Hovnanian Enterprises Inc (HOV) 2013 Q4 法說會逐字稿

Good morning, and thank you for joining us today for Hovnanian Enterprises fiscal 2013 fourth-quarter and year-end earnings conference call. An archive of the webcast will be available after the completion of the call and run for 12 months. This conference is being recorded for rebroadcast, and all participants are currently in a listen-only mode. Management will make some opening remarks about the fourth-quarter results and then open up the line for questions.

The Company will also be webcasting a slide presentation along with the opening comments from Management. The slides are available on the Investors page of the Company's website at www.khov.com. Those listeners who would like to follow along should log on to the website at this time. Before we begin, I would like to turn the call over to Jeff O'Keefe, Vice President, Investor Relations. Jeff, please go ahead.

Thank you. Before we get started, I would like to quickly read through our forward-looking statements. All statements in this Conference Call that are not historical facts should be considered as forward-looking statements. Such statements involve known and unknown risks, uncertainties, and other factors that may cause actual results, performance, or achievements of the Company to be materially different from any future results, performance, or achievements expressed or implied by the forward-looking statements. Although we believe that our plans, intentions, and expectations reflected in or suggested by such forward-looking statements are reasonable, we can give no assurance that such plans, intentions, or expectations will be achieved. Such risks, uncertainties, and other factors include, but are not limited to: changes in general and local economic industry and business conditions and impacts of the sustained homebuilding downturn, adverse weather and other environmental conditions and natural disasters, changes in market conditions and seasonality of the Company's business, changes in home prices and sales activity in the Markets where the Company builds homes, government regulation, including regulations concerning development of land, the homebuilding sales and customer financing processes, tax laws and the environment, fluctuations in interest rates and the availability of mortgage financing, shortages in and price fluctuations of raw materials and labor, the availability and cost of suitable land and improved lots, levels of competition, availability of Financing to the Company, utility shortages and outages or rate fluctuations, levels of indebtedness and restrictions on the Company's operations and activities imposed by the agreements governing the Company's outstanding indebtedness, the Company's sources of liquidity, changes in credit ratings, availability of net operating loss carryforwards, operations through joint ventures with third parties, product liability litigation, warranty claims and claims by mortgage investors, successful identification and integration of acquisitions, significant influence of the Company's controlling stockholders, changes in tax laws affecting the after-tax cost of owning a home, geopolitical risks, terrorists acts and other acts of war, and other factors described in detail in the Company's Annual Report on the Form 10-K for the year ended October 31, 2012. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events, changed circumstances, or any other reason.

Now, I'll turn the call over to Ara Hovnanian, our Chairman, President, and Chief Executive Officer.

Thanks, Jeff, and thank you all for participating in this morning's call to review the results of our fourth quarter and the year ended October 2013. Joining me on the call today are Larry Sorsby, Executive Vice President and CFO; Brad O'Connor, Vice President, Chief Accounting Officer, and Corporate Controller; David Valiaveedan, Vice President of Finance and Treasurer; and Jeff O'Keefe, Vice President of Investor Relations.

Let's start with slide 3. Here we show numerous operating metrics, all of which improved each quarter in Fiscal 2013. For the past several years, we've talked about our goal of achieving sustainable profitability through top line growth. In the top left-hand quadrant, you can see that our total revenues increased sequentially each quarter during Fiscal 2013. Moving across the top, we show that our gross margin also increased sequentially each quarter in Fiscal 2013. On our Conference Call last quarter, we discussed increasing our sales pace by implementing sales incentives at some of our communities, which would result in modest net price reductions. During the quarter, we implemented new pricing incentives in about 10% of our communities. In spite of these net price reductions, we grew our gross margins to 22.6% in the fourth quarter, the highest level we've had since the fourth quarter of 2006.

In the bottom left-hand quadrant, we show both total SG&A and interest expense as a percentage of total revenues. Both of these metrics improved throughout the year as we grew our top line. SG&A as a percentage of sales got close to a normalized level during the fourth quarter thanks to a typical seasonal surge in deliveries. We still have some more work to do to get this percentage down even further. These improvements will be driven by future revenue growth and our ability to control expenses. Our interest as a percentage of sales remains above normalized levels, but this too improved each quarter through the Fiscal Year.

In the bottom right-hand quadrant, we show pretax income for each quarter of Fiscal 2013. We started out the year with losses, but as we grew our revenues, we fully leveraged our fixed costs and returned to profitability in the third and fourth quarters of Fiscal 2013. We're pleased to report our first full year of pretax profitability since 2006. During last quarterly Conference Call, we reported slowing sales in the months of July and August compared to the previous year. As you can see on slide 4, the slowness continued into September. This coincided with the rise in mortgage rates, the sequester, and the fiscal showdown in Congress. However, the slower sales trends reversed in October as we got back to the same dollar amount in net contracts this year compared to last. The improvement continued in November of 2013 as the dollar amount of net contracts increased 11% over the same month in the previous year.

