ITEM 3 - LEGAL PROCEEDINGS
We are involved in litigation arising in the ordinary course of business, none of which is expected to have a material adverse effect on us. Over the past several years, general liability insurance for homebuilding companies and their suppliers and subcontractors has become very difficult to obtain. The availability of general liability insurance has been limited due to a decreased number of insurance companies willing to write for the industry. In addition, those few insurers willing to write liability insurance have significantly increased the premium costs. The Company has been able to obtain general liability insurance but at higher premium costs with higher deductibles. The Company has been advised that a significant number of its subcontractors and suppliers have also had difficulty obtaining insurance that also provides coverage to the Company. While no assurance can be given, the Company believes that it will be able to continue to obtain coverage but at higher total costs.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of the year ended October 31, 2003 no matters were submitted to a vote of security holders.
Executive Officers of the Registrant
Information on executive officers of the registrant is incorporated herein from Part III, Item 10.
PART II
ITEM 5
ITEM 5 - MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS
Our Class A Common Stock is traded on the New York Stock Exchange and was held by 459 shareholders of record at January 5, 2004. There is no established public trading market for our Class B Common Stock, which was held by 334 shareholders of record at January 5 , 2004. In order to trade Class B Common Stock, the shares must be converted into Class A Common Stock on a one-for-one basis. The high and low sales prices for our Class A Common Stock were as follows for each fiscal quarter during the years ended October 31, 2003, 2002, and 2001:
Certain debt instruments to which we are a party contain restrictions on the payment of cash dividends. As a result of the most restrictive of these provisions, approximately $372.8 million of retained earnings was free of such restrictions at October 31, 2003. We have never paid a cash dividend nor do we currently intend to pay cash dividends.
ITEM 6
ITEM 6 - SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected financial data and should be read in conjunction with the financial statements included elsewhere in this Form 10-K. Per common share data and weighted average number of common shares outstanding reflect all stock splits.
Note: See Item 7
ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Critical Accounting Policies
Management believes that the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements:
Business Combinations - When we make an acquisition of another company, we use the purchase method of accounting in accordance with the Statement of Financial Accounting Standards (“SFAS”) No. 141 “Business Combinations” (“SFAS 141”). Under SFAS 141 (for acquisitions subsequent to June 30, 2001) and Accounting Principles Board (“APB”) Opinion 16 (for acquisitions prior to June 30, 2001) we record as our cost the estimated fair value of the acquired assets less liabilities assumed. Any difference between the cost of an acquired company and the sum of the fair values of tangible assets less liabilities is recorded as goodwill, indefinite or definite life intangibles. The reported income of an acquired company includes the operations of the acquired company from the date of acquisition.
Income Recognition from Home and Land Sales - Income from home and land sales are recorded when title is conveyed to the buyer, adequate cash payment has been received and there is no continued involvement.
Income Recognition from Mortgage Loans - Profits and losses relating to the sale of mortgage loans are recognized when legal control passes to the buyer and the sales price is collected.
Inventories - For inventories of communities under development, a loss is recorded when events and circumstances indicate impairment and the undiscounted future cash flows generated are less than the related carrying amounts. The impairment loss is based on discounted future cash flows generated from expected revenue, cost to complete including interest, and selling costs. Inventories and long-lived assets held for sale are recorded at the lower of cost or fair value less selling costs. Fair value is defined as the amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. 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.
Insurance Deductible Reserves - Our deductible is $150,000 per occurrence for worker’s compensation and general liability insurance. Reserves have been established based upon actuarial analysis of estimated future losses during 2003 and 2002.
Interest - Costs related to properties under development are capitalized during the land development and home construction period and expensed along with the associated cost of sales as the related inventories are sold. Costs related to properties not under development are charged to interest expense.
Land Options - Costs are capitalized when incurred and either included as part of the purchase price when the land is acquired or charged to operations when we determine we will not exercise the option. In accordance with Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 (“FIN 46”)“Consolidation of Variable Interest Entities” an interpretation of Accounting Research Bulletin No. 51, SFAS No. 49 “Accounting for Product Financing Arrangements” (“SFAS 49”), SFAS No. 98 “Accounting for Leases” (“SFAS 98”), and Emerging Issues Task Force (“EITF”) No. 97-10 “The Effects of Lessee Involvement in Asset Construction” (“EITF 97-10”), we record on the Consolidated Balance Sheet specific performance options, options with variable interest entities, and other options under Consolidated inventory not owned with the offset to Liabilities from inventory not owned, Minority interest from inventory not owned and Minority interest from consolidated joint ventures.
Intangible Assets - The intangible assets recorded on our balance sheet are goodwill, tradenames, architectural designs, distribution processes, and contractual agreements with both definite and indefinite lives resulting from company acquisitions. We no longer amortize goodwill or indefinite life intangibles, but instead assess them periodically for impairment. We performed such assessments utilizing a fair value approach as of October 31, 2003 and 2002, and determined that no impairment of intangibles existed. We are amortizing the definite life intangibles over their expected useful life, ranging from three to seven years.
Post Development Completion 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 and is recorded in accounts payable and other liabilities in the accompanying consolidated balance sheets.
Capital Resources and Liquidity
Our operations consist primarily of residential housing development and sales in our Northeast Region (New Jersey, southern New York state, Pennsylvania, and Ohio), our Southeast Region (Washington D.C., Maryland, Virginia, West Virginia, North Carolina, South Carolina, and Florida), our Southwest Region (Texas and Arizona), and our West Region
(California). During the year ended October 31, 2002, we substantially liquidated our operations in the Mid-South. In addition, we provide financial services to our homebuilding customers.
Our cash uses during the twelve months ended October 31, 2003 were for operating expenses, increases in housing inventories, construction, income taxes, interest, the repurchase of common stock, the purchase of senior notes, the paydown of our revolving credit facility, and the acquisition of four homebuilders. We provided for our cash requirements from housing and land sales, the revolving credit facility, the issuance of $150 million Senior Subordinated Notes, financial service revenues, and other revenues. We believe that these sources of cash are sufficient to finance our working capital requirements and other needs.
At October 31, 2003, there was no cash balance outstanding under our $590 million revolving credit facility and we had approximately $120 million of cash. At October 31, 2003, we had issued $130.3 million of letters of credit which reduces cash available under our revolving credit facility.
Cash requirements for fiscal 2004 are projected to increase as we continue to open new communities and fund organic growth. We anticipate moderate usage under the existing revolving credit facility to replenish inventory associated with the construction of new homes. On November 3, 2003, we issued 6 1/2% Senior Notes which generated proceeds of approximately $215 million. The purpose of this issuance was to fund existing operations and to ensure that we maintain ample liquidity to fund future growth.
Our net income historically does not approximate cash flow from operating activities. The difference between net income and cash flow from operating activities is primarily caused by changes in receivables, prepaid and other assets, interest and other accrued liabilities, accounts payable, inventory levels, mortgage loans and liabilities, and non-cash charges relating to depreciation, the writeoff of computer software costs, and impairment losses. In 2001, a portion of the difference was also due to goodwill amortization. When we are expanding our operations, which was the case in fiscal 2003 and 2002, inventory levels, receivables, prepaids and other assets increase causing cash flow from operating activities to decrease. Liabilities also increase as operations expand. The increase in liabilities partially offsets the negative effect on cash flow from operations caused by the increase in inventory levels, receivables, prepaids and other assets. As our mortgage warehouse loan asset increases, cash flow from financing operations decrease. Conversely, as such warehouse loan assets decrease, cash flow from financing operations increase. Depreciation, intangible amortization and impairment losses always increase cash flow from operating activities since they are non-cash charges to operations.
On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 2 million shares of Class A Common Stock. As of October 31, 2003, 903,938 shares have been purchased under this program, of which 297,619 and 147,619 were repurchased during the twelve months ended October 31, 2003 and 2002, respectively. In addition, in 2003,we retired 0.8 million shares that were held by a seller of a previous acquisition.
