending on the stage of development of a land parcel when we acquire it, these may include costs of preparing land, finishing and entitling lots, installing roads, sewers, water systems and other utilities, taxes and other costs related to ownership of the land on which we plan to build homes. The market value of undeveloped land, buildable lots, and housing inventories can fluctuate significantly as a result of changing economic and market conditions. In the event of significant changes in economic or market conditions, we may have to sell homes at a loss or hold land in inventory longer than planned. In the case of land options, we could choose not to exercise them, in which case we would write-off the value of these options. Inventory carrying costs can be significant and can result in losses in a poorly performing project or market. The assessment of communities for indication of impairment is performed quarterly. While we consider available information to determine what we believe to be our best estimates as of the reporting period, these estimates are subject to change in future reporting periods as facts and circumstances change. See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Critical Accounting Policies.” For example, during more recent years, we did not have significant land option write-offs or impairments; however, during fiscal 2011, 2010 and 2009, we decided not to exercise many option contracts and walked away from land option deposits and predevelopment costs, which resulted in land option write-offs of $24.3 million, $13.2 million, and $45.4 million, respectively. Also, in fiscal 2011, 2010 and 2009, as a result of the difficult market conditions, we recorded inventory impairment losses on owned property of $77.5 million, $122.5 million and $614.1 million, respectively. If market conditions worsen, additional inventory impairment losses and land option write-offs will likely be necessary.

  

We conduct a significant portion of our business in Arizona, California, Florida, New Jersey, Ohio, Texas and Virginia, and accordingly, regional factors affecting home sales and activities in these markets may have a large impact on our results of operations.

 

We presently conduct a significant portion of our business in Arizona, California, Florida, New Jersey, Ohio, Texas and Virginia, which subjects us to risks associated with the regional and local economies of these markets. Home prices and sales activities in these markets and in most of the other markets in which we operate have declined from time to time, particularly as a result of slow economic growth. These markets may also depend, to a degree, on certain sectors of the economy and any declines in those sectors may impact home sales and activities in that region. For example, to the extent the oil and gas industries, which can be very volatile, are negatively impacted by declining commodity prices, climate change, legislation or other factors, it could result in reduced employment, or other negative economic consequences, which in turn could adversely impact our home sales and activities in Texas. Furthermore, precarious economic and budget situations at the state government level may adversely affect the market for our homes in the affected areas. Weather-related or other events impacting these markets could also negatively affect these markets as well as the other markets in which we operate. If home prices and sales activity decline in one or more of the markets in which we operate, our costs may not decline at all or at the same rate and the Company’s business, financial condition and results of operations could be materially adversely affected. See also “—The homebuilding industry is significantly affected by changes in general and local economic conditions, real estate markets, and weather and other environmental conditions, which could affect our ability to build homes at prices our customers are willing or able to pay, could reduce profits that may not be recaptured, could result in cancellation of sales contracts, and could affect our liquidity.”

 

Increases in cancellations of agreements of sale could have an adverse effect on our business.

 

Our backlog reflects agreements of sale with our home buyers for homes that have not yet been delivered. We have received a deposit from our home buyer for each home, which is reflected in our backlog, and we generally have the right to retain the deposit if the home buyer does not complete the purchase. In some situations, however, a home buyer may cancel the agreement of sale and receive a complete or partial refund of the deposit for reasons such as state and local law, his or her inability to obtain mortgage financing at prevailing interest rates (including financing arranged or provided by us), his or her inability to sell his or her current home, or our inability to complete and deliver the home within the specified time. At October 31, 2019, including unconsolidated joint ventures, we had a backlog of signed contracts for 2,652 homes with a sales value aggregating $1.1 billion. If mortgage financing becomes less accessible, or if economic conditions deteriorate, more home buyers may cancel their agreements of sale with us, which could have an adverse effect on our business and results of operations.

 

Interest rates have been at historic lows over the last several years and may increase. Because almost all of our customers require mortgage financing, increases in interest rates or the decreased availability of mortgage financing could impair the affordability of our homes, lower demand for our products, limit our marketing effectiveness, and limit our ability to fully realize our backlog.

 

Virtually all of our customers finance their acquisitions through lenders providing mortgage financing. Mortgage rates have remained low compared to most historical periods for the last several years, which has made the homes we sell more affordable. However, we cannot predict whether interest rates will continue to fall, remain low or rise. Increases in interest rates (or the perception that interest rates will rise, including as a result of government actions), increases in the costs to obtain mortgages or decreases in availability of mortgage financing could lower demand for new homes because of the increased monthly mortgage costs and cash required to close on mortgages to potential home buyers. Even if potential customers do not need financing, changes in interest rates and mortgage availability could make it harder for them to sell their existing homes to potential buyers who need financing. This could prevent or limit our ability to attract new customers as well as our ability to fully realize our backlog because our sales contracts generally include a financing contingency. Financing contingencies permit the customer to cancel his/her obligation in the event mortgage financing at prevailing interest rates, including financing arranged or provided by us, is unobtainable within the period specified in the contract. This contingency period is typically four to eight weeks following the date of execution of the sales contract. We believe that the availability of mortgage financing, including through federal government agencies or government-sponsored enterprises (such as Federal National Mortgage Association, Federal Home Loan Mortgage Corporation and FHA/VA financing), is an important factor in marketing many of our homes. Any limitations or restrictions on the availability of mortgage financing could reduce our sales. Further, if we are unable to originate mortgages for any reason going forward, our customers may experience significant mortgage loan funding issues, which could have a material impact on our homebuilding business and our consolidated financial statements.

  

 

Increases in the after-tax costs of owning a home could prevent potential customers from buying our homes and adversely affect our business or financial results.

 

Significant expenses of owning a home, including mortgage interest expenses and real estate taxes, have historically been deductible expenses for an individual’s federal, and in some cases state, income taxes, subject to limitations under tax law and policy. The "Tax Cuts and Jobs Act" which was signed into law in December 2017 includes provisions which impose significant limitations with respect to these income tax deductions. For instance, the annual deduction for real estate taxes and state and local income taxes (or sales taxes in lieu of income taxes) is now generally limited to $10,000. Furthermore, through the end of 2025, the deduction for mortgage interest is generally only available with respect to the first $750,000 of a new mortgage and there is no longer a federal deduction for interest on home equity loans. In addition, if the federal government or a state government further changes its income tax laws to further eliminate or substantially limit these income tax deductions, the after-tax cost of owning a new home would further increase for many of our potential customers. The loss or reduction of these homeowner tax deductions that have historically been available has and could further reduce the perceived affordability of homeownership, and therefore the demand for and sales price of new homes, including ours. In addition, increases in property tax rates or fees on developers by local governmental authorities, as experienced in response to reduced federal and state funding or to fund local initiatives, such as funding schools or road improvements, or increases in insurance premiums can adversely affect the ability of potential customers to obtain financing or their desire to purchase new homes, and can have an adverse impact on our business and financial results.

 

We conduct certain of our operations through unconsolidated joint ventures with independent third parties in which we do not have a controlling interest. These investments involve risks and are highly illiquid.

 

We currently operate through a number of unconsolidated homebuilding and land development joint ventures with independent third parties in which we do not have a controlling interest. At October 31, 2019, we had invested an aggregate of $127.0 million in these joint ventures, including advances to these joint ventures of $1.4 million. In addition, as part of our strategy, we intend to continue to evaluate additional joint venture opportunities; however, we may be limited in pursuing all such desirable opportunities because the indentures governing our outstanding debt securities and our credit facilities impose certain restrictions, among others, on investments by us and certain of our subsidiaries (including in joint ventures).

 

These investments involve risks and are highly illiquid. There are a limited number of sources willing to provide acquisition, development, and construction financing to land development and homebuilding joint ventures, and if market conditions become more challenging, it may be difficult or impossible to obtain financing for our joint ventures on commercially reasonable terms. Over the past few years, it has been difficult to obtain financing for newly created joint ventures. In addition, we lack a controlling interest in these joint ventures and, therefore, are usually unable to require that our joint ventures sell assets or return invested capital, make additional capital contributions, or take any other action without the vote of at least one of our venture partners. Therefore, absent partner agreement, we will be unable to liquidate our joint venture investments to generate cash.

  

Homebuilders are subject to a number of federal, local, state, and foreign laws and regulations concerning the development of land, the homebuilding, sales, and customer financing processes and the protection of the environment, which can cause us to incur delays and costs associated with compliance and which can prohibit or restrict our activity in some regions or areas.

 

We are subject to extensive and complex laws and regulations that affect the development of land and homebuilding, 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. In addition, some state and local governments in markets where we operate have approved, and others may approve, slow-growth or no-growth initiatives that could negatively impact the availability of land and building opportunities within those areas. Approval of these initiatives could adversely affect our ability to build and sell homes in the affected markets and/or could require the satisfaction of additional administrative and regulatory requirements, which could result in slowing the progress or increasing the costs of our homebuilding operations in these markets. Any of the above delays or costs could have a negative effect on our future revenues and earnings.

 

 

 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. In addition, there is a growing concern from advocacy groups and the general public that the emissions of greenhouse gases and other human activities have caused, or will cause, significant changes in weather patterns and temperatures and the frequency and severity of natural disasters. Government mandates, standards and regulations enacted in response to these projected climate change impacts could result in restrictions on land development in certain areas or increased energy, transportation and raw material costs. There is a variety of legislation being enacted, or considered for enactment at the federal, state, local and international levels relating to energy and climate change. This legislation relates to items such as carbon dioxide emissions control and building codes that impose energy efficiency standards. New building code requirements that impose stricter energy efficiency standards could significantly increase out cost to construct homes.

   

We anticipate that increasingly stringent requirements will continue to 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 was made 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. A February 2018 rule purported to delay the effective date of the June 2015 rule until February 2020, but was enjoined nationwide in August 2018 by a federal district court in South Carolina and later by a federal district court in the State of Washington in response to lawsuits (the net result of which, according to the EPA, is that the June 2015 rule applies in 22 states, the District of Columbia, and the United States territories, and that the pre-June 2015 regime applies in the rest). In October 2019, the EPA and U.S. Army Corps of Engineers promulgated a new rule, to become effective December 23, 2019, repealing the June 2015 rule and reinstating the previous rule scheme. 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 responded to the EPA’s demand letter on June 15, 2018 setting forth the Company’s defenses and expressing its willingness to enter into settlement negotiations. The parties subsequently executed a Tolling Agreement to toll the statute of limitations on collection until December 20, 2019 and are preparing an agreement to extend it to June 20, 2020 to allow the parties time to discuss settlement. The Company received a letter from the EPA on November 4, 2019 asking if the Company remained interested in settlement negotiations. The Company responded affirmatively and such negotiations are ongoing. Two other PRPs identified by the EPA are now also in negotiations with the EPA and in preliminary negotiations with the Company regarding the site. In the course of negotiations, the EPA informed the Company that the New Jersey Department of Environmental Protection has also incurred costs remediating part of the site. We believe that we have adequate reserves for this matter.