Slide 5 shows that during the month of October, net contracts increased sequentially to 465, and net contracts per community increased sequentially to 2.3. This pick-up follows a typical seasonal pattern. Looking at it compared to 2012, the absolute number of net contracts increased by one home in 2013, so they were essentially flat compared to last year. And, on a per community basis, they were down slightly from 2.5 in October of 2012 to 2.3 in October of 2013. While seasonality typically leads to increased sequential sales in October, November begins this seasonal winter slowdown. As is typical, we saw contracts per community down on a sequential basis. The year over year comparisons were relatively flat from a net contracts perspective and decreased slightly in our net contracts per community basis.

As we discussed in our Third Quarter Conference Call, we feel that we had been too aggressive on raising home prices in some of our communities. We did make minor adjustments to net pricing, primarily increasing incentives to try to drive some demand to our communities. Looking at our sales for November and October, it appears that the increased incentives in about 20 of our communities did in fact benefit our overall sales efforts. However, as I said earlier, we're now in a period that is seasonally slow. Historically, traffic and net contract slow down just before Thanksgiving and remain slow through the first couple of weeks in January. As we sit today, we are optimistic that the reality of higher new home prices and higher mortgage rates will have settled in, and that home buyers will once again be in the market to buy homes during the Spring selling season. Over the long term, household formations, the primary driver of housing demand, will return to normalized levels and should ultimately lead to increased demand for new homes. As such, we remain convinced that we're still in the early stages of a housing recovery.

Wrapping up the discussion about sales pace, we ended the year with annual net contracts per community of 30.7, which you can see on slide number 6. This is a 9% increase over Fiscal 2012 and a 44% increase over Fiscal 2011. These are solid increases, but at just over 30 net contracts per community, it's still a ways off from normal, which would be about 40 net contracts per community -- in the mid-40s actually. You can see that on the left hand portion of the slide that the average for 1997 through 2002, neither a boom nor bust period, was 44 net contracts per community. So, there is still a lot of room for substantial improvement here. On slide 7, we show you that for the prior 12 months, we were still selling more homes per community than most of our peers.

Lately, we are successful in growing our community count, particularly in the back half of Fiscal 2013. Slide 8 shows a positive trend in our consolidated community count. Each quarter during Fiscal 2013, our consolidated community count grew. For the full year, our community count increased by approximately 12%. It wasn't as simple as opening up 20 additional communities. We opened 91 communities during the Fiscal Year and closed out of 71 communities.

For the past six quarters, the number of net additions to our lot count have exceeded the number of deliveries by 7,100 lots as you can see on slide number 9. Here you can see that the last two quarters in particular, the net additions have more than doubled the number of deliveries that we've had. The plan for each of those new communities is to get them up and running as soon as practical. Our land acquisition departments remain busy and have been very busy throughout the country and the year as better home prices and sales paces have resulted in higher land residuals creating more willing sellers.

We feel that we're well positioned as we head into Fiscal 2014. On Slide 10, we show that our year over year backlog dollars increased 14.3%, and that our backlog in units increased 11.5%. Our growth in community count gives us the confidence that our revenues will grow in Fiscal 2014 even with flat sales pace per community. Needless to say a return to a more robust sales pace will only enhance our growth opportunities. This, combined with our growth in backlog and the composition of our backlog, gives us confidence that we will be able to grow both our top line and our bottom line again in Fiscal 2014. We are continuing to review unmothballing many of our communities as well. This would add additional stimulus to our growth.

I'll now turn it over to Larry to go through some of the data points that we typically give on our calls.

Thanks, Ara. Let me start with a discussion about our gross margin trends. The addition of newly identified communities is a major reason that our gross margins continued to improve. Slide 11 shows that the gross margin for the past 11 quarters. As you can see, the gross margin improvements have been steady. Below each bar, we show the percentage of deliveries from newly identified communities. Our newly identified communities have gross margins that are in a more normalized range or even exceeds our normal range in some communities where we've been able to raise home prices.

During the third quarter, we achieved normal gross margin levels for the first time in six years. Due to our ability to increase home prices, we reported a gross margin of 22.6% during the fourth quarter of 2013, which is slightly in excess of our normal range. Given the seasonal fall-off in deliveries that will occur during our first quarter and the fact that we have some fixed cost and construction overhead component of our cost of goods sold, we anticipate reporting a gross margin for the first quarter of Fiscal 2014 that is lower than what we have reported for the fourth quarter of Fiscal 2013, but one that likely exceeds the gross margin we reported in the first quarter of Fiscal 2013. Excluding any impact from future home price changes, it is likely that our gross margins will remain in the normal range of 20% to 21% for Fiscal 2014.