Our homebuilding bank borrowings are made pursuant to an amended and restated revolving credit agreement (the “Agreement”) that provides a revolving credit line and letter of credit line of $590 million through July 2006. Interest is payable monthly and at various rates of either the prime rate plus 0.275% or LIBOR plus 1.75%. In addition, we pay a fee equal to 0.350% per annum on the weighted average unused portion of the line. We believe that we will be able either to extend the Agreement beyond July 2006 or negotiate a replacement facility, but there can be no assurance of such extension or replacement facility. We currently are in compliance and intend to maintain compliance with the covenants under the Agreement. Each of our significant subsidiaries, except for our financial services subsidiaries and joint ventures, is a guarantor under the revolving credit agreement. As of October 31, 2003, there were no borrowings under the Agreement.
At October 31, 2003 we had $390.2 million of outstanding senior debt ($387.2 million, net of discount), comprised of $140.3 million 10 1/2% Senior Notes due 2007, $150 million 9 1/8% Senior Notes due 2009, and $100 million 8% Senior Notes due 2012. At October 31, 2003, we had $300 million outstanding senior subordinated debt comprised of $150 million 8 7/8% Senior Subordinated Notes due 2012, and $150 million 7 3/4% Senior Subordinated Notes due 2013. Each of our significant subsidiaries except for our financial services subsidiaries and joint ventures are a guarantor under the Senior Notes and Senior Subordinated Notes.
On January 22, 2002 we executed a $165 million five-year Term Loan. The Term Loan matures January 22, 2007, and bears interest at either the prime rate plus 1.25% or LIBOR plus 2.5%. Each of our significant subsidiaries except for our financial services subsidiaries and joint ventures is a guarantor under the Term Loan. At October 31, 2003, borrowings under the Term Loan were $115 million.
Our mortgage banking subsidiary’s warehousing agreement was amended and restated on July 31, 2003. Pursuant to the agreement, we may borrow up to $200 million. The agreement expires in July 2004 and interest is payable monthly at the Federal Funds Rate plus 1.375%. We believe that we will be able either to extend this agreement beyond July 2004 or negotiate a replacement facility, but there can be no assurance of such extension or replacement facility. As of October 31, 2003, the aggregate principal amount of all borrowings under this agreement was $166.7 million.
Total inventory increased $480.5 million during the twelve months ended October 31, 2003. This increase excluded the change in Consolidated Inventory Not Owned of $98 million consisting of specific performance options, options with variable interest entities, and other options that were added to our balance sheet in accordance with SFAS 49, SFAS 98, and EITF 97-10, and Variable Interest Entities in accordance with FIN 46. See the “Recent Accounting Pronouncements” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional explanation on FIN 46. Excluding the impact from acquisitions of $159.3 million, total inventory in our Northeast Region increased $129.4 million, the Southeast Region increased $75.9 million and our West Region increased $121.1 million. The increase in our existing regions was primarily the result of planned future organic growth. These increases were slightly offset by a $4.7 million decrease in our Southwest Region due to fewer active selling communities. Substantially all homes under construction or completed and included in inventory at October 31, 2003 are expected to be closed during the next twelve months. Most inventory completed or under development is financed through our line of credit, term loan, and senior subordinated indebtedness.
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 following table summarizes housing lots included in our total residential real estate:
Housing under contract at October 31, 2003 and October 31, 2002 was 5,761 homes and 3,857 homes, respectively, including our “build on your own lot” contracts not included in the above lot table.
The following table summarizes our started or completed unsold homes in active and substantially completed communities:
Receivables, deposits and notes increased $16.2 million to $42.5 million at October 31, 2003. The increase was primarily due to increased deposits and escrows related to construction activities and acquisitions in fiscal 2003. Deposits and escrows, and receivables from home sales amounted to $21.6 million and $4.1 million, respectively, at October 31, 2003.
Prepaid expenses and other assets increased $10.8 million to $97.4 million at October 31, 2003. The increase was primarily due to increases in joint ventures and prepaid project costs. We have entered into a few joint ventures with independent third parties to develop and sell land or to develop land to build and sell homes. At October 31, 2003 we have invested $23.2 million in joint ventures. We have no guarantees associated with these unconsolidated joint ventures. 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. At October 31, 2003, we have $34.2 million of prepaid project costs. Prepaid expenses and other assets also include debt issuance fees, prepaid insurance, non-qualified associate benefit plan assets and miscellaneous prepaids and assets.
Intangibles increased $57.3 million to $139.6 million at October 31, 2003. $82.7 million are categorized as goodwill and indefinite life intangibles. This amount resulted from company acquisitions prior to fiscal 2003. $57.0 million are categorized as definite life intangibles resulting from acquisitions made in fiscal 2003. To the extent the acquisition price was greater than the book value of tangible assets which were stepped up to fair values, purchase price premiums are classified as intangibles. Professionals were hired to appraise all acquired intangibles. Such appraisals resulted in all fiscal 2003 acquisition premiums to be categorized as definite life intangibles. See the “Critical Accounting Policies” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional explanation of intangibles. For tax purposes all our intangibles, except those resulting from an acquisition classified as a tax free exchange, are being amortized over 15 years.
Financial Services - Mortgage loans held for sale consist of residential mortgages receivable of which $223.9 million and $91.3 million at October 31, 2003 and October 31, 2002, respectively, are being temporarily warehoused and awaiting sale in the secondary mortgage market. The balance of mortgage loans held for sale are being held as an investment. We may incur risk with respect to mortgages that become 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 increased $31.7 million to $230 million at October 31, 2003. Accounts payable and other liabilities consist primarily of accounts payable, accrued expenses, accrued compensation and reserves, which amounted to $68.9 million, $46.8 million, $67.4 million, and $46.7 million, respectively, at October 31, 2003. The majority of the reserves consist of a warranty accrual for repair costs to homes over $1,000, for community amenities and land development infrastructure. We accrue for warranty costs at the time each home is closed and title and possession have been transferred to the homebuyer as part of cost of sales. In addition, we accrue for warranty costs under our $150,000 per occurrence general liability insurance deductibles as part of selling, general, and administration. Warranty accruals are based upon historical experience. At October 31, 2003 and 2002 the warranty and general liability accruals amounted to $39.5 million and $22.4 million, respectively.
Results of Operations
Total Revenues
Compared to the same prior period, revenues increased (decreased) as follows:
Homebuilding
Compared to the same prior period, housing revenues increased $667.7 million or 27.1% for the year ended October 31, 2003, increased $768.4 million or 45.4% for the year ended October 31, 2002, and increased $588.3 million or 53.2% for the year ended October 31, 2001. Housing revenues are recorded at the time when title is conveyed to the buyer, adequate cash payment has been received and there is no continued involvement.
Information on homes delivered by market area is set forth below:
(1) October 31, 2003 includes deliveries from our Texas, Ohio, and Arizona acquisitions beginning on November 1, 2002, January 1, 2003, April 1, 2003, and August 13, 2003, respectively.
(2) October 31, 2002 includes deliveries from our California acquisition beginning on January 10, 2002.
(3) October 31, 2001 includes deliveries from our Southeast Region acquisition beginning on January 24, 2001.
(4) Other includes operations from markets we have exited in recent years.
The increase in housing revenues during the year ended October 31, 2003 was primarily due to organic growth within our existing operations. Excluding acquisitions, housing revenues and average sales prices increased in all four of our regions combined by 16.8% and 10.9%, respectively. Deliveries increased 5.3% in all regions, combined after excluding deliveries for fiscal 2003 acquisitions. We realized increases in all regions except the Southeast. The decline in deliveries in the Southeast was due to delayed community openings because of severe weather conditions during the early part of fiscal 2003.
Unaudited quarterly housing revenues and net sales contracts by market area using base sales prices for the years ending October 31, 2003, 2002, and 2001 are set forth below:
An important indicator of our future results are recently signed contracts and our home contract backlog for future deliveries. Our contract backlog using base sales prices by market area is set forth below:
In the month of November 2003 we signed an additional 1,125 net contracts amounting to $312.9 million. Between our October 31, 2003 contract backlog and November 2003 net contracts, we have sold approximately 47% of our projected deliveries for fiscal 2004.