   

In 2015, the condominium association of the Four Seasons at Great Notch condominium community (the “Great Notch Plaintiff”) filed a lawsuit in the Superior Court of New Jersey, Law Division, Passaic County (the “Court”) alleging various construction defects, design defects, and geotechnical issues relating to the community. The operative complaint (“Complaint”) asserts claims against Hovnanian Enterprises, Inc. and several of its affiliates, including K. Hovnanian at Great Notch, LLC, K. Hovnanian Construction Management, Inc., and K. Hovnanian Companies, LLC. The Complaint also asserts claims against various other design professionals and contractors. The Great Notch Plaintiff has also filed a motion, which remains pending, to permit it to pursue a claim to pierce the corporate veil of K. Hovnanian at Great Notch, LLC to hold its alleged parent entities liable for any damages awarded against it. To date, the Hovnanian-affiliated defendants have reached a partial settlement with the Great Notch Plaintiff as to a portion of the Great Notch Plaintiff’s claims against them for an amount immaterial to the Company. On its remaining claims against the Hovnanian-affiliated defendants, the Great Notch Plaintiff has asserted damages of approximately $119.5 million, which amount is potentially subject to treble damages pursuant to the Great Notch Plaintiff’s claim under the New Jersey Consumer Fraud Act. On August 17, 2018, the Hovnanian-affiliated defendants filed a motion for summary judgment seeking dismissal of all of the Great Notch Plaintiff’s remaining claims against them, which was withdrawn without prejudice to re-file with supplemental evidence. The trial is currently scheduled for April 20, 2020. An initial court-ordered mediation session took place on November 19, 2019. An additional mediation session is contemplated, but has not yet been scheduled. The Hovnanian-affiliated defendants intend to defend these claims vigorously.

 

 

Legal claims not resolved in our favor, such as product liability litigation and warranty claims may be costly.

 

As discussed in Item 3 – “Legal Proceedings,” in the ordinary course of business we are involved in litigation from time to time, including with home owners associations, home buyers and other persons with whom we have relationships. For example, as a homebuilder, we are subject to construction defect and home warranty claims, including moisture intrusion and related claims, arising in the ordinary course of business. Such claims are common in the homebuilding industry and can be costly. For example, in the past we have received construction defect and home warranty claims associated with, and we were involved in a multidistrict litigation concerning, allegedly defective drywall manufactured in China that may have been responsible for noxious smells and accelerated corrosion of certain metals in certain homes we have constructed. We remediated certain homes in response to such claims and settled the litigation.

  

With regard to certain general liability exposures such as product liability claims, construction defect claims and related claims, assessment of claims and the related liability and reserve estimation process is highly judgmental and subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products we build, claim settlement patterns, insurance industry practices and legal interpretations, among others. Because of the high degree of judgment required in determining these estimated liability amounts, actual future costs could differ significantly from our currently estimated amounts. Furthermore, after claims are asserted for construction defects, it can be difficult to determine the extent to which assertions of such claims will expand geographically. For example, the Company has been a party to litigation in New Jersey concerning alleged defects in construction (see Item 3 – “Legal Proceedings” and Note 18 to our Consolidated Financial Statements for the year ended October 31, 2019). In addition, the amount and scope of coverage offered by insurance companies is currently limited, and this coverage may be further restricted and become more costly. If we are not able to obtain adequate insurance against such claims, if the costs associated with such claims significantly exceed the amount of our insurance coverage, or if our insurers do not pay on claims under our policies (whether because of dispute, inability, or otherwise), we may experience losses that could hurt our financial results.

  

Our financial results could also be adversely affected if we were to experience an unusually high number of claims or unusually severe claims. Our insurance companies have the right to review our claims and claims history, and do so from time to time, and could decline to pay on such claims if such reviews determine the claims did not meet the terms for coverage. Additionally, we may need to significantly increase our construction defect and home warranty reserves as a result of insurance not being available for any of the reasons discussed above, such claims or the results of our annual actuarial study.

 

Mortgage investors could seek to have us buy back loans or compensate them for losses incurred on mortgages we have sold based on claims that we breached our limited representations or warranties.

 

Our financial services segment originates mortgages, primarily for our homebuilding customers. Substantially all of the mortgage loans originated are sold within a short period of time in the secondary mortgage market on a servicing released, nonrecourse basis, although we remain liable for certain limited representations, such as fraud, and warranties related to loan sales. Accordingly, mortgage investors have in the past and could in the future seek to have us buy back loans or compensate them for losses incurred on mortgages we have sold based on claims that we breached our limited representations or warranties. While we believe these reserves are adequate for known losses and projected repurchase requests, given the volatility in the mortgage industry and the uncertainty regarding the ultimate resolution of these claims, if either actual repurchases or the losses incurred resolving those repurchases exceed our expectations, additional expense may be incurred. There can be no assurance that we will not have significant liabilities in respect of such claims in the future, which could exceed our reserves, or that the impact of such claims on our results of operations will not be material. Further, an increase in the default rate on the mortgages we originate may adversely affect our ability to sell mortgages or the pricing we receive upon the sale of mortgages.

 

We compete on several levels with homebuilders that may have greater sales and financial resources, which could hurt future earnings.

 

We compete not only for home buyers but also for desirable properties, financing, raw materials, and skilled labor often within larger subdivisions designed, planned, and developed by other homebuilders. Our competitors include other local, regional and national homebuilders, some of which have greater sales and financial resources or more established relationships with suppliers and subcontractors in the markets in which we operate. In addition, we compete with other housing alternatives, such as existing homes and rental housing. In the homebuilding industry, we compete primarily on the basis of reputation, price, location, design, quality, service and amenities. Our financial services segment competes with other mortgage providers, primarily on the basis of fees, interest rates and other features of mortgage loan products.

 

 

The competitive conditions in the homebuilding industry together with current market conditions have, and could continue to, result in:

 

	●	difficulty in acquiring suitable land at acceptable prices (see also “−Our success depends on the availability of suitable undeveloped land and improved lots at acceptable prices and our having sufficient liquidity to fund such investments”);
	●	increased selling incentives;
	●	lower sales;
	●	delays in construction; or
	●	impairment of our ability to implement our strategies and operational actions.

 

Any of these problems could increase costs and/or lower profit margins.

 

Our future growth may include additional acquisitions of companies that may not be successfully integrated and may not achieve expected benefits.

 

Acquisitions of companies have contributed to our historical growth and may again be a component of our growth strategy in the future. In the future, we may acquire businesses, some of which may be significant. As a result of acquisitions of companies, we may need to seek additional financing and integrate product lines, dispersed operations, and distinct corporate cultures. These integration efforts may not succeed or may distract our management from operating our existing business. Additionally, we may not be able to enhance our earnings as a result of acquisitions. Our failure to successfully identify and manage future acquisitions could harm our operating results.

  

Our controlling stockholders are able to exercise significant influence over us.

 

Members of the Hovnanian family, including Ara K. Hovnanian, our chairman of the board, president, and chief executive officer, have voting control, through personal holdings, the limited partnership and the limited liability company established for members of Mr. Hovnanian’s family and family trusts of Class A and Class B common stock that enabled them to cast approximately 56% of the votes that could be cast by the holders of our outstanding Class A and Class B common stock combined as of October 31, 2019. Their combined stock ownership enables them to exert significant control over us, including power to control the election of the Board of Directors and to approve matters presented to our stockholders. This concentration of ownership may also make some transactions, including mergers or other changes in control, more difficult or impossible without their support. Also, because of their combined voting power, circumstances may occur in which their interests could be in conflict with the interests of other stakeholders.

 

Our net operating loss carryforwards could be substantially limited if we experience an ownership change as defined in the Internal Revenue Code.

 

Based on past impairments and our current financial performance, we generated a federal net operating loss carryforward of $1.6 billion through the fiscal year ended October 31, 2019, and we may generate net operating loss carryforwards in future years.

 

Section 382 of the United States Internal Revenue Code of 1986, as amended (the “Code”), contains rules that limit the ability of a company that undergoes an ownership change, which is generally any change in ownership of more than 50% of its stock over a three-year period, to utilize its net operating loss carryforwards and certain built-in losses recognized in years after the ownership change. These rules generally operate by focusing on ownership shifts among stockholders owning directly or indirectly 5% or more of the stock of a company and any change in ownership arising from a new issuance of stock by the company.

 

If we undergo an ownership change for purposes of Section 382 as a result of future transactions involving our stock, including purchases or sales of stock between 5% shareholders, our ability to use our net operating loss carryforwards and to recognize certain built-in losses would be subject to the limitations of Section 382. Depending on the resulting limitation, a significant portion of our net operating loss carryforwards could expire before we would be able to use them. A limitation imposed under Section 382 on our ability to utilize our net operating loss carryforwards could have a negative impact on our financial position and results of operations.

 

 

The value of our deferred tax assets is also dependent upon the tax rates expected to be in effect at the time the taxable income is expected to be generated. A decrease in enacted corporate tax rates in our major jurisdictions, especially the U.S. federal corporate rate, would decrease the value of our deferred tax assets, which could be material.

 

 Our Board of Directors has adopted, and our shareholders have approved, a shareholder rights plan (the “Rights Plan”) designed to preserve shareholder value and the value of certain tax assets primarily associated with net operating loss carryforwards and built-in losses under Section 382 of the Code. The Rights Plan is intended to act as a deterrent to any person or group acquiring 4.9% or more of our outstanding Class A common stock (any such person an “Acquiring Person”), without the approval of the Company’s Board of Directors. Subject to the terms, provisions and conditions of the Rights Plan, if and when they become exercisable, each right would entitle its holder to purchase from the Company one ten-thousandth of a share of the Company’s Series B Junior Preferred Stock for a purchase price of $16.60 per share (the “purchase price”). The rights will not be exercisable until the earlier of (i) 10 business days after a public announcement by us that a person or group has become an Acquiring Person and (ii) 10 business days after the commencement of a tender or exchange offer by a person or group for 4.9% of the Class A common stock (the “distribution date”). If issued, each fractional share of Series B Junior Preferred Stock would give the stockholder approximately the same dividend, voting and liquidation rights as does one share of the Company’s Class A common stock. However, prior to exercise, a right does not give its holder any rights as a stockholder of the Company, including without limitation any dividend, voting or liquidation rights. After the distribution date, each holder of a right, other than rights beneficially owned by the Acquiring Person (which will thereupon become void), will thereafter have the right to receive upon exercise of a right and payment of the purchase price, that number of shares of Class A common stock or Class B common stock, as the case may be, having a market value of two times the purchase price. After the distribution date, our Board of Directors may exchange the rights (other than rights owned by an Acquiring Person which will have become void), in whole or in part, at an exchange ratio of one share of common stock, or a fractional share of Series B Junior Preferred Stock (or of a share of a similar class or series of Hovnanian’s preferred stock having similar rights, preferences and privileges) of equivalent value, per right (subject to adjustment).

 

In addition, our Restated Certificate of Incorporation restricts certain transfers of our common stock in order to preserve the tax treatment of our net operating loss carryforwards and built-in losses under Section 382 of the Code. Subject to certain exceptions pertaining to pre-existing 5% stockholders and Class B stockholders, the transfer restrictions in our Restated Certificate of Incorporation generally restrict any direct or indirect transfer (such as transfers of the Company’s stock that result from the transfer of interests in other entities that own the Company’s stock) if the effect would be to: (i) increase the direct or indirect ownership of the Company’s stock by any person (or public group) from less than 5% to 5% or more of the Company’s stock; (ii) increase the percentage of the Company’s stock owned directly or indirectly by a person (or public group) owning or deemed to own 5% or more of the Company’s stock; or (iii) create a new “public group” (as defined in the applicable United States Treasury regulations).