Based on the higher backlog and community count, we are confident that excluding any expenses related to early retirement of debt, Fiscal 2014 should result in greater levels of profitability for the full year. Excluding any expenses related to early retirement of debt, we expect the first quarter of 2014 to improve in virtually all metrics, including profitability, compared to last year's first quarter. However, due to seasonally low delivery volume, we expect to report a loss in the first quarter of 2014. Although we are confident that 2014 should be more profitable than 2013, similar to our historical trends, we expect most of the increases in profitability to occur during the second half of the year.

Turning to slide 12. We continue to make good progress on leveraging our total SG&A expense. On this slide, we show total SG&A as a percentage of total revenues. Here we show 2011 in gray, each quarter of 2012 is in yellow, and 2013 in blue. Below each of these bars, we show the absolute dollar amount of our total SG&A for each quarter. Prior to the fourth quarter of 2013, SG&A as a percentage of revenues had declined in each of the past seven quarters on a year over year basis. During the fourth quarter of Fiscal 2013, our total SG&A dollars increased to $63 million compared to $56 million during the third quarter of Fiscal 2013.

Of note, the dollar amount of our fourth quarter SG&A included $8.5 million of unusually large charges. Without those charges, our SG&A ratio for the fourth quarter of Fiscal 2013 would have been 9.2%, which is lower than last year's fourth quarter of 10%. As we do every year in our fourth quarter, we conducted an actuarial study to determine if we have sufficient construction defect reserves. We did not have any material changes in 2012 to those reserves. However, in the fourth quarter of Fiscal 2013, the study resulted in an increase to our reserves of about $6.5 million.

Keep in mind from a cash flow perspective, these reserves are used over an extended period of time, not necessarily at the time we make the change. The remainder of the increase was primarily related to a receivable related to a prior-year land sale. We do anticipate making continued improvement in our SG&A percentages during 2014. However, as we continue to grow, the absolute level of SG&A dollars spent will increase over the run rate of Fiscal 2013.

On slide 13, we show our annual total SG&A ratio as a percentage of total revenues. For all of Fiscal 2013, the SG&A ratio was 11.9%, which is much improved from the depths of the housing downturn and is approaching normalized levels. We consider approximately 10% as a normalized SG&A ratio. As we continue to generate revenue growth, we expect to be able to leverage our fixed SG&A expenses further and get this ratio back to a normalized level.

We remain extremely focused on controlling new land parcels. On slide 14, we show that since January 2009, we have controlled 33,900 lots in 542 communities. At the end of Fiscal 2013, there are still about 22,500 of those newly controlled lots remaining at attractive land values for our future deliveries. The right hand side of this slide shows there were 4,500 total gross additions during the fourth quarter, and that we walked away from about 700 newly identified lots. The net results for the fourth quarter was that our total lots purchased or controlled since January 2009 increased by about 3,800 lots sequentially from the third quarter of Fiscal 2013.

Turning now to slide 15. You'll see our owned and optioned land position broken out by publicly reported segments. At the end of the fourth quarter, 86% of our option lots are newly identified lots. Excluding mothballed lots, 79% of our total lots are newly identified lots. Our investment in land option deposits was $79 million at October 31, 2013 with $78 million in cash deposits and $1 million of deposits being held by letters of credit. Additionally, we have another $9 million invested in pre-development expenses.

Turning now to slide 16. We show our mothballed lots broken out by geographic segment. In total, we have about 6,500 mothballed lots within 50 communities that were mothballed as of the end of October, 2013. The book value at the end of the fourth quarter for these remaining mothballed lots was $116 million, net of an impairment balance of $432 million. We're carrying these mothballed lots at 21% of their original value. Since 2009, we've unmothballed approximately 3,600 lots within 63 communities. As home prices continue to rise, we expect to unmothball additional communities as we move forward.

Every quarter, we review each of our mothballed communities to see if they're ready to be put back into production. The combination of our 22,500 remaining newly identified lots and the 6,500 mothballed lots provides us approximately 29,000 lots at very attractive land values for future deliveries. Looking at all of our consolidated communities in the aggregate, including mothballed communities we have an inventory book value of $1.1 billion, net of $620 million of impairments. We recorded those impairments on 86 of our communities. For the properties that had been impaired, we are carrying them at 20% of their pre-impaired value.

Another area of discussion for the quarter is related to our current deferred tax asset valuation allowance. At the end of Fiscal 2013, the valuation allowance in the aggregate was $927 million. Our valuation allowance is a very significant asset, not currently reflected on our balance sheet, and we've taken numerous steps to protect it. We expect to be able reverse this allowance after we generate consecutive years of solid profitability and continue to project solid profitability going forward. We were profitable for our full Fiscal 2013 year. As we said for the last two quarters, if current market trends continue in Fiscal 2014, we are optimistic that we could reverse the vast majority of our valuation allowance in the fourth quarter of Fiscal 2014. When the reversal does occur, it will be added back to our shareholders' equity, further strengthening our balance sheet.