Cost of sales includes expenses for housing and land and lot sales. A breakout of such expenses for housing sales and housing gross margin is set forth below:
Cost of sales expenses as a percentage of home sales revenues are presented below:
We sell a variety of home types in various local communities, each yielding a different gross margin. As a result, depending on the mix of both the communities and of home types delivered, consolidated gross margin will fluctuate up or down. We achieved higher gross margins during the year ended October 31, 2003 compared to the same period last year. The consolidated gross margin increased 3.5% during the year ended October 31, 2003. This increased margin is primarily the result of higher sales prices. During the year ended October 31, 2003 our margins increased in all of our regions,
except in the Southwest Region where they remained flat. During the year ended October 31, 2002, our gross margin percentage increased 1.4% from the previous year. This increase was due to higher sales prices and lower costs resulting from our improvement initiatives. Gross margins for the year ended October 31, 2002 increased in our Southeast Region, West Region (excluding our California acquisition in fiscal 2002), and the Northeast Region. In the Southwest, gross margins declined very slightly in fiscal 2002. The dollar increases in gross margin for each of the three years ended October 31, 2003, 2002, and 2001 were attributed to increased sales, resulting from our acquisitions and increased deliveries in previously existing markets.
Homebuilding selling, general, and administrative expenses as a percentage of homebuilding revenues have averaged approximately 8.0% for the years ended October 31, 2003, 2002, and 2001. Such expenses increased to $253.7 million for the year ended October 31, 2003 and increased to $194.9 million for the year ended October 31, 2002 from $140.1 million for the previous year. The increased spending year over year was primarily due to our acquisitions and increased deliveries in previously existing markets.
We have written off or written down certain inventories totaling $5.2, $8.2, and $4.4 million during the years ended October 31, 2003, 2002, and 2001, respectively, to their estimated fair value. See “Notes to Consolidated Financial Statements - Note 11” for additional explanation. These write-offs and write-downs were incurred primarily because of the decision not to exercise certain options to purchase land, redesign of communities in planning, a change in the marketing strategy to liquidate a particular property or lower property values.
During the years ended October 31, 2003, 2002, and 2001, we wrote off residential land options and approval and engineering costs amounting to $4.5, $4.0, and $1.9 million, respectively, which are included in the total write-offs mentioned above. When a community is redesigned, abandonded engineering costs are written off. Option and approval and engineering costs are written off when a community’s proforma profitability does not produce adequate returns on the investment commensurate with the risk and we cancel the option. Such write-offs were located in our Northeast Region, Southeast Region, West Region, and Poland.
During the year ended October 31, 2003 we wrote down one community $0.7 million in our Southwest Region. This property was acquired as part of one of our acquisitions. A decision was made to liquidate this property resulting in lower sales prices.
The write-downs of residential inventory during the year ended October 31, 2002 were attributed to Poland and the Mid-South. The write-down in Poland was based upon changes in market conditions. In the Mid-South, land was written down based on a purchase offer. We have made a decision to discontinue selling homes in these two markets and offer the remaining lots for sale. The result of the above decisions was a reduction in inventory carrying amounts to fair value, resulting in a $4.2 million impairment loss.
During the year ended October 31, 2001, we wrote down two residential communities in the Northeast Region, and three in the Southeast Region. The write-down in the Northeast Region was attributed to two communities that were part of a large land acquisition, which resulted in a loss. The write-downs in the Southeast Region were based upon changes in market conditions. The result of the above decisions was a reduction in inventory carrying amounts to fair value, resulting in a $2.5 million impairment loss.
Land Sales and Other Revenues
Land sales and other revenues consist primarily of land and lot sales. A breakout of land and lot sales is set forth below:
Land and lot sales are incidental to our residential housing operations and are expected to continue in the future but may significantly fluctuate up or down.
Financial Services
Financial services consists primarily of originating mortgages from our homebuyers, selling such mortgages in the secondary market, and title insurance activities. During the years ended October 31, 2003, October 31, 2002, and October 31, 2001, financial services provided a $22.9, $18.2, and $10.0 million pretax profit, respectively. The increases in 2003, 2002, and 2001 were primarily due to a change in management, reduced costs, increased mortgage loan amounts, and the addition of mortgage operations from our acquisitions. In addition to our wholly-owned mortgage subsidiaries, customers obtained mortgages from our mortgage joint ventures in our Northeast Region (Ohio) in 2003, our West Region in 2002, and our Southwest Region in 2001. In the market areas served by our wholly-owned mortgage banking subsidiaries, approximately 74%, 71%, and 57% of our non-cash homebuyers obtained mortgages originated by these subsidiaries during the years ended October 31, 2003, 2002, and 2001, respectively. Servicing rights on new mortgages originated by us will be sold as the loans are closed.
Corporate General and Administrative
Corporate general and administrative expenses include the operations at our headquarters in Red Bank, New Jersey. Such expenses include our executive offices, information services, human resources, corporate accounting, training, treasury, process redesign, internal audit, construction services, and administration of insurance, quality, and safety. As a percentage of total revenues, such expenses were 2.0% for the years ended October 31, 2003 and 2002, respectively, and 2.5% for the year ended October 31, 2001. The percentage decrease from the year ended October 31, 2001 was due to increased housing revenues. Increases in corporate general and administrative dollar expenses are primarily attributed to higher employee incentives due to higher returns on equity.
Interest
Interest expense includes housing, and land and lot interest. Interest expense is broken down as follows:
Housing interest as a percentage of sale of home revenues amounted to 2.0%, 2.4%, and 3.0% for the years ended October 31, 2003, 2002, and 2001, respectively. These percentage decreases are primarily attributed to a decrease in debt leverage of our Company due to growth in equity from earnings and lower interest rates.
Other Operations
Other operations consist primarily of miscellaneous residential housing operations expenses, senior residential property operations, amortization of senior and senior subordinated note issuance expenses, earnout payments from homebuilding company acquisitions, amortization of the consultant’s agreement and the right of first refusal agreement from our California acquisition in fiscal 2002, minority interest relating to joint ventures, corporate-owned life insurance, expenses associated with the early extinguishment of debt, and certain contributions. Also reported in other operations are restructuring charges associated with our Southeast Region merger in fiscal 2001 and expenses associated with exiting our Mid-South market as well as the write off of costs associated with SAP in fiscal 2002, our enterprise-wide operating software. We were not successful in implementing SAP, due to the complexities and limitations in the software program.
Recent Accounting Pronouncements
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 elaborates on the existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must disclose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations does not apply to product warranties. The initial recognition and initial measurement provisions apply on a
prospective basis to guarantees issued or modified after December 31, 2002. The adoption of the initial recognition and initial measurement provisions of FIN 45 did not have a material effect on our financial position or results of operations. Our disclosure of guarantees is included in Note 20 to the consolidated financial statements.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (“SFAS 148”), which amends SFAS No. 123, “Accounting for Stock-Based Compensation”, (“SFAS 123”). The new standard provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. It also requires prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the affect of the method used on reported results. We have not elected to change to the fair value based method of accounting for stock-based employee compensation. We adopted the disclosure provisions of SFAS No. 148 in our second fiscal quarter ending April 30, 2003. Our disclosure of accounting for stock-based compensation is included in Notes 2 and 13 to the consolidated financial statements.
In January 2003, the FASB issued FIN 46. A Variable Interest Entity (“VIE”) is created when (i) the equity investment at risk is not sufficient to permit the entity from financing its activities without additional subordinated financial support from other parties or (ii) equity holders either (a) lack direct or indirect ability to make decisions about the entity, (b) are not obligated to absorb expected losses of the entity or (c) do not have the right to receive expected residual returns of the entity if they occur. If an entity is deemed to be a VIE, pursuant to FIN 46, an enterprise that absorbs a majority of the expected losses of the VIE is considered the primary beneficiary and must consolidate the VIE. FIN 46 is effective immediately for VIE’s created after January 31, 2003. Pursuant to FASB revision to FIN 46 (“FSP 46-6”), a public entity need not apply the provisions of FIN 46 to an interest held in a variable interest entity or potential variable interest entity until the end of the first interim or annual period ending after March 15, 2004, if the VIE was created before February 1, 2003, and the public entity has not issued financial statements reporting that VIE in accordance with FIN 46. We have elected to defer the application of FIN 46 to our interests in potential variable interest entities created prior to February 1, 2003 pursuant to FSP 46-6.
Based on the provisions of FIN 46, we have concluded that whenever we option land or lots from an entity and pay a non-refundable deposit, a VIE is created under condition (ii) (b) and (c) of the previous paragraph. We have been deemed to have provided subordinated financial support, which refers to variable interests that will absorb some or all of an entity’s expected theoretical losses if they occur. For each VIE created with a significant nonrefundable option fee, we will compute expected losses and residual returns based on the probability of future cash flows as outlined in FIN 46. If we are deemed to be the primary beneficiary of the VIE we will consolidate it on our balance sheet. The fair value of the VIE’s inventory will be reported as “Consolidated Inventory Not Owned - Variable Interest Entities”.