  

Utility shortages and outages or rate fluctuations could have an adverse effect on our operations.

 

In prior years, the areas in which we operate in California have experienced power shortages, including periods without electrical power, as well as significant fluctuations in utility costs. We may incur additional costs and may not be able to complete construction on a timely basis if such power shortages and outages and utility rate fluctuations continue. Furthermore, power shortages and outages and rate fluctuations may adversely affect the regional economies in which we operate, which may reduce demand for our homes. Our operations may be adversely affected if further rate fluctuations and/or power shortages and outages occur in California, the Northeast or in our other markets.

 

Geopolitical risks and market disruption could adversely affect our operating results and financial condition.

 

Geopolitical events, acts of war or terrorism, civil unrest, any outbreak or escalation of hostilities throughout the world, health pandemics, catastrophic storms, other severe weather or significant environmental accidents, may have a substantial impact on the economy, consumer confidence, the housing market, our associates and our customers. Further, perceived threats to national security and other actual or potential conflicts or wars and related geopolitical risks have created many economic and political uncertainties. If any such events were to occur, it could have a material adverse impact on our results of operations and financial condition.

 

We could be adversely impacted by the loss of key management personnel or if we fail to attract qualified personnel.

 

To a significant degree, our future success depends on the efforts of our senior management, many of whom have been with the Company for a significant number of years, and our ability to attract qualified personnel. Our operations could be adversely affected if key members of our senior management leave the Company or if we cannot attract qualified personnel to manage growth in our business.

 

 

Information technology failures and data security breaches could harm our business.

 

We use information technology, digital telecommunications and other computer resources to carry out important operational activities and to maintain our business records. In addition, we rely on the systems of third parties, such as third-party vendors. Our computer systems, including our backup systems, and those of the third-parties on whose systems we rely, are subject to damage or interruption from computer and telecommunications failures, computer viruses, power outages, security breaches (including through data-theft and cyber-attack), usage errors by our associates and catastrophic events, such as fires, floods, hurricanes and tornadoes. As part of our normal business activities, we collect and store certain personal identifying and confidential information relating to our homebuyers, employees, vendors and suppliers, and maintain operational and financial information related to our business. We may share some of this confidential information with our vendors. We rely on our vendors and third-party service providers to maintain effective cybersecurity measures to keep our information secure. If our computer systems and our backup systems, or those of the third-parties on whose systems we rely, are breached, compromised, damaged, or otherwise cease to function properly, we could suffer interruptions in our operations or the misappropriation of proprietary, personal identifying or confidential information, including information about our business partners and home buyers. Our or our vendors’ and third-party service providers’ failure to maintain the security of the data we are required to protect could result in damage to our reputation, financial obligations to third parties, fines, penalties, regulatory proceedings and private litigation with potentially large costs, and also in deterioration in customers’ confidence in us and other competitive disadvantages.

 

We maintain cybersecurity insurance coverage have implemented systems and processes intended to secure our information technology systems and prevent unauthorized access to or loss of sensitive, confidential and personal data, including through the use of encryption and authentication technologies. Additionally, we have increased our monitoring capabilities to enhance early detection and rapid response to potential security anomalies. These measures, which require ongoing monitoring and updating as technologies change and efforts to overcome security measures become increasingly sophisticated, are costly and may not be effective in preventing or mitigating significant negative occurrences or irregularities in our systems or those of third-parties on whose systems we rely. While, to date, we have not had a significant cybersecurity breach or attack that has a material impact on our business or results of operations, there can be no assurance that our efforts to maintain the security and integrity of our IT networks and related systems will be effective or that attempted security breaches or disruptions would not be successful or damaging.

 

Negative publicity could adversely affect our reputation and our business, financial results and stock price.

 

Unfavorable media related to our industry, company, brand, personnel, operations, business performance, or prospects may impact our stock price and the performance of our business, regardless of its accuracy or inaccuracy. The speed at which negative publicity is disseminated has increased dramatically through the use of electronic communication, including social media outlets, websites, "tweets", and blogs. Our success in maintaining and expanding our brand image depends on our ability to adapt to this rapidly changing media environment. Adverse publicity or negative commentary from any media outlets could damage our reputation and reduce the demand for our homes, which would adversely affect our business.

  

 

ITEM 1B

UNRESOLVED STAFF COMMENTS

 

None.

  

ITEM 2

PROPERTIES

 

We rent approximately 57,000 square feet of office space in the Northeast for our corporate headquarters. We own 215,000 square feet of office and warehouse space throughout the Midwest. We lease approximately 322,000 square feet of space for our segments located in the Northeast, Mid-Atlantic, Midwest, Southeast, Southwest and West.

  

ITEM 3

LEGAL PROCEEDINGS

 

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. The significant majority of our litigation matters are related to construction defect claims. Our estimated losses from construction defect litigation matters, if any, are included in our construction defect reserves as discussed in Note 16 to the Consolidated Financial Statements.

  

 

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 continue to 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 was made 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. A February 2018 rule purported to delay the effective date of the June 2015 rule until February 2020, but was enjoined nationwide in August 2018 by a federal district court in South Carolina and later by a federal district court in the State of Washington in response to lawsuits (the net result of which, according to the EPA, is that the June 2015 rule applies in 22 states, the District of Columbia, and the United States territories, and that the pre-June 2015 regime applies in the rest). In October 2019, the EPA and U.S. Army Corps of Engineers promulgated a new rule, to become effective December 23, 2019, repealing the June 2015 rule and reinstating the previous rule scheme. 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 responded to the EPA’s demand letter on June 15, 2018 setting forth the Company’s defenses and expressing its willingness to enter into settlement negotiations. The parties subsequently executed a Tolling Agreement to toll the statute of limitations on collection until December 20, 2019 and are preparing an agreement to extend it to June 20, 2020 to allow the parties time to discuss settlement. The Company received a letter from the EPA on November 4, 2019 asking if the Company remained interested in settlement negotiations. The Company responded affirmatively and such negotiations are ongoing. Two other PRPs identified by the EPA are now also in negotiations with the EPA and in preliminary negotiations with the Company regarding the site. In the course of negotiations, the EPA informed the Company that the New Jersey Department of Environmental Protection has also incurred costs remediating part of the site. We believe that we have adequate reserves for this matter.

 

   

 

In 2015, the condominium association of the Four Seasons at Great Notch condominium community (the “Great Notch Plaintiff”) filed a lawsuit in the Superior Court of New Jersey, Law Division, Passaic County (the “Court”) alleging various construction defects, design defects, and geotechnical issues relating to the community. The operative complaint (“Complaint”) asserts claims against Hovnanian Enterprises, Inc. and several of its affiliates, including K. Hovnanian at Great Notch, LLC, K. Hovnanian Construction Management, Inc., and K. Hovnanian Companies, LLC. The Complaint also asserts claims against various other design professionals and contractors. The Great Notch Plaintiff has also filed a motion, which remains pending, to permit it to pursue a claim to pierce the corporate veil of K. Hovnanian at Great Notch, LLC to hold its alleged parent entities liable for any damages awarded against it. To date, the Hovnanian-affiliated defendants have reached a partial settlement with the Great Notch Plaintiff as to a portion of the Great Notch Plaintiff’s claims against them for an amount immaterial to the Company. On its remaining claims against the Hovnanian-affiliated defendants, the Great Notch Plaintiff has asserted damages of approximately $119.5 million, which amount is potentially subject to treble damages pursuant to the Great Notch Plaintiff’s claim under the New Jersey Consumer Fraud Act. On August 17, 2018, the Hovnanian-affiliated defendants filed a motion for summary judgment seeking dismissal of all of the Great Notch Plaintiff’s remaining claims against them, which was withdrawn without prejudice to re-file with supplemental evidence. The trial is currently scheduled for April 20, 2020. An initial court-ordered mediation session took place on November 19, 2019. An additional mediation session is contemplated, but has not yet been scheduled. The Hovnanian-affiliated defendants intend to defend these claims vigorously.

 

ITEM 4

MINE SAFETY DISCLOSURES

 

Not applicable

 

INFORMATION ABOUT OUR EXECUTIVE OFFICERS

 

Information on executive officers of the registrant is incorporated herein from Part III, Item 10.

  

Part II

 

ITEM 5

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Our Class A Common Stock is traded on the New York Stock Exchange under the symbol “HOV” and was held by 416 stockholders of record at December 13, 2019. There is no established public trading market for our Class B Common Stock, which was held by 214 stockholders of record at December 13, 2019. If a shareholder desires to sell shares of Class B Common Stock (other than to Permitted Transferees (as defined in the Company’s amended Certificate of Incorporation)), such stock must be converted into shares of Class A Common Stock at a one to one conversion rate. 

 

Recent Sales of Unregistered Equity Securities

 

On October 31, 2019, in connection with the issuance of the 7.75% Senior Secured 1.25 Lien Notes due 2026, we issued and sold an aggregate of 178,427 shares of Class A Common Stock, par value $0.01 per share (and associated Preferred Stock Purchase Rights), to the purchasers of such Notes for an aggregate purchase price of $1,784.27. The issuance was exempt from registration under Section 4(a)(2) of the Securities Act of 1933.

 

Issuer Purchases of Equity Securities

 

No shares of our Class A Common Stock or Class B Common Stock were purchased by or on behalf of the Company or any affiliated purchaser during the fiscal fourth quarter of 2019. The maximum number of shares that may yet be purchased under the Company’s repurchase plans or programs is 22 thousand.

  

 

ITEM 6

SELECTED FINANCIAL DATA

 

The following table sets forth our selected consolidated financial data and should be read in conjunction with Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and Notes thereto included elsewhere in this Annual Report on Form 10-K. 

