Hovnanian Enterprises Inc (HOVNP) 2005 Q2 法說會逐字稿

Good morning and thank you for joining us today for Hovnanian Enterprises’ Fiscal Year 2005 Second Quarter Earnings Conference Call. By now you should have received a copy of the earnings press release. However, if anyone is missing a copy, and would like one, please call Donna Seshi [ph], at (732)747-7800, and we will send you a copy of the release and ensure you're on the Company's distribution list. There'll be a telephone replay of today's call available after the completion and be available for eight days. The telephone replay can be accessed by dialing (888) 286-8010 and the pass code is 73077903. Again, the number is (888)286-8010 and the pass code is 73077903. There's also a Webcast that will be available for 12 months on the Company's Web site. This conference is being recorded for rebroadcast and all participants are in a listen-only mode.

Management would like to make some opening remarks about the second 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. Slides are available on the Investors page of the Company's Web site at www.khov.com. Those listeners who would like to follow along should log on to the Web site at this time.

Before we begin, I would like to remind everyone that the cautionary language about forward-looking statements contained in the press release also applies to any comments made during the conference call, and to the information in the slide presentation. I would now like to turn the conference call over to Ara Hovnanian, President and Chief Executive Officer of Hovnanian Enterprises. Ara, please go ahead.

Thank you. Good morning and thanks for participating in today's call to review the results of our second quarter ended April 30th. Joining me today from the Company are Larry Sorsby, Executive Vice President and Chief Financial Officer; Paul Buchanan, Senior Vice President and Corporate Controller; Kevin Hake, Senior Vice President and Treasurer; Brad O'Connor, Vice President and Associate Corporate Controller; and Jeff O'Keefe, Director of Investor Relations.

Once again, we're proud to report that we set all time second-quarter records in almost all categories, including net contracts, contract backlog deliveries, revenues, and net income. We're pleased to share the results and provide an updated outlook for the remainder of fiscal '05. I'll review the financial highlights and comment on our operations and Larry will then spend some more time reviewing our financial performance in a little greater depth.

For those of you that are reviewing the slides on the Investors page of our website, www. khov.com, you can turn to slide number three. For the second quarter of '05, we reported record earnings of $1.62 per fully diluted share. This represents a 53% increase from '04's record earnings of $1.06 per fully diluted share. When compounded with the 33% increase in last year's second quarter we have doubled our EPS over the last two years. As shown on slide number four, net income rose 51% in the second quarter to 106.1 million after taxes, compared with 70.5 million in the second quarter of fiscal '04.

Slide five. For the trailing 12 months, we posted an after-tax return on beginning equity of 42.1% and an after-tax return on beginning capital of 22.5%. Both return measures continue to improve when compared with the trailing 12 month returns in end of the first quarter. It's not an easy task as we grow larger and add acquisitions, which typically have lower returns in the earlier years. Our entire industry is posting great results and we're pleased that our year-over-year growth, our return on capital and our return on equity continue to be among the highest in a great industry.

Slide six. Total revenues for the second quarter increased 32% to $1.2 billion up from 919 million in the prior year, setting another record quarter in revenues for the second quarter. Side seven. Consolidated deliveries increased 12% in the second quarter to 3,748 homes, another record. We achieved these record levels despite delays in California, largely due to the record rainy season we had this past winter, which pushed some of our deliveries from the second quarter into the second half of '05.

Our significant growth and healthy returns are the result of many factors, including, one, continued pricing power in a number of our more regulated markets, leading to higher gross margins in many communities. Two, higher average price points due to our mix of communities, leading to higher profits per home on an absolute basis. Three, growth in communities from our most recent acquisitions. Four, stable labor -- stable labor and material costs. Five, continued progress in our broadening product offerings in many of our markets, which allows us to further penetrate those markets. And last but not least, we just have a great management team running our particular offices. We refer to them as "intrapreneurs" and they're really highly energized and excited.

Although our recent acquisitions added to our performance for the quarter, 93% of our growth in the second quarter EPS came from organic operations. We're extremely pleased with our progress to date on the ongoing integration of Town & Country Homes and Cambridge Homes. These two transactions were completed about a month into our second quarter. Both contributed to our second quarter results and are on plan with our expectations.

As a reminder, the Town & Country acquisition was structured in a joint venture with the Blackstone Group so there's less of an impact on our overall results. However, I am pleased to report that we have subsequently contracted numerous new parcels in all three markets, which we will be developing on our own as we begin the gradual transition process from 100% joint venture communities to 100% Hovnanian communities over the next five years. Again, the premium will be amortized in the joint venture structure, so the 100% Hovnanian communities will have no drag from the premium amortization as we do in our typical acquisitions.

We continue to look at additional acquisition opportunities as a way to enter new markets, as well as a means of further geographic penetration of an existing market, or perhaps as a way to add a complementary product offering. The level of potential acquisition activity and the amount of looking remains very high, however, we remain extremely disappointed in our approach -- excuse me, not disappointed -- we remain extremely disciplined in our approach to acquisition. We're actually very pleased with them, obviously, and we'll move forward once we are comfortable with the company's track record, the management team, operating culture, market position, and financial returns, based on a reasonable price. As I've mentioned in the past, integration of acquisition is a core strength in our Company. We been acquiring companies for many years and I think our track record speaks for itself.

Slide eight. I’ll now briefly walk through each of our current markets and update you on the current market conditions and our competitive position. Our major markets on slide eight are labeled with our relative market position and our expected deliveries for Fiscal '05. I'll try to keep my discussions brief, and remark on noteworthy activities in each market. If you look at the map on slide eight, I'll start with California, Northern California in particular, and there we maintain a strong presence in the Sacramento Central Market area, Central Valley market area. We're primarily focused there on the more moderate price ranges for that marketplace. Yet consistent with our product diversification strategy, we recently opened our first two active adult communities in this area, and they're off to a fine start.

Our Southern California operations also remained strong. As you know, this part of California's getting a lot of media attention with respect to affordability, especially along the coast. While this market paused slightly last fall due to a little overhang in the resale market, and due to very aggressive pricing on a lot of homebuilders’ parts, we’ve recently begun to see the market firming in many respects and also begun in certain locations to see the prices rising once again, albeit not at the appreciation rate that we experienced a year to a year-and-a-half ago. We do believe that affordability is stretched along the coastal markets and it will be difficult for the market to sustain much more in the way of significant price increases. We think it will gradually get back to a more normal market depreciation.