Management believes FIN 46 was not clearly thought out for application in the homebuilding industry for land and lot options. Under FIN 46, we can have an option and put down a small deposit as a percentage of the purchase price and still have to consolidate the entity. Our exposure to loss as a result of our involvement with the VIE is only the deposit, not it’s total assets consolidated on the balance sheet. In certain cases we will have to place inventory on our balance sheet the VIE has optioned to other developers. In addition, if the VIE has creditors, it’s debt will be placed on our balance sheet even though the creditors have no recourse against our Company. Based on these observations we believe consolidating VIE’s based on land and lot option deposits does not reflect the economic realities or risks of owning and developing land.
At October 31, 2003, we consolidated VIE’s created from February 1, 2003 to October 31, 2003 as a result of our options to purchase land or lots from the selling entities. We paid cash or issued letters of credit deposits to these eleven VIE’s totaling $13 million. Our option deposits represent our maximum exposure to loss. The fair value of the property owned by the VIE’s was $100.3 million of which $6.2 million was not optioned to our Company. Because we could not get the remainder of the selling entities to provide us with any financial information, the fair value of the optioned property less our cash deposits and liabilities from inventory not owned, which totaled $90.3 million, was reported on the balance sheet as “Minority interest from inventory not owned”. Creditors of these VIE’s have no recourse against our Company.
We will continue to secure land and lots using options. Including the deposits with the eleven VIE’s above, at October 31, 2003 we have total cash and letters of credit deposits amounting to approximately $168.6 million to purchase land and lots with a total purchase price of $2.3 billion. Not all our deposits are with VIE’s. The maximum exposure to loss is limited to the deposits although some deposits are refundable at our request or refundable if certain conditions are not met.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities that fall within the scope of SFAS No. 133, “Account-
ing for Derivative Instruments and Hedging Activities”. SFAS 149 also amends certain other existing pronouncements, which will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting. SFAS 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material effect on our financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 is effective for financial instruments entered into or modified after May 15, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the Statement and still existing at the beginning of the interim period of adoption. The adoption of SFAS 150 did not have a material effect on our financial position or results of operations.
Total Taxes
Total taxes as a percentage of income before taxes amounted to approximately 37.5%, 39.0%, and 40.1% for the years ended October 31, 2003, 2002, and 2001, respectively. The decrease in this percentage from 2002 to 2003 is primarily attributed to state tax reduction initiatives adopted during Fiscal 2003. In addition, as our pretax profits increase, permanent tax differences that remain relatively constant in dollars have less impact on increasing the effective Federal income tax rate. 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 for some reason 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 to recover the deferred tax assets. As a result, management is confident such deferred tax assets reflected in the balance sheet are recoverable regardless of future income. (See “Notes to Consolidated Financial Statements - Note 10” for an additional explanation of taxes.)
Inflation
Inflation has a long-term effect on us 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 costs, including land and interest costs, will substantially outpace increases in the income of potential purchasers. In recent years, in the price ranges in which our homes sell, we have not found this risk to be a significant problem.
Inflation has a lesser short-term effect on us because we generally negotiate fixed price contracts with 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 four to twelve months. Construction costs for residential buildings represent approximately 56% of our homebuilding cost of sales.
Mergers and Acquisitions
On January 10, 2002, we acquired a California homebuilder for a total purchase price of $196.5 million, of which $151.6 million was paid in cash and 2,208,738 shares of our Class A Common Stock were issued. At the date of acquisition we also paid off approximately $88 million of their third party debt. During the second quarter ended April 30, 2003, we exercised the right to retire at no cost 750,000 Class A Common Stock shares that were held by the selling principal under the terms of the acquisition. On November 1, 2002, and December 31, 2002 we acquired two Texas homebuilding companies. On April 9, 2003, we acquired a build-on-your-own lot homebuilder in Ohio, and on August 8, 2003, we acquired a homebuilder in Arizona. Our aggregate net cash purchase price, including payment of third party debt, for fiscal year 2003 acquisitions was approximately $186.4 million. All 2003 acquisitions provide for other payments to be made, generally dependant upon achievement of certain future operating and return objectives.
Safe Harbor Statement
All statements in this Form 10-K that are not historical facts should be considered as “Forward-Looking Statements” within the meaning of the Private Securities Litigation 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 business conditions;
.
Weather conditions;
.
Changes in market conditions;
.
Changes in home prices and sales activity in the California, New Jersey, Texas, North Carolina, Virginia, and Maryland markets;
.
Government regulation, including regulations concerning development of land, the homebuilding process, 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; and
.
Geopolitical risks, terrorist acts and other acts of war.
Certain risks, uncertainties, and other factors are described in detail in Item 1 and 2 “Business and Properties” in this Form 10-K.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The primary market risk facing us is interest rate risk on our long term debt. In connection with our mortgage operations, mortgage loans held for sale and the associated mortgage warehouse line of credit are subject to interest rate risk; however, such obligations reprice frequently and are short-term in duration. In addition, we hedge the interest rate risk on mortgage loans by obtaining forward commitments from private investors. Accordingly the risk from mortgage loans is not material. We do not hedge interest rate risk other than on mortgage loans using financial instruments. We are also subject to foreign currency risk but this risk is not material. The following tables set forth as of October 31, 2003 and 2002, our long term debt obligations, principal cash flows by scheduled maturity, weighted average interest rates and estimated fair market value (“FMV”). There have been no significant changes in our market risk from October 31, 2002 to October 31, 2003.
(1) Does not include bonds collateralized by mortgages receivable.
(2) Libor plus 2.5%.
In addition, the Company has reassessed the market risk for its variable debt, which is based upon LIBOR, and believes that a one percent increase in the LIBOR rate would have an approximate $1.2 million annual increase in interest expense based on $115 million of variable rate debt outstanding at October 31, 2003 and 2002, respectively.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial statements of Hovnanian Enterprises, Inc. and its consolidated subsidiaries are set forth herein beginning on Page.
ITEM 9
ITEM 9 - CHANGES IN OR DISAGREEMENT WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
During the years ended October 31, 2003, 2002, and 2001, there have not been any changes in, or disagreements with, accountants on accounting and financial disclosure.
ITEM 9A
ITEM 9A - CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosures. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. The Company’s management, with the participation of the Company’s chief executive officer and chief financial officer, has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of October 31, 2003. Based upon that evaluation and subject to the foregoing, the Company’s chief executive officer and chief financial officer concluded that the design and operation of the Company’s disclosure controls and procedures are effective to accomplish their objectives.
In addition, there was no change in the Company’s internal control over financial reporting that occurred during the quarter ended October 31, 2003 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information called for by Item l0, except as set forth below in this Item 10, is incorporated herein by reference to our definitive proxy statement to be filed pursuant to Regulation l4A, in connection with the Company’s annual meeting of shareholders to be held on March 5, 2004, which will involve the election of directors.
Executive Officers of the Registrant
Our executive officers are listed below and brief summaries of their business experience and certain other information with respect to them are set forth following the table. Each executive officer holds such office for a one year term.
Mr. K. Hovnanian founded the predecessor of the Company in l959 (Hovnanian Brothers, Inc.) and has served as Chairman of the Board of the Company since its incorporation in l967. Mr. K. Hovnanian was also Chief Executive Officer of the Company from 1967 to July 1997.
Mr. A. Hovnanian was appointed President in April 1988, after serving as Executive Vice President from March 1983. He has also served as Chief Executive Officer since July 1997. Mr. A. Hovnanian was elected a Director of the Company in December l98l. Mr. A. Hovnanian is the son of Mr. K. Hovnanian.
Mr. Buchanan has been Senior Vice President-Corporate Controller since May l990. Mr. Buchanan resigned as a Director of the Company on September 13, 2002, a position in which he served since March 1982, for the purpose of reducing the number of non-independent board members.
Mr. Hake joined the Company in July 2000 as Vice President, Finance and Treasurer. Prior to joining the Company, Mr. Hake was Director, Real Estate Finance at BankBoston Corporation from 1994 to June 2000.
