Tuesday, October 13, 2009

Hovnanian Takes a Half-Step in the Wrong Direction

Getting Better and Worse
The worst seems to be over for the housing industry in the United States. It may even be on the mend. In the competition for building sites, companies with less financial risk will have an advantage. Hovnanian Enterprises, the sixth largest homebuilder in the country, has been doing so
me interesting financial deals to improve its competitive position

Hovnanian had the highest leverage among its closest competitors. At the end of 2008, the company’s debt-to-capital ratio was 88.7%, while its rivals averaged 66.2%. With competitors buying foreclosed land from banks at historic-low prices, Hovnanian is forced to spend money on debt service instead.

Worse, Hovnanian had even less financial flexibility than the competition. Looking at maturities of debt over the next five years, Hovnanian had 28.3% of its debt coming due, while its competitors had only 23.0%. Worse still, the company’s debt was much more concentrated in a single year, as the chart below shows.

Maximum 1-year debt maturities as a percent of total debt are the highest value for debt maturities over the next five years as a percent of current period total debt.

Having so much of its debt maturities crowded into a single year is a problem for Hovnanian. It has a lot more refinancing risk than the companies it competes with. If its credit quality gets weaker or the capital markets take another dive when all that debt matures, Hovnanian will be in serious trouble.

Less Progress than Meets the Eye
To its credit, Hovnanian saw the problem and did something about it. Through exchanges offers, open market repurchases, and cash tender offers in the first three quarters of 2009, Hovnanian repaid $780 million of its debt. About $271 million of that was debt maturing in the next five years.

Unfortunately, Hovnanian’s efforts reduced leverage but reduced flexibility as well. Maximum 1-year debt maturities actually increased to 37.7% of total debt. The company had more success retiring its longer-maturity debt than the debt coming due in the next five years.

Financial leverage is a risk in its own right, but embedded in leverage is another risk: financial flexibility. And financial risks are closely connected to competitive risk. Good financial strategy manages all of those dimensions of risk effectively. Hovnanian seems still to be struggling to do that.


Arthur James said...

First, I have to say, I love this blog. Each article is short, concise and informative. Have you guys written a book by any chance?

Second, a question. You measure the leverage by the debt to capital ratio, similar to using debt to equity. Intuitively, this is different from leverage measured on debt to EBITDA, which I see more often. Debt-capital is arguably more backward looking; a business that has historically been profitable (and therefore has high retained earnings/equity/capital) would have a debt-capital ratio that looks better, regardless of what its cash generation (proxied by EBITDA) looks like. What is your take on these different measurements of leverage? Should they be used in different circumstances?

Tim Delaney said...

We're glad you like the blog. A book (or the online equivalent) is a possibility some day. I've owed you a response for some time. My excuse is travel. I've been teaching in Beirut and Singapore and Ron's been all over Canada without time for a thoughtful answer to your question until now.

You're right that capital captures past earnings, so profitability is a key driver of debt capital over time. It also captures dividends and share repurchases, and that makes payments to shareholders another key driver. I like debt to capital because it includes so many elements of financial strategy: degree of leverage, shareholder payouts, and financial flexibility.

I agree with you that EBITDA is a proxy for cash flow. I dislike using EBITDA that way, but there's no escaping it. Everyone seems to use it in analysis and in financial covenants. That makes debt to EBITDA a repayment measure.

So the two measures really compliment each other. One says something about strategy and longer-term matters, the other says something about repayment and shorter-term factors. One is more stable, the other more volatile.

I would put more emphasis on debt to capital with a low-risk company at a sustainable capital structure. I'd emphasize debt to EBITDA where risk is higher and debt exceeds a comfortable level.

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