However, we also believe that the coastal markets remain among the most restrictive in the United States in terms of housing, approvals and entitlements and therefore availability, and thus these markets are likely to remain healthy because of the restricted supply, particularly with the job growth and population growth that's occurring in these markets. We have a sizable position and growing presence in the San Bernardino and Riverside County marketplaces, and more of an affordable product focus is our general mode of operation in those markets. We have a nice product mix in Southern California and that protects us from any softness in one particular market segment.

The active adult business is a growing segment, and we have a growing segment in the urban and infill suburban locations. In Arizona, we're pleased with the returns that we've been getting from our Great Western acquisition, which has primarily been focused on the entry-level product historically, but we're gradually diversifying that product range as well. We've recently expanded our presence outside of Phoenix to the adjacent Tucson market. This type of acquisition is a good example as to how we can leverage our existing infrastructure and achieve organic growth in new, adjacent satellite markets.

This is similar to what we are doing in the Bakersfield market, which is adjacent to our market activities in L.A., but with very different employment and job dynamics. What's advantageous is that we can do a startup economically by servicing the new adjacent satellite markets from our existing markets, in this case Southern California, until it is large enough to support and justify its own infrastructure. We're also doing this adjacent to our Philadelphia markets by entering the Lancaster and Reading, Pennsylvania, markets in very much the same way. Again, separate SMSAs, separate job growth drivers, etc. This is a mode of organic expansion that I think you'll see more of from our Company in the coming years.

Moving along the Rio Grande to Texas, our revenues, returns and deliveries are up in the Dallas-Fort Worth markets this year despite a market that does not have significant pricing power at the current time. We're one of the few builders who have been successful in this market over the past couple of years, which is a testament to the impact of our diversified product offerings and to our great management team there. In Houston, we continue to see some competitive pressures but our returns remain solid. Again, in this market, we have had great success with minimal price appreciation.

And now across the Gulf to Florida, Tampa is a strong market and we're back to pre-hurricane levels with regard to the availability of materials which impacted our operations at the start of our fiscal year. Our communities in Tampa continue to perform well. We are pleased with our sales to date in our Cambridge Homes operations and the Town & Country Homes as well. However, we are only two months into these new markets and we'll provide more information on these markets as time goes on. On the whole, however, I will report that the Florida market remains strong and we're very bullish on the long-term prospect here.

Moving up the Atlantic coast, North Carolina, which has been a weak market over the past several years, is starting to turn around -- and actually, I guess I should say continuing to turn around -- because we've seen that reversal from the slower market begin over a year ago. Two of our three markets are doing well. Charlotte is the exception, and we've taken steps to improve our operations in this market. Most builders in the Carolina markets would not characterize the last few years as booming housing markets. Although sales have been steady, these markets have provided good evidence as to how sales pace and pricing power, and thus profitability in housing markets, is more affected by job contraction and creation than by low mortgage rates.

Moving up into the Washington D.C. market, these general areas are very strong and very solid. We have a broad product offering and continue to raise prices in many of our communities. We are generating fabulous returns in the greater Washington D.C. market. The revitalization of the country's defense industry and related industry has been part of the positive job picture in both northern Virginia and Maryland. However, there are a diversity of industries performing well and creating job growth in these markets now. And both states continue to be difficult in terms of land supply and regulatory approvals. We are the second-largest builder here behind NVR in the very important greater Washington D.C. marketplace.

And finally, our Northeast market, consisting primarily of New Jersey and eastern Pennsylvania, is also doing very well. However, both net contracts and community count in the Northeast are down 20% on a year-over-year basis. Part of the difficulty is also part of the good story. The difficult regulatory environment keeps barriers to entry high, keep supply limited, But obviously, in spite of our solid positioning there, it affects even us. The low community count is consistent with what we've been seeing in the prior conference calls and is not unexpected. The majority of our planned openings in the Northeast have been scheduled to occur in the second half of the year.

Similar to Southern California, in the coastal market in particular, we have a very nicely diversified product mix in the Northeast. Active adult communities in the Northeast make up about 30% of our sales, and we have an increasing number of urban and infill suburban locations. We're also the long-standing number one builder in the state of New Jersey, which provides significant market powers and drives operating efficiencies in this highly profitable and important to market.

From a sales perspective, Ohio is our weakest market today. This is purely an economic-driven situation and does not give us any reason for concern as the employment situation will slowly correct itself. We still believe strongly in our on-your-lot operation there.

Our Town & Country communities, moving on to some of the new acquisitions, in the Chicago and Minneapolis markets are doing very well. Obviously, it's still early in the ownership of these operations, as I mentioned earlier, but we continue to feel very good about these markets which are both, by the way, in the top ten in the United States in terms of housing activity.

We also have our own startup operation in Minneapolis which we have had in place for about a year. We opened our first two communities during the second quarter in that operation and signed our first contracts. We plan on and anticipate our first deliveries from this operation early in '06. We're confident that, like other markets where we have two separate operations, we think our separate operations in Minnesota will allow us to achieve a strong market position there in a very short timeframe.

That completes the quick walk around the country looking at our operations in each of our markets. We feel very comfortable that the strength and diversity of these operations will allow us to continue achieving our long-term growth objectives.

Slide number nine. Contract backlog at April 30th reached 10,986 homes with a sales value of $3.9 billion including 2,150 homes from unconsolidated joint ventures. The number of homes in backlog and the dollar value of backlog are both all-time records for any quarter and in our history. The dollar value of our contract backlog represents a 61% increase over the end of April 04. As a result of our healthy backlog and a further improvement in our margins, we are increasing guidance for the current '05 fiscal year to greater than $7 per share.

Slide number ten. The revised projection represents over a 31% increase from '04's record earnings of $5.35 per share. This projection includes our first estimate of our third quarter '05 EPS, which we expect will be about $1.70 per share, up more than 28% compared to $1.33 per share in last year's third quarter. Fiscal '05 revenues are expected to increase more than 26% to 5.3 billion on deliveries of more than 16,400 homes. This excludes the joint ventures. Revenues will be closer to 5.9 billion in deliveries of around 18,000 homes including joint ventures.

