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HOVNANIAN ENTERPRISES INC – 10-Q – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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OVERVIEW
Since late 2006, the U.S. housing market has been impacted by declining consumer confidence, high home foreclosure rates and large supplies of resale and new home inventories. The result has been weakened demand for new homes, slower sales, higher than normal cancellation rates and increased price discounts and other sales incentives to attract homebuyers. Additionally, the availability of certain mortgage financing products became more constrained starting inFebruary 2007 when the mortgage industry began to more closely scrutinize subprime, Alt-A, and other nonprime mortgage products, and over the past few years, many lenders have significantly tightened their underwriting standards. The overall economy has weakened significantly and fears of further prolonged economic weakness are still present due, among other factors, to high unemployment levels, deterioration in consumer confidence and the reduction in extensions of credit and consumer spending. As a result, we experienced significant decreases in our revenues and gross margins during 2007, 2008, 2009 and 2010 compared with prior years. During 2011 and through the first quarter of fiscal 2012, the homebuilding market has exhibited a large degree of choppiness. Beginning in the second quarter of fiscal 2012, we began to see positive operating trends, including second quarter 2012 year over year improvements when comparing the second quarter of fiscal 2012 to the second quarter of fiscal 2011, such as: contract growth of 45.9%, an increase in gross margin percentage from 14.8% to 17.4% and a decrease in selling, general and administrative costs (including corporate and administrative expenses) as a percentage of total revenue from 20.3% to 13.9%. In addition, contract cancellation rates were 16% in the second quarter of fiscal 2012, compared to what we believe to be a more normalized level of 20% in the second quarter of fiscal 2011. As a result of these improvements, we have raised prices in approximately 40% of our communities during fiscal 2012. Active selling communities decreased to 177 compared to 189 in the same period a year ago, while net contracts per average active selling community increased to 13.1 for the six months endedApril 30, 2012 compared to 9.9 in the same period in the prior year. While we are encouraged by the positive operating trends for the second quarter of fiscal 2012, several challenges such as persistently high unemployment levels, economic weakness and uncertainty, and the potential for more foreclosures continue to threaten a recovery in the housing market. Over the course of this multiple year downturn in the homebuilding market, we have recorded$2.4 billion in inventory impairment and option walkaway charges from the first quarter of fiscal 2006 through the second quarter of 2012. We have exposure to additional impairments of our inventories, which, as ofApril 30, 2012 , have a book value of$946.1 million , net of$720.3 million of impairments recorded on 116 of our communities. This includes$24.2 million of cash invested in 9,372 lots under option as ofApril 30, 2012 . In addition, we had$1.2 million in letters of credit deposits on optioned lots as ofApril 30, 2012 . We write off amounts associated with an option if we determine it is probable we will not exercise it. As ofApril 30, 2012 , we had total investments in, and advances to, unconsolidated joint ventures of$60.5 million . Each of our joint ventures assesses its inventory and other long-lived assets for impairment and we separately assess our equity investment in joint ventures for other than temporary declines in value, which has resulted in total reductions in our equity investment in joint ventures of$119.1 million from the second half of fiscal 2006, the first period in which we had impairments on our joint ventures, throughApril 30, 2012 . There have been no write downs of our equity investment in unconsolidated joint ventures since fiscal 2009, however, a community in one of our joint ventures in the Northeast recorded an asset impairment in the fourth quarter of fiscal 2011. We recorded our proportional share of this impairment charge as part of our share of the net loss of the venture. We still have exposure to future write-downs of our equity investment in unconsolidated joint ventures if conditions deteriorate further in the markets in which our joint ventures operate. As the market for new homes declined, we adjusted our approach to land acquisition and construction practices and shortened our land pipeline, reduced production volumes, and balanced home price and profitability with sales pace. We delayed and cancelled planned land purchases and renegotiated land prices and significantly reduced our total number of controlled lots owned and under option. Additionally, we significantly reduced our total number of speculative homes put into production over the past several years. SinceJanuary 2009 , however, we have begun to see more opportunities to purchase land at prices that make economic sense in light of the current sales prices and sales paces and plan to continue pursuing such land acquisitions. New land purchases at pricing that we believe will generate appropriate investment returns and drive greater operating efficiencies are needed to return to profitability. During the first half of fiscal 2012, we opened 26 new communities, purchased approximately 1,000 lots within 108 newly identified communities (which we define as communities that were controlled subsequent toJanuary 31, 2009 ) and optioned approximately 2,300 lots in 126 newly identified communities. During fiscal 2011, our active selling communities fluctuated, but at the end of fiscal 2011 we had the same number of active selling communities as the end of fiscal 2010. FromOctober 31, 2011 throughApril 30, 2012 , our active community count decreased by 15 communities, as a result of increased sales pace. We continue to consider and make new land acquisitions to replenish our community count. We have also continued to closely evaluate and make reductions in selling, general and administrative expenses, including corporate general and administrative expenses, reducing these expenses$4.4 million from$51.8 million in the second quarter of fiscal 2011 to$47.4 million in the second quarter of fiscal 2012 due in part to a 1.8% reduction in head count for the same period and continued tightening of variable spending across all of our operating segments. Given the persistence of these difficult market conditions, improving the efficiency of our selling, general and administrative expenses will continue to be a significant area of focus. For the six months endedApril 30, 2012 , homebuilding selling, general and administrative costs declined 14.6% to$68.4 million compared to the six months endedApril 30, 2011 .
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CRITICAL ACCOUNTING POLICIES
Management believes that the following critical accounting policies require its most significant judgments and estimates used in the preparation of the condensed consolidated financial statements:
Income Recognition from Home andLand Sales - We are primarily engaged in the development, construction, marketing and sale of residential single-family and multi-family homes where the planned construction cycle is less than 12 months. For these homes, in accordance with ASC 360-20, "Property, Plant and Equipment - Real Estate Sales" ("ASC 360-20"), revenue is recognized when title is conveyed to the buyer, adequate initial and continuing investments have been received, and there is no continued involvement. In situations where the buyer's financing is originated by our mortgage subsidiary and the buyer has not made an adequate initial investment or continuing investment as prescribed by ASC 360-20, the profit on such sales is deferred until the sale of the related mortgage loan to a third-party investor has been completed. Income Recognition from Mortgage Loans - Our Financial Services segment originates mortgages, primarily for our homebuilding customers. We use mandatory investor commitments and forward sales of mortgage-backed securities ("MBS") to hedge our mortgage-related interest rate exposure on agency and government loans. We elected the fair value option for our loans held for sale for mortgage loans originated subsequent toOctober 31, 2008 in accordance with ASC 825, "Financial Instruments", which permits us to measure our loans held for sale at fair value. 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. In addition, we recognize the fair value of our rights to service a mortgage loan as revenue upon entering into an interest rate lock loan commitment with a borrower. The fair value of these servicing rights is included in loans held for sale. Fair value of the servicing rights is determined based on values in the Company's servicing sales contracts. Substantially all of the mortgage loans originated are sold within a short period of time in the secondary mortgage market on a servicing released, nonrecourse basis, although the Company remains liable for certain limited representations, such as fraud, and warranties related to loan sales. Mortgage investors could seek to have us buy back loans or compensate them for losses incurred on mortgages we have sold based on claims that we breached our limited representations and warranties. We believe there continues to be an industry-wide issue with the number of purchaser claims in which purchasers purport to have found inaccuracies related to the sellers' representations and warranties in particular loan sale agreements. To date, we have not made significant payments to the purchasers of our loans and we have established reserves for probable losses. Included in mortgage loans held for sale atApril 30, 2012 is$2.3 million of mortgage loans, which represent the fair value of loans that cannot currently be sold at reasonable terms in the secondary mortgage market. These loans are serviced by a third party until such time that they can be liquidated via alternative mortgage markets, foreclosure or repayment. Inventories - Inventories consist of land, land development, home construction costs, capitalized interest and construction overhead and property taxes. Construction costs are accumulated during the period of construction and charged to cost of sales under specific identification methods. Land, land development, and common facility costs are allocated based on buildable acres to product types within each community, then charged to cost of sales equally based upon the number of homes to be constructed in each product type. We record inventories in our condensed consolidated balance sheets at cost unless the inventory is determined to be impaired, in which case the inventory is written down to its fair value. Our inventories consist of the following three components: (1) sold and unsold homes and lots under development, which includes all construction, land, capitalized interest, and land development costs related to started homes and land under development in our active communities; (2) land and land options held for future development or sale, which includes all costs related to land in our communities in planning or mothballed communities; and (3) consolidated inventory not owned, which includes all costs related to specific performance options, variable interest entities, and other options, which consists primarily of model homes financed with an investor and inventory related to structured lot options. We have decided to mothball (or stop development on) certain communities where we have determined the current market conditions do not justify further investment at this time. When we decide to mothball a community, the inventory is reclassified from "Sold and unsold homes and lots under development" to "Land and land options held for future development or sale". As ofApril 30, 2012 , the net book value associated with our 54 mothballed communities was$141.0 million , net of impairment charges of$449.5 million . We regularly review communities to determine if mothballing is appropriate. During the first half of fiscal 2012, we did not mothball any communities, but re-activated two communities and sold three communities which were previously mothballed. The recoverability of inventories and other long-lived assets are assessed in accordance with the provisions of ASC 360-10, "Property, Plant and Equipment - Overall" ("ASC 360-10"). ASC 360-10 requires long-lived assets, including inventories, held for development to be evaluated for impairment based on undiscounted future cash flows of the assets at the lowest level for which there are identifiable cash flows. As such, we evaluate inventories for impairment at the individual community level, the lowest level of discrete cash flows that we measure. 30
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We evaluate inventories of communities under development and held for future development for impairment when indicators of potential impairment are present. Indicators of impairment include, but are not limited to, decreases in local housing market values, decreases in gross margins or sales absorption rates, decreases in net sales prices (base sales price net of sales incentives), or actual or projected operating or cash flow losses. The assessment of communities for indication of impairment is performed quarterly. As part of this process, we prepare detailed budgets for all of our communities at least semi-annually and identify those communities with a projected operating loss. For those communities with projected losses, we estimate the remaining undiscounted future cash flows and compare those to the carrying value of the community, to determine if the carrying value of the asset is recoverable.
