HOVNANIAN ENTERPRISES INC - Quarter Report: 2019 July (Form 10-Q)

 

 

Table of Contents

UNITED STATES

 

SECURITIES AND EXCHANGE COMMISSION

 

WASHINGTON, D.C. 20549

 

FORM 10-Q

  

(Mark One)

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

 

For the quarterly period ended JULY 31, 2019

OR

 

[    ]

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

 

Commission file number 1-8551

 

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

 

Delaware (State or Other Jurisdiction of Incorporation or Organization)

 

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

 

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

 

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

 

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

 

Securities registered pursuant to Section 12(b) of the Act.

 

Title of each class	Trading symbol(s)	Name of each exchange on which registered
Class A Common Stock $0.01 par value per share	HOV	New York Stock Exchange
Preferred Stock Purchase Rights(1)	N/A	New York Stock Exchange
Depositary Shares each representing 1/1,000th of a share of 7.625% Series A Preferred Stock	HOVNP	Nasdaq Global Market

 

(1) Each share of Common Stock includes an associated Preferred Stock Purchase Right. Each Preferred Stock Purchase Right initially represents the right, if such Preferred Stock Purchase Right becomes exercisable, to purchase from the Company one ten-thousandth of a share of its Series B Junior Preferred Stock for each share of Common Stock. The Preferred Stock Purchase Rights currently cannot trade separately from the underlying Common Stock.

 

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

Yes [ X ]    No [   ]

 

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

 

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

Large Accelerated Filer [   ]  Accelerated Filer  [ X ]

Non-Accelerated Filer  [   ]  Smaller Reporting Company [   ]     Emerging Growth Company [   ]

 

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

 

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

 

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 5,324,784 shares of Class A Common Stock and 622,780 shares of Class B Common Stock were outstanding as of August 30, 2019.

 

 

HOVNANIAN ENTERPRISES, INC.  

    

FORM 10-Q  

 

INDEX	PAGE NUMBER
PART I.  Financial Information
Item l.  Financial Statements:
Condensed Consolidated Balance Sheets (unaudited) as of July 31, 2019 and October 31, 2018	3
Condensed Consolidated Statements of Operations (unaudited) for the three and nine months ended July 31, 2019 and 2018	4
Condensed Consolidated Statement of Changes in Equity (unaudited) for the nine months ended July 31, 2019 and 2018	5
Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended July 31, 2019 and 2018	7
Notes to Condensed Consolidated Financial Statements (unaudited)	9
Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations	31
Item 3.  Quantitative and Qualitative Disclosures About Market Risk	51
Item 4.  Controls and Procedures	52
PART II.  Other Information
Item 1.  Legal Proceedings	52
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	52
Item 6.  Exhibits	53
Signatures	54

  

 

		July 31, 2019			October 31, 2018
		(Unaudited)
ASSETS
Homebuilding:
Cash and cash equivalents		$83,634			$187,871
Restricted cash and cash equivalents		16,919			12,808
Inventories:
Sold and unsold homes and lots under development		1,106,100			878,876
Land and land options held for future development or sale		69,176			111,368
Consolidated inventory not owned		179,642			87,921
Total inventories		1,354,918			1,078,165
Investments in and advances to unconsolidated joint ventures		134,111			123,694
Receivables, deposits and notes, net		32,536			35,189
Property, plant and equipment, net		20,488			20,285
Prepaid expenses and other assets		43,492			39,150
Total homebuilding		1,686,098			1,497,162
Financial services		109,164			164,880
Total assets		$1,795,262			$1,662,042
LIABILITIES AND EQUITY
Homebuilding:
Nonrecourse mortgages secured by inventory, net of debt issuance costs		$207,172			$95,557
Accounts payable and other liabilities		324,984			304,899
Customers’ deposits		40,358			30,086
Liabilities from inventory not owned, net of debt issuance costs		138,441			63,387
Revolving and term loan credit facilities, net of debt issuance costs		201,493			201,389
Notes payable (net of discount, premium and debt issuance costs) and accrued interest		1,284,624			1,273,446
Total homebuilding		2,197,072			1,968,764
Financial services		89,740			143,448
Income taxes payable		1,521			3,334
Total liabilities		2,288,333			2,115,546
Equity:
Hovnanian Enterprises, Inc. stockholders’ equity deficit:
Preferred stock, $0.01 par value - authorized 100,000 shares; issued and outstanding 5,600 shares with a liquidation preference of $140,000 at July 31, 2019 and at October 31, 2018		135,299			135,299
Common stock, Class A, $0.01 par value - authorized 16,000,000 shares; issued 5,792,858 shares at July 31, 2019 and 5,783,858 shares at October 31, 2018		58			58
Common stock, Class B, $0.01 par value (convertible to Class A at time of sale) - authorized 2,400,000 shares; issued 650,449 shares at July 31, 2019 and 649,673 shares at October 31, 2018		6			6
Paid in capital - common stock		710,517			710,349
Accumulated deficit		(1,224,166	)		(1,183,856	)
Treasury stock - at cost – 470,430 shares of Class A common stock and 27,669 shares of Class B common stock at July 31, 2019 and October 31, 2018		(115,360	)		(115,360	)
Total Hovnanian Enterprises, Inc. stockholders’ equity deficit		(493,646	)		(453,504	)
Noncontrolling interest in consolidated joint ventures		575			-
Total equity deficit		(493,071	)		(453,504	)
Total liabilities and equity		$1,795,262			$1,662,042

---

 

		Three Months Ended July 31,						Nine Months Ended July 31,
		2019			2018			2019			2018
Revenues:
Homebuilding:
Sale of homes		$467,849			$442,859			$1,257,536			$1,312,553
Land sales and other revenues		1,428			844			11,111			26,918
Total homebuilding		469,277			443,703			1,268,647			1,339,471
Financial services		12,764			13,009			34,679			36,951
Total revenues		482,041			456,712			1,303,326			1,376,422
Expenses:
Homebuilding:
Cost of sales, excluding interest		381,939			361,303			1,042,343			1,083,842
Cost of sales interest		19,029			13,424			43,169			45,080
Inventory impairment loss and land option write-offs		1,435			96			3,601			3,183
Total cost of sales		402,403			374,823			1,089,113			1,132,105
Selling, general and administrative		43,559			37,544			130,474			126,319
Total homebuilding expenses		445,962			412,367			1,219,587			1,258,424
Financial services		8,927			8,986			26,079			26,125
Corporate general and administrative		14,959			16,393			48,792			51,672
Other interest		22,377			24,859			67,313			80,078
Other operations		622			495			1,193			1,287
Total expenses		492,847			463,100			1,362,964			1,417,586
Loss on extinguishment of debt		-			(4,266	)		-			(5,706	)
Income from unconsolidated joint ventures		3,742			10,732			20,556			6,899
(Loss) income before income taxes		(7,064	)		78			(39,082	)		(39,971	)
State and federal income tax provision:
State		537			1,104			1,228			1,687
Federal		-			-			-			-
Total income taxes		537			1,104			1,228			1,687
Net (loss)		$(7,601	)		$(1,026	)		$(40,310	)		$(41,658	)
Per share data:
Basic and assuming dilution:
Net (loss) per common share		$(1.27	)		$(0.18	)		$(6.76	)		$(7.03	)
Weighted-average number of common shares outstanding		5,971			5,947			5,964			5,935

---

 

		A Common Stock						B Common Stock						Preferred Stock
		Shares						Shares						Shares-															Non
		Issued and Outstanding			Amount			Issued and Outstanding			Amount			Issued and Outstanding			Amount			Paid-In Capital			Accumulated Deficit			Treasury Stock			Controlling Interest			Total
Balance, October 31, 2018		5,313,428			$58			622,004			$6			5,600			$135,299			$710,349			$(1,183,856	)		$(115,360	)		$-			$(453,504	)
Stock options, amortization and issuances																				107												107
Restricted stock amortization, issuances and forfeitures		2,830						922												485												485
Conversion of Class B to Class A common stock		20						(20	)																							-
Net (loss)																							(17,452	)								(17,452	)
Balance, January 31, 2019		5,316,278			$58			622,906			$6			5,600			$135,299			$710,941			$(1,201,308	)		$(115,360	)		$-			$(470,364	)
Stock options, amortization and issuances																				108												108
Restricted Stock, amortization, issuances and forfeitures																				468												468
Conversion of Class B to Class A common stock		118						(118	)																							-
Changes in noncontrolling interest in consolidated joint ventures																													566			566
Net (loss)																							(15,257	)								(15,257	)
Balance, April 30, 2019		5,316,396			$58			622,788			$6			5,600			$135,299			$711,517			$(1,216,565	)		$(115,360	)		$566			$(484,479	)
Stock options, amortization and issuances																				438												438
Restricted Stock, amortization, issuances and forfeitures		6,024																		(1,438	)											(1,438	)
Conversion of Class B to Class A common stock		8						(8	)																							-
Changes in noncontrolling interest in consolidated joint ventures																													9			9
Net (loss)																							(7,601	)								(7,601	)
Balance, July 31, 2019		5,322,428			$58			622,780			$6			5,600			$135,299			$710,517			$(1,224,166	)		$(115,360	)		$575			$(493,071	)