Although the adverse winter weather we experienced in California early in our fiscal year delayed our ability to start and complete homes in a number of our communities, and delayed our ability to complete land development in order to get certain communities open, we are on track to exceed last year's results for the remaining two quarters in fiscal '04. However, the weather delays will result in a greater number of our homes being delivered in the latter half of the year than we would have liked. While our backlog is strong and we feel confident in raising our projections for the year, we are again dependent on reasonable weather in the fourth quarter to deliver a large percentage of our homes in that backlog. Details of our summary projections for the fiscal year ending October '05 will be available later today on the Financial Information page of the Investor Relations section of our Web site at khov.com. I will now turn it over to Larry Sorsby to discuss our financial performance in greater detail.

Thank you, Ara. I will go into more detail pertaining to the second quarter and six-month period, as well some specifics behind our heightened expectations for the second half of fiscal 2005.

A summary of our six-month results is displayed on slide 11. The improvements that we achieved in each of these line items demonstrates the strength of our markets and our operating strategy during the first half of the year. Total revenues increased 34% from $1.7 billion to $2.3 billion, and net income increased 46% from 128.2 million to 187.6 million. Earnings per share from the first six months fiscal 2005 were $2.87, up 49% from $1.93 per share during the same period last year.

Slide 12. At the end of the second quarter, excluding JV communities, we had 308 active selling communities companywide. We have a very strong pipeline of new communities scheduled to open during the second half of this year. Excluding JV communities, we expect to have approximately 330 active communities open for sale at October 31st 2005, an increase of 20% in community count over October 2004.

Slide 13. Including unconsolidated joint ventures, the dollar value of net contracts for the second quarter ended April 30th 2005 increased by 25% from the second quarter of fiscal 2004. The number of contracts for the quarter was 5,328, an increase of 8% compared with 4,911 contracts in last year's second quarter. As we open additional communities during the third and fourth quarters, we expect our year-over-year quarterly sales comparisons to gain further positive momentum.

Turning to slide 14. The average sales price per home delivered company-wide, excluding JVs, for the second quarter was approximately $317,000, an 18% increase from the average sales price of approximately 269,000 in the prior year second quarter. The average sales price in our markets increased primarily as a result of geographic and product mix of our deliveries, as well as our continued ability to raise prices in select locations. We expect that the average sales price per home, excluding unconsolidated joint ventures, will be around 315,000 for the remainder of fiscal 2005.

Slide 15. For the second quarter of 2005, the Company's consolidated home building gross margins, excluding land sales and prior to deducting interest in cost of sales, was 26.4%, a 120 basis-point increase from 25.2% in last year's second quarter. After interest and cost of sales, gross margin was 25.2%, 150 basis points higher than the 23.7% margin reported in the prior year's quarter. Based on the homes we have in backlog for delivery in fiscal 2005 we're projecting our homebuilding gross margins for the full year, prior to the effect of interest expense, to be up slightly compared to the 25.5% homebuilding gross margin we achieved in fiscal 2004.

Turning to slide 16. Total selling, general, and administrative expense, including corporate expense as a percent of total revenues, was 10% in the second quarter of 2005, a 40 basis-point decrease from 10.4% in last year's second quarter. We anticipate that our total SG&A expense as a percentage of total revenues will be in the range of 9.5% to 9.8% of total revenues for the full-year fiscal '05. Slide 17. The company's pretax margin in the second quarter increased an impressive 210 basis point to 14.3% from 12.2% in the prior year's second quarter.

Now, I'll cover the performance of the financial services operations. Turning to slide 18. Our financial services business continues to experience increased competition from third-party mortgage lenders as the number of mortgage refinancings has fallen significantly. So those lenders have been increasing competition by reducing margins in order to originate business. The increased competition combined with increased consumer demands for ARMS, which historically are less profitable than fixed rate mortgages, have adversely impacted the profitability of our financial services operations. The negative impact of these factors offset the positive growth in our mortgage volumes for the quarter on a year-over-year comparison, and thus, pretax earnings for financial services were flat at $4.8 million in the second quarter, compared to the pre-tax earnings in the prior year's second quarter.

Turning to slide 19, we are currently originating mortgages in all of our markets except Tampa, a portion of our Houston operation, and the markets that our Town & Country acquisition operates; Chicago, Minneapolis, West Palm Beach, Boca Raton and Fort Lauderdale. Through our acquisition of Cambridge, we are originating mortgages in Orlando. Our mortgage company will grow faster than our homebuilding operations as we start origination loans in Tampa, Chicago, the southeast portion of Florida, and Minnesota later next year.

Our recent data indicates that our customers' credit quality remains quite healthy. Our average loan to value ratio was 75% for the second quarter, slightly less than the 76% for our fiscal '04 results. For the second quarter of '05 our average FICO score was 711, compared to fiscal 2004's FICO score of 713. For the quarter, the average FICO score for customers utilized on adjustable-rate mortgage was 704. We believe that our customers' FICO scores are above mortgage-industry averages.

As we noted on our previous earnings calls, on a historical basis, we have seen an increase in the use of adjustable rate mortgage. That trend appears to have slowed and perhaps ended. In the second quarter, ARMS represented 41% of all of our origination volume, flat compared with ARMS originations for all of fiscal 2004. Turning to slide 20. For the quarter, EBITDA increased 48% to $206.2 million from $139.4 million in the second quarter of fiscal 2004. EBITDA represents earnings before interest expense, income taxes, depreciation and amortization. A reconciliation of our Company's consolidated EBITDA to net income can be found as an attachment to our quarterly earnings release.

Slide 21. EBITDA covered the amount of interest incurred by nine times for the quarter, an increase from 6.3 times during last year's second quarter. We expect to cover interest more than eight times for the full fiscal year, and the ratio of total recourse debt at year-end to EBITDA for the year is expected to be below 1.6 times. We ended the quarter with very strong coverage ratios, a solid balance sheet, and an ability to service our debt requirements equivalent to most investment-grade companies. Slide 22. We ended the quarter with a ratio of net recourse debt to capitalization at 48%. We anticipate that our average ratio of net recourse debt to capitalization will be below 50% for the full fiscal year of 2005, in line with our current operating strategies.