  

		Year Ended
Summary of Consolidated Statements of Operations Data (In thousands, except per share data)		October 31, 2019			October 31, 2018			October 31, 2017			October 31, 2016			October 31, 2015
Revenues		$2,016,916			$1,991,233			$2,451,665			$2,752,247			$2,148,480
Expenses excluding inventory impairment loss and land option write-offs		2,036,792			1,996,083			2,437,195			2,708,912			2,162,370
Inventory impairment loss and land option write-offs		6,288			3,501			17,813			33,353			12,044
Total expenses		2,043,080			1,999,584			2,455,008			2,742,265			2,174,414
Loss on extinguishment of debt		(42,436	)		(7,536	)		(34,854	)		(3,200	)		-
Income (loss) from unconsolidated joint ventures		28,932			24,033			(7,047	)		(4,346	)		4,169
(Loss) income before income taxes		(39,668	)		8,146			(45,244	)		2,436			(21,765	)
State and federal income tax provision (benefit)		2,449			3,626			286,949			5,255			(5,665	)
Net (loss) income		$(42,117	)		$4,520			$(332,193	)		$(2,819	)		$(16,100	)
Per share data:
Basic:
Net (loss) income per common share		$(7.06	)		$0.73			$(56.23	)		$(0.48	)		$(2.74	)
Weighted-average number of common shares outstanding		5,968			5,941			5,908			5,898			5,876
Assuming dilution:
Net (loss) income per common share		$(7.06	)		$0.72			$(56.23	)		$(0.48	)		$(2.74	)
Weighted-average number of common shares outstanding		5,968			6,072			5,908			5,898			5,876

 

Summary of Consolidated Balance Sheet Data

 

(In thousands)		October 31, 2019			October 31, 2018			October 31, 2017			October 31, 2016			October 31, 2015
Total assets(1)		$1,881,424			$1,662,042			$1,900,898			$2,354,956			$2,577,398
Mortgages and lines of credit (1)		$343,862			$208,733			$244,088			$294,015			$310,672
Term loans and revolving loans, senior notes, senior amortizing notes, senior exchangeable notes and tangible equity unit (“TEU”) senior subordinated amortizing notes (net of discount and premium)		$1,479,990			$1,439,238			$1,585,837			$1,573,333			$1,827,924
Total equity deficit		$(489,776	)		$(453,504	)		$(460,371	)		$(128,510	)		$(128,084	)

  

(1) In connection with our adoption of Accounting Standards Update 2015-03 in November 2016, certain prior year amounts for unamortized debt issuance costs were reclassified between the lines “Total assets” and “Mortgages and lines of credit” and “Term loans and revolving loans, senior notes, senior amortizing notes, senior exchangeable notes and tangible equity unit (“TEU”) senior subordinated amortizing note (net of discount and premium)”.

 

 

ITEM 7

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Hovnanian Enterprises, Inc. (“HEI”) conducts all of its homebuilding and financial services operations through its subsidiaries (references herein to the “Company,” “we,” “us” or “our” refer to HEI and its consolidated subsidiaries and should be understood to reflect the consolidated business of HEI’s subsidiaries).

 

Overview

 

Our community count increased 14.6% from 123 communities at October 31, 2018 to 141 at October 31, 2019. For seven consecutive quarters through the third quarter of fiscal 2019, our total number of lots controlled increased as compared to the same period of the prior year. Although there was a slight decrease in total lots controlled of 3.2% as of October 31, 2019 as compared to October 31, 2018, the growth in lots controlled in previous quarters has led to the year-over-year community count growth. Our strategy has been to grow through increased open for sale communities. As our recently opened communities begin delivering homes, we believe it should lead to additional delivery and revenue growth, and in turn profitability in future periods, absent adverse market factors.

 

Our cash position has allowed us to spend $562.8 million on land purchases and land development during fiscal 2019, and still have total liquidity of $275.9 million, including $131.0 million of homebuilding cash and cash equivalents as of October 31, 2019. We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices, sales pace and construction costs 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; however, we remain cautious and are carefully evaluating market conditions when pursuing new land acquisitions.

 

Additional results for the year ended October 31, 2019 were as follows:

 

● For the year ended October 31, 2019, sale of homes revenues increased 2.3% as compared to the prior year, as a result of a 2.0% increase in deliveries, primarily due to our increased community count.

 

● Gross margin percentage decreased from 15.2% for the year ended October 31, 2018 to 14.2% for the year ended October 31, 2019. This decrease was primarily due to the increase in cost of sales interest as a result of changes in estimates of interest per home for deliveries during fiscal 2019 in connection with our semi-annual community life planning process, along with a decrease due to the mix of communities delivering in each period. During this planning process, the duration of communities and timing of spending thereon could change, resulting in changes in total estimated community life capitalized interest. Estimated community life capitalized interest is written-off with each delivery. Gross margin percentage, before cost of sales interest expense and land charges, decreased slightly from 18.4% for the year ended October 31, 2018 to 18.1% for the year ended October 31, 2019, primarily due to the mix of communities delivering.

 

● Selling, general and administrative costs (including corporate general and administrative expenses) increased $4.3 million for the year ended October 31, 2019 as compared to the prior year, primarily as a result of our increased community count, along with a lower adjustment to our warranty reserves (as a result of our annual actuarial analysis) in fiscal 2019 as compared to fiscal 2018. However, as a percentage of total revenue, such costs remained relatively flat at 11.6% for the year ended October 31, 2019 compared to 11.5% for the year ended October 31, 2018.

 

● Active selling communities at October 31, 2019 increased 14.6% over last year, and our average active selling communities increased by 5.4% over last year. Net contracts increased 14.3% for the year ended October 31, 2019, compared to the prior year.

 

● Net contracts per average active selling community increased to 39.0 for the year ended October 31, 2019 compared to 35.9 in the prior year.

 

● Contract backlog increased from 1,826 homes at October 31, 2018 to 2,191 homes at October 31, 2019, with a dollar value of $880.1 million, representing a 18.0% increase in dollar value compared to the prior year.

   

When comparing sequentially from the third quarter of fiscal 2019 to the fourth quarter of fiscal 2019, our gross margin percentage increased slightly from 14.0% to 14.5% and our gross margin percentage, before cost of sales interest expense and land charges, also increased slightly from 18.4% to 18.9%, both primarily as a result of product mix, as well as a minor increase due to the increase in delivery volume. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenues decreased from 12.1% to 7.6%, as compared to the third quarter of fiscal 2019, primarily due to the increase in delivery volume.

     

 

Critical Accounting Policies

 

Management believes that the following critical accounting policies require its most significant judgments and estimates used in the preparation of the consolidated financial statements:

  

Income Recognition from Mortgage Loans - Our Financial Services segment originates mortgages, primarily for our homebuilding customers. We use mandatory investor commitments and forward sales of mortgage backed securities (“MBS”) to hedge our mortgage-related interest rate exposure on agency and government loans.

 

We elected the fair value option for our mortgage loans held for sale in accordance with Accounting Standards Codification (“ASC”) 825, “Financial Instruments,” which permits us to measure our loans held for sale at fair value. 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.

 

Substantially all of the mortgage loans originated are sold within a short period of time in the secondary mortgage market on a servicing released, nonrecourse basis, although the Company remains liable for certain limited representations, such as fraud, and warranties related to loan sales. Mortgage investors could seek to have us buy back loans or compensate them for losses incurred on mortgages we have sold based on claims that we breached our limited representations and warranties. We have established reserves for probable losses. While we believe these reserves are adequate for known losses and projected repurchase requests, given the volatility in the mortgage industry and the uncertainty regarding the ultimate resolution of these claims, if either actual repurchases or the losses incurred resolving those repurchases exceed our expectations, additional expense may be incurred.  

 

Inventories - Inventories consist of land, land development, home construction costs, capitalized interest, construction overhead and property taxes. Construction costs are accumulated during the period of construction and charged to cost of sales under specific identification methods. Land, land development and common facility costs are allocated based on buildable acres to product types within each community, then charged to cost of sales equally based upon the number of homes to be constructed in each product type.

 

We record inventories in our consolidated balance sheets at cost unless the inventory is determined to be impaired, in which case the inventory is written down to its fair value. Our inventories consist of the following three components: (1) sold and unsold homes and lots under development, which includes all construction, land, capitalized interest and land development costs related to started homes and land under development in our active communities; (2) land and land options held for future development or sale, which includes all costs related to land in our communities in planning or mothballed communities; and (3) consolidated inventory not owned, which includes all costs related to variable interest entities and other options, which consists primarily of model homes financed with an investor and inventory related to land banking arrangements accounted for as financings.

   

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 Consolidated Balance Sheets from “Sold and unsold homes and lots under development” to “Land and land options held for future development or sale.” As of October 31, 2019, the net book value associated with our 13 mothballed communities was $13.8 million, net of impairment charges recorded in prior periods of $138.1 million. We regularly review communities to determine if mothballing is appropriate. During fiscal 2019, we did not mothball any communities, but we sold two previously mothballed communities and re-activated three previously mothballed communities.

 

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 606-10-55-68, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheets, at October 31, 2019, inventory of $54.2 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $51.2 million recorded to “Liabilities from inventory not owned.”

   

 

We have land banking arrangements, whereby we sell our land parcels to the land banker and they provide us an option to purchase back finished lots on a quarterly basis. Because of our options to repurchase these parcels, for accounting purposes, in accordance with ASC 606-10-55-70, these transactions are considered financings rather than sales. For purposes of our Consolidated Balance Sheets, at October 31, 2019, inventory of $136.1 million was recorded as “Consolidated inventory not owned,” with a corresponding amount of $89.8 million recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions.

 

The recoverability of inventories and other long-lived assets is assessed in accordance with the provisions of ASC 360-10, “Property, Plant and Equipment − Overall” (“ASC 360-10”). ASC 360-10 requires long-lived assets, including inventories, held for development to be evaluated for impairment based on undiscounted future cash flows of the assets at the lowest level for which there are identifiable cash flows. As such, we evaluate inventories for impairment at the individual community level, the lowest level of discrete cash flows that we measure.

 

We evaluate inventories of communities under development and held for future development for impairment when indicators of potential impairment are present. Indicators of impairment include, but are not limited to, decreases in local housing market values, decreases in gross margins or sales absorption rates, decreases in net sales prices (base sales price net of sales incentives), or actual or projected operating or cash flow losses. The assessment of communities for indication of impairment is performed quarterly. As part of this process, we prepare detailed budgets for all of our communities at least semi-annually and identify those communities with a projected operating loss. For those communities with projected losses, we estimate the remaining undiscounted future cash flows and compare those to the carrying value of the community, to determine if the carrying value of the asset is recoverable.

 

The projected operating profits, losses, or cash flows of each community can be significantly impacted by our estimates of the following:

 

	●	future base selling prices;
	●	future home sales incentives;
	●	future home construction and land development costs; and
	●	future sales absorption pace and cancellation rates.

  

These estimates are dependent upon specific market conditions for each community. While we consider available information to determine what we believe to be our best estimates as of the end of a quarterly reporting period, these estimates are subject to change in future reporting periods as facts and circumstances change. Local market-specific conditions that may impact our estimates for a community include:

 

	●	the intensity of competition within a market, including available home sales prices and home sales incentives offered by our competitors;
	●	the current sales absorption pace for both our communities and competitor communities;
	●	community specific attributes, such as location, availability of lots in the market, desirability and uniqueness of our community, and the size and style of homes currently being offered;
	●	potential for alternative product offerings to respond to local market conditions;
	●	changes by management in the sales strategy of the community;
	●	current local market economic and demographic conditions and related trends of forecasts; and
	●	existing home inventory supplies, including foreclosures and short sales.

 

 

These and other local market-specific conditions that may be present are considered by management in preparing projection assumptions for each community. The sales objectives can differ between our communities, even within a given market. For example, facts and circumstances in a given community may lead us to price our homes with the objective of yielding a higher sales absorption pace, while facts and circumstances in another community may lead us to price our homes to minimize deterioration in our gross margins, although it may result in a slower sales absorption pace. In addition, the key assumptions included in our estimate of future undiscounted cash flows may be interrelated. For example, a decrease in estimated base sales price or an increase in homes sales incentives may result in a corresponding increase in sales absorption pace. Additionally, a decrease in the average sales price of homes to be sold and closed in future reporting periods for one community that has not been generating what management believes to be an adequate sales absorption pace may impact the estimated cash flow assumptions of a nearby community. Changes in our key assumptions, including estimated construction and development costs, absorption pace and selling strategies, could materially impact future cash flow and fair-value estimates. Due to the number of possible scenarios that would result from various changes in these factors, we do not believe it is possible to develop a sensitivity analysis with a level of precision that would be meaningful to an investor.