We ended the year with total shareholders' deficit of $433 million. If you add back the total valuation allowance as we've done on slide 17, then our shareholders' equity would be a positive $494 million. While we have no intentions of issuing equity any time soon, we could issue approximately 100 million of additional shares of Hovnanian Common Stock for cash without limiting our ability to utilize our net operating losses. Let me reiterate that the tax asset valuation allowance is for GAAP purposes only. For tax purposes, our tax assets may be carried forward for 20 years from occurrence, and we expect to utilize those tax loss carryforwards as we generate profits in the future. We will not have to pay federal income taxes on approximately the next $2 billion of future pretax profits.

Now, let me update you on our mortgage operations. Turning to slide 18, you can see that the credit quality of our mortgage customers continues to remain strong with average FICO scores of 746. For all of Fiscal 2013, our mortgage Company captured 71% of our non-cash home buying customers. Turning to slide 19, we show a break out of all of the various loan types originated by our mortgage operations for Fiscal 2013 compared to Fiscal 2012. 21.5% of originations were for FHA loans during Fiscal 2013 compared to 27.8% we saw during Fiscal 2012, and the 34.1% we saw for FHA during Fiscal 2011. Certainly our use of FHA mortgage clearly has been declining. At the same time, we saw our conforming conventional originations increase to 62.7% during Fiscal 2013 compared to 53.7% for 2012 and 47.1% during 2011.

Now, turning to our debt maturity ladder, which can be found on slide 20. We ended the year with $374 million of liquidity, which includes about $49 million undrawn on our $75 million unsecured revolving line of credit. In September, we did a small offering taking $42 million of our 2014 maturities and tacking them on to notes due in 2016. The red bars on this slide represent our unsecured debt. We have a lot of runway in front of us before any debt comes due.

Just after the quarter ended, we were pleased to announce that we increased our land banking arrangement with GSO by $150 million, which brings the total since July 2012 to $400 million. All of the land related to the first $250 million has been purchased by GSO, which totals approximately 2,500 lots. At Fiscal 2013 year-end, we had about 1,900 GSO lots remaining, which we have the option to take down over the next four years. Furthermore, we have already begun to identify new land parcels to fill the $150 million increase. In addition, we've identified other firms that are interested in beginning a land banking relationship with us as well.

As seen on Slide 21, our strong liquidity position, combined with our strategy of utilizing lot option contracts, land banking arrangements, and non-recourse property-specific financings clearly demonstrate we have the ability to grow. Even after we spent $125 million on land and land development during the fourth quarter, we ended Fiscal 2013 with $374 million in liquidity, which is significantly higher than the $279 million we had at the end of the third quarter. We ended the year above the $245 million upper end of our targeted liquidity range of $170 million to $245 million. We feel good about our liquidity position, and if we find sufficient new land parcels that meet our underwriting hurdle rates, we would remain comfortable even if liquidity was at the lower end of our target range.

Finally, over the past couple of years, we've been explaining to investors that we believe we would be able to increase our inventory turnover rate, which would allow us to grow the Company even if we did not increase our capital position. On slide 22, you can clearly see the progress we've made on this front during the past year. The first bar shows our inventory turnover rate at 2.1 times in Fiscal 2002 before the boom and bust of the industry. The next two bars indicate our turnover rates during Fiscal 2011 and 2012. We increased our inventory turnover rate to 1.1 times in Fiscal 2011 to 1.4 times during Fiscal 2012. Looking at the right hand side of the slide, you'll see that for Fiscal 2013 our inventory turnover rate increased further to 1.7 times. We believe our historical turnover rates in excess of 2 times will be achievable again in the future.

All-in all, we are delighted with the progress at the early stages of this homebuilding industry recovery. We continue to see land acquisition opportunities that make solid economic returns and opportunities to grow both our top and bottom lines while producing respectable gross margins and bottom line returns. 2014 should be another significant step in our recovery. That concludes our formal remarks, and we'll be happy to open it up for Q&A now.

(Operator Instructions)

Your first question comes from the line of Michael Rehaut of JPMorgan.

Thanks. Good morning, everyone. Had a question on -- I guess, first question on the gross margins. Appreciate the color there and some of the guidance. And, just trying to get a sense when you talk about Fiscal 2014 gross margins in the 20% to 21% range versus 22.6% in 4Q, recognizing there's some seasonality there, how are you thinking about that in terms of the back half of the year versus the back half of this past year with regards to incentives and perhaps home price inflation leveling out versus any potential rise in land costs that you might see flow through?

I would start by just saying that the guidance, or indication we gave you where we expect gross margins assume no changes in market conditions from what they are right this minute, Mike, if that helps you. (Multiple speakers) -- cost increases. Doesn't cook any home price appreciation, just kind of current conditions stay stable.