Turning to slide 23. At April 30th, 2005, shareholders' equity was 1.4 billion, a 41% increase from 970 million at the end of the second quarter of fiscal '04. Based on a revised earnings projection for fiscal '05, we expect shareholders' equity to grow to more than $1.6 billion by October 31st, 2005. At April 30th, turning to slide 24, excluding 10,114 JV lots that we control, we controlled on a consolidated basis 104,000 lots in our various homebuilding markets for future developments. Roughly 74% of our lots are controlled under option contract which minimizes our risk exposure to any significant decrease in the value of land. Our current land position represents more than a six-year supply based on our 2005 projected deliveries.

Turning to slide 25. It shows our aggregated option position for all of our lot options and the amount of aggregate deposits which we have at risk, which are only 6.9% on average of the total purchase price of the lots. We believe that this strategy minimizes our risk associated with land ownership. In addition, our controlled lot position gives us excellent forward visibility and confidence that we will be able to continue to generate strong earnings growth going forward.

Before I turn the call back to Ara, I'd like to mention a few other points regarding our activities in the second quarter as well as their impact on projections for the current fiscal year. We delivered EPS slightly ahead of our projections, despite higher than anticipated effective tax rate during 2005’s second quarter. We're now adjusting our projections for effective tax rate for all of fiscal 2005 to be in a range of 38.5% to 39%. This change is primarily due to increased state income tax burdens. During 2005’s second quarter, we repurchased 300,000 shares of HOV common stock at an average price of approximately $53 per share. This recent activity leads our current stock buyback authorization at 1.8 million shares. We will continue to buy back shares from time to time.

As a reminder, our updated fiscal 2005 projections, which include the effect of both our recent acquisitions, are net of all amortization of definite life intangibles and include 45.1 million of definite life intangible amortization representing a cost of about $0.42 per share. After this amortization, our total remaining definite life intangibles would be approximately $106.8 million at fiscal 2005 year end. Assuming no company acquisitions, during 2006 we anticipate amortization of definite life intangibles to be about $37 million with a year-end balance of about 69 million. We continue to believe that our financial treatment of acquisition premiums is among the most conservative in the industry and is the most appropriate way to represent our balance sheet. We did not book any goodwill in conjunction with our two recent acquisitions. At April 30th, 2005, we only had 32.7 million of goodwill on our balance sheet. Now I’ll turn it back to Ara for some closing comments.

Thanks Larry. With revenues up more than 34% and a 49% increase in earnings per share, we are pleased with our performance during the first half of '05. More importantly, our contract backlog and new community openings position us well for the remainder of this year and for '06. While we finished the second quarter with a record backlog, we still need to execute on delivering these homes with a high level of quality and in a timely fashion to delight our customers, and in a profitable fashion which should equally delight our shareholders. We have a number of quality initiatives throughout our company that we've been working on, and we recently launched a nationwide training initiative that will lead to a further strengthening of our relationships with our customers. Structurally, we believe that the housing market will adjust to a gradual rise in mortgage rates, if such an increase does occur over the next 12 months.

We can't recall a time when the national economy was strengthening as it is now and housing didn't continue to perform well, despite a rising rate environment. Although rising rates will impact affordability, we expect customers will adjust by purchasing smaller homes, less expensive homes, and by buying less features and upgrades. We do not expect our industry will experience a material dropoff in the overall demand for new homes.

Keep in mind that we need to build approximately 1.8 to 2 million new homes per year on average in the United States just to meet the needs of projected household formation in our growing population. This steady underlying demand for housing based on demographics, along with the increasing regulatory constraints on the availability of new homes, will continue to drive a healthy level of new home sales in most of our markets.

The long-term fundamentals for the housing industry remain strong and we are well-positioned with homebuilding operations in 17 states and a broad product offering that allows us to develop a community on just about any parcel of land in each of our markets. We expect to continue to grow, both organically and through strategic acquisitions, and we remain committed to achieving industry-leading returns. We've got an excellent team of senior managers and associates that will execute on this plan both in the short term, and more importantly, over the long term. This concludes our presentation and we'd be now happy to open up the call to questions.

[Operator instructions] We'll take a question from Michael Rehaut. Please go ahead.

Hi. Good morning.

Good morning.

I just wanted to ask about the gross margin expansion in the quarter, and my follow-up will be related to the gross margin as well. You finally had after a couple quarters of more flattish or slightly down. You had some expansion this quarter. I was wondering if you could give some detail on that if it was related to mix or just better pricing, or if land costs were perhaps a little bit lower.

Sure. Well, first of all, I’ll start by emphasizing that while gross margin is a very important measure, we are actually more focused on return on investment, which is a blend of the margins and inventory turns; and in some markets, we're more focused on inventory turns and low margins. So, I don't get overly concerned about the trends one way or the other, even though obviously the trends have been positive. On the whole at the moment, for this quarter though, I would say this has been a little bit more of a mix issue than any big significant trend one way or the other.

I think part of what happened, Mike, was the first quarter was adversely impacted by fewer deliveries from California, especially Southern California, because of weather-related issues. Some of those deliveries bunched up and occurred in the second quarter which had somewhat of a positive impact on gross margins.

Okay, and my follow-up question relates more broadly to Ara, some of your opening remarks regarding Southern California. You had mentioned that you believe that affordability is a little bit stretched and that perhaps the price increases will slow to a more normalized rate, or -- I don't know what you're thinking, maybe a low to mid single-digit rate. But what are your expectations in that type of market over the next couple of years in terms of -- I'll go back to margins -- but also returns? If considering that perhaps your land costs may continue to rise as you work through a land position there?

Sure. Well, first, you made a lot of points in somewhat of a lot of questions. I'll try to address them all -- remind me if I miss an important part. But on the whole, I think it's more reasonable to assume appreciation in the future to the low to mid single-digits as you kind of indicated going forward. Now, having said that, all of our budgets assume zero appreciation. So anything we achieve would be upside. Now, that is just something that we keep an eye on all the time. The market does continue to surprise us on the upside, but there is a point when it's just not feasible or possible.