   

If the undiscounted cash flows are more than the carrying value of the community, then the carrying amount is recoverable, and no impairment adjustment is required. However, if the undiscounted cash flows are less than the carrying amount, then the community is deemed impaired and is written down to its fair value. We determine the estimated fair value of each community by determining the present value of its estimated future cash flows at a discount rate commensurate with the risk of the respective community, or in limited circumstances, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale), and recent bona fide offers received from outside third parties. Our discount rates used for all impairments recorded from October 31, 2017 to October 31, 2019 ranged from 16.8% to 19.8%. The estimated future cash flow assumptions are virtually the same for both our recoverability and fair value assessments. Should the estimates or expectations used in determining estimated cash flows or fair value, including discount rates, decrease or differ from current estimates in the future, we may be required to recognize additional impairments related to current and future communities. The impairment of a community is allocated to each lot on a relative fair value basis.

 

From time to time, we write off deposits and approval, engineering and capitalized interest costs when we determine that it is no longer probable that we will exercise options to buy land in specific locations or when we redesign communities and/or abandon certain engineering costs. In deciding not to exercise a land option, we take into consideration changes in market conditions, the timing of required land takedowns, the willingness of land sellers to modify terms of the land option contract (including timing of land takedowns), and the availability and best use of our capital, among other factors. The write-off is recorded in the period it is deemed not probable that the optioned property will be acquired. In certain instances, we have been able to recover deposits and other pre-acquisition costs that were previously written off. These recoveries have not been significant in comparison to the total costs written off.

  

Inventories held for sale are land parcels ready for sale in their current condition, where we have decided not to build homes but are instead actively marketing for sale. These land parcels represented $6.4 million of our total inventories at October 31, 2018, and are reported at the lower of carrying amount or fair value less costs to sell. There were no inventories held for sale at October 31, 2019. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties.

  

Unconsolidated Homebuilding and Land Development Joint Ventures - Investments in unconsolidated homebuilding and land development joint ventures are accounted for under the equity method of accounting. Under the equity method, we recognize our proportionate share of earnings and losses earned by the joint venture upon the delivery of lots or homes to third parties. Our ownership interests in the joint ventures vary but our voting interests are generally 50% or less. In determining whether or not we must consolidate joint ventures where we are the managing member of the joint venture, 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 significant operating and capital decisions of the partnership, including budgets, in the ordinary course of business. The evaluation of whether or not we control a venture can require significant judgment. In accordance with ASC 323-10, “Investments - Equity Method and Joint Ventures – Overall,” we assess our investments in unconsolidated joint ventures for recoverability, and if it is determined that a loss in value of the investment below its carrying amount is other than temporary, we write down the investment to its fair value. We evaluate our equity investments for impairment based on the joint venture’s projected cash flows. This process requires significant management judgment and estimates. During fiscal 2019 and fiscal 2017, we wrote down certain joint venture investments by $0.9 million and $2.8 million, respectively. There were no write-downs in fiscal 2018.

 

Warranty Costs and Construction Defect Reserves - 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 2019 and 2018, 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 2019 and 2018 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 2019 and 2018. We do not have a deductible on our worker's compensation insurance. Reserves for estimated losses for construction defects, warranty and bodily injury claims have been established using the assistance of a third-party actuary. 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. These estimates are subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products we build, claim settlement patterns, insurance industry practices and legal interpretations, among others. Because of the high degree of judgment required in determining these estimated liability amounts, actual future costs could differ significantly from our currently estimated amounts. 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. See Note 16 to the Consolidated Financial Statements for additional information on the amount of warranty costs recognized in cost of goods sold and administrative expenses.

   

 

Recent Accounting Pronouncements

 

See Note 3 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K.

  

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 (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 October 31, 2019 decreased $56.9 million from October 31, 2018. We spent $562.8 million on land and land development during the period. After considering this land and land development and all other operating activities, including revenue received from deliveries, we used $249.1 million of cash from operations. However, as of October 31, 2019, we had $125.0 million of borrowing capacity under our Secured Credit Agreement (defined below), and therefore, our total liquidity at October 31, 2019 was $275.9 million, which is above our target liquidity range of $170.0 to $245.0 million. During fiscal 2019, we used $8.3 million of cash for investing activities, primarily for investments in joint ventures, partially offset by distributions from joint ventures. Cash provided by financing activities was $206.7 million during fiscal 2019, which included net proceeds of $8.2 million from debt issuances, $78.5 million from land banking and model sale leaseback programs, $109.0 million of net proceeds from nonrecourse mortgages and $27.1 million from in mortgage warehouse lines of credit. Subject to covenant restrictions in our debt instruments, we intend to continue to use nonrecourse mortgage financings, model sale leaseback, joint ventures, and land banking programs as our business needs dictate.

  

Our cash uses during the years ended October 31, 2019 and 2018 were for operating expenses, land purchases, land deposits, land development, construction spending, debt refinancings and payments, state income taxes, interest payments, litigation matters and investments in joint ventures. During these periods, we provided for our cash requirements from available cash on hand, housing and land sales, financing transactions, model sale leasebacks, land banking transactions, joint ventures, financial service revenues and other revenues. We believe that these sources of cash together with available borrowings under our senior secured revolving credit facility will be sufficient through fiscal 2020 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, causing us to generate positive cash flow from operations. In fiscal 2019 and 2018, with continued spending on land purchases and land development, we used cash in operations. As we continue to actively seek land investment opportunities, we will also remain focused on liquidity.

 

See “Inventory Activities” below for a detailed discussion of our inventory position.

 

 

Debt Transactions

 

Senior notes and credit facilities balances as of October 31, 2019 and October 31, 2018, were as follows:

(In thousands)		October 31, 2019(1)			October 31, 2018(1)
Senior Secured Notes:
9.5% Senior Secured Notes due November 15, 2020		$-			$75,000
2.0% Senior Secured Notes due November 1, 2021		-			53,203
5.0% Senior Secured Notes due November 1, 2021		-			141,797
10.0% Senior Secured Notes due July 15, 2022		218,994			440,000
10.5% Senior Secured Notes due July 15, 2024		211,391			400,000
7.75% Senior Secured 1.125 Lien Notes due February 15, 2026		350,000			-
10.5% Senior Secured 1.25 Lien Notes due February 15, 2026		282,322			-
11.25% Senior Secured 1.5 Lien Notes due February 15, 2026		103,141			-
Total Senior Secured Notes		$1,165,848			$1,110,000
Senior Notes:
8.0% Senior Notes due November 1, 2019 (2)		$-			$-
13.5% Senior Notes due February 1, 2026		90,590			90,590
5.0% Senior Notes due February 1, 2040		90,120			90,120
Total Senior Notes		$180,710			$180,710
Senior Unsecured Term Loan Credit Facility due February 1, 2027		$202,547			$202,547
Senior Secured Revolving Credit Facility (3)		$-			$-
Net discounts and premium		$(49,145)			$(39,934)
Net debt issuance costs		$(19,970)			$(14,085)
Total notes payable, net of discount, premium and debt issuance costs		$1,479,990			$1,439,238

 

(1) “ Notes payable” on our Consolidated Balance Sheets as of October 31, 2019 and 2018 consists of the total senior secured and senior notes shown above, as well as accrued interest of $19.1 million and $35.6 million, respectively.

 

(2) $26.0 million of 8.0% Senior Notes due 2019 are owned by a wholly-owned consolidated subsidiary of HEI. Therefore, in accordance with GAAP, such notes are not reflected on the Consolidated Balance sheets of HEI. On November 1, 2019, the maturity of the 8.0% Senior Notes was extended to November 1, 2027.

 

(3) At October 31, 2019, provides for up to $125.0 million in aggregate amount of senior secured first lien revolving loans. Availability thereunder will terminate on December 28, 2022.

 

Except for K. Hovnanian, the issuer of the notes and borrower under the senior unsecured term loan facility (the “Term Loan Facility”) and under our $125.0 million senior secured revolving credit facility (the “Secured Credit Facility” and together with the term loan facility, the “Credit Facilities”), our home mortgage subsidiaries, certain of our title insurance subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures, we and each of our subsidiaries are guarantors of the Credit Facilities, the senior secured notes and senior notes outstanding at October 31, 2019 (collectively, the “Notes Guarantors”), which include the subsidiaries that had guaranteed (collectively, the “Former New Secured Group Guarantors”) K. Hovnanian’s 9.50% Notes, 2.000% Notes and 5.000% Notes (each as defined under below). As a result of the 2019 Transactions (as defined in and described under below), K. Hovnanian’s obligations under the Credit Facilities, the senior secured notes and senior notes are guaranteed by the Notes Guarantors (including the Former New Secured Group Guarantors) and, in the case of the Secured Credit Facility and the senior secured notes, will be secured in accordance with the terms of the applicable Debt Instrument by substantially all of the assets owned by K. Hovnanian and the Notes Guarantors (including the assets owned by the Former New Secured Group Guarantors), subject to permitted liens and certain exceptions.

 

The credit agreements governing the Credit Facilities and the indentures governing the senior secured and senior notes (together, the “Debt Instruments”) outstanding at October 31, 2019 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 non-recourse indebtedness, certain permitted indebtedness and refinancing indebtedness), pay dividends and make distributions on common and preferred stock, repay certain indebtedness prior to its respective stated maturity, repurchase 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 of their assets and enter into certain transactions with affiliates. The Debt Instruments also contain customary events of default which would permit the lenders or holders thereof to exercise remedies with respect to the collateral (as applicable), declare the loans made under the Term Loan Facility (defined below) (the “Term Loans”) and loans made under the Secured Credit Agreement (as defined below) (the “Secured Revolving Loans”) or notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the Term Loans, Secured Revolving Loans or 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 Term Loans and Secured Revolving Loans, material inaccuracy of representations and warranties and with respect to the Term Loans and Secured Revolving Loans, a change of control, and, with respect to the Secured Revolving Loans and senior secured notes, the failure of the documents granting security for the Secured Revolving 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 Revolving Loans and senior secured notes to be valid and perfected. As of October 31, 2019, we believe we were in compliance with the covenants of the Debt Instruments.

 

If our consolidated fixed charge coverage ratio is less than 2.0 to 1.0, as defined in the applicable Debt Instrument, 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 (in the case of the payment of dividends on preferred stock, our secured debt leverage ratio must also be less than 4.0 to 1.0), 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 Instruments, 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 actively analyze and evaluate our capital structure and explore transactions to simplify our capital structure and to strengthen our balance sheet, including those that reduce leverage and/or extend maturities, and will seek to do so with the right opportunity. We may also continue to make debt purchases and/or exchanges for debt or equity from time to time through tender offers, exchange 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 15, 2019, pursuant to a Commitment Letter, the Company issued $25.0 million in aggregate principal amount of the Additional 10.5% 2024 Notes to certain funds managed, advised or sub-advised by GSO at a discount for a purchase price of $21.3 million in cash. The Additional 10.5% 2024 Notes were issued as additional notes of the same series as the 10.5% 2024 Notes.