---

		A Common Stock						B Common Stock						Preferred Stock
		Shares Issued and Outstanding			Amount			Shares Issued and Outstanding			Amount			Shares Issued and Outstanding			Amount			Paid-In Capital			Accumulated Deficit			Treasury Stock			Total
Balance, October 31, 2017		5,291,412			$58			612,304			$6			5,600			$135,299			$708,002			$(1,188,376	)		$(115,360	)		$(460,371	)
Stock options, amortization and issuances		960																		210									210
Restricted stock amortization, issuances and forfeitures		13,291						6,573												(219	)								(219	)
Conversion of Class B to Class A common stock		58						(58	)																				-
Net (loss)																							(30,809	)					(30,809	)
Balance, January 31, 2018		5,305,721			$58			618,819			$6			5,600			$135,299			$707,993			$(1,219,185	)		$(115,360	)		$(491,189	)
Stock options, amortization and issuances																				92									92
Restricted stock, amortization, issuances and forfeitures																				944									944
Conversion of Class B to Class A common stock																													-
Net (loss)																							(9,823	)					(9,823	)
Balance, April 30, 2018		5,305,721			$58			618,819			$6			5,600			$135,299			$709,029			$(1,229,008	)		$(115,360	)		$(499,976	)
Stock options, amortization and issuances		250																		867									867
Restricted stock, amortization, issuances and forfeitures		4,537						3,261												(496	)								(496	)
Conversion of Class B to Class A common stock		11						(11	)																				-
Net (loss)																							(1,026	)					(1,026	)
Balance, July 31, 2018		5,310,519			$58			622,069			$6			5,600			$135,299			$709,400			$(1,230,034	)		$(115,360	)		$(500,631	)

---

 

		Nine Months Ended
		July 31,
		2019			2018
Cash flows from operating activities:
Net (loss)		$(40,310	)		$(41,658	)
Adjustments to reconcile net (loss) to net cash used in operating activities:
Depreciation		2,942			2,320
Compensation from stock options and awards		197			2,706
Amortization of bond discounts, premiums and deferred financing costs		6,003			5,900
Gain on sale and retirement of property and assets		(19	)		(3,620	)
Income from unconsolidated joint ventures		(20,556	)		(6,899	)
Distributions of earnings from unconsolidated joint ventures		16,532			-
Loss on extinguishment of debt		-			5,706
Noncontrolling interest income in consolidated joint venture		(29	)		-
Inventory impairment and land option write-offs		3,601			3,183
(Increase) decrease in assets:
Origination of mortgage loans		(698,444	)		(716,954	)
Sale of mortgage loans		745,285			766,925
Receivables, prepaids, deposits and other assets		(892	)		15,546
Inventories		(280,354	)		(89,361	)
(Decrease) increase in liabilities:
State income tax payable		(1,813	)		13
Customers’ deposits		10,272			4,280
Accounts payable, accrued interest and other accrued liabilities		(473	)		(44,670	)
Net cash used in operating activities		(258,058	)		(96,583	)
Cash flows from investing activities:
Proceeds from sale of property and assets		23			38,302
Purchase of property, equipment and other fixed assets and acquisitions		(3,138	)		(4,211	)
Investments in and advances to unconsolidated joint ventures		(13,159	)		(24,337	)
Distributions of capital from unconsolidated joint ventures		6,766			28,536
Net cash (used in) provided by investing activities		(9,508	)		38,290
Cash flows from financing activities:
Proceeds from mortgages and notes		235,645			129,411
Payments related to mortgages and notes		(123,148	)		(110,570	)
Proceeds from model sale leaseback financing programs		21,276			22,244
Payments for model sale leaseback financing programs		(14,477	)		(26,835	)
Proceeds from land bank financing programs		87,734			16,957
Payments related to land bank financing programs		(18,740	)		(30,577	)
Net payments related to mortgage warehouse lines of credit		(46,284	)		(49,758	)
Proceeds from partner contribution to consolidated joint venture		604			-
Payments related to unsecured revolving credit facility		-			(26,000	)
Proceeds from senior unsecured term loan facility		-			202,547
Proceeds from senior secured notes, net of discount		21,348			-
Payments related to senior, senior secured and senior amortizing notes		-			(285,095	)
Deferred financing costs from land bank financing programs and note issuances		(4,586	)		(7,010	)
Net cash provided by (used in) financing activities		159,372			(164,686	)
Net decrease in cash and cash equivalents, and restricted cash and cash equivalents		(108,194	)		(222,979	)
Cash and cash equivalents, and restricted cash and cash equivalents balance, beginning of period		232,992			493,742
Cash and cash equivalents, and restricted cash and cash equivalents balance, end of period		$124,798			$270,763

---

		Nine Months Ended
		July 31,
		2019			2018
Supplemental disclosure of cash flow:
Cash paid during the period for:
Interest, net of capitalized interest (see Note 3 to the Condensed Consolidated Financial Statements)		$82,294			$105,854
Income taxes		$3,042			$1,674
Reconciliation of Cash, cash equivalents and restricted cash
Homebuilding: Cash and cash equivalents		$83,634			$216,707
Homebuilding: Restricted cash and cash equivalents		16,919			25,345
Financial Services: Cash and cash equivalents, included in Financial services assets		3,847			5,232
Financial Services: Restricted cash and cash equivalents, included in Financial services assets		20,398			23,479
Total cash, cash equivalents and restricted cash shown in the statement of cash flows		$124,798			$270,763

 

See notes to condensed consolidated financial statements (unaudited).

  

 

Supplemental disclosure of noncash investing activities:

 

In the first quarter of fiscal 2018, we acquired the remaining assets of one of our joint ventures, resulting in a $13.0 million reduction in our investment in the joint venture and a corresponding increase to inventory.

 

Supplemental disclosure of noncash financing activities:

 

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

 

 

HOVNANIAN ENTERPRISES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - UNAUDITED

 

1.	Basis of Presentation

 

Hovnanian Enterprises, Inc. (“HEI”) conducts all of its homebuilding and financial services operations through its subsidiaries (references herein to the “Company,” “we,” “us” or “our” refer to HEI and its consolidated subsidiaries and should be understood to reflect the consolidated business of HEI’s subsidiaries). HEI has reportable segments consisting of six Homebuilding segments (Northeast, Mid-Atlantic, Midwest, Southeast, Southwest and West) and the Financial Services segment (see Note 16).

 

The accompanying unaudited Condensed Consolidated Financial Statements include HEI's accounts and those of all of its consolidated subsidiaries after elimination of all of its significant intercompany balances and transactions. Noncontrolling interest represents the proportionate equity interest in a consolidated joint venture that is not 100% owned by the Company. One of HEI's subsidiaries owns a 99% controlling interest in the consolidated joint venture and therefore HEI is required to consolidate the joint venture within its Condensed Consolidated Financial Statements. The 1% that we do not own is accounted for as noncontrolling interest. 

 

The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X and accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. These Condensed Consolidated Financial Statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended October 31, 2018. In the opinion of management, all adjustments for interim periods presented have been made, which include normal recurring accruals and deferrals necessary for a fair presentation of our condensed consolidated financial position, results of operations and cash flows. The preparation of Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates, and these differences could have a significant impact on the Condensed Consolidated Financial Statements. Results for interim periods are not necessarily indicative of the results which might be expected for a full year.  

 

Reclassifications - Effective October 31, 2018 we early adopted Accounting Standards Update (“ASU”) 2016-18 “Statement of Cash Flows (Topic 230): Restricted Cash” (“ASU 2016-18”). As a result, restricted cash amounts are no longer shown within the operating and investing activities as these balances are now included in the beginning and ending cash balances in our Condensed Consolidated Statements of Cash Flows. The adoption of ASU 2016-18 also resulted in the reclassification of restricted cash in operating and investing activities of $1.0 million and $23.4 million, respectively, for the nine months ended July 31, 2018. These amounts are now included in the beginning and ending cash balances for the respective periods. See also the reconciliation of cash, cash equivalents and restricted cash on the Condensed Consolidated Statements of Cash Flows.

 

Reverse Stock Split – As discussed in Note 14, in March 2019, the Company's stockholders approved and the Board of Directors determined to effectuate a reverse stock split (the “Reverse Stock Split”) of the Company’s common stock at a ratio of 1-for-25, and a corresponding decrease in the number of authorized shares of the common stock. The Reverse Stock Split became effective on March 29, 2019, and every 25 issued shares (including treasury shares) of Class A Common Stock, par value $0.01 per share (the “Class A Common Stock”), were combined into one share of Class A Common Stock, and every 25 issued shares (including treasury shares) of Class B Common Stock, par value $0.01 per share (the “Class B Common Stock”), were combined into one share of Class B Common Stock. All share and per share amounts throughout this report have been retroactively adjusted to reflect the reverse stock split.