Now, at some point, as the price appreciation slows down, and again as I mentioned in my comments also, we saw a little bit of correction in the pricing there in the last six months. We’re not in Las Vegas, that got a lot of attention for the pricing correction; but in a gentler way, it did occur in southern California over the last six months and has really stabilized quite a bit. But over time, as that pricing stabilizes, assuming we don't have big decreases in material costs and assuming we continue to replenish with more recent land acquisitions, I think it's reasonable to assume that the price -- that the margins are going to go down. I mean, frankly, this is yet another year where we have return -- after-tax return on equity of 42%. I think it's unrealistic to assume that we can continue that forever into the future.

However, I absolutely believe that we could have really solid earnings per share growth and really solid returns on equity even in a normalized non-appreciating marketplace. We do our land acquisitions assuming zero price appreciation, and we work backwards to about a 30% IRR. If we achieve that -- obviously we’ve been doing better than that -- but if we achieve that, that will lead to some fabulous EPS growth and some very, very solid returns on equity, certainly when you compare us to the rest of the Fortune 500, and the S&P 500 Index as well.

In fact, Ara, I've made that calculation and if all of our communities only generated 30% IRR, which is our target -- none of them did better, none of them did worse, we just averaged the 30% -- we kept our 50% of the cap. That equates to a 25% average for the year return on equity. And if we get any home price depreciation, even if it's mid single-digits, there's upside to the 25% and it does compare very favorably to the S&P averages or Fortune 500 averages.

The other thing I think I would like to add is -- and this doesn't affect gross margin, obviously -- but as we continue to grow, our Corporate overhead as a percentage of sales becomes a little more efficient, number one; and number two, our buying power continues to improve, not unlike what happened in Wal-Mart and Home Depot. Our buying power improves. Third, I think the opportunities for us to take costs out of the homebuilding operation through a variety of efficiencies is just at the earliest stages, and while we may not get the price appreciation we've been achieving, I think we've just begun to scratch the surface on cost reduction opportunities in our industry. So, Mike, that was a long-winded answer to your question.

No, that was great. Thank you.

We'll take a question from Margaret Whelan.

Good morning, guys.

Good morning, Margaret.

Nice quarter. I have a couple of questions, but the one I had specifically, it's really a follow-up to Ara, what you said in your prepared comments, and also talking about efficiencies and scratching the surface. All of the builders are talking about the processes but no one's really quantifying the opportunity, or even on a quarterly basis, giving us an idea of what you are doing. You take the [inaudible] calls from Dave (ph) out of your cycle. I asked you this last quarter, but I am just wondering, do you have any specific examples for us now?

I'll be consistent with my prior quarter and the rest of the industry. It's really hard to be very specific and give some guidance. There are just so many areas, and I'd rather not give specifics at this point. As we go forward, and we get more concrete examples that we can share with everybody, we absolutely will. So at this stage, I won't get specific, but obviously, if we could take up 1% out of our cost structure which is not at all in any way out of reality, if we took 1% out, obviously it’s a huge increase. On our volume today, 1% is $60 million --

Yes.

And that's a lot of cost reduction.

Okay, and I'll come back to you then for specific examples next quarter.

That's fair. You're consistent too.

Exactly. The second question I have is about California. You’re talking about delighting your customers. But you have had delays out there, and it seems for longer than some of your peers, I know California is a bigger part of your total, but can you give us some specific examples in terms of what exactly you're doing to rectify that, are you having to pay out any additional costs because of these delays; at this stage does it impact your margins in the back half?

Well part of it, and one of the things we're doing is trying not to sell out in advance. In fact, in numerous communities in Southern California in particular, but even in Northern California, we have purposely throttled back releasing new sections, even in ongoing communities, just because construction of land development has gotten behind. And we don't want to disappoint our customers. And, frankly, some of our delays are more than what we had told customers, and we don't want to continue that. So we're holding off a bit to let development catch up to our sales, and I think that alone will help quite a bit.

Have you seen any change in your cancellation rates because of the delays?

We've not.

No, it's been pretty consistent. I'd say on the whole the market there really -- obviously the delays we're experiencing to a large extent affected everybody. The rains that occurred in the winter didn't just happen over our location, it happened over everybody's. So everybody's largely in the same boat.

Okay, and can I just ask a final housekeeping question in terms of the changes in the tax rate, where that came from or what we should expect for the rest of the year. And also, Larry, I missed your comments on the amortization. But it sounds like there’s going to be a meaningful change in the per-share amount next year; is that what you were saying?

No. I was just giving the dollar amount of the amortization that we were expecting, and actually increased in terms of the dollar amount, I think. Hold on --

No. The amortization amount in '06 is materially similar to '05. I think.

Okay.

37 million versus 45 million, it’s pretty close in terms of earnings per share.

Yes, and then just on the tax rate please.

The tax rate -- there were some state laws that changed that adversely affected us, and I think we think our tax rate is going to tweak up slightly.

Yes. It's not that the state income tax rates raised, it really has to do with how you consolidate and where deductions are allowed and so forth. The changes occurred at that level, and that's what affected our tax rate.

Okay, thank you very much.

We'll take our next question from Stephen Kim.

Thanks guys. Can you hear me?

Barely Steve.

Okay, hold on a second. Any better now?

Much better.

Okay, great. I guess I had a longer-term question, if I could. Ara, getting to the issue of the margins. Your company's been around for a long time and while I didn't cover you back then, I recall that in the late '80s and early '90s, Hovnanian was a pretty conservative company with respect to land ownership, much as you are today. My recollection was that you didn't own a tremendously large supply of land, and yet you saw a tremendous decline in your gross margins that occurred between the late '80s and 1991. You had margins that were actually a little higher than you're currently booking, if I'm not mistaken, and they almost all but vaporized for a couple of years before resurging back. Can you -- I have my own thoughts, but I'd love to hear your view -- because there's not too many guys that were around back then that are still around now. I would love to get your view on why that sort of thing is not likely to happen again.

Well, one of the big changes, Steve, in our company -- you're going back to periods 18 years ago-- We were a very different company. We were largely a single-market company dependent almost entirely on the New Jersey marketplace and what the economic condition and home building environment was like in one market place.

Right.

