Progress being made on the Hovnanian Preferreds
I wrote up my position in Hovnanian preferreds (HOVNP) in April 2013, so a little over 9 months ago. During that time the preferreds have went on a round trip to nowhere, peaking out at $18 in the summer before falling back to $14 in the last few weeks of the year.
I waited patiently through most of the year, not adding to my position but not reducing it either. When the preferred shares touched the $14’s though, I decided to add with the rationale that we are another year closer to the housing recovery.
I didn’t, however, put in any new work before my purchase. I took the lazy way out, falling back on the thesis of choppy but improving fundamentals of the housing market and my work from nine months earlier that suggested that by 2014 Hovnanian should cross the fixed interest coverage restriction that has kept them from paying interest on their preferreds.
This week I filled the void and did some work on the progress made by Hovnanian. In the table below I have calculated the interest coverage ratio that restricts dividends on the preferreds. If you want the language of the preferred document you can go back and read my original comment but in simple terms it is a ratio of consolidated cash flow from operations (so cash flows that do not include cash from unconsolidated subsidiarie) to the interest paid during the period. That ratio has to be above 2.0 for the previous 12 months before Hovnanian can reinstate payments on the preferreds.
So progress is indeed being made. The fourth quarter was the first quarter where the ratio exceeded the 2x threshold.
My original assumption was that Hovnanian would exceed the threshold in 2014, and this was based on 16% top-line growth in both 2013 and 2014 and costs that were in-line with historical margins. In 2013 the company exceeded my estimate on the top line, posting revenue of $1.85 billion, versus $1.48 billion in 2012, which works out to about 25%. The company should easily hit my $2 billion revenue target this year. Meanwhile, interest costs have declined from around $100 million annually to something less than $90 million. Admittedly the recent $150 million note offering of 7% senior notes is going to bump that up somewhat, but hopefully that money will be quickly put to work at higher rates of returns.
So I still expect the company to exceed the interest coverage ratio within a year. When they do, I expect interest to once again be paid on the preferreds, and thus for the price of the preferreds to move close to their $25 par value. Even today at $15, that represents a 50% return in a year (to get 50% I am assuming the preferreds continue to trade at a discount to par even after the dividend is reinstated, reflecting remaining uncertainty about the dividends sustainability).
While the preferreds are not in the portfolio I track on-line because of the limitation of the practice portfolio I use for those purposes (it doesn’t let you buy preferreds), they represent a 4.5% position in my portfolio. So its not huge, in part because the stock is not terribly liquid and in part because it remains a risky bet; keep in mind that these preferreds traded down to as little as $2 during the crisis and it was only in 2012 that they returned to above $10.
Nevertheless, the upside is there and the company is on-track to follow the ever slowly recovering economy back toward normalcy. I think there is a good chance that I will selling these in the $20’s around this time next year.