Mr. Reinhart has been Senior Vice President and General Counsel since April 1985. Mr. Reinhart resigned as a Director of the Company on September 13, 2002, a position in which he served since December l98l, for the purpose of reducing the number of non-independent board members.
Mr. Sorsby was appointed Executive Vice President and Chief Financial Officer of the Company in October 2000 after serving as Senior Vice President, Treasurer, and Chief Financial Officer from February 1996 and as Vice President-Finance/Treasurer of the Company since March 1991.
CODE OF ETHICS AND CORPORATE GOVERNANCE GUIDELINES
We have adopted a Code of Ethics that applies to Hovnanian’s principal executive officer, principal financial officer, controller, and all other associates of the Company, including its directors and other officers. We have posted the text of this Code of Ethics on our website at www.khov.com under “Investor Relations/Corporate Governance.” We have also adopted Corporate Governance Guidelines and posted them on our website at www.khov.com under “Investor Relations/Corporate Governance.” A printed copy of the Code and Guidelines is also available to the public at no charge by writing to: Hovnanian Enterprises, Inc., Attn: Human Resources Department, 10 Highway 35, P.O. Box 500, Red Bank, N.J. 07701 or calling Corporate headquarters at 732-747-7800.
Audit Committee and Compensation Committee Charters
We have adopted charters that apply to Hovnanian’s Audit Committee and Compensation Committee. We have posted the text of these charters on our website at www.khov.com under “Investor Relations/Corporate Governance”. A printed copy of each charter is available to any shareholder who requests it by writing to: Hovnanian Enterprises, Inc., Attn: Human Resources Department, 10 Highway 35, P. O. Box 500, Red Bank, N.J. 07701 or calling corporate headquarters at 732-747-7800.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
The information called for by Item 11 is incorporated herein by reference to our definitive proxy statement to be filed pursuant to Regulation 14A, in connection with our annual meeting of shareholders to be held on March 5, 2004, which will involve the election of directors.
ITEM 12
ITEM 12 -
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information called for by Item l2 is incorporated herein by reference to our definitive proxy statement to be filed pursuant to Regulation l4A, in connection with our annual meeting of shareholders to be held on March 5, 2004, which will involve the election of directors.
The following table provides information as of October 31, 2003 with respect to compensation plans (including individual compensation arrangements) under which our equity securities are authorized for issuance.
Equity Compensation Plan Information
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by Item l3 is incorporated herein by reference to our definitive proxy statement, with the exception of the information regarding certain relationships, as described below, to be filed pursuant to Regulation l4A, in connection with our annual meeting of shareholders to be held on March 5, 2004, which will involve the election of directors.
At October 31, 2002 we stopped making loans to both Mr. K. Hovnanian and Mr. A. Hovnanian. The weighted average interest rate on Mr. K. Hovnanian and Mr. A. Hovnanian’s related party debt was 1.79% and 3.90% for the years ended October 31, 2002 and 2001, respectively. The largest amount of debt outstanding held by Mr. K. Hovnanian for the years ending October 31, 2002 and 2001 was $22,000 and $56,000, respectively. The largest amount of debt outstanding held by Mr. A. Hovnanian for the years ending October 31, 2002 and 2001 was $1,729,000 and $3,002,000, respectively. The interest rate on six month Treasury bills at October 31, 2002 and 2001 was 1.55% and 2.01%, respectively. During the years ended October 31, 2003, 2002, and 2001, we received $62,000, $62,000, and $76,000, respectively, from our affected partnerships.
PART IV
ITEM 15
ITEM 15 - EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
No schedules have been prepared because the required information of such schedules is not present, is not present in amounts sufficient to require submission of the schedule or because the required information is included in the financial statements and notes thereto.
Exhibits:
Reports on Form 8-K
The following reports have been filed during the quarter ended October 31, 2003:
The following reports have been furnished during the quarter ended October 31, 2003:
SIGNATURES
Pursuant to the requirements of Section l3 or l5(d) of the Securities Exchange Act of l934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Hovnanian Enterprises, Inc.
By:
/s/ KEVORK S. HOVNANIAN
Kevork S. Hovnanian
Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of l934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated
HOVNANIAN ENTERPRISES, INC.
Index to Consolidated Financial Statements
No schedules have been prepared because the required information of such schedules is not present, is not present in amounts sufficient to require submission of the schedule or because the required information is included in the financial statements and notes thereto.
Report of Independent Auditors
To the Stockholders and
Board of Directors of
Hovnanian Enterprises, Inc.
We have audited the accompanying consolidated balance sheets of Hovnanian Enterprises, Inc. and subsidiaries as of October 31, 2003 and 2002 and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended October 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hovnanian Enterprises, Inc. and subsidiaries at October 31, 2003 and 2002 and the consolidated results of their operations and their cash flows for each of the three years in the period ended October 31, 2003 in conformity with accounting principles generally accepted in the United States.
As discussed in Notes 2 and 17 to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill, and in 2003, the Company adopted FASB Interpretation No. 46 “Consolidation of Variable Interest Entities”.
Ernst & Young LLP
New York, New York
December 8, 2003
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidated Balance Sheets
See notes to consolidated financial statements.
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidated Balance Sheets
See notes to consolidated financial statements.
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidated Statements of Income
See notes to consolidated financial statements.
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidated Statements of Stockholders’ Equity
See notes to consolidated financial statements.
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
See notes to consolidated financial statements.
Notes to Consolidated Financial Statements
For the Years Ended October 31, 2003, 2002, and 2001
1.
Basis of Presentation and Segment Information
Basis of Presentation - The accompanying consolidated financial statements include our accounts and all wholly-owned subsidiaries after elimination of all significant intercompany balances and transactions.
Segment Information - Statement of Financial Accounting Standards (SFAS) No. 131 “Disclosures About Segments of an Enterprise and Related Information” establishes standards for segment reporting based on the way management organizes segments within a company for making operating decisions and assessing performance. Our financial reporting segments consist of homebuilding, financial services, and corporate. Our homebuilding operations comprise the most substantial part of our business, with approximately 98% of consolidated revenues in the years ended October 31, 2003, 2002, and 2001 contributed by the homebuilding operations. We are a Delaware corporation, currently building and selling homes in more than 257 new home communities in New Jersey, Pennsylvania, New York, Ohio, Virginia, West Virginia, Maryland, North Carolina, South Carolina, Texas, Arizona, and California. We offer a wide variety of homes that are designed to appeal to first time buyers, first and second time move up buyers, luxury buyers, active adult buyers and empty nesters. Our financial services operations provide mortgage banking and title services to the homebuilding operations’ customers. We do not retain or service the mortgages that we originate but rather, sell the mortgages and related servicing rights to investors. Corporate primarily includes the operations of our corporate office whose primary purpose is to provide executive services, accounting, information services, human resources, management reporting, training, cash management, internal audit, risk management, and administration of process redesign, quality and safety. Assets, liabilities, revenues and expenses of our reportable segments are separately included in the consolidated balance sheets and consolidated statements of income.
2.
Summary of Significant Accounting Policies
Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and these differences could have a significant impact on the financial statements.
Business Combinations - When we make an acquisition of another company, we use the purchase method of accounting in accordance with the Statement of Financial Accounting Standards (“SFAS”) No. 141 “Business Combinations” (“SFAS 141”). Under SFAS No. 141 (for acquisitions subsequent to June 30, 2001) and Accounting Principles Board (“APB”) Opinion 16 (for acquisitions prior to June 30, 2001) we record as our cost the estimated fair value of the acquired assets less liabilities assumed. Any difference between the cost of an acquired company and the sum of the fair values of tangible assets less liabilities is recorded as goodwill, indefinite or definite life intangibles. The reported income of an acquired company includes the operations of the acquired company from the date of acquisition.
Income Recognition from Home and Land Sales - Income from home sales are recorded when title is conveyed to the buyer, adequate cash payment has been received and there is no continued involvement.
Income Recognition from Mortgage Loans - Profits and losses relating to the sale of mortgage loans are recognized when legal control passes to the buyer and the sales price is collected.
Cash and Cash Equivalents - Cash and cash equivalents include cash deposited in checking accounts, overnight repurchase agreements, certificates of deposit, Treasury bills and government money market funds with original maturities of 90 days or less when purchased.