Today, while New Jersey is still an important contributor, we also have significant earnings from Southern California, which has a very different economic engine from Northern California, which is very different from the Washington D.C. market, and so on and so forth. We have absolutely seen, and we even see it quarter to quarter, variations in the strength of one market versus another market, and we think that alone will make a huge difference.

Obviously, the other factor besides diversification is we were much smaller then. So 18 years ago, if you had four or five new communities that came on, that didn't have the same margins, well, that had a big impact. Today, when we have 300 plus different locations, what happens in a handful of communities has far less impact on our overall operations today. So I would say that in our case, it's probably the biggest driver of some of those changes.

I guess one other thing I might add in is -- the other thing that has changed in our Company is that we'd greatly diversified our product offerings from 18 years ago. We are now at the high price points, we're at the low price points and everything in between. We're doing active adult communities. We're doing far, far more urban infill communities. So I am confident that we are just a very different Company than we were a couple decades ago.

Yes, I would agree, and I think you are right about the diversification issue. If I could ask a follow-up with respect to the gross margins.

Yes, yes. I will add one more point that I just remembered as well.

Sure.

If you look of some of the highly regulated markets that we build in, including New Jersey, where we were two decades ago and looking at Southern California where we were not but are today, the level of activity today in those markets, in spite of the fact that they're very strong, is dramatically less today than it was then. So I think the opportunity for it to fall off is simply less, because household creation is more. And to give you a statistic I know off the top of my head, in the late '80s New Jersey peaked at about 57,000 housing starts per year. Last year, I think the number was 28,000 or 29,000 starts.

Right.

I would describe the market today as being stronger than it was then, and the market can only produce half as many homes. Yet household creation in the United States is far more, well, I'd say far more, probably about 20% more annually than it was a year ago. So you have more household creation, less in the way of permits -- at least in the regulated markets that's the case. Southern California has similar numbers. That, I think, creates a very different environment than we had in the '80s, where supply was still difficult, but not nearly as difficult as it is today. It has just gotten more and more complex and more and more restrained.

Yes, clearly the lack of an overhang of inventories.

Absolutely.

My follow-up question relates to, again, dealing with ancient history here. And that relates to the average price trends. You mention that you're pretty much a single market builder and you weren't nearly as diversified across price points as at that time. One of the things that intrigues me is that if you look back in the 1989 to 1991 timeframe, your average, your closing price, if my numbers are correct, rose. So you didn't have a dramatic decline at least in the home prices that you recorded; and yet your margin, of course, completely went the other way. My question is, is that a reflection of the fact that you were -- your margin degradation was primarily the result of higher land costs running through your income statement? Because it wouldn't seem to be tied to the home price itself.

Steve, the home prices that you observe -- if you remember the first, or the third point I made, I guess, is that we really diversified our product offerings. In the early '80s to mid '80s, we were largely an entry-level builder, and built primarily, particularly in New Jersey, entry-level condominiums and townhouses. Period. We literally, in the mid '80s, did not build one single-family detached home. Not one.

Right. I remember.

During the period you are referencing, we begin to diversify both for upscale town houses and condominiums. For example, town houses, we did not ever build a town house with a garage. We never built one with a basement. There were always two bedrooms. They never had volume ceilings. We did not even know what a Jacuzzi tub was. Well, that all changed. So what you observed in our price points really had more to do with the broadening of our product line than it did on a price for a like kind house. In fact there was a correction in the marketplace and for a short period of time, in that single market, we did see a correction and a reduction in like kind prices. The good thing about it is, as you continue to follow from there, that tougher market for us was also a tougher market for others. Many opportunities of land became available and it really gave us a great platform to increase our market share and solidify our long-term position.

Yes, I remember Ara, you went with the Presidential series with the single-family homes, I think.

Good memory.

So summing up then, it sounds like what you're saying is at least part of the margin degradation you saw last down cycle was attributable to your Company not being very diversified, and becoming more diversified, and as you do that, obviously in a tough market, your margin is going to suffer. You'd say today, number one, you have much better demographics -- or I should say no inventory overhang, and you already accomplished the diversification you needed to do, and so therefore you should not have that drag going forward.

I think that's accurate.

Okay, thanks a lot.

We'll take our next question from Dan Oppenheimer.

Thank you very much. I wonder if you could talk about the expectation of deliveries for the final two quarters of the year, in that you talk about 16,400 for the fiscal year and about 7,000 first half. Wondering what we should think about for the third and fourth quarters as you talk about the fourth quarter being back-end loaded there.

We really don't give more guidance quarter to quarter than we have already given, which is basically the EPS. Obviously, you can do the math and see what the fourth quarter is. We just gave one quarter forward EPS which is our tradition. I just don't think we're going to publicly give you much more than that, Dan.

In general though, Dan, I'd say unfortunately we've got more of a weighting to the fourth quarter, which we don't like. But between weather and entitlements it's unavoidable right now.

Sure, and then in terms of the talk about affordability in Southern California, could you talk about the recent pace of sales there that you’ve seen at some of your communities, or just things that you've done? Are you building greater densities now to combat that?

Well, southern California is in fact several different markets for us. The coastal market, which is a much higher price in general for us, and then the inland markets, which are much more affordable. I would say the last month, the inland markets in particular really showed a lot more strength and volume. However, we have continued with -- running into land development snags and delays. So as of last week, we consciously decided to throttle back on releasing new openings until we can catch up a little bit.

The market overall in the inland market remains very solid and healthy. We're very, very pleased there, and we're projecting for the full year substantial growth over last year's activity and substantial profitability increase over last year. It's a great market right now. In the coastal area, it's a slightly different picture. That's where we probably got a little more aggressive in our pricing. And we did have to react a little more in a handful of communities to correct some of the pricing, and as such, there was a little more sluggishness in our sales there. And, on top of that, we have run into the same kind of land development and entitlement issues which have delayed some of our new communities.

On the whole, however, even with the corrections, the margins are excellent. I mean, really really solid. We were hoping to get ridiculous margins, and I'd say we just got fabulous margins instead. So we're very, very pleased with the marketplace. I think we've made the corrections we need to make, all of which are already factored into our projections, and we've got sales pace starting to pick up, and then if we can supplement that with some of these final entitlements and openings happening, we really will start gaining momentum. We're quite pleased in Southern California. If anything, we'd probably like to strengthen our position there and we're really aggressively looking for more land acquisitions to continue to grow that marketplace.