Okay, well I appreciate that. I guess what I was also getting at was you mentioned that you've increased incentives in roughly 10% of your communities that had likely some positive impact in the most recent month or two. As you look into next year --?

We're in 2014. I think that's what you're talking about?

Yes, I'm sorry. In calendar 2014, as you look to the Spring selling season, do you anticipate additional perhaps strategic adjustments on incentives to continue some of the momentum you've seen?

No, Mike. This is Ara. We're definitely seeing the market firm up a little bit. Having said that, it's a quiet time of the year as you know, so you can't read too much into it. But, at the moment, the market has definitely gotten a little stronger. So I would not foresee a strategic increase in incentives at this time.

Okay, thank you.

Thank you for your question. Your next question comes from the line of Ivy Zelman of Zelman & Associates.

Good morning. It's actually Alan on for Ivy. Nice quarter. Ara, I know it's a seasonally slow time of year, but I was hoping you can give a little bit of color on your traffic trends? And, I guess specifically thinking about it in the communities where you've seen those increased incentives?

Has that served as any type of catalyst for either increased traffic or better conversion rates? And, just on a year-over-year basis, are you still looking at positive comps on a traffic standpoint?

Traffic didn't slow much even when we saw sales slow in the summer and early fall. Conversion rates fell a bit, but traffic has been relatively stable on a seasonal basis.

Got it. So, then in terms of the incentives, can you kind of frame that in terms of either percentage of base price? Or, talk a little bit about the structure of the incentives? Are they more geared towards spec product, or are they across-the-board in the communities?

And, how have you kind of thought about laying that out either in the form of option upgrades, financing type of incentives? Where have you seen the most positive feedback from the consumers?

Well, first of all, keep in perspective, I know there's a lot of attention and interest in incentives. But again, we only increased them in about 10% of our communities. 90% of our communities, we really saw no change at all.

Having said that, we did generally bias incentives toward specs where we had specs. In general, we're running a little lower on specs than in the past, and probably we would like to increase that count just a little bit. But, it has been challenging getting construction to catch up in this environment, and the types of incentives really vary all over the place.

Our divisions have full autonomy in deciding how to approach incentives, and it's very micro-specific in terms of their strategies. It just depends on what the competitors are doing in that exact local market, and what they feel would be the most impactful for them. Whether it be free upgrades, whether it be increased closing costs, they're really free to decide, and the incentives are all over the place.

The other thing just to keep in mind is we're -- there is a lot of turnover in our communities. So, just this past year demonstrates that with 91 new communities and 71 closing out. So, there's always a change. Overall, we're feeling very good about the direction and stability of pricing right now.

Great, thank you.

Thank you for your question. Your next question comes from the line of Nishu Sood of Deutsche Bank. Please proceed.

Thanks, and thanks for all the detailed information. Going off the chart, you talked about inventory turns. There has been some impressive progress in that regard. I was looking -- thinking of looking ahead to 2014.

If conditions remain stable, and we're in an environment where volume growth is mainly coming from increased community count as opposed to absorptions, is that sort of environment still one where you can increase inventory turnover? Or, does the inventory turnover improvement really depend mostly upon increasing absorptions per community?

It's a combination of factors. Certainly, if you don't have any improvement in pace per community, inventory turns improvement is harder to come by. But, we didn't have strong improvements in pace per community that reflect the improvement we've made in our inventory turns over the past few years.

So, it's more than just pace per community, and just for example, just the average size of our community and getting rid -- getting a higher percentage of our deliveries coming from newly identified communities versus legacy communities improves that drag from the legacy communities as well.

So, there's a whole bunch of factors that go into it, including how we're structuring our land purchases. Both the size of the communities, the way that we've used options, and land banking arrangements, all of that adds to our ability to increase inventory turns.

Got it. And, community count growth, I'm sorry, I may have missed it, but did you mention a community count growth target for next year?

No, but I think it's safe to say we're working hard to make sure that it continues to grow.

Got it. And, speaking of the different ways you've been purchasing land, the GSO agreement going from $250 million -- I think you mentioned -- to $400 million. Typically, those sorts of arrangements are accompanied by some dilution to gross margin, but that doesn't seem to have been the case for you folks. You've had a very nice gross margin trend the past year or two.

So, I was just wondering, has it been in there? Or, has it just been masked by the stronger backdrop of new communities and home prices rising? Or, are there certain sorts of communities that you're putting into these land banking arrangements, which may be more well suited, and so does the gross margin dilution isn't as great? How is that -- how are we not seeing that come through more?

Well, we've been saying fairly consistently over multiple, multiple quarters as we've entered into these agreements with GSOs, it would be hard for you to see the impact on gross margins because it's such a tiny percentage of our quarterly deliveries.