 

On October 31, 2019, K. Hovnanian, the Company, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent, and affiliates of certain investment managers (the “Investors”), as lenders, entered into a credit agreement (the “Secured Credit Agreement”) providing for up to $125.0 million in aggregate amount of Secured Revolving Loans to be used for general corporate purposes, upon the terms and subject to the conditions set forth therein. Secured Revolving Loans are to be borrowed by K. Hovnanian and guaranteed by the Notes Guarantors. Availability under the Secured Credit Agreement will terminate on December 28, 2022 and the Secured Revolving Loans will bear interest at a rate per annum equal to 7.75%, and interest will be payable in arrears, on the last business day of each fiscal quarter. In connection with the entering into of the Secured Credit Agreement, K. Hovnanian terminated its then existing Secured Credit Facility.

 

On October 31, 2019, K. Hovnanian completed private placements of senior secured notes as follows: (i) K. Hovnanian issued an aggregate of $350.0 million of 7.75% Senior Secured 1.125 Lien Notes due 2026 (the “1.125 Lien Notes”) in part pursuant to a Note Purchase Agreement, dated October 31, 2019, among K. Hovnanian, the Notes Guarantors and certain Investors as purchasers thereof (the “1.125 Lien Notes Purchase Agreement”) and in part pursuant to the Exchange Agreement (as defined below), with the proceeds from the sale of 1.125 Lien Notes under the 1.125 Lien Notes Purchase Agreement used to fund the cash payments to certain Exchanging Holders (as defined below) under the Exchange Agreement; and (ii) K. Hovnanian issued an aggregate of $282.3 million of 10.5% Senior Secured 1.25 Lien Notes due 2026 (the “1.25 Lien Notes”), pursuant to a Note Purchase Agreement (the “1.25 Lien Notes Purchase Agreement”), dated October 31, 2019, among K. Hovnanian, the Notes Guarantors and certain Investors as purchasers thereof (the “1.25 Lien Notes Purchasers”), the proceeds of which were used to fund the Satisfaction and Discharge (as defined below).

 

In addition, on October 31, 2019, K. Hovnanian completed private exchanges of (i) approximately $221.0 million aggregate principal amount of its 10.0% Senior Secured Notes due 2022 (the “10.0% 2022 Notes”) and approximately $114.0 million aggregate principal amount of its 10.5% Senior Secured Notes due 2024 (the “10.5% 2024 Notes” and, together with the 10.0% 2022 Notes, the “Second Lien Notes”) held by certain participating bondholders (the “Exchanging Holders”) for a portion of the $350.0 million aggregate principal amount of 1.125 Lien Notes described above and/or cash, and (ii) approximately $99.6 million aggregate principal amount of its 10.5% 2024 Notes held by certain of the Exchanging Holders for approximately $103.1 million aggregate principal amount of 11.25% Senior Secured 1.5 Lien Notes due 2026 (the “1.5 Lien Notes” and, together with the 1.125 Lien Notes and the 1.25 Lien Notes, the “New Secured Notes”), pursuant to an Exchange Agreement, dated October 30, 2019 (the “Exchange Agreement”), among K. Hovnanian, the Notes Guarantors and the Exchanging Holders.

 

On October 31, 2019, K. Hovnanian issued notices of redemption for all of its outstanding 9.50% Senior Secured Notes due 2020 (the “9.50% Notes”), 2.000% Senior Secured Notes due 2021 (the “2.000% Notes”) and 5.000% Senior Secured Notes due 2021 (the “5.000% Notes”) and deposited with Wilmington Trust, National Association, as trustee under the indenture (the “9.50% Notes Indenture”) governing the 9.50% Notes and as trustee under the indenture (the “5.000%/2.000% Notes Indenture”) governing the 5.000% Notes and the 2.000% Notes sufficient funds to satisfy and discharge (collectively, the “Satisfaction and Discharge”) (i) the 9.50% Indenture and to fund the redemption of all outstanding 9.50% Notes and to pay accrued and unpaid interest on the redeemed notes to, but not including, the November 10, 2019 redemption date and (ii) the 5.000%/2.000% Indenture and to fund the redemption of all outstanding 5.000% Notes and 2.000% Notes and to pay accrued and unpaid interest on the redeemed notes to, but not including, the November 30, 2019 redemption date. Proceeds from the issuance of the 1.25 Lien Notes together with cash on hand were used to fund the Satisfaction and Discharge. Upon the Satisfaction and Discharge of the 9.50% Notes Indenture, all of the collateral securing the 9.50% Notes was released and the restrictive covenants and events of default contained therein ceased to have effect and upon the Satisfaction and Discharge of the 5.000%/2.000% Notes Indenture, all of the collateral securing the 5.000% Notes and the 2.000% Notes was released and the restrictive covenants and events of default contained therein ceased to have effect as to both such series of Notes.

 

The Company and K. Hovnanian obtained the consent of certain lenders/holders under its existing debt instruments to amend such debt instruments in connection with the issuance of the New Secured Notes and the execution of the indentures governing the New Secured Notes and the Secured Credit Agreement. The Company, K. Hovnanian and the guarantors also amended such debt instruments to add the Former New Secured Group Guarantors as guarantors thereunder and, in the case of the Second Lien Notes, to add the Former New Secured Group Guarantors as pledgors and grantors of their assets (subject to permitted liens and certain exceptions) to secure such Second Lien Notes.

 

 

The transactions that were consummated on October 31, 2019, as described, are collectively referred to herein as the “2019 Transactions.” The 2019 Transactions resulted in a loss in extinguishment of debt of $42.4 million for the year ended October 31, 2019 which is included as “Loss on Extinguishment of Debt” on the Consolidated Statement of Operations.

 

See Note 9 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for a further discussion of K. Hovnanian’s Credit Facilities, senior secured notes and senior notes.

 

Mortgages and Notes Payable

 

We have nonrecourse mortgage loans for certain communities totaling $203.6 million and $95.6 million (net of debt issuance costs) at October 31, 2019 and October 31, 2018, respectively, which are secured by the related real property, including any improvements, with an aggregate book value of $410.2 million and $241.9 million, respectively. The weighted-average interest rate on these obligations was 8.3% and 6.1% at October 31, 2019 and October 31, 2018, respectively, and the mortgage loan payments on each community primarily correspond to home deliveries.

    

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 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. The loans are secured by the mortgages held for sale and repaid when we sell the underlying mortgage loans to permanent investors. As of October 31, 2019 and 2018, we had an aggregate of $140.2 million and $113.2 million, respectively, outstanding under several of K. Hovnanian Mortgage’s short-term borrowing facilities.

   

 See Note 8 to the Consolidated Financial Statements for a discussion of these agreements and facilities.

 

Equity

 

On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 0.2 million shares of Class A Common Stock. We did not repurchase any shares under this program during fiscal 2019 or 2018. As of October 31, 2019, the maximum number of shares of Class A Common Stock that may yet be purchased under this program is 22 thousand. (See Part II, Item 5 for information on equity purchases).  

  

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.” In fiscal 2019, 2018 and 2017, we did not make any dividend payments on the Series A Preferred Stock as a result of covenant restrictions in our debt instruments. Certain debt instruments to which we are a party contain restrictions on the payment of cash dividends. As a result of the most restrictive of these provisions, we are not currently able to pay any cash dividends. We have never paid a cash dividend to common stockholders. We anticipate that we will continue to be restricted from paying dividends, which are not cumulative, for the foreseeable future. 

 

On October 31, 2019, in connection with the issuance of the 7.75% Senior Secured 1.25 Lien Notes due 2026, we issued and sold an aggregate of 178,427 shares of Class A Common Stock, par value $0.01 per share (and associated Preferred Stock Purchase Rights), to the purchasers of such Notes for an aggregate purchase price of $1,784.27. The issuance was exempt from registration under Section 4(a)(2) of the Securities Act of 1933.

 

Inventory Activities

 

Total inventory, excluding consolidated inventory not owned, increased $111.9 million during the year ended October 31, 2019 from October 31, 2018. Total inventory, excluding consolidated inventory not owned, increased in the Northeast by $12.6 million, in the Mid-Atlantic by $46.5 million, in the Midwest by $9.7 million, in the Southeast by $3.8 million, in the Southwest by $7.5 million and in the West by $31.8 million. These inventory fluctuations were primarily attributable to new land purchases and land development, partially offset by home deliveries and land sales during the period. During the year ended October 31, 2019, we had aggregate impairments in the amount of $2.7 million. We wrote-off costs in the aggregate amount of $3.6 million during the year ended October 31, 2019 related to land options that expired or that we terminated, as the communities’ forecasted profitability was not projected to produce adequate returns on investment commensurate with the risk. In the last few years, we have been able to acquire new land parcels at prices that we believe will generate reasonable returns under current homebuilding market conditions. There can be no assurances that this trend will continue in the near term. Substantially all homes under construction or completed and included in inventory at October 31, 2019 are expected to be closed during the next six to nine months.  

  

 

Consolidated inventory not owned increased $102.4 million. Consolidated inventory not owned consists of options related to land banking and model financing transactions that were added to our Consolidated Balance Sheets in accordance with US GAAP. The increase from October 31, 2018 to October 31, 2019 was primarily due to an increase in land banking transactions along with an increase in the sale and leaseback of certain model homes during the period. We have land banking arrangements, whereby we sell 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 606-10-55-70, these transactions are considered a financing rather than a sale. For purposes of our Consolidated Balance Sheet, at October 31, 2019, inventory of $136.1 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $89.8 million (net of debt issuance costs) recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. In addition, 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 606-10-55-68, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheet, at October 31, 2019, inventory of $54.2 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $51.2 million (net of debt issuance costs) recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions.

  

When possible, we option property for development prior to acquisition. By optioning property, we are only subject to the loss of the cost of the option and predevelopment costs if we choose not to exercise the option. As a result, our commitment for major land acquisitions is reduced. The costs associated with optioned properties are included in “Land and land options held for future development or sale” on the Consolidated Balance Sheets. Also included in “Land and land options held for future development or sale” are amounts associated with inventory in mothballed communities. We mothball (or stop development on) certain communities when we determine the current performance does not justify further investment at the time. That is, we believe we will generate higher returns if we decide against spending money to improve land today and save the raw land until such time as the markets improve or we determine to sell the property. As of October 31, 2019, we had mothballed land in 13 communities. The book value associated with these communities at October 31, 2019 was $13.8 million, which was net of impairment charges recorded in prior periods of $138.1 million. We continually review communities to determine if mothballing is appropriate. During fiscal 2019, we did not mothball any additional communities, but we sold two previously mothballed communities and re-activated three previously mothballed communities.

  

Inventories held for sale, which are land parcels where we have decided not to build homes, and are actively marketing the land for sale, represented $6.4 million of our total inventories at October 31, 2018, and are reported at the lower of carrying amount or fair value less costs to sell. There were no inventories held for sale at October 31, 2019. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties.