The projected operating profits, losses, or cash flows of each community can be significantly impacted by our estimates of the following:
• future base selling prices; • future home sales incentives; • future home construction and land development costs; and • future sales absorption pace and cancellation rates. These estimates are dependent upon specific market conditions for each community. While we consider available information to determine what we believe to be our best estimates as of the end of a quarterly reporting period, these estimates are subject to change in future reporting periods as facts and circumstances change. Local market-specific conditions that may impact our estimates for a community include: • the intensity of competition within a market, including available home sales prices and home sales incentives offered by our competitors;
• the current sales absorption pace for both our communities and competitor
communities;
• community-specific attributes, such as location, availability of lots in
the market, desirability and uniqueness of our community, and the size and
style of homes currently being offered;
• potential for alternative product offerings to respond to local market
conditions; • changes by management in the sales strategy of the community;
• current local market economic and demographic conditions and related trends
and forecasts; and
• existing home inventory supplies, including foreclosures and short sales.
These and other local market-specific conditions that may be present are considered by management in preparing projection assumptions for each community. The sales objectives can differ between our communities, even within a given market. For example, facts and circumstances in a given community may lead us to price our homes with the objective of yielding a higher sales absorption pace, while facts and circumstances in another community may lead us to price our homes to minimize deterioration in our gross margins, although it may result in a slower sales absorption pace. In addition, the key assumptions included in our estimate of future undiscounted cash flows may be interrelated. For example, a decrease in estimated base sales price or an increase in homes sales incentives may result in a corresponding increase in sales absorption pace. Additionally, a decrease in the average sales price of homes to be sold and closed in future reporting periods for one community that has not been generating what management believes to be an adequate sales absorption pace may impact the estimated cash flow assumptions of a nearby community. Changes in our key assumptions, including estimated construction and development costs, absorption pace and selling strategies, could materially impact future cash flow and fair-value estimates. Due to the number of possible scenarios that would result from various changes in these factors, we do not believe it is possible to develop a sensitivity analysis with a level of precision that would be meaningful. If the undiscounted cash flows are more than the carrying value of the community, then the carrying amount is recoverable, and no impairment adjustment is required. However, if the undiscounted cash flows are less than the carrying amount, then the community is deemed impaired and is written-down to its fair value. We determine the estimated fair value of each community by determining the present value of its estimated future cash flows at a discount rate commensurate with the risk of the respective community, or in limited circumstances, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale), and recent bona fide offers received from outside third parties. Our discount rates used for all impairments recorded fromOctober 31, 2006 toApril 30, 2012 range from 13.5% to 20.3%. The estimated future cash flow assumptions are virtually the same for both our recoverability and fair value assessments. Should the estimates or expectations used in determining estimated cash flows or fair value, including discount rates, decrease or differ from current estimates in the future, we may be required to recognize additional impairments related to current and future communities. The impairment of a community is allocated to each lot on a relative fair value basis.
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From time to time, we write off deposits and approval, engineering and capitalized interest costs when we determine that it is no longer probable that we will exercise options to buy land in specific locations or when we redesign communities and/or abandon certain engineering costs. In deciding not to exercise a land option, we take into consideration changes in market conditions, the timing of required land takedowns, the willingness of land sellers to modify terms of the land option contract (including timing of land takedowns), and the availability and best use of our capital, among other factors. The write-off is recorded in the period it is deemed probable that the optioned property will not be acquired. In certain instances, we have been able to recover deposits and other pre-acquisition costs that were previously written off. These recoveries have not been significant in comparison to the total costs written off. Inventories held for sale, which are land parcels where we have decided not to build homes, represented$12.5 million of our total inventories atApril 30, 2012 , and are reported at the lower of carrying amount or fair value less costs to sell. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. Insurance Deductible Reserves - For homes delivered in fiscal 2012 and 2011, our deductible under our general liability insurance is$20 million per occurrence for construction defect and warranty claims. For bodily injury claims, our deductible per occurrence in fiscal 2012 and 2011 is$0.1 million up to a$5 million limit. Our aggregate retention in 2012 and 2011 is$21 million for construction defect, warranty and bodily injury claims. We do not have a deductible on our worker's compensation insurance in fiscal 2012 and 2011. Reserves for estimated losses for construction defects, warranty, bodily injury and worker's compensation claims have been established using the assistance of a third-party actuary. We engage a third-party actuary that uses our historical warranty and construction defect data, worker's compensation data, and other industry 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 worker's compensation programs. The estimates include provisions for inflation, claims handling and legal fees. These estimates are subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products we build, claim settlement patterns, insurance industry practices, and legal interpretations, among others. Because of the high degree of judgment required in determining these estimated liability amounts, actual future costs could differ significantly from our currently estimated amounts. Land Options - Costs incurred to obtain options to acquire improved or unimproved home sites are capitalized. Such amounts are either included as part of the purchase price if the land is acquired or charged to operations if we determine we will not exercise the option. If the options are with variable interest entities and we are the primary beneficiary, we record the land under option on the Condensed Consolidated Balance Sheets under "Consolidated inventory not owned" with an offset under "Liabilities from inventory not owned". The evaluation of whether or not we are the primary beneficiary can require significant judgment. Similarly, if the option obligation is to purchase under specific performance or has terms that require us to record it as financing, then we record the option on the Condensed Consolidated Balance Sheets under "Consolidated inventory not owned" with an offset under "Liabilities from inventory not owned". We record costs associated with other options on the Condensed Consolidated Balance Sheets under "Land and land options held for future development or sale".Unconsolidated Homebuilding and Land Development Joint Ventures - Investments in unconsolidated homebuilding and land development joint ventures are accounted for under the equity method of accounting. Under the equity method, we recognize our proportionate share of earnings and losses earned by the joint venture upon the delivery of lots or homes to third parties. Our ownership interest in joint ventures varies but our voting interests are generally less than or equal to 50%. In determining whether or not we must consolidate joint ventures where we are the managing member of the joint venture, 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 significant operating and capital decisions of the partnership, including budgets, in the ordinary course of business. The evaluation of whether or not we control a venture can require significant judgment. In accordance with ASC 323-10, "Investments -Equity Method and Joint Ventures - Overall" ("ASC 323-10"), we assess our investments in unconsolidated joint ventures for recoverability, and if it is determined that a loss in value of the investment below its carrying amount is other than temporary, we write down the investment to its fair value. We evaluate our equity investments for impairment based on the joint venture's projected cash flows. This process requires significant management judgment and estimates. During fiscal 2011 and the first half of fiscal 2012, there were no write-downs of our joint venture investments. Post-Development Completion and Warranty Costs - In those instances where a development is substantially completed and sold and we have additional construction work to be incurred, an estimated liability is provided to cover the cost of such work. In addition, we estimate and accrue warranty costs as part of cost of sales for repair costs under$5,000 per occurrence to homes, community amenities and land development infrastructure. In addition, we accrue for warranty costs over$5,000 per occurrence as part of our general liability insurance deductible expensed as selling, general, and administrative costs. Warranty accruals require our management to make significant estimates about the cost of future claims. Both of these liabilities are recorded in "Accounts payable and other liabilities" on the Condensed Consolidated Balance Sheets.
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Income Taxes - Deferred income taxes or income tax benefits are provided for temporary differences between amounts recorded for financial reporting and for income tax purposes. If the combination of future years' income (or loss) combined with the reversal of the timing differences results in a loss, such losses can be carried back to prior years or carried forward to future years to recover the deferred tax assets. In accordance with ASC 740-10, "Income Taxes - Overall" ("ASC 740-10"), we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740-10 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. See "Total Taxes" below under "Results of Operations" for further discussion of the valuation allowances. We recognize tax liabilities in accordance with ASC 740-10, and we adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a liability that is materially different from our current estimate. These differences will be reflected as increases or decreases to income tax expense in the period in which they are determined. Recent Accounting Pronouncements - See Note 20 to the Condensed Consolidated Financial Statements included elsewhere in this Form 10-Q. There have been no accounting pronouncements that have been issued but not yet implemented that we believe will materially impact our financial statements.