 

2.	Stock Compensation

 

For the nine months ended July 31, 2019, the Company’s total stock-based compensation expense was $0.2 million and for the three and nine months ended July 31, 2018, $0.6 million and $2.7 million, respectively. For the three months ended July 31, 2019, there was stock-based compensation income of $1.0 million (pre and post-tax), as a result of the cancellation of certain market stock units awards based on performance conditions which were not met. Included in the total stock-based compensation expense was the vesting of stock options of $0.4 million and $0.7 million for the three and nine months ended July 31, 2019, respectively, and $0.9 million and $1.1 million for the three and nine months ended July 31, 2018, respectively.

  

 

3.

Interest

 

Interest costs incurred, expensed and capitalized were:

 

 

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

(2)

Other interest expensed includes interest that does not qualify for interest capitalization because our assets that qualify for interest capitalization (inventory under development) do not exceed our debt, which amounted to $13.7 million and $20.2 million for the three months ended July 31, 2019 and 2018, respectively, and $46.4 million and $59.7 million for the nine months ended July 31, 2019 and 2018, respectively. Other interest also includes interest on completed homes, land in planning and fully developed lots without homes under construction, which does not qualify for capitalization, and therefore, is expensed. This component of other interest was $8.7 million and $4.6 million for the three months ended July 31, 2019 and 2018, respectively, and $21.0 million and $20.4 million for the nine months ended July 31, 2019 and 2018, respectively.

(3)

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

 

 

 

(4)	Represents capitalized interest which was included as part of the assets contributed to a joint venture the company entered into in June 2019. There was no impact to the Condensed Consolidated Statement of Operations as a result of this transaction.
(5)	Capitalized interest amounts are shown gross before allocating any portion of impairments, if any, to capitalized interest.

 

4.	Reduction of Inventory to Fair Value

 

We record impairment losses on inventories related to communities under development and held for future development when events and circumstances indicate that they may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than their related carrying amounts. If the expected undiscounted cash flows are less than the carrying amount, then the community is written down to its fair value. We estimate the fair value of each impaired community by determining the present value of the estimated future cash flows at a discount rate commensurate with the risk of the respective community. For the nine months ended July 31, 2019, our discount rate used for the impairments recorded ranged from 18.0% to 18.3%. For the nine months ended July 31, 2018, our discount rate used for the impairments recorded ranged from 16.8% to 19.8%. Should the estimates or expectations used in determining cash flows or fair value decrease or differ from current estimates in the future, we may need to recognize additional impairments. 

 

 

During the nine months ended July 31, 2019 and 2018, we evaluated inventories of all 398 and 405 communities under development and held for future development or sale, respectively, for impairment indicators through preparation and review of detailed budgets or other market indicators of impairment. We performed detailed impairment calculations during the nine months ended July 31, 2019 and 2018 for seven and five of those communities (i.e., those with a projected operating loss or other impairment indicators), respectively, with an aggregate carrying value of $52.8 million and $11.2 million, respectively. As a result of our impairment analysis, we recorded an impairment loss of $0.1 million in one community (which had a pre-impairment value of $1.2 million) for the three months ended July 31, 2019, and aggregate impairment losses of $1.1 million in four communities (which had aggregate pre-impairment values of $11.4 million) for the nine months ended July 31, 2019. For the nine months ended July 31, 2018, we recorded aggregate impairment losses of $2.1 million in all five communities (which had an aggregate pre-impairment value of $11.2 million). We did not record impairment losses for the three months ended July 31, 2018. These impairment losses are included in the Condensed Consolidated Statements of Operations on the line entitled “Homebuilding: Inventory impairment loss and land option write-offs” and deducted from inventory. The pre-impairment value represents the carrying value, net of prior period impairments, if any, at the time of recording the impairment. Of those communities tested for impairment during the nine months ended July 31, 2019, three communities with an aggregate carrying value of $41.3 million had undiscounted future cash flows that exceeded the carrying amount by less than 20%. During the nine months ended July 31, 2018, none of the five communities tested for impairment had undiscounted future cash flows that exceeded the carrying amount by less than 20%.

 

The Condensed Consolidated Statements of Operations line entitled “Homebuilding: Inventory impairment loss and land option write-offs” also includes write-offs of options and approval, engineering and capitalized interest costs that we record when we redesign communities and/or abandon certain engineering costs and we do not exercise options in various locations because the communities' pro forma profitability is not projected to produce adequate returns on investment commensurate with the risk. Total aggregate write-offs related to these items were $1.3 million and $0.1 million for the three months ended July 31, 2019 and 2018, respectively, and $2.5 million and $1.1 million for the nine months ended July 31, 2019 and 2018, respectively. Occasionally, these write-offs are offset by recovered deposits (sometimes through legal action) that had been written off in a prior period as walk-away costs. Historically, these recoveries have not been significant in comparison to the total costs written off. The number of lots walked away from during the three months ended July 31, 2019 and 2018 were 1,852 and 76, respectively, and 4,022 and 1,417 during the nine months ended July 31, 2019 and 2018, respectively.

  

We decide to mothball (or stop development on) certain communities when we determine that the current performance does not justify further investment at the time. When we decide to mothball a community, the inventory is reclassified on our Condensed Consolidated Balance Sheets from “Sold and unsold homes and lots under development” to “Land and land options held for future development or sale.” During the first three quarters of fiscal 2019, we did not mothball any additional communities, but sold two previously mothballed communities and re-activated two previously mothballed communities. As of July 31, 2019 and October 31, 2018, the net book value associated with our 14 and 18 total mothballed communities was $14.2 million and $24.5 million, respectively, which was net of impairment charges recorded in prior periods of $146.9 million and $186.1 million, respectively.

 

From time to time we enter into option agreements that include specific performance requirements whereby we are required to purchase a minimum number of lots. Because of our obligation to purchase these lots, for accounting purposes in accordance with Accounting Standards Codification (“ASC”) 360-20-40-38, we are required to record this inventory on our Condensed Consolidated Balance Sheets. As of July 31, 2019 and October 31, 2018, we had no specific performance options.

 

We sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 606-10-55-68, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Condensed Consolidated Balance Sheets, at July 31, 2019 and October 31, 2018, inventory of $55.8 million and $50.5 million, respectively, was recorded to “Consolidated inventory not owned,” with a corresponding amount of $50.7 million and $43.9 million (net of debt issuance costs), respectively, recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions.

  

We have land banking arrangements, whereby we sell our land parcels to the land bankers and they provide us an option to purchase back finished lots on a predetermined schedule. Because of our options to repurchase these parcels, for accounting purposes, in accordance with ASC 606-10-55-70, these transactions are considered a financing rather than a sale. For purposes of our Condensed Consolidated Balance Sheets, at July 31, 2019 and October 31, 2018, inventory of $123.8 million and $37.4 million, respectively, was recorded to “Consolidated inventory not owned,” with a corresponding amount of $87.7 million and $19.5 million (net of debt issuance costs), respectively, recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions.

 

5.	Variable Interest Entities

 

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

 

 

In compliance with ASC 810, the Company analyzes its option purchase contracts to determine whether the corresponding land sellers are VIEs and, if so, whether the Company is the primary beneficiary. Although the Company does not have legal title to the underlying land, ASC 810 requires the Company to consolidate a VIE if the Company is determined to be the primary beneficiary. In determining whether it is the primary beneficiary, the Company considers, among other things, whether it has the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance. Such activities would include, among other things, determining or limiting the scope or purpose of the VIE, selling or transferring property owned or controlled by the VIE, or arranging financing for the VIE. The Company also considers whether it has the obligation to absorb losses of the VIE or the right to receive benefits from the VIE. As a result of its analyses, the Company determined that as of July 31, 2019 and October 31, 2018, it was not the primary beneficiary of any VIEs from which it is purchasing land under option purchase contracts.

  

We will continue to secure land and lots using options, some of which are with VIEs. Including deposits on our unconsolidated VIEs, at July 31, 2019, we had total cash and letters of credit deposits amounting to $71.6 million to purchase land and lots with a total purchase price of $1.3 billion. The maximum exposure to loss with respect to our land and lot options is limited to the deposits plus any pre-development costs invested in the property, although some deposits are refundable at our request or refundable if certain conditions are not met.

 

 

6.	Warranty Costs

 

General liability insurance for homebuilding companies and their suppliers and subcontractors is very difficult to obtain. The availability of general liability insurance is limited due to a decreased number of insurance companies willing to underwrite for the industry. In addition, those few insurers willing to underwrite liability insurance have significantly increased the premium costs. To date, we have been able to obtain general liability insurance but at higher premium costs with higher deductibles. Our subcontractors and suppliers have advised us that they have also had difficulty obtaining insurance that also provides us coverage. As a result, we have an owner controlled insurance program for certain of our subcontractors whereby the subcontractors pay us an insurance premium (through a reduction of amounts we would otherwise owe such subcontractors for their work on our homes) based on the risk type of the trade. We absorb the liability associated with their work on our homes as part of our overall general liability insurance at no additional cost to us because our existing general liability and construction defect insurance policy and related reserves for amounts under our deductible covers construction defects regardless of whether we or our subcontractors are responsible for the defect. For the three months ended July 31, 2019 and 2018, we received $1.2 million and $1.3 million, respectively, and for the nine months ended July 31, 2019 and 2018, we received $3.4 million and $3.3 million, respectively, from subcontractors related to the owner controlled insurance program, which we accounted for as a reduction to inventory.