 

 

The following tables summarize home sites included in our total residential real estate. 

 

		Total Home Sites			Contracted Not Delivered			Remaining Home Sites Available
October 31, 2019:
Northeast		3,297			152			3,145
Mid-Atlantic		5,297			343			4,954
Midwest		3,898			450			3,448
Southeast		4,693			282			4,411
Southwest		7,188			663			6,525
West		5,260			301			4,959
Consolidated total		29,633			2,191			27,442
Unconsolidated joint ventures		4,226			461			3,765
Owned		11,374			1,658			9,716
Optioned		18,004			278			17,726
Construction to permanent financing lots		255			255			-
Consolidated total		29,633			2,191			27,442
Lots controlled by unconsolidated joint ventures		4,226			461			3,765
October 31, 2018:
Northeast		3,920			51			3,869
Mid-Atlantic		4,795			296			4,499
Midwest		4,758			394			4,364
Southeast		4,671			251			4,420
Southwest		6,783			523			6,260
West		5,630			311			5,319
Consolidated total		30,557			1,826			28,731
Unconsolidated joint ventures		4,029			366			3,663
Owned		12,729			1,356			11,373
Optioned		17,610			252			17,358
Construction to permanent financing lots		218			218			-
Consolidated total		30,557			1,826			28,731
Lots controlled by unconsolidated joint ventures		4,029			366			3,663

  

 

The following table summarizes our started or completed unsold homes and models, excluding unconsolidated joint ventures, in active and substantially completed communities. The increase in the total homes from October 31, 2018 to October 31, 2019 is primarily due to the increase in community count during the period, along with a planned increase of additional unsold homes in certain markets to take advantage of increased sales pace. 

 

		October 31, 2019									October 31, 2018
		Unsold Homes			Models			Total			Unsold Homes			Models			Total
Northeast		58			12			70			24			5			29
Mid-Atlantic		63			12			75			38			19			57
Midwest		31			10			41			19			10			29
Southeast		78			15			93			62			11			73
Southwest		320			12			332			335			14			349
West		213			19			232			93			12			105
Total		763			80			843			571			71			642
Started or completed unsold homes and models per active selling communities (1)		5.4			0.6			6.0			4.6			0.6			5.2

 

(1)

Active selling communities (which are communities that are open for sale with ten or more home sites available) were 141 and 123 at October 31, 2019 and 2018, respectively. This ratio does not include substantially completed communities, which are communities with less than ten home sites available.

  

Other Balance Sheet Activities

 

Homebuilding – Restricted cash and cash equivalents increased $8.1 million from October 31, 2018 to $20.9 million at October 31, 2019. The increase was primarily due to cash collateral for new letters of credit issued during the period.

 

Investments in and advances to unconsolidated joint ventures increased $3.3 million during the fiscal year ended October 31, 2019 compared to October 31, 2018. The increase was primarily due to the income from two of our joint ventures during fiscal 2019, along with new capital contributions for existing joint ventures and a new joint venture during fiscal 2019, partially offset by a note receivable from one of our joint ventures that was paid off the fourth quarter of fiscal 2019, along with partner distributions during the period. As of October 31, 2019 and October 31, 2018, we had investments in ten and nine unconsolidated homebuilding joint ventures, respectively, and one unconsolidated land development joint venture for both periods. We have no guarantees associated with our unconsolidated joint ventures, other than guarantees limited only to performance and completion of development, environmental indemnification and standard warranty and representation against fraud, misrepresentation and similar actions, including a voluntary bankruptcy.

 

Receivables, deposits and notes, net increased $9.7 million from October 31, 2018 to $44.9 million at October 31, 2019. The increase was primarily due to an increase in receivables for reimbursements of expenditures in connection with certain structured lot option agreements, along with increased receivables related to the timing of home closings during the period, as well as a new insurance receivable for premium adjustments and a new receivable related to the funding of the Satisfaction and Discharge as described under “ – Capital Resources and Liquidity”. These increases were partially offset by a decrease related the return of a municipal receivable during the period.

   

Prepaid expenses and other assets were as follows as of:

 

(In thousands)		October 31, 2019			October 31, 2018			Dollar Change
Prepaid insurance		$2,061			$2,514			$(453	)
Prepaid project costs		32,015			28,667			3,348
Other prepaids		10,808			7,505			3,303
Other assets		820			464			356
Total		$45,704			$39,150			$6,554

 

Prepaid insurance decreased slightly due to the timing of premium payments. These costs are amortized over the life of the associated insurance policy, which can be one to three years. Prepaid project costs consist of community specific expenditures that are used over the life of the community. Such prepaids are expensed as homes are delivered, and therefore have increased as our community count has increased. Other prepaids increased primarily due to costs associated with the refinancing of our senior secured revolving credit facility in the fourth quarter of fiscal 2019.

 

 

Financial services assets consist primarily of residential mortgages receivable held for sale of which $163.0 million and $129.0 million at October 31, 2019 and 2018, respectively, were being temporarily warehoused and are awaiting sale in the secondary mortgage market. The increase in mortgage loans held for sale from October 31, 2018 was primarily related to an increase in the volume of loans originated during the fourth quarter of 2019 compared to the fourth quarter of 2018, partially offset by a decrease in the average loan value.

  

Nonrecourse mortgages secured by inventory increased to $203.6 million at October 31, 2019, from $95.6 million at October 31, 2018. The increase was primarily due to a new mortgage on several communities that are part of a consolidated joint venture entered into in the second quarter of fiscal 2019, along with new mortgages for other communities in most of our segments obtained during fiscal 2019, as well as additional loan borrowings on existing mortgages, partially offset by the payment of existing mortgages during the period.

 

Accounts payable and other liabilities are as follows as of:

 

(In thousands)		October 31, 2019			October 31, 2018			Dollar Change
Accounts payable		$141,667			$127,795			$13,872
Reserves		92,083			99,229			(7,146	)
Accrued expenses		19,208			14,884			4,324
Accrued compensation		53,157			53,200			(43	)
Other liabilities		14,078			9,791			4,287
Total		$320,193			$304,899			$15,294

 

The increase in accounts payable was primarily due to the increase in deliveries in the fourth quarter of fiscal 2019 as compared to the fourth quarter of fiscal 2018. Reserves decreased during the period, primarily due to a reduction in our construction defect reserves in connection with our annual assessment as our loss experience has continued to improve over the past few years. Accrued expenses increased primarily due to accruals for legal fees associated with the 2019 Transactions (as previously defined). Other liabilities increased primarily due to several new municipal loans and bonds for land development issued during the period.

 

Customers’ deposits increased $5.8 million from October 31, 2018 to $35.9 million at October 31, 2019. The increase was primarily related to the increase in backlog during the year.

 

Liabilities from inventory not owned increased $77.6 million to $141.0 million at October 31, 2019. The increase was due an increase in land banking transactions during the period, along with an increase in the sale and leaseback of certain model homes, both of which are accounted for as financing transactions as described above.

  

Accrued interest decreased $16.5 million to $19.1 million at October 31, 2019. The decrease was primarily due to interest payments made on debt in connection with the 2019 Transactions (as previously defined) during the fourth quarter of fiscal 2019.

 

Financial Services (liabilities) increased $25.7 million from $143.4 million at October 31, 2018, to $169.1 million at October 31, 2019. The increase is primarily due to an increase in amounts outstanding under our mortgage warehouse lines of credit, and directly correlates to the increase in the volume of mortgage loans held for sale during the period.

 

 

Results of Operations

 

Total Revenues

 

Compared to the prior period, revenues increased (decreased) as follows:

 

		Year Ended
(Dollars in thousands)		October 31, 2019			October 31, 2018			October 31, 2017
Homebuilding:
Sale of homes		$43,454			$(433,805	)		$(260,757	)
Land sales		(15,066	)		(24,319	)		(27,445	)
Other revenues		(3,502	)		3,080			1,494
Financial services		797			(5,388	)		(13,874	)
Total change		$25,683			$(460,432	)		$(300,582	)
Total revenues percent change		1.3	%		(18.8	)%		(10.9	)%

  

Homebuilding

 

Sale of homes revenues increased $43.5 million, or 2.3%, for the year ended October 31, 2019, decreased $433.8 million, or 18.5%, for the year ended October 31, 2018, and decreased $260.8 million, or 10.0%, for the year ended October 31, 2017 as compared to the same period of the prior year. The increased revenues in fiscal 2019 were primarily due to the number of home deliveries increasing 2.0%, and the average price per home increasing to $394,194 in fiscal 2019 from $393,280 in fiscal 2018. The increase in deliveries in fiscal 2019 were primarily due to the result of an increase in community count in fiscal 2019 as compared to fiscal 2018 of 14.6%. The decreased revenues in fiscal 2018 were primarily due to the number of home deliveries decreasing 13.5% and the average price per home decreasing to $393,280 in fiscal 2018 from $417,714 in fiscal 2017. The decreased revenues in fiscal 2017 were primarily due to the number of home deliveries decreasing 13.3%, partially offset by the average price per home increasing to $417,714 in fiscal 2017 from $402,350 in fiscal 2016. The decrease in fiscal 2018 and 2017 deliveries were primarily the result of a reduction in community count by 5.4% and 22.2%, respectively. The fluctuations in average prices for fiscal 2019, 2018, and 2017 were primarily the result of geographic and community mix of our deliveries. For fiscal 2018, there were also home price decreases (which we increase or decrease in communities depending on the respective community’s performance), partially offset by price increases in some communities primarily in the West. For fiscal 2017, we were also able to raise home prices in certain communities. For further detail on changes in segment revenues see “Homebuilding Operations by Segment” below. For further detail on land sales and other revenue, see the section titled “Land Sales and Other Revenues” below.

 

 

Information on homes delivered by segment is set forth below:

 

		Year Ended
(Housing Revenue in thousands)		October 31, 2019			October 31, 2018			October 31, 2017
Northeast:
Housing revenues		$116,889			$96,012			$166,752
Homes delivered		192			178			351
Average price		$608,797			$539,393			$475,077
Mid-Atlantic:
Housing revenues		$356,674			$354,153			$463,271
Homes delivered		652			672			856
Average price		$547,046			$527,013			$541,205
Midwest:
Housing revenues		$203,734			$196,307			$199,009
Homes delivered		680			662			640
Average price		$299,609			$296,536			$310,951
Southeast:
Housing revenues		$219,860			$237,948			$257,066
Homes delivered		545			596			614
Average price		$403,413			$399,242			$418,675
Southwest:
Housing revenues		$627,201			$637,568			$826,422
Homes delivered		1,866			1,873			2,357
Average price		$336,121			$340,399			$350,624
West:
Housing revenues		$425,324			$384,240			$427,513
Homes delivered		1,011			866			784
Average price		$420,696			$443,695			$545,297
Consolidated total:
Housing revenues		$1,949,682			$1,906,228			$2,340,033
Homes delivered		4,946			4,847			5,602
Average price		$394,194			$393,280			$417,714
Unconsolidated joint ventures:(1)
Housing revenues		$485,324			$599,979			$310,573
Homes delivered		774			984			547
Average price		$627,034			$609,735			$567,774

 

(1) Represents housing revenue and home deliveries for our unconsolidated homebuilding joint ventures for the period. We provide this data as a supplement to our consolidated results as an indicator of the volume managed in our unconsolidated joint ventures. See Note 20 to the Consolidated Financial Statements for a further discussion of our joint ventures.