CAPITAL RESOURCES AND LIQUIDITY
Our operations consist primarily of residential housing development and sales in the Northeast (New Jersey ,Pennsylvania ), the Mid-Atlantic (Delaware ,Maryland , Virginia,West Virginia ,Washington D.C. ), the Midwest (Illinois ,Minnesota ,Ohio ), the Southeast (Florida ,Georgia ,North Carolina ,South Carolina ), the Southwest (Arizona ,Texas ), and the West (California ). In addition, we provide certain financial services to our homebuilding customers. We have historically funded our homebuilding and financial services operations with cash flows from operating activities, borrowings under our bank credit facilities and the issuance of new debt and equity securities. In light of the challenging homebuilding market conditions we have been experiencing since late 2006, we had been operating with a primary focus to generate cash flows from operations through reductions in assets during fiscal 2007 through fiscal 2009. The generation of cash flow, together with debt repurchases and exchanges at prices below par, allowed us to reduce net debt (debt less cash) over these years. Since the later half of fiscal 2009, we have seen more opportunities to purchase land at prices that make economic sense given the then-current home sales prices and sales paces. As such, since that time we have acquired new land at higher levels than in the previous few years. As a result, our net debt has increased since the last half of fiscal 2010. However, despite this increase in net debt, we have been able to continue to reduce our total debt. Our net income (loss) historically does not approximate cash flow from operating activities. The difference between net income (loss) and cash flow from operating activities is primarily caused by changes in inventory levels together with changes in receivables, prepaid and other assets, interest and other accrued liabilities, deferred income taxes, accounts payable, mortgage loans and liabilities, and noncash charges relating to depreciation, amortization of computer software costs, stock compensation awards and impairment losses for inventory. When we are expanding our operations, inventory levels, prepaids, and other assets increase causing cash flow from operating activities to decrease. Certain liabilities also increase as operations expand and partially offset the negative effect on cash flow from operations caused by the increase in inventory levels, prepaids and other assets. Similarly, as our mortgage operations expand, net income from these operations increases, but for cash flow purposes net income is offset by the net change in mortgage assets and liabilities. The opposite is true as our investment in new land purchases and development of new communities decrease, which is what happened during the last half of fiscal 2007 through fiscal 2009, allowing us to generate positive cash flow from operations during this period. Since the latter part of fiscal 2009 cumulative throughApril 30, 2012 , as a result of the new land purchases and land development we have used cash in operations as we add new communities. Looking forward, given the depressed housing market, it will continue to be difficult to generate positive cash flow from operations until we return to sustained profitability. However, we will continue to make adjustments to our structure and our business plans in order to maximize our liquidity while also taking steps to return to profitability, including through land acquisitions. Our homebuilding cash balance atApril 30, 2012 decreased by$49.2 million fromOctober 31, 2011 . The significant uses of cash during the first half of fiscal 2012 were primarily due to spending approximately$118.3 million on land and land development,$74.0 million , including$3.3 million for accrued interest, for the repurchase of certain of our senior notes and senior subordinated amortizing notes and$22.1 million for theNovember 2011 debt exchange, including accrued interest and costs associated with the transaction. These items were partially offset by$47.3 million of proceeds received through theApril 2012 common stock issuance,$26.7 million of proceeds from model sale leaseback financing programs and a$25.3 million reduction of restricted cash. Most of this restricted cash became unrestricted as the letters of credit the cash collateralized were released during the second quarter of fiscal 2012. The remaining change in cash came from normal operations. Our cash uses during the six months endedApril 30, 2012 and 2011 were for operating expenses, land purchases, land deposits, land development, construction spending, debt payments, repurchases, state income taxes, interest payments and investments in joint ventures. During these periods, we funded our cash requirements from available cash on hand, equity issuances, housing and land sales, financial service revenues, and other revenues. We believe that these sources of cash will be sufficient through fiscal 2012 to finance our working capital requirements and other needs. However, if necessary, potential additional sources to generate cash could include entering into additional joint ventures or land banking deals, issuing equity for cash or debt, selling excess land, entering into model sale leasebacks, limiting started unsold homes, delaying or reducing land purchases and take-downs or reducing land development spending. 33
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As ofApril 30, 2012 , we had$992.0 million of outstanding senior secured notes ($967.2 million , net of discount), comprised of$797.0 million 10 5/8% Senior Secured Notes due 2016,$53.2 million 2.0% Senior Secured Notes due 2021 and$141.8 million 5.0% Senior Secured Notes due 2021. As ofApril 30, 2012 , we also had$483.6 million of outstanding senior notes ($481.4 million , net of discount), comprised of$36.7 million 6 1/2% Senior Notes due 2014,$3.0 million 6 3/8% Senior Notes due 2014,$21.4 million 6 1/4% Senior Notes due 2015,$138.9 million 6 1/4% Senior Notes due 2016,$90.5 million 7 1/2% Senior Notes due 2016,$130.3 million 8 5/8% Senior Notes due 2017 and$62.8 million 11 7/8% Senior Notes due 2015. In addition, as ofApril 30, 2012 , we had outstanding$7.9 million 7.25% Tangible Equity Units. During the three and six months endedApril 30, 2012 , we repurchased in open market and privately negotiated transactions$15.2 million and$21.0 million , respectively, principal amount of our 6 1/4% Senior Notes due 2016 and$22.8 million and$61.1 million , respectively, principal amount of 7 1/2% Senior Notes due 2016. In addition, during the second quarter of fiscal 2012, we repurchased$37.4 million principal amount of 8 5/8% Senior Notes due 2017. The aggregate purchase price for these repurchases was$51.7 million and$70.7 million , respectively, for the three and six months endedApril 30, 2012 , plus accrued and unpaid interest. These repurchases resulted in a gain on extinguishment of debt of$23.3 million and$48.0 million , respectively, for the three and six months endedApril 30, 2012 , net of the write-off of unamortized discounts and fees. The gain is included in the Condensed Consolidated Statement of Operations as "Gain on extinguishment of debt". Certain of these repurchases were funded with the proceeds from ourApril 11, 2012 issuance of 25,000,000 shares of our Class A Common Stock (see Notes 11 and 15 to the Condensed Consolidated Financial Statements). During the second quarter of fiscal 2012, we also issued an aggregate of 3,064,330 shares of our Class A Common Stock, in exchange for an aggregate of approximately$12.2 million of our outstanding indebtedness, consisting of$9.1 million aggregate principal amount of our outstanding 8.625% Senior Notes due 2017 and approximately$3.1 million aggregate principal amount of our 12.072% senior subordinated amortizing notes (the "exchanges"). These transactions resulted in a gain on extinguishment of debt of$3.7 million for the three months endedApril 30, 2012 . OnApril 11, 2012 , we issued 25,000,000 shares of our Class A Common Stock at a price of$2.00 per share, resulting in net proceeds of$47.3 million . The net proceeds of the issuance, together with cash on hand, were used to purchase$75.4 million principal amount of our senior notes (see Note 11 to our Condensed Consolidated Financial Statements). OnNovember 1, 2011 , we issued$141.8 million aggregate principal amount of 5.0% Senior Secured Notes due 2021 ("the 5.0% 2021 Notes") and$53.2 million aggregate principal amount of 2.0% Senior Secured Notes due 2021 (the "2.0% 2021 Notes", and together with the 5.0% 2021 Notes the "2021 Notes") in exchange for$195.0 million of certain of our unsecured senior notes with maturities ranging from 2014 through 2017. Holders of the senior notes due 2014 and 2015 that were exchanged in the exchange offer also received an aggregate of approximately$14.2 million in cash payments and all holders of senior notes that were exchanged in the exchange offer received accrued and unpaid interest (in the aggregate amount of approximately$3.3 million ). Costs associated with this transaction were$4.7 million . 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 accounting for the debt exchange is being treated as a troubled debt restructuring. Under this accounting, the Company did not recognize any gain or loss on extinguishment of debt and the costs associated with the debt exchange were expensed as incurred as shown in "Other operations" in the Condensed Consolidated Statement of Operations.See Note 11 to the Condensed Consolidated Financial Statements. OnJuly 3, 2001 , our Board of Directors authorized a stock repurchase program to purchase up to 4 million shares of Class A Common Stock. There were no shares purchased during the three months endedApril 30, 2012 . During the six months endedApril 30, 2012 , we purchased approximately 0.1 million shares. As ofApril 30, 2012 , 3.5 million shares of Class A Common Stock have been purchased under this program. OnJuly 12, 2005 , we issued 5,600 shares of 7.625% Series A Preferred Stock, with a liquidation preference of$25,000 . 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 beginning on the fifth anniversary of their issuance. 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 theNASDAQ Global Market under the symbol "HOVNP". During the three and six months endedApril 30, 2012 and 2011, we did not make any dividend payments on our Series A Preferred Stock as a result of 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. We do not have a revolving credit facility. We have certain stand alone cash collateralized letter of credit agreements and facilities under which there were a total of$33.1 million and$54.1 million of letters of credit outstanding as ofApril 30, 2012 andOctober 31, 2011 , 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. As ofApril 30, 2012 andOctober 31, 2011 , the amount of cash collateral in these segregated accounts was$33.8 million and$57.7 million , respectively, which is reflected in "Restricted cash" on the Condensed Consolidated Balance Sheets.
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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 and related servicing rights are sold in the secondary mortgage market within a short period of time. Our secured Master Repurchase Agreement withJPMorgan Chase Bank, N.A. ("Chase Master Repurchase Agreement") is a short-term borrowing facility that provides up to$75 million throughNovember 1, 2012 and thereafter up to$50 million throughMarch 28, 2013 . 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 the current LIBOR subject to a floor of 1.625% plus the applicable margin ranging from 2.5% to 3.0% based on the takeout investor and type of loan. As ofApril 30, 2012 , the aggregate principal amount of all borrowings under the Chase Master Repurchase Agreement was$64.5 million . The Chase Master Repurchase Agreement requiresK. 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 byK. 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 facilities, 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 agreement, we do not consider any of these covenants to be substantive or material. As ofApril 30, 2012 , we believe we were in compliance with the covenants of the Chase Master Repurchase Agreement. The 10 5/8% Senior Secured Notes due 2016 are secured by a first-priority lien, subject to permitted liens and other exceptions, on substantially all the assets owned by us,K. Hovnanian Enterprises, Inc. ("K. Hovnanian") (the issuer of the senior secured notes) and the guarantors of such senior secured notes. AtApril 30, 2012 , the aggregate book value of the real property collateral securing these notes was approximately$687.1 million , which does not include the impact of inventory investments, home deliveries, or impairments thereafter and which may differ from the appraised value. In addition, cash collateral securing these notes was$135.9 million as ofApril 30, 2012 , which includes$33.8 million of restricted cash collateralizing certain letters of credit. Subsequent to such date, cash uses include general business operations and real estate investments. Except forK. Hovnanian , the issuer of the notes, our home mortgage subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures, certain of our title insurance subsidiaries and our foreign subsidiary, we and each of our subsidiaries are guarantors of the senior secured and senior notes and Amortizing Notes (see Note 12 to the Condensed Consolidated Financial Statements.) outstanding atApril 30, 2012 (see Note 22 to the Condensed Consolidated Financial Statements.). In addition, the 2021 Notes are guaranteed byK. Hovnanian JV Holdings, L.L.C. and its subsidiaries except for certain joint ventures and joint venture holding companies (collectively, the "Secured Group "). The guarantees with respect to the 2021 Notes of theSecured Group are secured, subject to permitted liens and other exceptions, by a first-priority lien on substantially all of the assets of the members of theSecured Group . As ofApril 30, 2012 , the collateral securing the guarantees primarily included (1)$92.0 million of cash and cash equivalents and (2) equity interests in guarantors that are members of theSecured Group . Subsequent to such date, cash uses include general business operations and real estate and other investments. The aggregate book value of the real property of theSecured Group collateralizing the 2021 Notes was approximately$31.5 million as ofApril 30, 2012 (not including the impact of inventory investments, home deliveries, or impairments thereafter and which may differ from the appraised value), Members of theSecured Group also own equity in joint ventures, either directly or indirectly through ownership of joint venture holding companies, with a book value of$48.4 million as ofApril 30, 2012 ; this equity is not pledged to secure, and is not collateral for, the 2021 Notes. Members of theSecured Group are "unrestricted subsidiaries" underK. Hovnanian's other senior notes, senior secured notes and senior subordinated amortizing notes, and thus have not guaranteed such indebtedness. Under the terms of the indentures (including with respect to the senior subordinated amortizing notes described in Note 12 to the Condensed Consolidated Financial Statements), we have the right to make certain redemptions and, depending on market conditions and covenant restrictions, may do so from time to time. We also continue to evaluate our capital structure and 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. The indentures governing the notes 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, includingK. Hovnanian , to incur additional indebtedness (other than certain permitted indebtedness, refinancing indebtedness and non-recourse indebtedness), pay dividends and make distributions on common and preferred stock, repurchase senior and senior subordinated notes (with respect to the senior secured first-lien notes indenture), make other restricted payments, make investments, sell certain assets, incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all assets and enter into certain transactions with affiliates. The indentures also contain events of default which would permit the holders of the notes to declare the notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the notes or other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy, and insolvency and, with respect to the indentures governing the senior secured notes, the failure of the documents granting security for the 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 senior secured notes to be valid and perfected. As ofApril 30, 2012 we believe we were in compliance with the covenants of the indentures governing our outstanding notes.