 

We accrue for warranty costs that are covered under our existing general liability and construction defect policy as part of our general liability insurance deductible. This accrual is expensed as selling, general and administrative costs. For homes delivered in fiscal 2019 and 2018, our deductible under our general liability insurance is a $20 million aggregate for construction defect and warranty claims. For bodily injury claims, our deductible per occurrence in fiscal 2019 and 2018 is $0.25 million, up to a $5 million limit. Our aggregate retention for construction defect, warranty and bodily injury claims is $20 million for fiscal 2019 and 2018. In addition, we establish a warranty accrual for lower cost-related issues to cover home repairs, community amenities and land development infrastructure that are not covered under our general liability and construction defect policy. We accrue an estimate for these warranty costs as part of cost of sales at the time each home is closed and title and possession have been transferred to the homebuyer. Additions and charges in the warranty reserve and general liability reserve for the three and nine months ended July 31, 2019 and 2018 were as follows:

 

  

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

 

Insurance claims paid by our insurance carriers, excluding insurance deductibles paid, for prior year deliveries were less than $0.1 million for the three months ended July 31, 2019 and 2018, and $0.1 million for the nine months ended July 31, 2019 and 2018.

 

 

7.	Commitments and Contingent Liabilities

 

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

  

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

   

We anticipate that increasingly stringent requirements will be imposed on developers and homebuilders in the future. For example, for a number of years, the EPA and U.S. Army Corps of Engineers have been engaged in rulemakings to clarify the scope of federally regulated wetlands, which included a June 2015 rule many affected businesses contend impermissibly expanded the scope of such wetlands that was challenged in court, stayed, and remains in litigation. A proposal was made in June 2017 to formally rescind the June 2015 rule and reinstate the rule scheme previously in place while the agencies initiate a new substantive rulemaking on the issue. A February 2018 rule purported to delay the effective date of the June 2015 rule until February 2020, but was enjoined nationwide in August 2018 by a federal district court in South Carolina and later by a federal district court in the State of Washington in response to lawsuits (the net result of which, according to the EPA, is that the June 2015 rule applies in 22 states, the District of Columbia, and the United States territories, and that the pre-June 2015 regime applies in the rest). The federal government has withdrawn its appeals of those decisions and the EPA and U.S. Army Corps of Engineers are focusing efforts on promulgating a new rule addressing the issue; the comment period on the proposed rule, which was published in February 2019, closed in April 2019. It is unclear how these and related developments, including at the state or local level, ultimately may affect the scope of regulated wetlands where we operate. Although we cannot reliably predict the extent of any effect these developments regarding wetlands, or any other requirements that may take effect may have on us, they could result in time-consuming and expensive compliance programs and in substantial expenditures, which could cause delays and increase our cost of operations. In addition, our ability to obtain or renew permits or approvals and the continued effectiveness of permits already granted or approvals already obtained is dependent upon many factors, some of which are beyond our control, such as changes in policies, rules and regulations and their interpretations and application.

  

In March 2013, we received a letter from the Environmental Protection Agency (“EPA”) requesting information about our involvement in a housing redevelopment project in Newark, New Jersey that a Company entity undertook during the 1990s. We understand that the development is in the vicinity of a former lead smelter and that tests on soil samples from properties within the development conducted by the EPA showed elevated levels of lead. We also understand that the smelter ceased operations many years before the Company entity involved acquired the properties in the area and carried out the re-development project. We responded to the EPA’s request. In August 2013, we were notified that the EPA considers us a potentially responsible party (or “PRP”) with respect to the site, that the EPA will clean up the site, and that the EPA is proposing that we fund and/or contribute towards the cleanup of the contamination at the site. We began preliminary discussions with the EPA concerning a possible resolution but do not know the scope or extent of the Company’s obligations, if any, that may arise from the site and therefore cannot provide any assurance that this matter will not have a material impact on the Company. The EPA requested additional information in April 2014 and again in March 2017 and the Company responded to the information requests. On May 2, 2018 the EPA sent a letter to the Company entity demanding reimbursement for 100% of the EPA’s costs to clean-up the site in the amount of $2.7 million. The Company responded to the EPA’s demand letter on June 15, 2018 setting forth the Company’s defenses and expressing its willingness to enter into settlement negotiations. The parties have subsequently executed a Tolling Agreement to toll the statute of limitations on collection until December 20, 2019 to allow the parties time to discuss settlement. We believe that we have adequate reserves for this matter.

  

 

In 2015, the condominium association of the Four Seasons at Great Notch condominium community (the “Great Notch Plaintiff”) filed a lawsuit in the Superior Court of New Jersey, Law Division, Passaic County (the “Court”) alleging various construction defects, design defects, and geotechnical issues relating to the community. The operative complaint (“Complaint”) asserts claims against Hovnanian Enterprises, Inc. and several of its affiliates, including K. Hovnanian at Great Notch, LLC, K. Hovnanian Construction Management, Inc., and K. Hovnanian Companies, LLC. The Complaint also asserts claims against various other design professionals and contractors. The Great Notch Plaintiff has also filed a motion, which remains pending, to permit it to pursue a claim to pierce the corporate veil of K. Hovnanian at Great Notch, LLC to hold its alleged parent entities liable for any damages awarded against it. To date, the Hovnanian-affiliated defendants have reached a partial settlement with the Great Notch Plaintiff as to a portion of the Great Notch Plaintiff’s claims against them for an amount immaterial to the Company. On its remaining claims against the Hovnanian-affiliated defendants, the Great Notch Plaintiff has asserted damages of approximately $119.5 million, which amount is potentially subject to treble damages pursuant to the Great Notch Plaintiff’s claim under the New Jersey Consumer Fraud Act. On August 17, 2018, the Hovnanian-affiliated defendants filed a motion for summary judgment seeking dismissal of all of the Great Notch Plaintiff’s remaining claims against them, which was withdrawn without prejudice to re-file with supplemental evidence. The trial is currently scheduled for January 13, 2020. The previously ordered Court mediation sessions have been adjourned and have not been re-scheduled at this time. The Hovnanian-affiliated defendants intend to defend these claims vigorously.

 

8.	Cash and Cash Equivalents, Restricted Cash and Cash Equivalents and Customer’s Deposits

 

Cash represents cash deposited in checking accounts. Cash equivalents include certificates of deposit, Treasury bills and government money–market funds with maturities of 90 days or less when purchased. Our cash balances are held at a few financial institutions and may, at times, exceed insurable amounts. We believe we help to mitigate this risk by depositing our cash in major financial institutions. At July 31, 2019 and October 31, 2018, $91.8 million and $199.6 million, respectively, of the Cash and cash equivalents and Restricted cash and cash equivalents was in cash equivalents, the book value of which approximates fair value.

 

Homebuilding - Restricted cash and cash equivalents on the Condensed Consolidated Balance Sheets totaled $16.9 million and $12.8 million as of July 31, 2019 and October 31, 2018, respectively, which primarily consists of cash collateralizing our letter of credit agreements and facilities as discussed in Note 11.

 

Financial services restricted cash and cash equivalents, which are included in “Financial services” assets on the Condensed Consolidated Balance Sheets, totaled $20.4 million and $25.4 million as of July 31, 2019 and October 31, 2018, respectively. Included in these balances were (1) financial services customers’ deposits of $18.1 million at July 31, 2019 and $23.4 million as of October 31, 2018 which are subject to restrictions on our use, and (2) $2.3 million at July 31, 2019 and $2.0 million at October 31, 2018, respectively, of restricted cash under the terms of our mortgage warehouse lines of credit.

 

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

 

9.	Mortgage Loans Held for Sale

 

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

 

At July 31, 2019 and October 31, 2018, $68.7 million and $115.2 million, respectively, of mortgages held for sale were pledged against our mortgage warehouse lines of credit (see Note 10). We may incur losses with respect to mortgages that were previously sold that are delinquent and which had underwriting defects, but only to the extent the losses are not covered by mortgage insurance or resale value of the home. The reserves for these estimated losses are included in the “Financial services” liability balances on the Condensed Consolidated Balance Sheets. As of July 31, 2019 and 2018, we had reserves specifically for 21 and 45 identified mortgage loans, respectively, as well as reserves for an estimate for future losses on mortgages sold but not yet identified to us.

   

 

The activity in our loan origination reserves during the three and nine months ended July 31, 2019 and 2018 was as follows:

 

 

 

10.