Again, I forget what it was -- 1,900 remaining lots that we have the option to take down over the next four years. So, if you kind of take that on a quarterly basis, it's just a tiny amount of our quarterly deliveries each quarter, so there is some dilutive impact, if you look at those -- what the margins would have been had we paid cash for the lots versus doing a land banking arrangement. But, it is accretive to our return on capital deployed pretty dramatically, but I just don't think you'll ever see -- you'll never be able to model, and you'll never notice the impact of gross margin dilution from our land banking arrangements.

The only other thing I'd add is we typically use land banking arrangements on the larger communities with longer lives. Those communities typically have much higher gross margins to begin with. They have to in order to get their IRRs to pencil to meet our hurdle rates. So, given that they're pretty high gross margins to begin with, entering into a land banking arrangement with those still typically leaves you with a higher than normal gross margin.

Okay, that's very helpful. Thank you.

Thank you for your question. Your next question comes from the line of Dan Oppenheim of Credit Suisse. Please go ahead.

Thanks very much. I was wondering if you could talk a little bit about land. It looks as though during the quarter, the lot additions were really in the Midwest and the Southeast. Does that reflect your view of the values in those markets?

And then, secondly, wondering about the West where there wasn't so much an addition. Are you looking at some of the mothballed lots there, thinking they will become unmothballed soon enough so that not really looking for land right now? Just some color on that.

Sure. Well, first of all, we have generally been sticking to our discipline where we do not factor in appreciation into our land acquisition decisions. What that's meant on the West Coast, in particular, is that we were outbid in some of our land acquisition efforts there.

Looking backwards, that was probably an overly conservative stance, and we lost out on opportunities in an appreciating market. Over the long term, we still think that's the right discipline to stay on the conservative side there, but we're not consciously looking to shrink down in that marketplace.

We are seeing new opportunities coming up now, and we think we'll have better opportunities for success. We do have a disproportionately large amount of our mothballed lots on the West Coast, thankfully, and that market has been appreciating nicely. So, that will help us with our growth, but nonetheless, we are focused on increasing our land acquisition on the West Coast.

And, I would say with respect to the Midwest, even though this particular quarter maybe we had a disproportionate increase there. I don't have the numbers right in front of me, Dan. I would say we're willing to buy in any of our markets where we can meet our unleveraged hurdle rate requirements.

So it's not a conscious decision to shift the investment to the Midwest. We would be just as happy investing in any of our existing markets as long as they bring us deals that meet our hurdle rate requirements.

Great, thank you.

Thank you. Your next question comes from the line of David Goldberg of UBS. Please proceed.

Thanks. Good morning everybody.

Good morning.

My first question kind of follows up on Dan's question a little bit. But, it's really about the underwriting and some of the volatility that we had in the housing market in 2013. And, given the price appreciation that we saw, have you actually thought about maybe doing some more sensitivity analysis on the downside when you're buying lots? Maybe raising hurdle rates a little bit?

Just given that there's so much uncertainty heading into 2014 especially around prices, it feels like it's easy to get out over your skis at this point a little bit. So, maybe just talk about how you're thinking about hurdle rates, and whether we need to be a little bit more conservative on the price side in the analysis?

We generally underwrite to a minimum 20% IRR. That includes all overheads other than corporate, but that's an unlevered IRR. We feel that's an appropriate spot to be in, and in fact, many exceed that minimum IRR in our acquisition opportunities. Frankly, if we raise the threshold beyond that, we would not be very active. And, that would be more painful at the moment.

But, we're in general -- we're confident about the direction of the market. We think there is a better opportunity for upside than downside, but we've been sticking to our guns at 20% hurdle rates, and we think that gives us protection -- sufficient protection on the downside.

Yes, and in addition, because we underwrite based on then current absorption rates, then current construction costs, then current home prices, what happened in the late Summer and Fall where we saw absorption rates fall or home prices decline, that was built into any new land deals that we're talking to.

So, our criteria, although it remains the same, constantly adjusts for what's going on in the marketplace on a realtime basis.

Of course. And then, just as a follow-up question, I was wondering if we could get a little bit more detail into the increase on the actuarial -- on the warranty reserves. I would assume that there were some claim history that suggests that you needed to reserve more on a go-forward basis.

Was there a specific vintage of construction or a specific region or something that kind of drove that? I know in 2012 you didn't have to change the reserves, and now at the end of this year, there was a change. And, just maybe more color on what really drove that?

It's 10 years worth of claim history, and that's what we do and consistently apply it each and every year. I wouldn't say that there's any particular single claim that came into play to drive that. Just from one year to the next shifted the numbers a bit.

In general, regarding geographic concentrations, New Jersey and California tend to be the disproportionate, overweighting locations from our defect and warranty costs. Those are both fairly litigious environments.

The other thing is that most of the expenses today relate to homes that were built way back in 2005 or 2004 or 2006 where we were building five times -- or four times as many homes as today. So, the impact is a little more pronounced when you compare to our lower volume today as we are at the early stages of the recovery. So, you get a little bit more volatility, but hopefully we're at the right spot in our reserve amounts right now.