The Company’s cash balances are held primarily at one financial institution and may, at times, exceed insurable amounts. The Company believes it mitigages its risk by investing in or through a major financial institution.
Fair Value of Financial Instruments - The fair value of financial instruments is determined by reference to various market data and other valuation techniques as appropriate. Our financial instruments consist of cash equivalents, receivables, customer deposits and notes, accounts payable and other liabilities, mortgages and notes receivable, mortgages and notes payable, our term loan, and the senior and senior subordinated notes payable. The fair value of both the Senior Notes and Senior Subordinated Notes is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to us for debt of the same remaining maturities. The fair value of the Senior Notes and Senior Subordinated Notes is estimated at $444.3 million and $321 million, respectively, as of October 31, 2003. Unless otherwise disclosed, the fair value of financial instruments approximates their recorded values.
Inventories - For inventories of communities under development, a loss is recorded when events and circumstances indicate impairment and the undiscounted future cash flows generated are less than the related carrying amounts. The impairment loss is based on discounted future cash flows generated from expected revenue, cost to complete including interest, and selling costs. Inventories and long-lived assets held for sale are recorded at the lower of cost or fair value less selling costs. Fair value is defined as the amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. 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.
Insurance Deductible Reserves - Our deductible is $150,000 per occurrence for worker’s compensation and general liability insurance. Reserves have been established based upon actuarial analysis of estimated future losses during 2003 and 2002.
Interest - Costs related to properties under development are capitalized during the land development and home construction period and expensed along with the associated cost of sales as the related inventories are sold. Costs related to properties not under development are charged to interest expense.
Interest costs incurred, expensed and capitalized were:
(1) Data does not include interest incurred by our mortgage and finance subsidiaries.
(2) Represents interest on borrowings for construction, land and development costs which are charged to interest expense when homes are delivered or when land is not under active development.
Land Options - Costs are capitalized when incurred and either included as part of the purchase price when the land is acquired or charged to operations when we determine we will not exercise the option. In accordance with Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 “Consolidation of Variable Interest Entities” an interpretation of Accounting Research Bulletin No. 51 (“FIN 46”), SFAS No. 49 “Accounting for Product Financing Arrangements” (“SFAS 49”), SFAS No. 98 “Accounting for Leases” (“SFAS 98”), and Emerging Issues Task Force (“EITF”) No. 97-10 “The Effects of Lessee Involvement in Asset Construction” (“EITF 97-10”), we record on the Consolidated Balance Sheet specific performance options, options with variable interest entities, and other options under Consolidated inventory not owned with the offset to Liabilities from inventory not owned, Minority interest from inventory not owned and Minority interest from consolidated joint ventures.
Intangible Assets - The intangible assets recorded on our balance sheet are goodwill, tradenames, architectural designs, distribution processes, and contractual agreements with both definite and indefinite lives resulting from our acquisitions. We no longer amortize goodwill or indefinite life intangibles, but instead assess them periodically for impairment. We performed such assessments utilizing a fair value approach as of October 31, 2003 and 2002, and determined that no impairment of intangibles existed. We are amortizing the definite life intangibles over their expected useful life, ranging from three to seven years.
Finance Subsidiary Net Worth - In accordance with Statement of Position 01-6 (“SOP 01-6”) of the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants, we are required to disclose the minimum net worth requirements by regulatory agencies, secondary market investors and states in which it conducts business. At October 31, 2003 and 2002, our mortgage subsidiary’s net worth was $61.5 million and $18.7 million, respectively, which exceeded all our regulatory agencies net worth requirements.
Deferred Bond Issuance Costs - Costs associated with the issuance of our Senior and Senior Subordinated Notes are capitalized and amortized over the associated term of each note issuance into other operations on the consolidated statements of income.
Debt Issued At a Discount - Debt issued at a discount to the face amount is credited back up to its face amount utilizing the effective interest method over the term of the note and recorded as a component of Interest on the consolidated statements of income.
Post Development Completion 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 and is recorded in accounts payable and other liabilities in the accompanying consolidated balance sheets.
Advertising Costs - Advertising costs are treated as period costs and expensed as incurred. During the years ended October 31, 2003, 2002, and 2001, advertising costs expensed amounted to $30.8 million, $23.4 million, and $18.5 million, respectively.
Deferred Income Tax - Deferred income taxes or income tax benefits are provided for temporary differences between amounts recorded for financial reporting and for income tax purposes.
Common Stock - Each share of Class A Common Stock entitles its holder to one vote per share and each share of Class B Common Stock entitles its holder to ten votes per share. The amount of any regular cash dividend payable on a share of Class A Common Stock will be an amount equal to 110% of the corresponding regular cash dividend payable on a share of Class B Common Stock. If a shareholder desires to sell shares of Class B Common Stock, such stock must be converted into shares of Class A Common Stock.
On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 2 million shares of Class A Common Stock. As of October 31, 2003, 903,938
shares have been purchased under this program, of which 297,619 and 147,619 were repurchased during the twelve months ended October 31, 2003 and 2002, respectively. In addition, we retired 0.8 million shares under the terms of the acquisition agreements that were held by sellers of two previous acquisitions.
Depreciation - Property, plant and equipment are depreciated using the straight-line method over the estimated useful life of the assets.
Prepaid Expenses - Prepaid expenses which relate to specific housing communities (model setup, architectural fees, homeowner warranty program fees, etc.) are amortized to costs of sales as the applicable inventories are sold. All other prepaid expenses are amortized over a specific time period or as used and charged to overhead expense.
Stock Options - SFAS No. 123 “Accounting for Stock-Based Compensation”, (“SFAS 123”) establishes a fair value-based method of accounting for stock-based compensation plans, including stock options. Registrants may elect to continue accounting for stock option plans under APB Opinion No. 25 “Accounting for Stock Issued to Employees” (“APB 25”), but are required to provide pro forma net income and earnings per share information “as if” the new fair value approach had been adopted. We intend to continue accounting for our stock option plan under APB 25. Under APB 25, no compensation expense is recognized when the exercise price of our employee stock options equals the market price of the underlying stock on the date of grant (see Note 13).
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (“SFAS 148”). SFAS 148 amends SFAS 123 to provide alternative methods of transition for an entity that voluntarily adopts the fair value recognition method of recording stock option expense. SFAS 148 also amends the disclosure provisions of SFAS 123 and APB Opinion No. 28, “Interim Financial Reporting” to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock options on reported net income and earnings per share in annual and interim financial statements.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period. Our pro forma information follows (dollars in thousands except for earnings per share information):
Pro forma information regarding net income and earnings per share is to be calculated as if we had accounted for our stock options under the fair value method of SFAS No. 123. The fair value for those options is established at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 2003, 2002, and 2001: risk- free interest rate of 4.3%, 4.3%, and 4.4%, respectively; dividend yield of zero; volatility factor of the expected market price of our common stock of 0.43, 0.43, and 0.38, respectively; and a weighted-average expected life of the option of 5.1, 5.5, and 5.1 years, respectively.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of our traded options, and changes in the subjective input assumptions can materially affect the fair value estimate, management believes the existing models do not necessarily provide a reliable measure of the fair value of its employee stock options.
Per Share Calculations - Basic earnings per common share is computed using the weighted average number of shares outstanding. Diluted earnings per common share is computed using the weighted average number of shares outstanding adjusted for the incremental shares attributed to outstanding options to purchase common stock shares of approximately 1,809,000, 1,750,000, and 982,000 for the years ended October 31, 2003, 2002, and 2001, respectively.
Computer Software Development - We capitalize certain costs incurred in connection with developing or obtaining software for internal use. Upon entering the application and development phase, the capitalized costs are amortized over the systems estimated useful life. For the years ended October 31, 2002 and 2001 we recorded amortization expense of the SAP system in the amount of approximately $2.0 million based on an estimated useful life of 10 years, respectively. We wrote off the majority of the capitalized costs associated with the development and implementation of the SAP systems during the year ended October 31, 2002, totaling $12.4 million pretax included in other operations in the accompanying consolidated statements of income, or $7.6 million after taxes equal to $0.24 per fully diluted share. Such costs were written off as a result of the decision to not use the SAP software after October 31, 2003. Certain costs in the amount of $2.0 million related to active communities using the SAP software were not written off in 2002, but were amortized over the life of these communities. As of October 31, 2003 all costs associated with the SAP software have been expensed.