And we have in fact done some of the higher-density urban type products to get more homes more affordable because of the stretched affordability in the coastal areas. We did a high-rise in San Diego last year, we've got a couple others that are underway as we speak. And we’re looking at other sites to get higher densities so that we can provide a more affordable home for the consumer.

Yes, it's interesting, basically, where our prices are the highest is where we have the most diversity of products, particularly with multi-family. In the Northeast, in Washington, and in Southern California in particular, we do everything from condominiums to town houses, to very high-density single families. And if anything, and it's interesting, even in the inland area in Southern California, where in the past we would never have considered attached product, prices have risen enough that attached product makes sense there and we're opening our first condominium community out in Riverside County, which is unusual for us. I think that's a smart play for us defensively as well as offensively because if interest rates gradually do go up, there will be more demand for the multifamily higher density product and we're very, very good at that product and we're starting to gear up communities now in anticipation of a gradual rise.

Okay, thanks. I'm wondering -- this is the last question -- in terms of Florida, another area where we've seen affordability looking a bit stretched, if you can just talk about some of the trends that you've see there as you did with Southern California. That would be fantastic.

Yes, I'd say some of the same things there. We are doing a -- we have a bit of mix of multifamily and I say we're expanding that mix in some of the areas where we didn't have it. Now, again, we're quite new to West Palm and Orlando with our new acquisitions, but in West Palm we are doing more multifamily attached. In Orlando, we're getting there as well. In Tampa, where we've been for a couple of years we were primarily single-family detached but that is changing now as we implement our general corporate strategy of broadening product array, but also as we prepare for a potential rise in rates, we want to have even more affordable products, so we're also there going to be expanding into attached product of a variety of types.

Thanks very much.

We'll take our next question from Alex Baring.

Yes, good morning and great job.

Thanks Alex.

Thank you.

I wanted to ask you about your community count. You mentioned that you expected to be up 20% by the end of the year. I'm hoping you could give us a little bit more insight in terms of the regions. I mean, is the Northeast going to bounce back? Is that where the majority of your communities are going to be coming from?

Well not the majority but certainly we expect to get the -- we have a number of new community openings in the Northeast which will put them back on the right track of a growing community count.

Okay.

We also have quite a few coming up in Southern and Northern California. I'd probably say the least community openings will be in the North Carolina market, where we'rer just not getting as high a return as we do in the other markets. So we're channeling more of our capital to our real higher-return markets.

And I'll tell you in the Northeast, Alex, we can throw a very large amount of home sites that the regulatory approval process is also probably one of the most painful and long in the United States and we're marching through it very diligently and we have got 15 attorneys on board whose full-time job it is to take it through that approval process. We're getting them done just as fast as we possibly can and if you don't say over the next quarter or two but if you say over the next several years we certainly can see the light at the end of the tunnel of significantly growing our presence in New Jersey over the next few years because we do have a very, very strong land position here.

Yes, I guess I was just wondering since you had mentioned your orders were down roughly 20% and I know a lot of that was probably more from Ohio then from New Jersey.

Right.

I was just trying to get a feel for when that might turn around?

I think you'll begin to see a turnaround in the second half of the year.

Okay, and then as it relates to your two most recent acquisitions. Wondering if you could give us how much each one -- deliveries contributed this quarter and also like what the impact was on purchase accounting to gross margins?

No. We're not going to give you that break out. We just don't provide market-by-market public data.

All right.

I mean you could figure out a little bit if you want to work backwards since we said 93% of our growth in earnings have been from our organic operations. Therefore 7% growth from the new acquisitions. That will give you a little material to work from.

Okay. That's good. Thanks.

We'll take our next question from Ivy Zelman.

Good afternoon guys actually Dennis McGill in for Ivy. Larry, I just wanted to follow up on a comment you made about the financial services operations where you commented on just the overall competitiveness is hurting Hovnanian's operations. But if we kind of step back, are you concerned at all that that competitiveness industry-wide and some of the newer products that are coming on is increasing the risk and may be fueling some of the market's and some of the price depreciation that we've seen?

I think you are trying to ask a question about the mortgage companies that relates to homebuilding and Dennis maybe give another a shot at it because I'm not sure I think you're real question's on homebuilding but ask me again.

It's -- they're inter-related. I guess my question is you've talked about the competitive mortgage atmosphere, which is impacting your --.

Right. Right. I really said that the refinance business has dried up and therefore the third party mortgage originators that were making their living on refinancing loans for third party customers have now come back into the purchased money mortgages operation and driven down margins, and therefore, it's more competitive combined with the higher usage of adjustable rate mortgages which when you sell those loans, you make less profit. So that's what's driving impact of profitability on the mortgage side.

Okay, let me rephrase. I understand that. I guess my question is realizing that that competition is coming in the form of arms and IOs and new mortgage products, are you at all concerned that that is driving some of the home price depreciation in the markets or driving the markets?

No. I think demand is what is driving home price appreciation restricted supply. I don't think it's mortgages. People buy homes because they want a home and there's strong demand for homes. I don't think it's the mortgage market that's causing home price appreciation.

Keep in mind the same mortgages are available in North Carolina, Texas, Houston, and a variety of other markets but those markets are not seeing big price appreciation. Mortgage rates are part of the formula but by no means are the big driver. If it did, all the markets would be phenomenal and have big price appreciation but they're not. The price appreciation has really been in the highly regulated markets and that has nothing to do with interest rates. That is a restricted, severely restricted supply scenario. I kind of gave you the New Jersey market number. I wish I had the Southern California ones at the top of my head but in a booming market with a lot of demand, the permit process only allows us as an industry to supply about half the amount of houses as we were in the '80s.

Actually, I have that data memorized. In 1986 to 2004, there's been a 60% decline in permit activity in Los Angeles, Ventura, Orange, and San Diego Counties. 60% less than we did in the mid to late 1980's.

Similar if not more significant in the reduction that we experience in New Jersey. So that is just a different story and that's really the driver of what's going on right now.