But, it's fair to include -- just to make sure I understand -- it's not a subcontractor-specific issue? It's not a water intrusion issue. It's more widespread than that?

Yes, I think that's true. I would say maybe there were more expenses related to some old stucco claims perhaps as many builders experienced in the past. But, generally speaking, there was not a specific issue. It was pretty widespread and not concentrated in any particular community.

That's great color. Thank you.

Thank you for your question. Your next question comes from the line of Joel Locker of FBN Securities.

Hello, nice quarter. I guess was looking at your November orders. How many of those were joint ventures?

Jeff, you got it there? I know we'll put it out after the call. We'll put it out after the call. We don't have that right at our fingertips.

But, I will say in general, the number of joint ventures has been shrinking a bit, not consciously. We actually have some great partners that would like to do more joint ventures. We're just not seeing as many opportunities on the joint venture front in terms of larger transactions that would warrant a joint venture. So, we're still out there looking, and we're hopeful we'll see some more opportunities soon.

Okay, and the second question on community count. It looks like you opened several communities in November already based on the 1.8 absorptions on the 382? And, just wanted to get your take on how many communities you're going to open in 2014? And, how many you did in November?

We're going to try to grow. We're not going to make a projection. It's a very difficult number to project because you're not sure exactly how many you are going to close out. You're, not sure whether you'll have regulatory delays on opening new ones and that type of thing. So, it's probably the most difficult number for a builder to precisely project, but we are working hard to insure that it grows during Fiscal 2014.

In general, over the next two years, we are planning to grow, and we are not projecting increased sales pace. So, we're projecting to increase our community count. We're hoping we get a little sales pace increase on top of that and can grow even faster than our budgets.

But, there's no range for 2014?

[Not that we're comfortable making] public. (laughter)

Just for openings?

Nope.

Thanks a lot.

Okay.

Thank you. Your next question comes from the line of Adam Rudiger of Wells Fargo. Please proceed.

Hi, this is Joey Matthews on for Adam. Wondering if you could talk about your increase in optioned lots over the past year? They're up about 42%. Was wondering if you could give us a rough split of the split between options to buy developed land or finished lots versus raw, undeveloped lots?

Well -- silence. None of us have that number off the top of our head either.

We'll have to follow-up on that one. It's just not something we track very regularly.

Not on that basis.

No problem. Wondering if you could kind of describe the competitive environment for construction labor right now? And, how you expect it to unfold this Spring selling season?

Sure.

Maybe which subcontractors in particular you see as particularly tight or competitive?

Yes. The subcontracting trades that are particularly tight are all of them right now. (laughter)

Depending on the market it's a different one.

Yes, but as you can imagine, with the market growing from its lows as much as it has, there has been strain on the market. On the whole, I think in the beginning, the subcontractors were hesitant to add additional labor having just been through such a tough downturn. I think as they're gaining confidence and their own balance sheets are improving, they're slowly making the commitments to hires that are helping.

That being said, I'd say I wouldn't expect dramatic improvement over the next year, nor would I expect it to get worse. The market is projected to continue its gradual trend of improvement, and I think the labor force -- just a guess -- is going to keep up with that. I don't see it getting a lot better or a lot worse. It's just going to kind of move with the overall improvement.

Anecdotal comments from our business units is in recent months, they're admitting for the first time that maybe it's actually extending their construction build cycle time modestly in certain markets because they're struggling with one trade or another. So, I think it's just further indication that it's real -- it's hard to quantify.

We like the modest growth industry recovery better than the rocket ship, super-fast recovery for the industry because we think one of the biggest barriers to growth is the limit on trained, high quality labor. And, the last thing we want to do is use an apprentice to start building our houses and have reserve -- or have warranty reserve issues.

Great. Can I slip in another question since my option lots question got shot down?

Sure.

The trends in floor plan sizes -- I know when interest rates were low, there was a trend to size up. Have you noticed any recent trend to the downside due to the higher interest rates? And, possibly limited -- more limited purchasing power among your customers?

Yes, in general, I'd say the homes are still much larger. The ones that are in demand still tend to be on the larger end of our range in all of our locations, and certainly much higher than they've been trending over the last five years.

There has been a little calming down of what I'd call the hotel homes -- the mini hotels. It was an odd phenomenon where markets that were used to selling 2,500 square foot homes started selling 4,500 square foot homes. There were very big Econo boxes that became very popular for awhile, but that has died down a little bit. Nonetheless, the home sizes definitely are on the larger size, and I don't see that changing dramatically. I think it will be a gradual reduction down as rates slowly creep up.

Great, thank you.

Thank you. Your next question comes from the line of Megan McGrath of MKM Partners.