Accounting for Derivative Instruments and Hedging Activities - In April 2003, the Financial Accounting Standards Board issued (SFAS) No. 149, “Amendment of Derivative Instruments and Hedging Activities.” SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities that fall within the scope of SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS 149 also amends certain other existing pronouncements, which will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting. SFAS 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material effect on our financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 is effective for financial instruments entered into or modified after May 15, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for
financial instruments created before the issuance date of the Statement and still existing at the beginning of the interim period of adoption. The adoption of SFAS 150 did not have a material effect on our financial position or results of operations.
We manage our interest rate risk on mortgage loans held for sale and our estimated future commitments to originate and close mortgage loans at fixed prices through the use of best-efforts whole loan delivery commitments. These instruments are classified as derivatives and generally have maturities of three months or less. Accordingly, gains and losses are recognized in current earnings during the period of change.
Reclassifications - Certain amounts in the 2002 and 2001 consolidated financial statements have been reclassified to conform to the 2003 presentation.
3.
Corporate Initiatives
We have embarked on long term improvement initiatives of total quality, process redesign, and training. Included in Corporate General and Administrative expense is $2.8 million, $4.1 million, and $7.2 million for the years ended October 31, 2003, 2002, and 2001, respectively, related to such initiatives. These amounts are in addition to software development costs capitalized in those years.
4. Property
Homebuilding property, plant, and equipment consists of land, land improvements, buildings, building improvements, furniture and equipment used to conduct day to day business and are recorded at cost less accumulated depreciation. Homebuilding accumulated depreciation related to these assets at October 31, 2003 and October 31, 2002 amounted to $23.9 million and $18.5 million, respectively. In addition we have two senior citizen residential rental communities recorded as senior residential rental properties on the consolidated balance sheets. Accumulated depreciation on senior residential rental properties at October 31, 2003 and October 31, 2002 amounted to $3.5 million and $3.1 million, respectively.
We hold escrow cash amounting to $8.0 million and $3.5 million at October 31, 2003 and October 31, 2002, respectively, which primarily represents customers’ deposits which are restricted from use by us. We are able to release other escrow cash by pledging letters of credit and surety bonds. Escrow cash accounts are substantially invested in short-term certificates of deposit, time deposits, or money market accounts. The remaining deposits are not restricted from use by us.
6.
Mortgage Loans Held for Sale
Our wholly-owned mortgage banking subsidiary originates mortgage loans, primarily from the sale of our homes. Such mortgage loans are sold in the secondary mortgage market with servicing released. At October 31, 2003 and 2002, respectively, $223.9 million and $91.3 million of such mortgages were pledged against our mortgage warehouse line (see Note 7). We may incur risk with respect to mortgages that are delinquent, but only to the extent the losses are not covered by mortgage insurance or resale value of the home. Historically, we have incurred minimal credit losses. The mortgage loans held for sale are carried at the lower of cost or market value, determined on an aggregate basis. There was no valuation adjustment at October 31, 2003 or 2002.
7.
Mortgages and Notes Payable
Substantially all of the nonrecourse land mortgages are short-term borrowings. Nonrecourse mortgages secured by operating properties are installment obligations having annual principal maturities in the following years ending October 31, of approximately $0.1 million in 2004, 2005, 2006, 2007 and 2008, and $0.3 million after 2008. The interest rates on these obligations range from 6.0% to 10.5%.
We have an unsecured Revolving Credit Agreement (“Agreement”) with a group of banks that provides a revolving credit line of $590 million through July 2006. Interest is payable monthly and at various rates of either the prime rate plus 0.275% or LIBOR plus 1.75%. In addition, we pay a fee equal to 0.350% per annum on the weighted average unused portion of the line. Each of our significant subsidiaries, except for our financial services subsidiaries and joint ventures, are a guarantor under the revolving credit agreement. As of October 31, 2003 and 2002, there was no outstanding balance under the Agreement.
On January 22, 2002, we issued a $165 million five year Term Loan. The Term Loan matures January 22, 2007, and bears interest at either the prime rate plus 1.25% or LIBOR plus 2.5%. The proceeds from the issuance of the Term Loan were primarily used to partially fund our California acquisition on January 10, 2002. Each of our significant subsidiaries, except for our financial services subsidiaries and joint ventures, are a guarantor under the Term Loan. As of October 31, 2003 and 2002, borrowings under the Term Loan were $115,000,000. See Note 20 for loan guarantee.
Average interest rates and average balances outstanding under the Agreement are as follows:
(1) Average interest rate at the end of the period excludes any charges on unused loan balances.
In addition, we have a secured mortgage loan warehouse agreement with a group of banks, which is a short-term borrowing, that provides up to $200 million through July 2004. Interest is payable monthly at the Federal Funds Rate plus 1.375% (approximately 2.41% and 3.195% at October 31, 2003 and 2002, respectively) of the outstanding loan balance. The loan is repaid when the underlying mortgage loans are sold to permanent investors by the Company. As of October 31, 2003 borrowings under the agreement were $166.7 million.
8.
Senior and Senior Subordinated Notes
On June 7, 1993, we issued $100 million principal amount of 9 3/4% Subordinated Notes due June 1, 2005. In April 2001, we retired $0.3 million of these notes. Interest is payable semi-annually. The notes were redeemable in whole or in part at our option, initially at 104.875% of their principal amount on or after June 1, 1999 and reducing to 100% of their principal amount on or after June 1, 2002. On April 29, 2002 we used a portion of the proceeds from our March 2002 debt issuance (see below) to redeem the remainder of these notes. We recorded $0.9 million of expenses associated with the early extinguishment of this debt in Other operations on the Consolidated Statement of Income in 2002.
On May 4, 1999, we issued $150 million principal amount of 9 1/8% Senior Notes due May 1, 2009. Interest is payable semi-annually. The notes are redeemable in whole or in part at our option, initially at 104.563% of their principal amount on or after May 1, 2004 and reducing to 100% of their principal amount on or after May 1, 2007.
On October 2, 2000, we issued $150 million principal amount of 10 1/2% Senior Notes due October 1, 2007. During the year ended October 31, 2003 we paid down $9.8 million of these notes. The 10 1/2% Senior Notes were issued at a discount to yield 11% and have been reflected net of the unamortized discount in the accompanying Consolidated Balance Sheet. Interest is payable semi-annually. The notes are redeemable in whole or in part at our option at 100% of their principal amount upon payment of a make-whole price.
On March 26, 2002, we issued $100 million 8% Senior Notes due 2012 and $150 million 8 7/8% Senior Subordinated Notes due 2012. The 8% Senior Notes were issued at a discount to yield 8.125% and have been reflected net of the unamortized discount in the accompanying Consolidated Balance Sheet. Interest on both notes is paid semi-annually. The notes are redeemable in whole or in part at our option at 100% of their principal amount upon payment of a make-whole price. The proceeds were used to redeem the remaining 9 3/4% Subordinated Notes (see above), repay a portion of our Term Loan Facility (see Note 7), repay the current outstanding indebtedness under our Revolving Credit Agreement, and the remainder for general corporate purposes.
On May 9, 2003, we issued $150 million 7 3/4% Senior Subordinated Notes due 2013. The net proceeds of the note offering were used to repay the current outstanding indebtedness under the Revolving Credit Agreement and the remainder for general corporate purposes.
On November 3, 2003, we issued $215 million 6 1/2% Senior Notes due 2014. The net proceeds of the issuance were used for general corporate purposes.
The indentures relating to the Senior and Subordinated Notes and the Revolving Credit Agreement contain a Company guarantee (see Note 20) and restrictions on the payment of cash dividends. At October 31, 2003, $372.8 million of retained earnings were free of such restrictions.
At October 31, 2003, we had total issued and outstanding $690.2 million Senior and Senior Subordinated Notes. These notes plus the $215.0 million Senior Notes issued November 3, 2003 have annual principal maturities in the following years ending October 31, of $140.2 million in 2007 and $765.0 million after 2008.
In December 1982, we established a defined contribution savings and investment retirement plan. Under such plan there are no prior service costs. All associates are eligible to participate in the retirement plan and employer contributions are based on a percentage of associate contributions. Plan costs charged to operations amount to $7.5 million, $6.6 million, and $3.7 million for the years ended October 31, 2003, 2002, and 2001, respectively. The year over year increases are the result of increased number of participants from acquisitions and increased profit sharing contributions resulting from higher Company Returns on Equity.