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If our consolidated fixed charge coverage ratio, as defined in the indentures governing our senior secured and senior notes, 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 non-recourse indebtedness. As a result of this restriction, we are currently restricted from paying dividends, which are not cumulative, on our 7.625% Series A Preferred Stock. If current market trends continue or worsen, 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 bond indentures or otherwise affect compliance with any of the covenants contained in the bond indentures.
During fiscal 2011 and thereafter, Fitch Ratings ("Fitch"),
· On
· On
of default ratings to Caa2 from Caa1. Moody's also lowered the rating on our
10 5/8% senior secured notes to B2 from B1 and our senior unsecured notes to
Caa3 from Caa2. The rating on our preferred stock was affirmed at Ca, and our
speculative grade liquidity assessment remained SGL-3.
· On
ratings on our 10 5/8% senior secured notes to "CC" from "CCC". S&P also
lowered the rating on our senior unsecured notes to C from CC.
· On
Caa2/LD from Caa2 and also lowered the rating on our 10 5/8% senior secured
notes to B3 from B2 and assigned a rating of B3 to our 2.0% and 5.0% senior
secured notes (issued in
the LD designation on our probability of default ratings was removed.
· On
Default ("SD") from CC and lowered our rating on our senior unsecured notes
from C to D. Subsequently, on
corporate credit rating to CCC- from SD. S&P also raised our ratings on our
10 5/8% senior secured notes to CCC- from CC and our senior unsecured notes to
CC from D.
· On
Restricted Default ("RD") from CCC. Subsequently, on
raised our IDR from RD back to CCC. Downgrades in our credit ratings do not accelerate the scheduled maturity dates of our debt or affect the interest rates charged on any of our debt issues or our debt covenant requirements or cause any other operating issue. A potential risk from negative changes in our credit ratings is that they may make it more difficult or costly for us to access capital. However, due to our available cash resources, the downgrades and revisions to our credit ratings in 2011 discussed above have not impacted management's operating plans, or our financial condition, results of operations or liquidity. Total inventory, excluding consolidated inventory not owned, decreased$46.6 million during the six months endedApril 30, 2012 . Total inventory, excluding consolidated inventory not owned, increased in the Midwest$7.1 million . This increase was offset by decreases in the Northeast of$6.0 million , in the Mid-Atlantic of$16.3 million , in the Southeast of$4.9 million , in the Southwest of$6.3 million , and in the West of$20.2 million . The decreases are primarily attributable to delivering homes at a faster pace than replenishing with new land, as noted by the decrease in our community count fromOctober 31, 2011 toApril 30, 2012 . These decreases were partially offset by the acquisition of new land parcels. During the six months endedApril 30, 2012 , we incurred$5.2 million in impairments, the majority of which related to properties that are held for sale in the Northeast. In addition, we wrote-off costs in the amount of$1.3 million during the six months endedApril 30, 2012 related to land options that expired or that we terminated, as the communities' forecasted profitability was not projected to produce adequate returns on investment commensurate with the risk. In the last few years, we have been able to acquire new land parcels at prices that we believe will generate reasonable returns under current homebuilding market conditions. There can be no assurances that this trend will continue in the near term. Substantially all homes under construction or completed and included in inventory atApril 30, 2012 are expected to be closed during the next 12 months. The total inventory decrease discussed above excluded the increase in consolidated inventory not owned of$24.6 million consisting of specific performance options and other options that were added to our balance sheet in accordance with ASC 470-40, "Debt-Product Financing Arrangements" and ASC 840-40, "Leases-Sales-Leaseback Transactions". This increase was primarily due to the sale and leaseback of certain of our model homes with the right to participate in the potential profit when the home is sold to a third party at the end of the lease. As a result of our continued involvement, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Condensed Consolidated Balance Sheet, the inventory is reclassified to inventory not owned, with a corresponding liability from inventory not owned for the amount of cash received. Offsetting this increase, was a decrease due to the purchase of properties in the Southwest and West during the period, which had a specific performance obligation.
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We usually option property for development prior to acquisition. By optioning property, we are only subject to the loss of the cost of the option and predevelopment costs if we choose not to exercise the option. As a result, our commitment for major land acquisitions is reduced. The costs associated with optioned properties are included in "Land and land options held for future development or sale inventory". Also included in "Land and land options held for future development or sale inventory" are amounts associated with inventory in mothballed communities. We mothball (or stop development on) certain communities when we determine the current performance does not justify further investment at this time. That is, we believe we will generate higher returns if we decide against spending money to improve land today and save the raw land until such times as the markets improve. As ofApril 30, 2012 , we have mothballed land in 54 communities. The book value associated with these communities atApril 30, 2012 was$141.0 million , net of impairment charges of$449.5 million . We continually review communities to determine if mothballing is appropriate. During the first half of fiscal 2012, we did not mothball any communities, but re-activated two communities and sold three communities which were previously mothballed. Our inventory representing "Land and land options held for future development or sale" atApril 30, 2012 , on the Condensed Consolidated Balance Sheets, decreased by$17.0 million compared toOctober 31, 2011 . The decrease is due to the movement of certain of our communities from held for future development to sold and unsold homes and lots under development during the quarter, combined with land sales in the Northeast and Southeast and additional impairments taken primarily in the Northeast and Southeast in the first half of fiscal 2012, offset by an increase due to the acquisition of new land in all segments during the first half of fiscal 2012. The following tables summarize home sites included in our total residential real estate. The decrease in total home sites available atApril 30, 2012 compared toOctober 31, 2011 is attributable to terminating certain option agreements and delivering homes, offset by signing new land option agreements and acquiring new land parcels. Active
Proposed
Active Communities Developable Total Communities(1) Homes Homes HomesApril 30, 2012 : Northeast 14 1,368 3,276 4,644 Mid-Atlantic 20 2,073 3,718 5,791 Midwest 27 1,802 529 2,331 Southeast 23 1,023 726 1,749 Southwest 77 3,636 1,522 5,158 West 16 2,061 4,852 6,913 Consolidated total 177 11,963 14,623 26,586 Unconsolidated joint ventures 2,112 274 2,386 Total including unconsolidated joint ventures 14,075 14,897 28,972 Owned 6,964 10,087 17,051 Optioned 4,836 4,536 9,372 Controlled lots 11,800 14,623 26,423 Construction to permanent financing lots 163 - 163 Consolidated total 11,963 14,623 26,586 Lots controlled by unconsolidated joint ventures 2,112 274 2,386 Total including unconsolidated joint ventures 14,075 14,897 28,972
(1) Active communities are open for sale communities with 10 or more home sites available.
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Active Proposed Active Communities Developable Total Communities(1) Homes Homes HomesOctober 31, 2011 : Northeast 15 1,511 3,228 4,739 Mid-Atlantic 24 2,256 3,336 5,592 Midwest 26 1,354 745 2,099 Southeast 22 1,950 896 2,846 Southwest 89 3,963 1,564 5,527 West 16 2,334 5,168 7,502 Consolidated total 192 13,368 14,937 28,305 Unconsolidated joint ventures 2,160 571 2,731 Total including unconsolidated joint ventures 15,528 15,508 31,036 Owned 7,651 10,626 18,277 Optioned 5,602 4,311 9,913 Controlled lots 13,253 14,937 28,190 Construction to permanent financing lots 115 - 115 Consolidated total 13,368 14,937 28,305 Lots controlled by unconsolidated joint ventures 2,160 571 2,731 Total including unconsolidated joint ventures 15,528 15,508 31,036
(1) Active communities are open for sale communities with 10 or more home sites available.
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The following table summarizes our started or completed unsold homes and models, excluding unconsolidated joint ventures:
April 30, 2012
Unsold Homes Models Total Unsold Homes Models Total Northeast 100 8 108 86 18 104 Mid-Atlantic 55 5 60 73 30 103 Midwest 44 34 78 45 38 83 Southeast 54 27 81 58 30 88 Southwest 380 25 405 431 81 512 West 73 26 99 118 52 170 Total 706 125 831 811 249 1,060 Started or completed unsold homes and models per active selling communities (1) 4.0 0.7 4.7 4.2 1.3 5.5
(1) Active selling communities (which are communities that are
open for sale with 10 or more home sites) available were 177 and 192 atApril 30, 2012 andOctober 31, 2011 , respectively. Total unsold homes and models compared to the prior year end has decreased, as we placed an emphasis on selling started unsold homes and models during the six months endedApril 30, 2012 . 39
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Prepaid expenses and other assets were as follows as of:
April 30, October 31, Dollar (In thousands) 2012 2011 Change Prepaid insurance $ 1,765 $ 1,808 $ (43 ) Prepaid project costs 25,758 27,206 (1,448 ) Senior residential rental properties 7,075 7,374 (299 ) Other prepaids 19,793 21,699 (1,906 ) Other assets 9,562 9,611 (49 ) Total $ 63,953 $ 67,698 $ (3,745 ) Prepaid project costs consist of community specific expenditures that are used over the life of the community. Such prepaids are expensed as homes are delivered. Prepaid project costs decreased for homes delivered and were not fully offset by prepaid spending for new communities. Other prepaids decreased mainly due to the amortization of the remaining prepaid debt costs. Financial Services - Mortgage loans held for sale consist primarily of residential mortgages receivable held for sale of which$72.8 million and$71.2 million atApril 30, 2012 andOctober 31, 2011 , respectively, were being temporarily warehoused and are awaiting sale in the secondary mortgage market. The increase in mortgage loans held for sale fromOctober 31, 2011 is primarily related to an increase in the average loan value during the second quarter of 2012 compared to the fourth quarter of 2011. Also included are residential mortgages receivable held for sale of$2.3 million and$1.0 million atApril 30, 2012 andOctober 31, 2011 , respectively, which represent loans that cannot currently be sold at reasonable terms in the secondary mortgage market. We may incur losses with respect to mortgages that were previously sold that are delinquent, but only to the extent the losses are not covered by mortgage insurance or resale value of the house. Historically, we have incurred minimal credit losses.