I think that's absolutely fair. I agree with that. My only question was really getting to the financing side of things because end of the day people have to qualify for the mortgage and if the home prices are going up regardless if it's constrictive or spot supply or not, it's still going to come down to people having to get the money and I was just curious whether these products have changed that dynamic.

Yes. We agree that has an effect at the end of the day. Again, and we kind of mention this, our assumption is that as rates tweak up, and as you said at the end of the day you've just got to afford it, I do think it's likely that a customer that was going to buy a 3200 square foot house is going to have to settle for a 2800 square foot house. Or instead of a granite counter top, they are going to have to settle for a ceramic tile countertop. But in the end, I think that households are being created while they may delay a little bit they may sit and wait for a little bit, I'm not concerned at all over anything more than a quarter or two because the household creation is there, the demand is restricted -- excuse me, supply is restricted and I think they're going to be buying and just scaling back their expectations. Typically in most of our communities, whether they buy model type type number one our model type number five, while the price may be different, our profit percentages are priced quite comparably between product offerings. The absolute dollar per house may be less but profit percentages should be pretty consistent regardless of what model type they select.

Okay, thank you for that guys. Larry, I just had one -- make sure I have the numbers that you mentioned earlier correct. You had said that your return on equity currently gained 40% would --.

Average return on equity currently is in the mid 35, 36% level the last couple of years. If all all our communities generated our targeted feasibility hurdle rate of a 30% unlevered IRR and we maintained our 50% debt to cap, we would, instead of generating a mid 30% ROE we'd generate a 25% ROE.

The 40% number I referred to is based on beginning equity analysts quoted two different ways. Some quote return on beginning equity and in that measure the last few years, hopefully this year were north of 40% after tax on beginning and that typically translates to a mid-30% on average equity which is what Larry was just quoting.

Okay, so pricing has driven about a third of it.

Or another way to think about it is is even if we had 0 high price appreciation, our company could generate returns that are better than 90% of the Fortune 500 and S&P 500 company's.

Absolutely. Thanks a lot, guys.

We'll take a question from Joel Walker.

Hey guys. I just wanted to talk to you about the backlog conversion in the west. I saw that it dropped from 85% a year ago to 54% this quarter and was wondering what do you expect it going forward from? From the West?

That's just really not a statistic that we monitor. We have better data than that. I know that an outsider looking at our data that's one of the few things they can grab onto to try to guess what's going to happen next quarter but we actually, every month review our forward-looking projections with each of our divisions and get community by community, area by area, division by division, region by region how many homes are going to close and that's what we focus on. So it's just not something that we monitor.

And so it's nothing that you really look at or I mean --?

We just have better data. Why would we focus on backlog conversion rates, when I can actual ask our area president, in community A how many are you going to deliver this month and community B how many are you going to -- and then we monitor their performance against what they told us rather than backlog conversion because all kinds of things can impact conversion rates of the backlog. And how far out we're sold in advance is further today than it was a year ago, and Ara mentioned that we're consciously following backsales so that we're not so far out in advance in certain Southern California locations as well as in some Northern California locations. So we just don't find it that meaningful of a measure to monitor internally when we can actually look community by community and get better data.

And obviously we've done that and looking forward one quarter as you were kind of trying to look out, we've done that and we're calculating about $1.70 EPS. We're trying to get more and more accurate in our guidance. Of course there's a lot that are out of our hands, vinyl permits and weather and so forth. But at this point that is our best estimate for the next quarter. And by the way, obviously, we've given you our full year so you can kind of work backwards to the fourth quarter, and again, based on that month to month more detailed review, far more than the backlog conversion rate. That is our best estimate at this point and frankly, I think over the last five plus years our guidance has been pretty good. In the past it was overly conservative and we were dramatically outperforming. We're trying to get a little closer in our guidance going forward.

All right. Thanks a lot.

We'll take your next question from William Madler.

Got to get off.

We'll take our next question from Timothy Jones.

Good morning. Hi, Larry. Okay. A couple questions, then just a statement since I do remember when you used to sell the homes in a weekend in the mid-80s. If I recall, I bought a house in New Hampton in '83, it doubled to 89 and then it went down about 30% to 92. What I believe that New Jersey experienced somewhat similar of a price trend like that. Am I like right?

Well, we certainly had price corrections. I really can't quote specifics because they're so community specific. Obviously, what you also did see is very different dynamics in different markets at different times and kind of getting back to what we discussed before, today we are dramatically more diversified and we see the market's peaking and troughing at different parts of the country.

No question about that. Couple questions, first of all have you heard anything about in Florida that they are going to allow people to transfer they're homestead exemptions. That would just cause the market to explode.

I can't really comment on that myself if you're curious we can --.

Explode positive or explode negative?

Oh, it would just explode positive if they go to buy a higher priced home right now their tax is tripled. If they allow you to take your old homestead taxes the turnover would go up dramatically.

Okay.

I've not heard that but not to say it's not happening.

Frankly, that market is so strong and solid right now, boy, we don't need any additional fuel in that one.

I understand that. Would you give me an idea. I mean I happen to be just going around and talk to a bunch of your competitors. I mean a lot of them have more homes off the market until November down here in Florida where I live. What are you experiencing? What percentage, let's say of your projected deliveries are you just deliberately holding back, either because you're ahead of yourself or you can't deliver it or the demand is so great or whatever for any reason? I mean is it 10%, is it 30%?

I mean it's very community specific and I would say 5 to 10% would be my gut reaction there. Do you have one?

That's probably a good guess right now. A little higher maybe in parts of Southern California, dramatically less in places like North Carolina, Houston, or Dallas. So it varies dramatically.

I think it would be all in California and in Florida pretty much in Florida and pretty much in the D.C. markets wouldn't it.

Yes, and clearly in the regulated markets, yes.

And lastly, can you just tell me your lot count and how much you've got options?

We control about 104,000 homes sites of which 74% are options?

Excellent, thank you.

And we have no other questions at this time. I'll turn the call back over to Ara for closing remarks.

Okay, well, thank you very much. We're obviously very pleased once again with our quarterly results. We're anticipating continued great results. The next two quarters and on into '06. We're very comfortable with the market conditions. We feel great about our particular locations and we're very excited about the new communities we've got coming up and look forward to continuing to report some great results. Thanks so much and we'll have our team around for further questions after the call.

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