Mortgages

 

We have nonrecourse mortgage loans for certain communities totaling $207.2 million and $95.6 million (net of debt issuance costs) at July 31, 2019 and October 31, 2018, respectively, which are secured by the related real property, including any improvements, with an aggregate book value of $409.3 million and $241.9 million, respectively. The weighted-average interest rate on these obligations was 8.1% and 6.1% at July 31, 2019 and October 31, 2018, respectively, and the mortgage loan payments on each community primarily correspond to home deliveries.

    

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

 

Our secured Master Repurchase Agreement with JPMorgan Chase Bank, N.A. (“Chase Master Repurchase Agreement”) is a short-term borrowing facility that provides up to $50.0 million through its maturity on January 31, 2020. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable monthly on outstanding advances at an adjusted LIBOR rate, which was 2.22% at July 31, 2019, plus the applicable margin of 2.5% or 2.625% based upon type of loan. As of July 31, 2019 and October 31, 2018, the aggregate principal amount of all borrowings outstanding under the Chase Master Repurchase Agreement was $25.0 million and $40.3 million, respectively.

    

K. Hovnanian Mortgage has another secured Master Repurchase Agreement with Customers Bank (“Customers Master Repurchase Agreement”) which is a short-term borrowing facility that provides up to $50.0 million through its maturity on February 14, 2020. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable daily or as loans are sold to permanent investors on outstanding advances at the current LIBOR rate, plus the applicable margin ranging from 2.25% to 5% based on the type of loan and the number of days outstanding on the warehouse line. As of July 31, 2019 and October 31, 2018, the aggregate principal amount of all borrowings outstanding under the Customers Master Repurchase Agreement was $25.9 million and $40.2 million, respectively.

 

K. Hovnanian Mortgage also has a secured Master Repurchase Agreement with Comerica Bank (“Comerica Master Repurchase Agreement”), which was amended on June 20, 2019 and is a short-term borrowing facility that provides up to $50.0 million through its maturity on June 17, 2020. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable monthly at the current LIBOR rate, subject to a floor of .25%, plus the applicable margin of 2.0% or 3.25% based upon the type of loan. As of July 31, 2019 and October 31, 2018, the aggregate principal amount of all borrowings outstanding under the Comerica Master Repurchase Agreement was $16.0 million and $32.7 million, respectively.

  

The Chase Master Repurchase Agreement, Customers Master Repurchase Agreement and Comerica Master Repurchase Agreement (together, the “Master Repurchase Agreements”) require K. Hovnanian Mortgage to satisfy and maintain specified financial ratios and other financial condition tests. Because of the extremely short period of time mortgages are held by K. Hovnanian Mortgage before the mortgages are sold to investors (generally a period of a few weeks), the immateriality to us on a consolidated basis of the size of the Master Repurchase Agreements, the levels required by these financial covenants, our ability based on our immediately available resources to contribute sufficient capital to cure any default, were such conditions to occur, and our right to cure any conditions of default based on the terms of the applicable agreement, we do not consider any of these covenants to be substantive or material. As of July 31, 2019, we believe we were in compliance with the covenants under the Master Repurchase Agreements.

 

 

11.	Senior Notes and Credit Facilities

 

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

 

 

(1) “Notes payable” on our Condensed Consolidated Balance Sheets as of July 31, 2019 and October 31, 2018 consists of the total senior secured and senior notes shown above, as well as accrued interest of $22.5 million and $35.6 million, respectively.

 

(2) Unamortized debt issuance costs at July 31, 2019 and October 31, 2018 were $12.3 million and $14.1 million, respectively.

 

(3) $26.0 million of 8.0% Senior Notes due 2019 are owned by a wholly-owned consolidated subsidiary of HEI. Therefore, in accordance with GAAP, such notes are not reflected on the Condensed Consolidated Balance Sheets of HEI.

 

(4) Availability under the Secured Credit Facility will terminate on December 28, 2019 and any loans thereunder on such date will convert to secured term loans maturing on December 28, 2022.

 

General

 

Except for K. Hovnanian, the issuer of the notes and borrower under the Credit Facilities (as defined below), our home mortgage subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures and certain of our title insurance subsidiaries, we and each of our subsidiaries are guarantors of the Credit Facilities, the senior secured notes and senior notes outstanding at July 31, 2019 (collectively, the “Notes Guarantors”). In addition to the Notes Guarantors, the 5.0% Senior Secured Notes due 2021 (the “5.0% 2021 Notes”), the 2.0% Senior Secured Notes due 2021 (the “2.0% 2021 Notes” and together with the 5.0% 2021 Notes, the “2021 Notes”) and the 9.50% Senior Secured Notes due 2020 (the “9.50% 2020 Notes” and collectively with the 2021 Notes, the “JV Holdings Secured Group Notes”) are guaranteed by K. Hovnanian JV Holdings, L.L.C. and its subsidiaries, except for certain joint ventures and joint venture holding companies (collectively, the “JV Holdings Secured Group”). Members of the JV Holdings Secured Group do not guarantee K. Hovnanian's other indebtedness.

 

 

The credit agreements governing the Credit Facilities and the indentures governing the senior secured and senior notes (together, the “Debt Instruments”) outstanding at July 31, 2019 do not contain any financial maintenance covenants, but do contain restrictive covenants that limit, among other things, the Company’s ability and that of certain of its subsidiaries, including K. Hovnanian, to incur additional indebtedness (other than nonrecourse indebtedness, certain permitted indebtedness and refinancing indebtedness (under the 9.50% 2020 Notes, any new or refinancing indebtedness may not be scheduled to mature earlier than January 15, 2021 (so long as no member of the JV Holdings Secured Group is an obligor thereon), or February 15, 2021 (if otherwise), and under the 10.0% Senior Secured Notes due 2022 (the “10.0% 2022 Notes”), any refinancing indebtedness of K. Hovnanian's previously outstanding 7.0% Senior Notes due 2019 (the “7.0% Notes”) (which includes the Term Loans (as defined below)) and 8.0% Senior Notes due 2019 (the “8.0% Notes” and together with the 7.0% Notes, the “2019 Notes”) (which includes the New Notes (as defined below) and the Term Loans) may not be scheduled to mature earlier than July 16, 2024 (such restrictive covenant in respect of the 10.5% Senior Secured Notes due 2024 (the “10.5% 2024 Notes”) was eliminated as described below under “—Fiscal 2018”)), pay dividends and make distributions on common and preferred stock, repurchase subordinated indebtedness and common and preferred stock, make other restricted payments, including investments, sell certain assets (including in certain land banking transactions), incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all assets, enter into certain transactions with affiliates and make cash repayments of the 2019 Notes and refinancing indebtedness in respect thereof (with respect to the 10.0% 2022 Notes). The Debt Instruments also contain events of default which would permit the lenders or holders thereof to exercise remedies with respect to the collateral (as applicable), declare the loans made under the Term Loan Facility (defined below) (the “Term Loans”) and loans made under the Secured Credit Facility (as defined below) (the “Secured Revolving Loans”) or notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the Term Loans, Secured Revolving Loans or notes or other material indebtedness, cross default to other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy and insolvency, with respect to the Term Loans and Secured Revolving Loans, material inaccuracy of representations and warranties and with respect to the Term Loans and Secured Revolving Loans, a change of control, and, with respect to the Secured Revolving Loans and senior secured notes, the failure of the documents granting security for the Secured Revolving Loans and senior secured notes to be in full force and effect, and the failure of the liens on any material portion of the collateral securing the Secured Revolving Loans and senior secured notes to be valid and perfected. As of July 31, 2019, we believe we were in compliance with the covenants of the Debt Instruments.

  

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

 

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

  

Fiscal 2019

 

On January 15, 2019, pursuant to the Commitment Letter (defined below) the Company issued $25.0 million in aggregate principal amount of the Additional 10.5% 2024 Notes (defined below) to the GSO Entities (defined below) at a discount for a purchase price of $21.3 million in cash. The Additional 10.5% 2024 Notes were issued as additional notes of the same series as the 10.5% 2024 Notes. The Additional 10.5% 2024 Notes and the guarantees are secured by pari passu liens with the 10.5% 2024 Notes on substantially all of the assets of K. Hovnanian and the Notes Guarantors, subject to permitted liens and certain exceptions.  See “—Secured Obligations” below.