Accounts payable and other liabilities are as follows:
April 30, October 31, Dollar (In thousands) 2012 2011 Change Accounts payable $ 80,422 $ 85,415 $ (4,993 ) Reserves 135,729 141,496 (5,767 ) Accrued expenses 30,525 43,151 (12,626 ) Accrued compensation 18,290 23,432 (5,142 ) Other liabilities 10,649 10,139 510 Total $ 275,615 $ 303,633 $ 28,018 The decrease in accounts payable was primarily due to the lower volume of deliveries in the second quarter of fiscal 2012 compared to the fourth quarter of fiscal 2011. The decrease in the reserves is primarily related to various legal settlements. The decrease in accrued expenses is primarily due to decreases in property tax and payroll expenses and amortization of abandoned lease space accruals. The decrease in accrued compensation is primarily due to the payment of our fiscal year 2011 bonuses during the first quarter of 2012 only partially offset by two quarters of our fiscal 2012 bonus accrual.
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Customer deposits increased$4.3 million from$16.7 million atOctober 31, 2011 to$21.0 million atApril 30, 2012 . This increase is primarily attributable to the increase in backlog during the six months endedApril 30, 2012 . Liabilities from inventory not owned increased from$2.4 million atOctober 31, 2011 to$26.7 million atApril 30, 2012 . The increase is primarily due to the model home financing programs, described with the sale and leaseback discussion under "Capital Resources and Liquidity". Offsetting the increase, was a decrease due to the take-down of properties in the Southwest and West during the period, which had a specific performance purchase obligation.
Accrued interest decreased
RESULTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED
Total revenues
Compared to the same prior period, revenues increased/(decreased) as follows: Three Months Ended April 30, April 30, Percentage (Dollars in thousands) 2012 2011 Dollar Change Change Homebuilding: Sale of homes $ 312,494 $ 246,974 $ 65,520 26.5 % Land sales and other revenues 20,691 2,819 17,872 634.0 % Financial services 8,513 5,304 3,209 60.5 % Total revenues $ 341,698 $ 255,097 $ 86,601 33.9 % Six Months Ended April 30, April 30, Percentage (Dollars in thousands) 2012 2011 Dollar Change Change Homebuilding: Sale of homes $ 564,824 $ 482,859 $ 81,965 17.0 % Land sales and other revenues 31,270 12,407 18,863 152.0 % Financial services 15,203 12,398 2,805 22.6 % Total revenues $ 611,297 $ 507,664 $ 103,633 20.4 % Homebuilding For the three and six months endedApril 30, 2012 , sale of homes revenues increased$65.5 million or 26.5% and$82.0 million , or 17.0%, respectively, as compared to the same period of the prior year. This increase was primarily due to the number of home deliveries increasing 16.0% and 10.8% for the three and six months endedApril 30, 2012 , compared to the three and six months endedApril 30, 2011 . The average price per home increased to$300,000 in the three months endedApril 30, 2012 from$275,000 in the three months endedApril 30, 2011 . The average price per home increased to$292,000 in the six months endedApril 30, 2012 from$277,000 in the six months endedApril 30, 2011 . The fluctuations in average prices were a result of geographic and community mix of our deliveries, as well as price increases in individual communities. During fiscal 2012, we were also able to raise prices in approximately 40% of our communities. Land sales are ancillary to our homebuilding operations and are expected to continue in the future but may significantly fluctuate up or down. For further details on the increase in land sales and other revenues, see the section titled "Land Sales and Other Revenues" below.
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Information on homes delivered by segment is set forth below:
Three Months Ended April 30, Six Months Ended April 30, (Dollars in thousands) 2012 2011 % Change 2012 2011 % Change Northeast: Dollars $ 49,834 $ 36,126 37.9 % $ 82,911 $ 79,410 4.4 % Homes 115 82 40.2 % 191 183 4.4 % Mid-Atlantic: Dollars $ 64,432 $ 46,643 38.1 % $ 117,545 $ 92,906 26.5 % Homes 157 127 23.6 % 283 248 14.1 % Midwest: Dollars $ 23,590 $ 17,466 35.1 % $ 41,747 $ 31,500 32.5 % Homes 109 89 22.5 % 189 170 11.2 % Southeast: Dollars $ 21,462 $ 16,684 28.6 % $ 41,587 $ 32,188 29.2 % Homes 93 73 27.4 % 180 141 27.7 % Southwest: Dollars $ 114,284 $ 97,339 17.4 % $ 205,437 $ 184,566 11.3 % Homes 446 403 10.7 % 834 763 9.3 % West: Dollars $ 38,892 $ 32,716 18.9 % $ 75,597 $ 62,289 21.4 % Homes 123 125 (1.6 )% 255 239 6.7 %
Consolidated total:
Dollars $ 312,494 $ 246,974 26.5 % $ 564,824 $ 482,859 17.0 % Homes 1,043 899 16.0 % 1,932 1,744 10.8 % Unconsolidated joint ventures Dollars $ 77,066 $ 29,291 163.1 % $ 129,466 $ 51,825 149.8 % Homes 164 68 141.2 % 287 115 149.6 % Totals: Housing revenues $ 389,560 $ 276,265 41.0 % $ 694,290 $ 534,684 29.9 % Homes delivered 1,207 967 24.8 % 2,219 1,859 19.4 % The overall increase in housing revenues and deliveries during the three and six months endedApril 30, 2012 , as compared to the same periods of the prior year, was primarily attributed to an increase in sales pace per community from 5.5 to 8.2 for the three months endedApril 30, 2011 and 2012, respectively, and from 9.9 to 13.1 for the six months endedApril 30, 2011 and 2012, respectively.
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An important indicator of our future results are recently signed contracts and our home contract backlog for future deliveries. Our sales contracts and homes in contract backlog by segment are set forth below: Net Contracts (1) for the Contract Backlog as of Six Months Ended April 30, April 30, (Dollars in thousands) 2012 2011 2012 2011 Northeast: Dollars $ 83,085 $ 94,829 $ 114,148 $ 106,387 Homes 194 217 268 249 Mid-Atlantic: Dollars $ 131,744 $ 107,888 $ 151,456 $ 113,349 Homes 318 289 360 274 Midwest: Dollars $ 73,839 $ 32,852 $ 79,138 $ 38,592 Homes 349 163 386 215 Southeast: Dollars $ 63,776 $ 38,985 $ 52,261 $ 27,450 Homes 273 166 217 107 Southwest: Dollars $ 270,388 $ 189,796 $ 152,629 $ 99,358 Homes 1,053 801 550 375 West: Dollars $ 91,876 $ 54,705 $ 49,319 $ 19,946 Homes 279 202 140 73 Consolidated total: Dollars $ 714,708 $ 519,055 $ 598,951 $ 405,082 Homes 2,466 1,838 1,921 1,293
Unconsolidated joint ventures:
Dollars $ 181,040 $ 77,116 $ 163,842 $ 108,207 Homes 388 178 377 258 Totals: Dollars $ 895,748 $ 596,171 $ 762,793 $ 513,289 Homes 2,854 2,016 2,298 1,551
(1) Net contracts are defined as new contracts executed during the period for the purchase of homes, less cancellations of contracts in the same period.
In the first half of 2012, our open for sale community count decreased to 177 from 192 atOctober 31, 2011 , which is the net result of opening 26 new communities and closing 41 communities since the beginning of fiscal 2012. Our reported level of sales contracts (net of cancellations) has been impacted by an increase in the pace of sales in most of the Company's segments, due to better market conditions and lower interest rates on mortgages during the first half of fiscal 2012 as compared to the same period in the prior year. Contracts per average active selling community for the six months endedApril 30, 2012 were 13.1 compared to 9.9 of the same period in the prior year, demonstrating an increase in sales pace.
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Cancellation rates represent the number of cancelled contracts in the quarter divided by the number of gross sales contracts executed in the quarter. For comparison, the following are historical cancellation rates, excluding unconsolidated joint ventures:
Quarter 2012 2011 2010 2009 2008 First 21% 22% 21% 31% 38% Second 16% 20% 17% 24% 29% Third 18% 23% 23% 32% Fourth 21% 24% 24% 42%
Another common and meaningful way to analyze our cancellation trends is to compare the number of contract cancellations as a percentage of beginning backlog. The following table provides this historical comparison, excluding unconsolidated joint ventures:
Quarter 2012 2011 2010 2009 2008 First 18% 18% 13% 22% 16% Second 21% 22% 17% 31% 24% Third 20% 15% 23% 20% Fourth 18% 25% 20% 30% Historically, most cancellations occur within the legal rescission period, which varies by state but is generally less than two weeks after the signing of the contract. Cancellations also occur as a result of a buyer's failure to qualify for a mortgage, which generally occurs during the first few weeks after signing. However, beginning in fiscal 2007, we started experiencing higher than normal numbers of cancellations later in the construction process. These cancellations were related primarily to falling prices, sometimes due to new discounts offered by us and other builders, leading the buyer to lose confidence in their contract price and due to tighter mortgage underwriting criteria leading to some customers' inability to be approved for a mortgage loan. In some cases, the buyer will walk away from a significant nonrefundable deposit that we recognize as other revenues. Our cancellation rate based on gross sales contracts for the second quarter of fiscal 2012 is the lowest it has been since before 2008 and below what we believe to be a more normalized level of 20%. Our cancellation rate as a percentage of beginning backlog for the second quarter of 2012 is closer to more normalized levels and is slightly higher when compared to the percentage in the fourth quarter of fiscal 2011. Given market conditions, it is difficult to predict if this trend will continue.