Hi, good morning. Just a quick follow-up on gross margins, just a quick modeling question here. It looks like your capitalized interest ended the year about 3.5% of COGS. What's your expectation for where that's going to trend next year?

I don't think we've made any public projection on that as well. I'd just follow the trend.

Okay, and then, on a different topic. There has been a lot of talk lately on sort of what's happening in terms of mortgage credit availability, higher prices should be helping. But, then we've got QM kicking in at the beginning of the year. So, any color you can provide on changes you're seeing there, and expectations into next year?

Again, qualified individuals with decent credit scores and jobs -- we have no problem getting people qualified. For the people that have some blemishes on their credit, it's hard. But, that hasn't been the change, and I don't think the things that you're citing are going to be a material impact. I think Congress will be smart enough not to really reign in mortgage availability such to a point that it shuts down the housing industry whether that be used houses or new houses because it will have such a huge negative impact on the US economy. So, I just don't think anything too negative will be allowed to occur.

Okay, thanks.

Thank you. Your next question comes from the line of Alex Barron of Housing Research Center.

Thanks. I was hoping you could elaborate a little bit on the gross margin improvement this quarter? And then, on your comment that gross margins are going to be down again next quarter. Is that due to some type of gross margin leverage? Or, was there some type of product type or geographic impact that caused the bump-up this quarter?

For the first quarter specifically, similar to what happened last year's first quarter when we had a decline in gross margins in the first quarter of 2013 versus the fourth quarter of 2012 is purely the fixed cost component of certain overheads in COGS that did that. We told you that at the time, and then you could see the rebound that we had in subsequent quarters where we returned to higher volume. You are going to see that again in the first quarter of 2014 compared to the fourth quarter of 2013.

Yes, it seems counterintuitive because gross margin you wouldn't think would be affected by volume. But, construction overhead is an important part, and the first quarter in the middle of the winter as we are right now, we don't have as many deliveries. But, we're preparing and gearing up for the Spring selling season, so you get the double whammy.

We're incurring some more costs and have fewer homes to offset that, and that does on that one component of overhead affect gross margin in the first quarter.

We actually put a slide together when we did the Analyst call for the first quarter of 2013 that broke that out to where you could see what direct margin was without that impact. That direct margins from the first quarter versus the fourth quarter of -- first quarter of 2013 versus the fourth quarter of 2012 actually went up. The gross margin went down because of that fixed component of overhead, so you might want to look at that or call Jeff. He can send it to you if you want, but that's really what happened. And, it's going to happen again.

I've got it. Okay, thanks. That's helpful. The other question, I guess, had to do with the trend in the ASP. Obviously, it looks like it keeps going higher, and even this quarter both sequentially and year-over-year looked to me like most regions were higher? So, is that due to the fact that -- are you continuing to increase prices? Or, are you just seeing a higher mix shift towards bigger homes?

Yes, to all of the above. But, if you look at the breakout in contract dollars amount for the last quarter, you see the biggest increases in California. And, while mix has been a factor in California, in particular, we had some very aggressive price increases there. So, there was a lot of price appreciation there that was not due to mix. That was just due to raw increases in price. That's part of the reason why we saw a sales pace decrease there, even with flat community count, but we think that has leveled off right now.

So, is that still happening in the most recent quarter, you are still raising prices? Or, have you --?

No. There is probably some instances where we had price increases, but it was the minority of instances. And, certainly, there's 10% of our communities where we decreased net sales prices as we talked about earlier. So, this shift you're seeing is mainly mix rather than home price appreciation.

When I referred to the quarter, I really meant the statistics in our release, and it just compared our most recent quarter -- the fourth quarter -- to the same quarter last year. And, in California, we're up over 41%, and a lot of that amazingly was pure price increases.

Okay, thanks.

(Operator Instructions)

Your next question comes from the line of Michael Rehaut of JPMorgan. Please go ahead.

Thanks, I appreciate it. Just wanted to circle back if I could for a moment to the gross margins again. You had mentioned that -- I believe you said that for the first quarter, while it should be down sequentially, it should likely be up year-over-year? And, given the strong amount of year-over-year improvement that we've seen over the past two or three quarters, I was wondering -- maybe I'm reading into language too much. But, why it wouldn't be more likely that there maybe wouldn't be stronger language used that it would appear that given the trend that you're seeing that it would be more de facto that you should see improvement.

Don't parse the words that carefully is probably the answer.

Fair enough. Wanted to make sure I wasn't missing anything. Thanks.

Okay.

Thank you for your questions, ladies and gentlemen. I'd now like to turn the call over to Ara Hovnanian for the closing remarks.

Great. Well, thank you very much. We're obviously pleased with both the quarter and the full-year results, and we'll look forward to reporting an even better Fiscal 2014. Thank you.

This concludes our conference call for today. Thank you all for participating, and have a nice day. All parties may now disconnect.