 

Fiscal 2018

 

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

 

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

 

Pursuant to the Commitment Letter, the GSO Entities agreed to, among other things, provide the principal amount of the following: (i) a senior unsecured term loan credit facility (the “Term Loan Facility”) to be borrowed by K. Hovnanian and guaranteed by the Company and the Notes Guarantors, pursuant to which the GSO Entities committed to lend K. Hovnanian Term Loans consisting of $132.5 million of initial term loans (the “Initial Term Loans”) on the settlement date of the Exchange Offer for purposes of refinancing K. Hovnanian’s 7.0% Notes, and up to $80.0 million of delayed draw term loans (the “Delayed Draw Term Loans”) for purposes of refinancing certain of the 8.0% Notes, in each case, upon the terms and subject to the conditions set forth therein, and (ii) a senior secured first lien credit facility (the “Secured Credit Facility” and together with the Term Loan Facility, the “Credit Facilities”) to be borrowed by K. Hovnanian and guaranteed by the Notes Guarantors, pursuant to which the GSO Entities committed to lend to K. Hovnanian up to $125.0 million of senior secured first priority loans to fund the repayment of K. Hovnanian’s then outstanding secured term loans and for general corporate purposes, upon the terms and subject to the conditions set forth therein. In addition, pursuant to the Commitment Letter, the GSO Entities committed to purchase, and K. Hovnanian agreed to issue and sell, on January 15, 2019, $25.0 million in aggregate principal amount of additional 10.5% 2024 Notes (the “Additional 10.5% 2024 Notes”), upon the terms and subject to conditions set forth therein.

 

 

On January 29, 2018, K. Hovnanian, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent, and the GSO Entities entered into the Term Loan Facility. K. Hovnanian borrowed the Initial Term Loans on February 1, 2018 to fund, together with cash on hand, the redemption on February 1, 2018 of all $132.5 million aggregate principal amount of 7.0% Notes, which resulted in a loss on extinguishment of debt of $0.5 million for the nine months ended July 31, 2018. On May 29, 2018, K. Hovnanian completed the redemption of $65.7 million aggregate principal amount of the 8.0% Notes (representing all of the outstanding 8.0% Notes, excluding the $26 million of 8% Notes held by the Subsidiary Purchaser (as defined below)) with approximately $70.0 million in borrowings on the Delayed Draw Term Loans under the Unsecured Term Loan Facility (with the completion of this redemption, the remaining committed amounts under the Delayed Draw Term Loans may not be borrowed). This transaction resulted in a loss on extinguishment of debt of $4.3 million for the three months ended July 31, 2018. The Term Loans bear interest at a rate equal to 5.0% per annum and interest is payable in arrears, on the last business day of each fiscal quarter. The Term Loans will mature on February 1, 2027.

  

On January 29, 2018, K. Hovnanian, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent, and the GSO Entities entered into the Secured Credit Facility. Availability under the Secured Credit Facility will terminate on December 28, 2019 and any outstanding Secured Revolving Loans on such date shall convert to secured term loans maturing on December 28, 2022. The Secured Revolving Loans and the guarantees thereof are secured (subject to perfection timing requirements under the terms of the Secured Credit Facility) by substantially all of the assets owned by K. Hovnanian and the Notes Guarantors, subject to permitted liens and certain exceptions, on a first lien basis relative to the liens securing K. Hovnanian’s 10.0% 2022 Notes and 10.5% 2024 Notes and Additional 10.5% 2024 Notes pursuant to an intercreditor agreement. The collateral securing the Secured Revolving Loans are the same as that securing the 10.0% 2022 Notes and the 10.5% 2024 Notes and Additional 10.5% 2024 Notes. The Secured Revolving Loans bear interest at a rate equal to 10.0% per annum, and interest will be payable in arrears, on the last business day of each fiscal quarter.

   

On February 1, 2018, K. Hovnanian accepted all of the $170.2 million aggregate principal amount of 8.0% Notes validly tendered and not validly withdrawn in the Exchange Offer (representing 72.14% of the aggregate principal amount of 8.0% Notes outstanding prior to the Exchange Offer), and in connection therewith, K. Hovnanian issued $90.6 million aggregate principal amount of its 13.5% Senior Notes due 2026 (the “New 2026 Notes”) and $90.1 million aggregate principal amount of its 5.0% Senior Notes due 2040 (the “New 2040 Notes” and together with the New 2026 Notes, the “New Notes”) under a new indenture. Also, as part of the Exchange Offer, K. Hovnanian at Sunrise Trail III, LLC, a wholly-owned subsidiary of the Company (the “Subsidiary Purchaser”), purchased for $26.5 million in cash an aggregate of $26.0 million in principal amount of the 8.0% Notes (the “Purchased 8.0% Notes”). The New Notes were issued by K. Hovnanian and guaranteed by the Notes Guarantors, except the Subsidiary Purchaser, which does not guarantee the New Notes. The New 2026 Notes bear interest at 13.5% per annum and mature on February 1, 2026. The New 2040 Notes bear interest at 5.0% per annum and mature on February 1, 2040. Interest on the New Notes is payable semi-annually on February 1 and August 1 of each year to holders of record at the close of business on January 15 or July 15, as the case may be, immediately preceding each such interest payment date. The Exchange Offer was treated as a substantial modification of debt, and resulted in a loss on extinguishment of debt of $0.9 million for the nine months ended July 31, 2018. The New Notes were recorded at fair value (based on management's estimate using available trades for similar debt instruments) on the date of the issuance of the New Notes.

 

K. Hovnanian’s New 2026 Notes are redeemable in whole or in part at K. Hovnanian’s option at any time prior to February 1, 2026 at a redemption price equal to 100% of their principal amount plus an applicable “Make Whole Amount”. At any time and from time to time on or after February 1, 2019, K. Hovnanian may also redeem some or all of the New 2026 Notes at a redemption price equal to 100.0% of their principal amount.

 

K. Hovnanian’s New 2040 Notes are redeemable in whole or in part at K. Hovnanian’s option at any time prior to February 1, 2040 at a redemption price equal to 100.0% of their principal amount plus an applicable “Make-Whole Amount”. At any time and from time to time on or after February 1, 2040, K. Hovnanian may also redeem some or all of the New 2040 Notes at a redemption price equal to 100.0% of their principal amount.

 

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

  

 

Secured Obligations

 

The 10.0% 2022 Notes have a maturity of July 15, 2022 and bear interest at a rate of 10.0% per annum payable semi-annually on January 15 and July 15 of each year, to holders of record at the close of business on January 1 and July 1, as the case may be, immediately preceding such interest payment dates. K. Hovnanian may also redeem some or all of the 10.0% 2022 Notes at 105.0% of principal commencing July 15, 2019, at 102.50% of principal commencing July 15, 2020 and at 100.0% of principal commencing July 15, 2021. 

 

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

  

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

 

At July 31, 2019, the aggregate book value of the real property that constituted collateral securing the 10.0% 2022 Notes, 10.5% 2024 Notes and the Additional 10.5% 2024 Notes was $386.7 million, which does not include the impact of inventory investments, home deliveries or impairments thereafter and which may differ from the value if it were appraised. Cash and cash equivalents collateral that secured the 10.0% 2022 Notes, 10.5% 2024 Notes and the Additional 10.5% 2024 Notes was $63.1 million as of July 31, 2019, which included $16.5 million of restricted cash collateralizing certain letters of credit. Subsequent to such date, fluctuations as a result of cash uses include general business operations and real estate and other investments along with cash inflow primarily from deliveries.

 

The 9.50% 2020 Notes have a maturity of November 15, 2020, and bear interest at a rate of 9.5% per annum, payable semi-annually on February 15 and August 15 of each year, to holders of record at the close of business on February 1 and August 1, as the case may be, immediately preceding such interest payment dates. The 9.50% 2020 Notes are redeemable in whole or in part at our option at any time prior to November 15, 2018 at 100% of their principal amount plus an applicable “Make-Whole Amount.” At any time and from time to time on or after November 15, 2018, K. Hovnanian may also redeem some or all of the 9.50% 2020 Notes at a redemption price equal to 100% of their principal amount.

 

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

 

The 9.5% 2020 Notes and the 2021 Notes are guaranteed by the Notes Guarantors and the members of the JV Holdings Secured Group. The guarantees of the JV Holdings Secured Group with respect to the 2021 Notes and the 9.50% 2020 Notes are secured, subject to permitted liens and certain exceptions, by a first-priority lien on substantially all of the assets of the members of the JV Holdings Secured Group. As of July 31, 2019, the collateral securing the guarantees included (1) $30.7 million of cash and cash equivalents (subsequent to such date, fluctuations as a result of cash uses include general business operations and real estate and other investments along with cash inflow primarily from deliveries); (2) $161.0 million aggregate book value of real property of the JV Holdings Secured Group, which does not include the impact of inventory investments, home deliveries or impairments thereafter and which may differ from the value if it were appraised; and (3) equity interests owned by guarantors that are members of the JV Holdings Secured Group. Members of the JV Holdings Secured Group also own equity in joint ventures, either directly or indirectly through ownership of joint venture holding companies, with a book value of $182.3 million as of July 31, 2019; this equity is not pledged to secure, and is not collateral for, the 9.50% 2020 Notes or the 2021 Notes. Members of the JV Holdings Secured Group are “unrestricted subsidiaries” under K. Hovnanian's other senior secured notes and senior notes and Credit Facilities, and thus have not guaranteed such indebtedness. 