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"Total cost of sales" includes expenses for consolidated housing and land and lot sales, including inventory impairment loss and land option write-offs (defined as "land charges" in the tables below). A breakout of such expenses for housing sales and housing gross margin is set forth below: Three Months Ended Six Months Ended April 30, April 30, (Dollars in thousands) 2012 2011 2012 2011 Sale of homes $ 312,494 $ 246,974 $ 564,824 $ 482,859
Cost of sales, net of impairment reversals
and excluding interest 258,034 210,463
468,608 406,377
Homebuilding gross margin, before
cost of sales interest expense and
land charges 54,460 36,511
96,216 76,482
Cost of sales interest expense,
excluding land sales interest expense 9,715 13,956
20,651 27,449
Homebuilding gross margin, after cost
of sales interest expense, before
land charges 44,745 22,555 75,565 49,033 Land charges 3,216 16,925 6,541 30,450
Homebuilding gross margin, after cost
of sales interest expense and land charges
Gross margin percentage, before cost
of sales interest expense and land charges 17.4 % 14.8 %
17.0 % 15.8 %
Gross margin percentage, after cost of
sales interest expense, before land charges 14.3 % 9.1 %
13.4 % 10.2 %
Gross margin percentage, after cost of
sales interest expense and land charges 13.3 % 2.3 % 12.2 % 3.8 % 45
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Cost of sales expenses as a percentage of consolidated home sales revenues are presented below: Three Months Ended Six Months Ended April 30, April 30, 2012 2011 2012 2011 Sale of homes 100.0 % 100.0 % 100.0 % 100.0 %
Cost of sales, net of impairment reversals
and excluding interest:
Housing, land and development costs 71.1 % 71.9 % 71.1 % 71.4 % Commissions 3.5 % 3.9 % 3.5 % 3.7 % Financing concessions 1.8 % 2.1 % 1.8 % 2.1 % Overheads 6.2 % 7.3 % 6.6 % 7.0 % Total cost of sales, before interest expense and land charges 82.6 % 85.2 % 83.0 % 84.2 % Gross margin percentage, before cost of
sales interest expense and land charges 17.4 % 14.8 %
17.0 % 15.8 %
Cost of sales interest 3.1 % 5.7 % 3.6 % 5.6 % Gross margin percentage, after cost of sales interest expense and before land charges 14.3 % 9.1 % 13.4 % 10.2 % We sell a variety of home types in various communities, each yielding a different gross margin. As a result, depending on the mix of communities delivering homes, consolidated gross margin may fluctuate up or down. Total homebuilding gross margins, before interest expense and land impairment and option write off charges, increased to 17.4% during the three months endedApril 30, 2012 , compared to 14.8% for the same period last year and increased to 17.0% during the six months endedApril 30, 2012 compared to 15.8% for the same period last year. The increase in gross margin percentage is primarily due to the mix of higher margin homes delivered in the second quarter of 2012 compared to the same period of the prior year. We have begun to see an increase in the pace of sales in some of our markets and, as a result, in some communities we have been able to increase base prices and increase lot premiums, without adversely impacting the sales pace. In addition, we are currently delivering more homes in communities where we acquired the land more recently with better pricing. Reflected as inventory impairment loss and land option write-offs in cost of sales ("land charges"), we have written-off or written-down certain inventories totaling$3.2 million and$16.9 million during the three months endedApril 30, 2012 and 2011, respectively, and$6.5 million and$30.4 million during the six months endedApril 30, 2012 and 2011, respectively, to their estimated fair value. During the three and six months endedApril 30, 2012 , we wrote-off residential land options and approval and engineering costs amounting to$1.1 million and$1.3 million compared to$0.6 million and$7.3 million for the three and six months endedApril 30, 2011 , which are included in the total land charges discussed above. When a community is redesigned or abandoned, engineering costs are written-off. Option, approval and engineering costs are written-off when a community's pro forma profitability is not projected to produce adequate returns on the investment commensurate with the risk and we believe it is probable we will cancel the option. Such write-offs were located in our Northeast, Mid-Atlantic, Midwest, and Southeast segments in the first half of fiscal 2012, and in our Northeast, Mid-Atlantic, Midwest, Southeast and West segments in the first half of fiscal 2011. We recorded inventory impairments of$2.1 million and$16.3 million during the three months endedApril 30, 2012 and 2011, respectively, and$5.2 million and$23.1 million during the six months endedApril 30, 2012 and 2011, respectively. Inventory impairments in the first half of 2012 and 2011 were lower than they had been in several years as we have begun to see some stabilization in prices and sales pace in some of our segments. It is difficult to predict if this trend will continue and, should it become necessary to further lower prices, or should the estimates or expectations used in determining estimated cash flows or fair value decrease or differ from current estimates in the future, we may need to recognize additional impairments. See "Notes to Condensed Consolidated Financial Statements" - Note 5 for an additional information of segment impairments.
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Land sales and other revenues consist primarily of land and lot sales. A breakout of land and lot sales is set forth below:
Three Months Ended Six Months Ended April 30, April 30, (In thousands) 2012 2011 2012 2011 Land and lot sales $ 18,310 $ - $ 26,914 $ 8,043 Cost of sales, excluding interest 13,529 - 20,382
5,516
Land and lot sales gross margin,
excluding interest 4,781 - 6,532
2,527
Land sales interest expense 3,602 - 5,142
2,133
Land and lot sales gross margin,
including interest $ 1,179 $ - $ 1,390 $ 394 Land sales are ancillary to our residential homebuilding operations and are expected to continue in the future but may significantly fluctuate up or down. Although we budget land sales, they are often dependent upon receiving approvals and entitlements, the timing of which can be uncertain. As a result, projecting the amount and timing of land sales is difficult. There were several land sales in the three months endedApril 30, 2012 compared to none in the same period of the prior year, which resulted in an increase of$18.3 million in land sales revenue. There were also several land sales for the six months endedApril 30, 2012 compared to only a few in the same period of the prior year, which resulted in an increase of$18.9 million in land sales revenue. Land sales and other revenues increased$17.9 million and$18.9 million</money> for the three and six months ended April 30, 2012 , compared to the same period in the prior year. Other revenues include income from contract cancellations where the deposit has been forfeited due to contract terminations, interest income, cash discounts, buyer walk-aways and miscellaneous one-time receipts. For the three and six months endedApril 30, 2012 , compared to the three and six months endedApril 30, 2011 , there were minor fluctuations in other revenues, resulting in a net decrease of$0.4 million for the three months and no change for the six months, which is offsetting the increase in land sales revenue, described above.
Homebuilding Selling, General and Administrative
Homebuilding selling, general and administrative expenses decreased$4.7 million and$11.7 million for the three and six months endedApril 30, 2012 compared to the same period last year as we have continued to reduce these costs through headcount reduction, administration consolidation, and other cost saving measures. In addition, homebuilding selling, general and administrative as a percentage of homebuilding revenues improved to 10.5% and 11.5% for the three and six months endedApril 30, 2012 compared to 15.9% and 16.2% for the three and six months endedApril 30, 2011 .
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HOMEBUILDING OPERATIONS BY SEGMENT
Segment Analysis
Three Months Ended April 30, (Dollars in thousands, except average sales price) 2012 2011
Variance Variance %
Northeast
Homebuilding revenue $ 51,775 $ 36,643 $ 15,132 41.3 % Loss before income taxes $ (125 ) $ (20,086 ) $ 19,961 (99.4 )% Homes delivered 115 82 33 40.2 % Average sales price $ 433,339 $ 440,549 $ (7,210 ) (1.6 )% Contract cancellation rate 21.3 % 13.1 %
8.2 %
Mid-Atlantic
Homebuilding revenue $ 64,776 $ 46,840 $ 17,936 38.3 % Income (loss) before income taxes $ 5,058 $ (5,830 ) $ 10,888 (186.8 )% Homes delivered 157 127 30 23.6 % Average sales price $ 410,395 $ 367,268 $ 43,127 11.7 % Contract cancellation rate 22.7 % 29.6 % (6.9 )% Midwest Homebuilding revenue $ 23,631 $ 17,484 $ 6,147 35.2 % Loss before income taxes $ (91 ) $ (2,407 ) $ 2,316 (96.2 )% Homes delivered 109 89 20 22.5 % Average sales price $ 216,422 $ 196,247 $ 20,175 10.3 % Contract cancellation rate 12.7 % 16.9 % (4.2 )% Southeast Homebuilding revenue $ 36,346 $ 16,918 $ 19,428 114.8 % Loss before income taxes $ (3,876 ) $ (3,660 ) $ (216 ) 5.9 % Homes delivered 93 73 20 27.4 % Average sales price $ 230,774 $ 228,548 $ 2,226 1.0 % Contract cancellation rate 13.6 % 20.3 % (6.7 )% Southwest Homebuilding revenue $ 114,716 $ 99,248 $ 15,468 15.6 % Income before income taxes $ 8,235 $ 6,469 $ 1,766 27.3 % Homes delivered 446 403 43 10.7 % Average sales price $ 256,242 $ 241,536 $ 14,706 6.1 % Contract cancellation rate 14.6 % 19.4 % (4.8 )% West Homebuilding revenue $ 42,011 $ 32,724 $ 9,287 28.4 % Loss before income taxes $ (2,948 ) $ (8,394 ) $ 5,446 (64.9 )% Homes delivered 123 125 (2 ) (1.6 )% Average sales price $ 316,195 $ 261,728 $ 54,467 20.8 % Contract cancellation rate 16.8 % 18.5 % (1.7 )% 48
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Six Months Ended April 30, (Dollars in thousands, except average sales price) 2012 2011
Variance Variance %
Northeast
Homebuilding revenue $ 93,307 $ 81,984 $ 11,323 13.8 % Loss before income taxes $ (5,773 ) $ (34,724 ) $ 28,951 (83.4 )% Homes delivered 191 183 8 4.4 % Average sales price $ 434,089 $ 433,934 $ 155 0.0 % Contract cancellation rate 27.6 % 16.5 %
11.1 %
Mid-Atlantic
Homebuilding revenue $ 119,171 $ 93,262 $ 25,909 27.8 % Income (loss) before income taxes $ 7,669 $ (8,989 ) $ 16,658 (185.3 )% Homes delivered 283 248 35 14.1 % Average sales price $ 415,353 $ 374,621 $ 40,732 10.9 % Contract cancellation rate 25.7 % 29.5 % (3.8 )% Midwest Homebuilding revenue $ 41,829 $ 31,574 $ 10,255 32.5 % Loss before income taxes $ (1,247 ) $ (4,333 ) $ 3,086 (71.2 )% Homes delivered 189 170 19 11.2 % Average sales price $ 220,884 $ 185,294 $ 35,590 19.2 % Contract cancellation rate 12.5 % 19.3 % (6.8 )% Southeast Homebuilding revenue $ 56,555 $ 32,438 $ 24,117 74.3 % Loss before income taxes $ (6,733 ) $ (6,680 ) $ (53 ) 0.8 % Homes delivered 180 141 39 27.7 % Average sales price $ 231,039 $ 228,284 $ 2,755 1.2 % Contract cancellation rate 13.9 % 19.4 % (5.5 )% Southwest Homebuilding revenue $ 206,540 $ 190,641 $ 15,899 8.3 % Income before income taxes $ 12,785 $ 11,872 $ 913 7.7 % Homes delivered 834 763 71 9.3 % Average sales price $ 246,327 $ 241,895 $ 4,432 1.8 % Contract cancellation rate 16.5 % 20.1 % (3.6 )% West Homebuilding revenue $ 78,763 $ 65,473 $ 13,290 20.3 % Loss before income taxes $ (3,920 ) $ (17,008 ) $ 13,088 (77.0 )% Homes delivered 255 239 16 6.7 % Average sales price $ 296,459 $ 260,623 $ 35,836 13.8 % Contract cancellation rate 18.9 % 19.8 % (0.9 )% 49