  

The increase in housing revenues during year ended October 31, 2019, as compared to year ended October 31, 2018, was primarily attributed to our increased deliveries, as our community count has increased year over year, and by the increase in average sales price. Housing revenues in fiscal 2019 increased in all of our homebuilding segments combined by 2.3%, and average sales price increased by 0.2%, excluding unconsolidated joint ventures. In our homebuilding segments, homes delivered increased in fiscal 2019 as compared to fiscal 2018 by 7.9%, 2.7% and 16.7% in the Northeast, Midwest and West, respectively, and decreased by 3.0%, 8.6% and 0.4% in the Mid-Atlantic, Southeast and Southwest, respectively. Overall in fiscal 2019 as compared to fiscal 2018 homes delivered increased 2.0% across all our segments, excluding unconsolidated joint ventures.

 

The decrease in housing revenues during year ended October 31, 2018, as compared to year ended October 31, 2017, was primarily attributed to our decreased deliveries, as our community count decreased year over year, and by the decrease in average sales price. Housing revenues in fiscal 2018 decreased in all of our homebuilding segments combined by 18.5%, and average sales price decreased by 5.8%, excluding unconsolidated joint ventures. In our homebuilding segments, homes delivered decreased in fiscal 2018 as compared to fiscal 2017 by 49.3%, 21.5%, 2.9% and 20.5% in the Northeast, Mid-Atlantic, Southeast and Southwest, respectively, and increased by 3.4% and 10.5% in the Midwest and West, respectively. Overall in fiscal 2018 as compared to fiscal 2017 homes delivered decreased 13.5% across all our segments, excluding unconsolidated joint ventures.

 

 

Quarterly housing revenues and net sales contracts by segment, excluding unconsolidated joint ventures, for the years ended October 31, 2019, 2018 and 2017 are set forth below (net contracts are defined as new contracts executed during the period for the purchase of homes, less cancellations of contracts in the same period):

 

		Quarter Ended
(In thousands)		October 31, 2019			July 31, 2019			April 30, 2019			January 31, 2019
Housing revenues:
Northeast		$70,650			$20,694			$13,040			$12,505
Mid-Atlantic		135,866			86,811			80,818			53,179
Midwest		68,714			47,261			42,870			44,889
Southeast		76,414			50,217			49,346			43,883
Southwest		213,089			152,615			143,634			117,863
West		127,413			110,251			97,844			89,816
Consolidated total		$692,146			$467,849			$427,552			$362,135
Sales contracts (net of cancellations):
Northeast		$37,860			$37,560			$62,580			$34,950
Mid-Atlantic		86,296			99,807			118,245			81,514
Midwest		54,682			58,794			68,744			37,046
Southeast		69,765			58,648			64,772			40,460
Southwest		166,723			202,553			192,630			115,338
West		102,460			131,483			120,616			57,018
Consolidated total		$517,786			$588,845			$627,587			$366,326

 

		Quarter Ended
(In thousands)		October 31, 2018			July 31, 2018			April 30, 2018			January 31, 2018
Housing revenues:
Northeast		$25,606			$26,701			$23,513			$20,192
Mid-Atlantic		99,493			79,593			104,058			71,009
Midwest		67,395			45,579			42,816			40,517
Southeast		72,828			47,472			60,974			56,674
Southwest		193,000			157,406			158,958			128,204
West		135,353			86,108			77,798			84,981
Consolidated total		$593,675			$442,859			$468,117			$401,577
Sales contracts (net of cancellations):
Northeast		$16,044			$18,045			$15,278			$25,363
Mid-Atlantic		84,027			76,324			117,399			63,213
Midwest		44,167			43,596			67,308			49,416
Southeast		41,126			71,381			62,741			50,455
Southwest		123,485			177,174			198,487			141,458
West		83,933			102,183			93,213			69,397
Consolidated total		$392,782			$488,703			$554,426			$399,302

 

 

		Quarter Ended
(In thousands)		October 31, 2017			July 31, 2017			April 30, 2017			January 31, 2017
Housing revenues:
Northeast		$27,913			$40,015			$45,917			$52,907
Mid-Atlantic		149,881			113,111			100,120			100,159
Midwest		72,944			40,620			41,794			43,651
Southeast		78,267			68,408			54,005			56,386
Southwest		209,223			209,041			224,898			183,260
West		128,555			103,087			100,819			95,052
Consolidated total		$666,783			$574,282			$567,553			$531,415
Sales contracts (net of cancellations):
Northeast		$24,407			$26,648			$29,918			$38,045
Mid-Atlantic		77,112			97,017			123,045			102,246
Midwest		38,139			48,257			61,489			45,566
Southeast		56,354			73,896			55,577			46,451
Southwest		142,926			177,285			227,500			170,884
West		91,048			103,342			142,522			84,423
Consolidated total		$429,986			$526,445			$640,051			$487,615

 

Contracts per average active selling community in fiscal 2019 were 39.0 compared to fiscal 2018 of 35.9. Our reported level of sales contracts (net of cancellations) has been positively impacted by an increase in community count, along with an increase in the pace of sales in most of the Company’s segments during fiscal 2019. Cancellation rates represent the number of cancelled contracts in the quarter divided by the number of gross sales contracts executed in the quarter. For comparison, the following are historical cancellation rates, excluding unconsolidated joint ventures:

 

Quarter		2019			2018			2017			2016			2015
First		24	%		18	%		19	%		20	%		16	%
Second		19	%		17	%		18	%		19	%		16	%
Third		19	%		19	%		19	%		21	%		20	%
Fourth		21	%		23	%		22	%		20	%		20	%

 

Another common and meaningful way to analyze our cancellation trends is to compare the number of contract cancellations as a percentage of the beginning backlog. The following table provides this historical comparison, excluding unconsolidated joint ventures.

 

Quarter		2019			2018			2017			2016			2015
First		16	%		12	%		12	%		13	%		11	%
Second		20	%		15	%		16	%		14	%		14	%
Third		16	%		14	%		13	%		12	%		13	%
Fourth		14	%		13	%		12	%		11	%		12	%

 

Most cancellations occur within the legal rescission period, which varies by state but is generally less than two weeks after the signing of the contract. Cancellations also occur as a result of a buyer's failure to qualify for a mortgage, which generally occurs during the first few weeks after signing. As shown in the tables above, the contract cancellations over the past several years have been within what we believe to be a normal range. However, market conditions remain uncertain and it is difficult to predict what cancellation rates will be in the future.

 

 

An important indicator of our future results is recently signed contracts and our home contract backlog for future deliveries. Our consolidated contract backlog, excluding unconsolidated joint ventures, by segment is set forth below:

 

(Dollars in thousands)		October 31, 2019			October 31, 2018			October 31, 2017
Northeast:
Total contract backlog		$86,557			$30,496			$51,778
Number of homes		152			51			98
Mid-Atlantic: (1)
Total contract backlog		$193,387			$180,546			$185,123
Number of homes		343			296			309
Midwest:
Total contract backlog		$122,681			$107,149			$98,969
Number of homes		450			394			382
Southeast:
Total contract backlog		$121,921			$108,137			$120,382
Number of homes		282			251			285
Southwest:
Total contract backlog		$230,898			$180,854			$177,818
Number of homes		663			523			509
West:
Total contract backlog		$124,700			$138,448			$173,963
Number of homes		301			311			400
Totals: (1)
Total consolidated contract backlog		$880,144			$745,630			$808,033
Number of homes		2,191			1,826			1,983

 

(1)	Contract backlog as of October 31, 2019 excludes 29 homes that were sold to one of our joint ventures at the time of the joint venture formation.

 

Contract backlog dollars increased 18.0% as of October 31, 2019 compared to October 31, 2018, and the number of homes in backlog increased 20.0% for the same period. The increase in backlog was driven by a 14.3% increase in net contracts and the increase in community count for the year ended October 31, 2019 compared to the prior fiscal year. In the month of November 2019, excluding unconsolidated joint ventures, we signed an additional 404 net contracts amounting to $159.1 million in contract value.

  

Total cost of sales on our Consolidated Statements of Operations includes expenses for consolidated housing and land and lot sales, including inventory impairment loss and land option write-offs (defined as “land charges” in the tables below). A breakout of such expenses for housing sales and homebuilding gross margin is set forth below.

 

Homebuilding gross margin before cost of sales interest expense and land charges is a non-GAAP financial measure. This measure should not be considered as an alternative to homebuilding gross margin determined in accordance with GAAP as an indicator of operating performance.

 

Management believes this non-GAAP measure enables investors to better understand our operating performance. This measure is also useful internally, helping management evaluate our operating results on a consolidated basis and relative to other companies in our industry. In particular, the magnitude and volatility of land charges for the Company, and for other homebuilders, have been significant and, as such, have made financial analysis of our industry more difficult. Homebuilding metrics excluding land charges, as well as interest amortized to cost of sales, and other similar presentations prepared by analysts and other companies are frequently used to assist investors in understanding and comparing the operating characteristics of homebuilding activities by eliminating many of the differences in companies’ respective level of impairments and levels of debt.

 

 

		Year Ended
(Dollars in thousands)		October 31, 2019			October 31, 2018			October 31, 2017
Sale of homes		$1,949,682			$1,906,228			$2,340,033
Cost of sales, excluding interest expense and land charges		1,596,237			1,555,894			1,937,116
Homebuilding gross margin, before cost of sales interest expense and land charges		353,445			350,334			402,917
Cost of sales interest expense, excluding land sales interest expense		70,520			56,588			76,902
Homebuilding gross margin, after cost of sales interest expense, before land charges		282,925			293,746			326,015
Land charges		6,288			3,501			17,813
Homebuilding gross margin		$276,637			$290,245			$308,202
Gross margin percentage		14.2	%		15.2	%		13.2	%
Gross margin percentage, before cost of sales interest expense and land charges		18.1	%		18.4	%		17.2	%
Gross margin percentage, after cost of sales interest expense, before land charges		14.5	%		15.4	%		13.9	%

 

Cost of sales expenses as a percentage of consolidated home sales revenues are presented below:

 

		Year Ended
		October 31, 2019			October 31, 2018			October 31, 2017
Sale of homes		100.0	%		100	%		100	%
Cost of sales, excluding interest expense and land charges:
Housing, land and development costs		72.1	%		71.9	%		73.1	%
Commissions		3.7	%		3.6	%		3.4	%
Financing concessions		1.4	%		1.2	%		1.2	%
Overheads		4.7	%		4.9	%		5.1	%
Total cost of sales, before interest expense and land charges		81.9	%		81.6	%		82.8	%
Cost of sales interest		3.6	%		3.0	%		3.3	%
Land charges		0.3	%		0.2	%		0.7	%
Gross margin percentage		14.2	%		15.2	%		13.2	%
Gross margin percentage, before cost of sales interest expense and land charges		18.1	%		18.4	%		17.2	%
Gross margin percentage, after cost of sales interest expense and before land charges		14.5	%