 

 

Other

 

We have certain stand–alone cash collateralized letter of credit agreements and facilities under which there was a total of $15.9 million and $12.5 million letters of credit outstanding at July 31, 2019 and October 31, 2018, respectively. These agreements and facilities require us to maintain specified amounts of cash as collateral in segregated accounts to support the letters of credit issued thereunder, which will affect the amount of cash we have available for other uses. At July 31, 2019 and October 31, 2018, the amount of cash collateral in these segregated accounts was $16.5 million and $12.7 million, respectively, which is reflected in “Restricted cash and cash equivalents” on the Condensed Consolidated Balance Sheets.

 

12.	Per Share Calculation

 

Basic earnings per share is computed by dividing net income (loss) (the “numerator”) by the weighted-average number of common shares outstanding, adjusted for nonvested shares of restricted stock (the “denominator”) for the period. Computing diluted earnings per share is similar to computing basic earnings per share, except that the denominator is increased to include the dilutive effects of options and nonvested shares of restricted stock. Any options that have an exercise price greater than the average market price are considered to be anti-dilutive and are excluded from the diluted earnings per share calculation.   

  

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

 

Incremental shares attributed to nonvested stock and outstanding options to purchase common stock of 0.2 million and 0.3 million for the three and nine months ended July 31, 2019, respectively, and 0.1 million for both the three and nine months ended July 31, 2018, respectively, which were excluded from the computation of diluted earnings per share because we had a net loss for the period. Also, for the nine months ended July 31, 2018, 44 thousand shares of common stock issuable upon the exchange of our senior exchangeable notes (which were issued in fiscal 2012 and matured and were fully paid in December 2017) were excluded from the computation of diluted earnings per share because the Company had a net loss for the period.

 

In addition, shares related to out-of-the money stock options that could potentially dilute basic earnings per share in the future that were not included in the computation of diluted earnings per share were 0.2 million for both the three and nine months ended July 31, 2019, respectively, and 0.3 million and 0.2 million for the three and nine months ended July 31, 2018, respectively, because to do so would have been anti-dilutive for the periods presented.

 

13.	Preferred Stock

 

On July 12, 2005, we issued 5,600 shares of 7.625% Series A Preferred Stock, with a liquidation preference of $25,000 per share. Dividends on the Series A Preferred Stock are not cumulative and are payable at an annual rate of 7.625%. The Series A Preferred Stock is not convertible into the Company’s common stock and is redeemable in whole or in part at our option at the liquidation preference of the shares. The Series A Preferred Stock is traded as depositary shares, with each depositary share representing 1/1000th of a share of Series A Preferred Stock. The depositary shares are listed on the NASDAQ Global Market under the symbol “HOVNP.” During the three and nine months ended July 31, 2019 and 2018, we did not pay any dividends on the Series A Preferred Stock due to covenant restrictions in our debt instruments. We anticipate that we will continue to be restricted from paying dividends, which are not cumulative, for the foreseeable future.

  

 

14.	Common Stock

 

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

  

On March 19, 2019, the Company's stockholders approved at an annual meeting an amendment to our Certificate of Incorporation to effect a reverse stock split (the “Reverse Stock Split”) of the Company’s common stock at a ratio of 1-for-25, and a corresponding decrease in the number of authorized shares of the common stock. Following the stockholders' approval, the Board of Directors, on March 19, 2019, determined to effectuate the Reverse Stock Split, which became effective on March 29, 2019, and every 25 issued shares (including treasury shares) of Class A Common Stock, par value $0.01 per share (the “Class A Common Stock”), were combined into one share of Class A Common Stock, and every 25 issued shares (including treasury shares) of Class B Common Stock, par value $0.01 per share (the “Class B Common Stock”), were combined into one share of Class B Common Stock. No fractional shares were issued in connection with the Reverse Stock Split. All share and per share amounts have been retroactively adjusted to reflect the reverse stock split.

 

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

 

On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 0.2 million shares of Class A Common Stock. There were no shares purchased during the three and nine months ended July 31, 2019. As of July 31, 2019, the maximum number of shares of Class A Common Stock that may yet be purchased under this program is 22 thousand.

  

 

15.	Income Taxes

  

The total income tax expense for the three and nine months ended July 31, 2019 was $0.5 million and $1.2 million, respectively, and $1.1 million and $1.7 million, respectively, for the same periods of the prior year. For both the three and nine months ended July 31, 2019 and the three and nine months ended July 31, 2018, the total income tax expense was primarily related to state tax expense from income generated that was not offset by tax benefits in states where we fully reserve the tax benefit from net operating losses. 

 

Our federal net operating losses of $1.6 billion expire between 2028 and 2037, and $23.5 million have an indefinite carryforward period. Of our $2.5 billion of state NOLs, $145.3 million expire between 2019 through 2023; $691.2 million expire between 2024 through 2028; $1.3 billion expire between 2029 through 2033; $316.1 million expire between 2034 through 2038; and $43.2 million have an indefinite carryforward period.

 

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

 

 

As of July 31, 2019, we considered all available positive and negative evidence to determine whether, based on the weight of that evidence, our valuation allowance for our DTAs was appropriate in accordance with ASC 740. Listed below, in order of the weighting of each factor, is the available positive and negative evidence that we considered in determining that it is more likely than not that all of our DTAs will not be realized. In analyzing these factors, overall the negative evidence, both objective and subjective, outweighed the positive evidence. Based on this analysis, we determined that the current valuation allowance for deferred taxes of $644.6 million as of July 31, 2019, which fully reserves for our DTAs, is appropriate. 

 

1.

Fiscal 2017 financial results, especially the $50.2 million pre-tax loss in the third quarter of fiscal 2017 primarily from the $42.3 million loss on extinguishment of debt during the quarter, that put us in a cumulative three-year pre-tax loss position as of July 31, 2017. We are still in a cumulative three-year loss position as of July 31, 2019. Per ASC 740, cumulative losses are one of the most objectively verifiable forms of negative evidence. (Negative Objective Evidence)

 

2.

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

 

3.

Recent financial results of $48.1 million pre-tax income in the fourth quarter of fiscal 2018 and $8.1 million pre-tax income for the year ended October 31, 2018. (Positive Objective Evidence)

 

4.

Our net contracts per community and our absolute net contracts increased in the third quarter of fiscal 2019 compared to the third quarter of 2018. This is a reversal of the negative trend we had seen in the second quarter of 2019. (Positive Objective Evidence)

 

5.

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

 

6.

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

 

7.

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

  

 

16.	Operating and Reporting Segments

 

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

 

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

 

Homebuilding:

	(1)	Northeast (New Jersey and Pennsylvania)
	(2)	Mid-Atlantic (Delaware, Maryland, Virginia, Washington D.C. and West Virginia)
	(3)	Midwest (Illinois and Ohio)
	(4)	Southeast (Florida, Georgia and South Carolina)
	(5)	Southwest (Arizona and Texas)
	(6)	West (California)

  

Financial Services

 

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

 

 

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

 

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

 

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

 

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

 

  

 

(1)  Corporate and unallocated for the three months ended July 31, 2019 included corporate general and administrative costs of $15.0 million, interest expense of $14.7 million (a component of Other interest on our Condensed Consolidated Statements of Operations), $(0.3) million of other income and expenses primarily related to interest income and stock compensation. Corporate and unallocated for the nine months ended July 31, 2019 included corporate general and administrative costs of $48.8 million, interest expense of $45.4 million (a component of Other interest on our Condensed Consolidated Statements of Operations), and $(1.4) million of other income and expenses. Corporate and unallocated for the three months ended July 31, 2018 included corporate general and administrative costs of $16.4 million, interest expense of $20.2 million (a component of Other interest on our Condensed Consolidated Statements of Operations), loss on extinguishment of debt of $4.3 million and $(2.3) million of other income and expenses primarily related to an adjustment to our insurance reserves, resulting from a legal settlement. Corporate and unallocated for the nine months ended July 31, 2018 included corporate general and administrative costs of $51.7 million, interest expense of $59.7 million (a component of Other interest on our Condensed Consolidated Statements of Operations), loss on extinguishment of debt of $5.7 million and $(6.4) million of other income and expenses primarily related to interest income and gain on sale of our corporate headquarters building. 

 

 

 

 

 

17.	Investments in Unconsolidated Homebuilding and Land Development Joint Ventures

 

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

  

During the first quarter of fiscal 2018, we acquired the remaining assets of one of our joint ventures, resulting in a $13.0 million reduction in our investment in the joint venture and a corresponding increase to inventory.

 

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

 

 

 

   

As of July 31, 2019 and October 31, 2018, we had advances and a note receivable outstanding of $3.9 million and $4.6 million, respectively, to these unconsolidated joint ventures. These amounts were included in the “Accounts payable and accrued liabilities” balances in the tables above. On our Condensed Consolidated Balance Sheets, our “Investments in and advances to unconsolidated joint ventures” amounted to $134.1 million and $123.7 million at July 31, 2019 and October 31, 2018, respectively. In some cases, our net investment in these joint ventures is less than our proportionate share of the equity reflected in the table above because of the differences between asset impairments recorded against our joint venture investments and any impairments recorded in the applicable joint venture. Impairments of joint venture investments are recorded at fair value while impairments recorded in the joint venture are recorded when undiscounted cash flows trigger the impairment. During the nine months ended July 31, 2019, we recorded a $0.9 million write down in our investment in one of our joint ventures in the West. During the nine months ended July 31, 2018, we did not write-down any of our joint venture investments; however, one of our joint ventures in the Northeast recorded an asset impairment. We recorded our proportionate share of this impairment charge of $0.7 million as part of our share of the net loss of the venture.