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Homebuilding Results by Segment
Northeast - Homebuilding Revenues increased 41.3% for the three months endedApril 30, 2012 compared to the same period of the prior year. The increase for the three months endedApril 30, 2012 was attributed to a 40.2% increase in homes delivered and a$1.4 million increase in land sales and other revenue, partially offset by a 1.6% decrease in average sales price. The decrease in average sales price was the result of the mix of communities delivering in the three months endedApril 30, 2012 compared to the same period of 2011. Loss before income taxes decreased$20.0 million compared to the prior year to a loss of$0.1 million for the three months endedApril 30, 2012 . This decrease is mainly due to a$12.0 million decrease in inventory impairment losses and land option write-offs recorded for the three months endedApril 30, 2012 . In addition, selling, general and administrative costs were down$2.1 million due to decreased salaries from headcount reductions and other overhead cost savings. Also, gross margin percentage before interest expense increased for the three months endedApril 30, 2012 . Homebuilding Revenues increased 13.8% for the six months endedApril 30, 2012 compared to the same period of the prior year. The increase for the six months endedApril 30, 2012 was attributed to a 4.4% increase in homes delivered and by a$7.8 million increase in land sales and other revenue, while average sales prices were flat. Loss before income taxes decreased$29.0 million compared to the prior year to a loss of$5.8 million for the six months endedApril 30, 2012 . This decrease is mainly due to a$18.1 million decrease in inventory impairment losses and land option write-offs recorded for the six months endedApril 30, 2012 . In addition, selling, general and administrative costs were down$4.5 million due to decreased salaries from headcount reductions and other overhead cost savings. In addition, gross margin percentage before interest expense increased for the six months endedApril 30, 2012 . Mid-Atlantic - Homebuilding revenues increased 38.3% for the three months endedApril 30, 2012 compared to the same period in the prior year. The increase was primarily due to a 23.6% increase in homes delivered and an 11.7% increase in average sales price for the three months endedApril 30, 2012 . The increase in average sales prices was the result of the mix of communities delivering in the three months endedApril 30, 2012 compared to the same period of 2011. Income (loss) before income taxes decreased$10.9 million to a profit of$5.1 million for the three months endedApril 30, 2012 due primarily to the increase in homebuilding revenues discussed above, combined with a$1.7 million decrease in inventory impairment losses and land option write-offs and a$0.8 million decrease in selling, general and administrative costs for the three months endedApril 30, 2012 . In addition, gross margin percentage before interest expense increased for the three months endedApril 30, 2012 . Homebuilding revenues increased 27.8% for the six months endedApril 30, 2012 compared to the same period in the prior year. The increase was primarily due to a 14.1% increase in homes delivered and a 10.9% increase in average sales price for the six months endedApril 30, 2012 . The increase in average sales prices was the result of the mix of communities delivering in the six months endedApril 30, 2012 compared to the same period of 2011. Income (loss) before income taxes decreased$16.7 million to a profit of$7.7 million for the six months endedApril 30, 2012 due primarily to the increase in homebuilding revenues discussed above, combined with a$2.0 million decrease in inventory impairment losses and land option write-offs and a$2.0 million decrease in selling, general and administrative costs for the six months endedApril 30, 2012 . Also, gross margin percentage before interest expense increased for the six months endedApril 30, 2012 . Midwest - Homebuilding revenues increased 35.2% for the three months endedApril 30, 2012 compared to the same period in the prior year. The increase was primarily due to a 22.5% increase in homes delivered and a 10.3% increase in average sales price for the three months endedApril 30, 2012 . The increase in average sales price was the result of the mix of communities delivering in the three months endedApril 30, 2012 compared to the same period of 2011. Loss before income taxes decreased$2.3 million to a loss of$0.1 million for the three months endedApril 30, 2012 . The decrease in the loss for the three months endedApril 30, 2012 was primarily due to an increase in gross margin percentage before interest expense for the period and a$0.3 million decrease in inventory impairment losses and land option write-offs. Homebuilding revenues increased 32.5% for the six months endedApril 30, 2012 compared to the same period in the prior year. The increase was primarily due to a 11.2% increase in homes delivered and a 19.2% increase in average sales price for the six months endedApril 30, 2012 . The increase in average sales price was the result of the mix of communities delivering in the six months endedApril 30, 2012 compared to the same period of 2011.
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Loss before income taxes decreased$3.1 million to a loss of$1.2 million for the six months endedApril 30, 2012 . The decrease in the loss for the six months endedApril 30, 2012 was primarily due to an increase in gross margin percentage before interest expense for the period and a$0.2 million decrease in inventory impairment losses and land option write-offs. Southeast - Homebuilding revenues increased 114.8% for the three months endedApril 30, 2012 compared to the same period in the prior year. The increase for the three months endedApril 30, 2012 was attributed to the 27.4% increase in homes delivered, by a 1.0% increase in average sales price and was further impacted by a$14.7 million increase in land sales and other revenue. The increase in average sales price was primarily due to the different mix of communities delivering in 2012 compared to 2011. Loss before income taxes increased$0.2 million to a loss of$3.9 million for the three months endedApril 30, 2012 primarily due to an increase in inventory impairment losses and land option write-offs of$2.5 million , offset by a$1.1 million decrease in selling, general and administrative costs, partially offset by a decrease in gross margin percentage before interest expense. Homebuilding revenues increased 74.3% for the six months endedApril 30, 2012 compared to the same period in the prior year. The increase for the six months endedApril 30, 2012 was attributed to the 27.7% increase in homes delivered, by a 1.2% increase in average sales price and was further impacted by a$14.7 million increase in land sales and other revenue. The increase in average sales price was primarily due to the different mix of communities delivering in 2012 compared to 2011. Loss before income taxes increased$0.1 million to a loss of$6.7 million for the six months endedApril 30, 2012 primarily due to an increase in inventory impairment losses and land option write-offs of$2.7 million , offset by a$1.6 million decrease in selling, general and administrative costs, partially offset by a decrease in gross margin percentage before interest expense. Southwest - Homebuilding revenues increased 15.6% for the three months endedApril 30, 2012 compared to the same period in the prior year. The increase was primarily due to a 10.7% increase in homes delivered and a 6.1% increase in average sales price for the three months endedApril 30, 2012 , as a result of the different mix of communities delivering in 2012 compared to the same period in 2011. Income before income taxes increased$1.8 million to$8.2 million for the three months endedApril 30, 2012 . The increase was primarily due to the increase in homebuilding revenues discussed above. Gross margin percentage before interest expense for the three months endedApril 30, 2012 was relatively flat compared to the same period of the prior year. Homebuilding revenues increased 8.3% for the six months endedApril 30, 2012 compared to the same period in the prior year. The increase was primarily due to a 9.3% increase in homes delivered and a 1.8% increase in average sales price for the six months endedApril 30, 2012 , as a result of the different mix of communities delivering in the six months endedApril 30, 2012 compared to the same period in 2011. This was offset by a$5.0 million decrease in land sale and other revenue for the six months endedApril 30, 2012 compared to the same period of the prior year. Income before income taxes increased$0.9 million to$12.8 million for the six months endedApril 30, 2012 . The increase was primarily due to a decrease of$0.5 million in selling, general and administrative costs for the six months endedApril 30, 2012 compared to the same period of the prior year. Gross margin percentage before interest expense for the six months endedApril 30, 2012 was relatively flat compared to the same period of the prior year. West - Homebuilding revenues increased 28.4% for the three months endedApril 30, 2012 compared to the same period in the prior year. The increase for the three months endedApril 30, 2012 was attributed to a 20.8 % increase in average sales price, due to the different mix of communities delivering in the three months endedApril 30, 2012 compared to the same period of the prior year, as well as a$3.1 million increase in land sales and other revenue for the three months endedApril 30, 2012 compared to the same period of the prior year. Loss before income taxes decreased$5.4 million to a loss of$2.9 million for the three months endedApril 30, 2012 . The decreased loss for the six months endedApril 30, 2012 was primarily due to the impact of the increase in homebuilding revenue discussed above, a$2.2 million decrease in inventory impairments and land option write-offs taken and a$1.5 million decrease in selling, general and administrative costs for the three months endedApril 30, 2012 compared to the same period in the prior year. Also, gross margin percentage before interest expense for the three months endedApril 30, 2012 was flat compared to the same period of the prior year. Homebuilding revenues increased 20.3% for the six months endedApril 30, 2012 compared to the same period in the prior year. The increase for the six months endedApril 30, 2012 was attributed to a 6.7% increase in homes delivered, along with a 13.8% increase in average sales price, due to the different mix of communities delivering in the six months endedApril 30, 2012 compared to the same period of the prior year. Loss before income taxes decreased$13.1 million to a loss of$3.9 million for the six months endedApril 30, 2012 . The decreased loss for the six months endedApril 30, 2012 was primarily due to a$6.3 million decrease in inventory impairments and land option write-offs taken and a$3.3 million decrease in selling, general and administrative costs for the six months endedApril 30, 2012 compared to the same period in the prior year. Gross margin percentage before interest expense for the six months endedApril 30, 2012 was flat compared to the same period of the prior year.