 

 

 

 

 

 

“Income (loss) from unconsolidated joint ventures” is reflected as a separate line in the accompanying Condensed Consolidated Statements of Operations and reflects our proportionate share of the income or loss of these unconsolidated homebuilding and land development joint ventures. The difference between our share of the income or loss from these unconsolidated joint ventures in the tables above compared to the Condensed Consolidated Statements of Operations is due primarily to the reclassification of the intercompany portion of management fee income from certain joint ventures and the deferral of income for lots purchased by us from certain joint ventures. For the nine months ended July 31, 2019, the difference can also be attributed to a return of capital from a joint venture in which we had previously written off our investment. To compensate us for the administrative services we provide as the manager of certain joint ventures, we receive a management fee based on a percentage of the applicable joint venture’s revenues. These management fees, which totaled $4.1 million and $7.2 million for the three months ended July 31, 2019 and 2018, respectively, and $11.9 million and $12.1 million for the nine months ended July 31, 2019 and 2018, respectively, are recorded in “Homebuilding: Selling, general and administrative” on the Condensed Consolidated Statements of Operations.

     

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

  

Typically, our unconsolidated joint ventures obtain separate project specific mortgage financing. For some of our joint ventures, obtaining financing was challenging, therefore, some of our joint ventures are capitalized only with equity. The total debt to capitalization ratio of all our joint ventures is currently 42%. Any joint venture financing is on a nonrecourse basis, with guarantees from us limited only to performance and completion of development, environmental warranties and indemnification, standard indemnification for fraud, misrepresentation and other similar actions, including a voluntary bankruptcy filing. In some instances, the joint venture entity is considered a VIE under ASC 810-10 “Consolidation – Overall” due to the returns being capped to the equity holders; however, in these instances, we have determined that we are not the primary beneficiary, and therefore we do not consolidate these entities. 

 

18.	Recent Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2014-09, “Revenue from Contracts with Customers” (Topic 606), (“ASU 2014-09”). ASU 2014-09 requires entities to recognize revenue that represents the transfer of promised goods or services to customers in an amount equivalent to the consideration to which the entity expects to be entitled to in exchange for those goods or services. The following steps should be applied to determine this amount: (1) identify the contract(s) with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when (or as) the entity satisfies a performance obligation. ASU 2014-09 supersedes the revenue recognition requirements in ASC 605, “Revenue Recognition,” and most industry-specific guidance in the Accounting Standards Codification. The FASB has also issued a number of updates to this standard. The standard was effective for us for annual and interim periods beginning November 1, 2018 and we applied the modified retrospective method of adoption. The implementation did not result in any significant changes to our business processes, systems, or internal controls, or have a material impact on our Condensed Consolidated Financial Statements. 

 

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)” (“ASU 2016-02”), which provides guidance for accounting for leases. ASU 2016-02 requires lessees to classify leases as either finance or operating leases and to record a right-of-use asset and a lease liability for all leases with a term greater than 12 months regardless of the lease classification. The lease classification will determine whether the lease expense is recognized based on an effective interest rate method or on a straight line basis over the term of the lease. Accounting for lessors remains largely unchanged from current GAAP. ASU 2016-02 is effective for the Company beginning November 1, 2019. Early adoption is permitted. In July 2018, the FASB issued ASU No. 2018-10 “Codification Improvements to Topic 842, Leases” (“ASU 2018-10”) and ASU No. 2018-11 “Leases (Topic 842) Targeted Improvements” (“ASU 2018-11”). ASU 2018-10 provides certain amendments that affect narrow aspects of the guidance issued in ASU 2016-02. ASU 2018-11 allows all entities adopting ASU 2016-02 to choose an additional (and optional) transition method of adoption, under which an entity initially applies the new leases standard at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. ASU 2018-11 also allows lessors to not separate nonlease components from the associated lease component if certain conditions are met. We are currently evaluating both the method and the impact of adopting this guidance on our Condensed Consolidated Financial Statements.

 

 

In July 2018, the FASB issued ASU No. 2018-09, “Codification Improvements” (“ASU 2018-09”). ASU 2018-09 provides amendments to a wide variety of topics in the FASB’s Accounting Standards Codification, which applies to all reporting entities within the scope of the affected accounting guidance. The transition and effective date guidance are based on the facts and circumstances of each amendment. Some of the amendments in ASU 2018-09 do not require transition guidance and were effective upon issuance of ASU 2018-09. However, many of the amendments do have transition guidance with effective dates for annual periods beginning after December 15, 2018. We are currently evaluating the potential impact of adopting the applicable guidance on our Condensed Consolidated Financial Statements.

 

In August 2018, the FASB issued ASU No. 2018-13, “Fair Value Measurement (Topic 820) - Disclosure Framework” (“ASU 2018-13”), which improves the disclosure requirements for fair value measurements. ASU 2018-13 is effective for us beginning November 1, 2020. Early adoption is permitted for any removed or modified disclosures. We are currently evaluating the potential impact of adopting this guidance on our Condensed Consolidated Financial Statements.

 

In August 2018, the FASB issued ASU No. 2018-15 “Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40): Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That is a Service Contract” (“ASU 2018-15”). ASU 2018-15 aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. ASU 2018-15 is effective for us beginning November 1, 2020. Early adoption is permitted. We are currently evaluating the potential impact of adopting this guidance on our Condensed Consolidated Financial Statements.

 

19.	Fair Value of Financial Instruments

 

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

 

Level 1:

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

 

Level 2:

Fair value determined using significant other observable inputs.

 

Level 3:

Fair value determined using significant unobservable inputs.

   

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

  

 

(1)  The aggregate unpaid principal balance was $81.4 million and $127.6 million at July 31, 2019 and October 31, 2018, respectively.

 

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

 

 

The Financial Services segment had a pipeline of loan applications in process of $602.5 million at July 31, 2019. Loans in process for which interest rates were committed to the borrowers totaled $51.6 million as of July 31, 2019. Substantially all of these commitments were for periods of 60 days or less. Since a portion of these commitments is expected to expire without being exercised by the borrowers, the total commitments do not necessarily represent future cash requirements.

  

The Financial Services segment uses investor commitments and forward sales of mandatory MBS to hedge its mortgage-related interest rate exposure. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk is managed by entering into MBS forward commitments, option contracts with investment banks, federally regulated bank affiliates and loan sales transactions with permanent investors meeting the segment’s credit standards. The segment’s risk, in the event of default by the purchaser, is the difference between the contract price and fair value of the MBS forward commitments and option contracts. At July 31, 2019, the segment had open commitments amounting to $18.0 million to sell MBS with varying settlement dates through August 21, 2019.

  

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

  

   

 

 

 

The Company’s assets measured at fair value on a nonrecurring basis are those assets for which the Company has recorded valuation adjustments and write-offs during the three and nine months ended July 31, 2019 and 2018. The assets measured at fair value on a nonrecurring basis are all within the Company’s Homebuilding operations and are summarized below:

 

Nonfinancial Assets

 

 

 

  

  

  

We record impairment losses on inventories related to communities under development and held for future development when events and circumstances indicate that they may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than their related carrying amounts. If the expected undiscounted cash flows are less than the carrying amount, then the community is written down to its fair value. We estimate the fair value of each impaired community by determining the present value of its estimated future cash flows at a discount rate commensurate with the risk of the respective community. Should the estimates or expectations used in determining cash flows or fair value decrease or differ from current estimates in the future, we may be required to recognize additional impairments. We recorded inventory impairments, which are included in the Condensed Consolidated Statements of Operations as “Inventory impairment loss and land option write-offs” and deducted from inventory, of $0.1 million and $1.1 million for the three and nine months ended July 31, 2019, and $2.1 million for the nine months ended July 31, 2018. We did not record any inventory impairments for the three months ended July 31, 2018. See Note 4 for further detail of the communities evaluated for impairment.

 

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

 

The fair value of each series of our Notes are listed below. Level 2 measurements are estimated based on recent trades or quoted market prices for the same issues or based on recent trades or quoted market prices for our debt of similar security and maturity to achieve comparable yields. Level 3 measurements are estimated based on third-party broker quotes or management’s estimate of the fair value based on available trades for similar debt instruments.

 

Fair Value as of July 31, 2019

 

 

Fair Value as of October 31, 2018

 

The Senior Secured Revolving Credit Facility is not included in the above tables because there were no borrowings outstanding thereunder as of July 31, 2019 and October 31, 2018.