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Financial Services
Financial services consist primarily of originating mortgages from our homebuyers, selling such mortgages in the secondary market, and title insurance activities. We use mandatory investor commitments and forward sales of mortgage-backed securities ("MBS") to hedge our mortgage-related interest rate exposure on agency and government loans. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk associated with MBS forward commitments and loan sales transactions is managed by limiting our counterparties to investment banks, federally regulated bank affiliates and other investors meeting our credit standards. Our risk, in the event of default by the purchaser, is the difference between the contract price and fair value of the MBS forward commitments. In an effort to reduce our exposure to the marketability and disposal of nonagency and nongovernmental loans, we no longer originate Alt-A or sub-prime loans. As Alt-A and sub-prime originations were eliminated, we have seen an increase in our level of Federal Housing Administration and Veterans Administration ("FHA/VA") loan origination. FHA/VA loans represented 45.5% and 50.4% for the six months ended April 30, 2012 and 2011, respectively, of our total loans. Profits and losses relating to the sale of mortgage loans are recognized when legal control passes to the buyer of the mortgage and the sales price is collected. During the three and six months ended April 30, 2012 , financial services provided a $3.2 million and $4.7 million pretax profit compared to $0.1 million and $1.8 million of pretax profit for the same period of fiscal 2011. Revenues were up 60.5% for the three months ended April 30, 2012 compared to the same period of the prior year and costs were up 4.0% for such period. Mortgage settlements and the average price of loans settled increased for the three months ended April 30, 2012 compared to the same period in the prior year, contributing to the increase in revenues. The slight increase in costs is attributed to the increase in the number of loans closed during such period. While revenues were up 22.6% for the six months ended April 30, 2012 compared to the same period of the prior year, costs were down 1.0% for such period. Mortgage settlements and the average price of loans settled increased for the six months ended April 30, 2012 compared to the same period in the prior year, contributing to the increase in revenues. The slight decrease in costs are due to the decrease in salaries from a reduction in headcount and other overhead cost savings, offset by the increase in costs associated with the increase in the number of loans closed during such period. In the market areas served by our wholly owned mortgage banking subsidiaries, approximately 75.3% and 76.2% of our non-cash homebuyers obtained mortgages originated by these subsidiaries during the three months ended April 30, 2012 and 2011, respectively, and 77.0% of our non-cash homebuyers obtained mortgages originated by these subsidiaries for both the six months ended April 30, 2012 and 2011, respectively. Servicing rights on new mortgages originated by us are sold with the loans.
Corporate General and Administrative
Corporate general and administrative expenses include the operations at our headquarters inRed Bank, New Jersey . These expenses include payroll, stock compensation, facility and other costs associated with our executive offices, information services, human resources, corporate accounting, training, treasury, process redesign, internal audit, construction services, and administration of insurance, quality and safety. Corporate general and administrative expenses increased to$12.3 million for the three months endedApril 30, 2012 compared to$12.0 million for the three months endedApril 30, 2011 , and decreased to$25.0 million for the six months endedApril 30, 2012 compared to$27.0 million for the six months endedApril 30, 2011 . The minor increase for the three months endedApril 30, 2012 from the prior year period is attributed to additional professional services for various corporate operations, while the decrease for the six months endedApril 30, 2012 from the prior year period is primarily due to a reduction in depreciation expense, resulting mainly from capitalized software becoming fully depreciated, coupled with no new significant additions of depreciable assets. Also contributing to the decrease was reduced salaries from headcount reduction and a continued tightening of variable spending.
Other Interest
Other interest increased$1.2 million for the three months endedApril 30, 2012 compared to the three months endedApril 30, 2011 and decreased$0.8 million for the six months endedApril 30, 2012 compared to the six months endedApril 30, 2011 . Our assets that qualify for interest capitalization (inventory under development) are less than our debt, and therefore a portion of interest not covered by qualifying assets must be directly expensed. For the three months endedApril 30, 2012 , our inventory balances for the qualifying assets have decreased enough to cause the amount of interest required to be directly expensed to increase. For the six months endedApril 30, 2012 , our inventory balances for the qualifying assets have decreased and our debt decreased, the net impact of which caused the amount of interest required to be directly expensed to decrease slightly.
Other Operations
Other operations consist primarily of miscellaneous residential housing operations expenses, senior rental residential property operations, rent expense for commercial office space, amortization of prepaid bond fees, noncontrolling interest relating to consolidated joint ventures, and corporate owned life insurance. Other operations increased to$1.0 million and$6.4 million for the three and six months endedApril 30, 2012 compared to$0.7 million and$1.6 million for the three and six months endedApril 30, 2011 . The minor increase for the three months endedApril 30, 2012 is due to lower life insurance proceeds offsetting expenses in the first half of fiscal 2012, compared to the prior year. The increase for the six months endedApril 30, 2012 was primarily due to$4.7 million of costs incurred from the debt exchange onNovember 1, 2011 . This debt exchange was accounted for as troubled debt restructuring, which requires any cost incurred associated with the exchange to be expensed as incurred. See Note 11 to the Condensed Consolidated Financial Statements.
52
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Gain on Extinguishment of Debt
For the three and six months endedApril 30, 2012 , our gain on extinguishment of debt was$27.0 million and$51.7 million , respectively. During the three months endedJanuary 31, 2012 , we repurchased in the open market a total of$44.0 million principal amount of various issues of our unsecured senior notes due 2016 for an aggregate purchase price of$19.0 million , plus accrued and unpaid interest. We recognized a gain of$24.7 million net of the write-off of unamortized discounts and fees related to these purchases, which represents the difference between the aggregate principal amounts of the notes purchased and the total purchase price. As noted above, the accounting for theNovember 1, 2011 debt exchange is being treated as a troubled debt restructuring. Under this accounting, the Company did not recognize any gain or loss on extinguishment of debt. During the three months endedApril 30, 2012 , we repurchased a total of$75.4 million principal amount of various issues of our unsecured notes due 2016 and 2017 for an aggregate purchase price of$51.7 million , plus accrued and unpaid interest. We recognized a gain of$23.3 million net of the write-off of unamortized discounts and fees related to these purchases, which represents the difference between the aggregate principal amounts of the notes purchased and the total purchase price. During the second quarter of fiscal 2012, we exchanged$9.1 million aggregate principal amount of our outstanding 8.625% Senior Notes due 2017 and$3.1 million aggregate principal amount of our 12.072% Senior Subordinated Amortizing Notes for Class A Common Stock, as discussed in Notes 11, 12 and 15 to the Condensed Consolidated Financial Statements. These transactions resulted in a gain on extinguishment of debt of$3.7 million for the three months endedApril 30, 2012 . In February of 2011, we purchased a portion of our subordinated notes ($97.9 million face for$98.6 million cash in a tender offer), and redeemed early the remainder of those notes ($57.8 million in debt for$58.1 million cash). In both transactions we paid a premium, incurred fees, and wrote off discounts and prepaid costs that we were amortizing over the term of notes. These transactions resulted in a loss of$1.6 million . Under the terms of our indentures governing our bonds, we have the right to make certain redemptions and, depending on market conditions and covenant restrictions, may do so from time to time. We may also continue to make additional debt purchases and/or exchanges for debt or equity from time to time through tender offers, open market purchases, private transactions or otherwise from time to time depending on market conditions and covenant restrictions
Income From
Income from unconsolidated joint ventures increased$4.7 million and$5.7 million , for the three and six months endedApril 30, 2012 , respectively. Income was$1.5 million for both the three and six months endedApril 30, 2012 , compared to a loss of$3.2 million and$4.2 million for the three and six months endedApril 30, 2011 , respectively. The decrease in the loss for both periods is due to five of our homebuilding joint ventures delivering more homes and reporting profits in the second quarter and year to date for fiscal 2012 that had reported losses in the prior year. In addition, we recognized profit from one of our land development joint ventures during the second quarter of fiscal 2012, which did not have any activity in the prior year.
Total Taxes
The total income tax expense was$1.2 million for the six months endedApril 30, 2012 primarily due to various state tax expenses and an increase in tax reserves for uncertain tax positions. Deferred federal and state income tax assets primarily represent the deferred tax benefits arising from 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 deferred tax assets 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. Given the continued downturn in the homebuilding industry in recent years, resulting in additional inventory and intangible impairments, we are in a three-year cumulative loss position as ofApril 30, 2012 . According to ASC 740, a three-year cumulative loss is significant negative evidence in considering whether deferred tax assets are realizable. Our valuation allowance for current and deferred taxes amounted to$906.8 million and$899.4 million atApril 30, 2012 andOctober 31, 2011 , respectively. The valuation allowance increased during the six months endedApril 30, 2012 primarily due to additional reserves recorded for the federal and state tax benefits related to the losses incurred during the period. 53
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Inflation
Inflation has a long-term effect, because increasing costs of land, materials, and labor result in increasing sale prices of our homes. In general, these price increases have been commensurate with the general rate of inflation in our housing markets and have not had a significant adverse effect on the sale of our homes. A significant risk faced by the housing industry generally is that rising house construction costs, including land and interest costs, will substantially outpace increases in the income of potential purchasers. Inflation has a lesser short-term effect, because we generally negotiate fixed price contracts with many, but not all, of our subcontractors and material suppliers for the construction of our homes. These prices usually are applicable for a specified number of residential buildings or for a time period of between three to twelve months. Construction costs for residential buildings represent approximately 56% of our homebuilding cost of sales.
Safe Harbor Statement
All statements in this Quarterly Report on Form 10-Q that are not historical facts should be considered "Forward-Looking Statements" within the meaning of the "Safe Harbor" provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Although we believe that our plans, intentions and expectations reflected in, or suggested by, such forward-looking statements are reasonable, we can give no assurance that such plans, intentions, or expectations will be achieved. Such risks, uncertainties and other factors include, but are not limited to:
· Changes in general and local economic and industry and business conditions and
impacts of the sustained homebuilding downturn;
· Adverse weather and other environmental conditions and natural disasters;
· Changes in market conditions and seasonality of the Company's business;
· Changes in home prices and sales activity in the markets where the Company
builds homes;
· Government regulation, including regulations concerning development of land,
the home building, sales and customer financing processes, tax laws and the
environment;
· Fluctuations in interest rates and the availability of mortgage financing;
· Shortages in, and price fluctuations of, raw materials and labor; · The availability and cost of suitable land and improved lots; · Levels of competition; · Availability of financing to the Company; · Utility shortages and outages or rate fluctuations;
· Levels of indebtedness and restrictions on the Company's operations and
activities imposed by the agreements governing the Company's outstanding indebtedness; · The Company's sources of liquidity; · Changes in credit ratings; · Availability of net operating loss carryforwards; · Operations through joint ventures with third parties;
· Product liability litigation, warranty claims and claims made by mortgage
investors; · Successful identification and integration of acquisitions;
· Changes in tax laws affecting the after-tax costs of owning a home;
· Significant influence of the Company's controlling stockholders; and · Geopolitical risks, terrorist acts and other acts of war. 54
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Certain risks, uncertainties, and other factors are described in detail in Part I, Item 1 "Business" and Part I, Item 1A "Risk Factors" in our Annual Report on Form 10-K for the year endedOctober 31, 2011 . Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason after the date of this Quarterly Report on Form 10-Q.
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