Income Taxes (receivable) payable including deferred benefits, consists of the following:
The provision for income taxes is composed of the following charges (benefits):
(1) The current state income tax expense is net of the use of state loss carryforwards amounting to $13.5 million, $45.8 million, and $26.8 million for the years ended October 31, 2003, 2002, and 2001, respectively.
The deferred tax liabilities or assets have been recognized in the consolidated balance sheets due to temporary differences as follows:
The effective tax rates varied from the expected rate. The sources of these differences were as follows:
We have state net operating loss carryforwards for financial reporting and tax purposes of $335.3 million due to expire between the years October 31, 2004 and October 31, 2017.
We record impairment losses on inventories related to communities under development when events and circumstances indicate that they may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than their related carrying amounts. As of October 31, 2003, inventory with a carrying amount of $3.1 million was written down by $0.7 million in our Southeast Region. This property was acquired as part of one of our acquisitions. In 2003, a decision was made to liquidate this property resulting in lower sales prices. As of October 31, 2002, inventory with a carrying amount of $9.4 million was written down by $4.2 million to its fair market value. This write-down was attributed to two properties in Poland and one community in the Mid-South. We have made a decision to discontinue selling homes in these two markets and offer the remaining lots for sale. During the year ended October 31, 2001, inventory with a carrying amount of $13.5 million was written down $2.5 million to its fair value. The 2001 writedowns were primarily the result of the acquisition of two communities in the Northeast Region that were part of a large land acquisition and were subsequently revalued, resulting in a loss.
The total aggregate impairment losses, which are presented in the Consolidated Statements of Income and deducted from inventory held for future development or sale were $0.7 million, $4.2 million, and $2.5 million for the years ended October 31, 2003, 2002, and 2001, respectively.
On the Statement of Income the line entitled “Homebuilding - Inventory impairment loss” also includes write-offs of options, and approval, engineering, and capitalized interest costs. During the years ended October 31, 2003, 2002, and 2001 write-offs amounted to $4.5 million, $4.0 million, and $1.9 million, respectively. During the years ended October 31, 2003, 2002, and 2001 we redesigned communities, abandoning certain engineering costs, and we did not exercise options in various locations because the communities pro forma profitability did not produce adequate returns on investment commensurate with the risk. Those communities were located in our Northeast Region, Southeast Region, West Region, and Poland.
Our Board of Directors adopted a general policy providing that it will not make loans to our officers or directors or their relatives at an interest rate less than the interest rate at the date of the loan on six month U.S. Treasury Bills, that the aggregate of such loans will not exceed $3 million at any one time, and that such loans will be made only with the approval of the members of our Board of Directors who have no interest in the transaction. At October 31, 2003 and 2002 related party receivables from officers and directors amounted to zero. Interest income from these loans for the years ended October 31, 2003, 2002, and 2001 amounted to zero, $18,000, and $84,000, respectively.
We provide property management services to various limited partnerships including one partnership in which Mr. A. Hovnanian, our Chief Executive Officer, President and a Director, is a general partner, and members of his family and certain officers and directors are limited partners. During the years ended October 31, 2003, 2002, and 2001 we received $0.1 million in fees for such management services. At October 31, 2003 and 2002, no amounts were due us by these partnerships.
During the year ended October 31, 2003, we entered into an agreement to purchase land in California for approximately $33.4 million from an entity that is owned by a family relative of our Chairman of the Board and our Chief Executive Officer. As of October 31, 2003, we have an option deposit of $3.9 million related to this land acquisition agreement. In connection with this agreement, we also have consolidated $29.5 million in accordance with FIN 46 under “Consolidated Inventory Not Owned” in the Consolidated Balance Sheet (see Note 17). Neither the Company nor the Chairman of the Board and Chief Executive Officer has a financial interest in the relative’s company from whom the land was purchased.
During the year ended October 31, 2001, we entered into an agreement to purchase land from an entity that is owned by a family relative of our Chairman of the Board and our Chief Executive Officer, totalling $26.9 million. As of October 31, 2003 and 2002, land aggregating $18.4 million and $10.3 million, respectively, has been purchased. Neither the Company nor the Chairman of the Board and Chief Executive Officer has a financial interest in the relative’s company from whom the land was purchased.
We have a stock option plan for certain officers and key employees. Options are granted by a Committee appointed by the Board of Directors. The exercise price of all stock options must be at least equal to the fair market value of the underlying shares on the date of the grant. Options granted prior to May 14, 1998 vest in three equal installments on the first, second and third anniversaries of the date of the grant. Options granted on or after May 14, 1998 vest in four equal installments on the third, fourth, fifth and sixth anniversaries of the date of the grant. Certain Southeast Region associates were granted and held options to purchase their stock prior to the January 23, 2001 acquisition. These options vest in three installments: 25% on the first and second anniversary, and 50% on the third anniversary of the date of the grant. In connection with the acquisition (see Note 18) the options were exchanged for options to purchase the Company’s Class A Common Stock. All options expire ten years after the date of the grant. During the year ended October 31, 2002 each of the four outside directors of the Company were granted options to purchase 7,500 shares. All shares granted to the outside directors were issued at the same price and terms as those granted to officers and key employees. Stock option transactions are summarized as follows:
(1) Fair value of options at grant date approximate exercise price.
The following table summarizes the exercise price range and related number of options outstanding at October 31, 2003:
During the year ended October 31, 1999, we modified our bonus plan for certain associates. A portion of their bonus is paid by issuing a deferred right to receive our Class A Common Stock. The number of shares is calculated by dividing the portion of the bonus subject to the deferred right award by our stock price on the date the bonus is earned. 25% of the deferred right award will vest and shares will be issued one year after the year end and then 25% a year for the next three years. During the years ended October 31, 2003 and 2002, we issued 88,579 and 63,815 shares under the plan. During the years ended October 31, 2003 and 2002 10,034 and 8,328 shares were forfeited under this plan, respectively. For the years ended October 31, 2003, 2002, and 2001, approximately 251,000, 278,000, and 368,000 deferred rights were awarded in lieu of $11.9 million, $7.2 million, and $4.3 million of bonus payments, respectively.
We provide a warranty accrual for repair costs over $1,000 to homes, community amenities, and land development infrastructure. We accrue for warranty costs at the time each home is closed and title and possession have been transferred to the homebuyer as part of cost of sales. In addition, we accrue for warranty costs under our $150,000 per occurrence general liability insurance deductible as part of selling, general and administration costs. Warranty accruals are based upon historical experience. Charges in the warranty accrual and general liability accrual for the year ended October 31, 2003 are as follows:
We are involved in litigation arising in the ordinary course of business, none of which is expected to have a material adverse effect on us.
As of October 31, 2003 and 2002, respectively, we are obligated under various performance letters of credit amounting to $130.3 million and $100 million. (see Note 5).
In January 2003, the FASB issued FIN 46. A Variable Interest Entity (“VIE”) is created when (i) the equity investment at risk is not sufficient to permit the entity from financing its activities without additional subordinated financial support from other parties or (ii) equity holders either (a) lack direct or indirect ability to make decisions about the entity, (b) are not obligated to absorb expected losses of the entity or (c) do not have the right to receive expected residual returns of the entity if they occur. If an entity is deemed to be a VIE, pursuant to FIN 46, an enterprise that absorbs a majority of the expected losses of the VIE is considered the primary beneficiary and must consolidate the VIE. FIN 46 is effective immediately for VIE’s created after January 31, 2003. Pursuant to FASB revision to FIN 46 (“FSP46-6”), a public entity need not apply the provisions of FIN 46 to an interest held in a variable interest entity or potential variable interest entity until the end of the first interim or annual period ending after March 15, 2004, if the VIE was created before February 1, 2003, and the public entity has not issued financial statements reporting that VIE in accordance with FIN 46. We have elected to defer the application of FIN 46 to its interests in potential variable interest entities created prior to February 1, 2003 pursuant to FSP 46-6.
Based on the provisions of FIN 46, we have concluded that whenever we option land or lots from an entity and pay a non-refundable deposit, a VIE is created under condition (ii) (b) and (c) of the previous paragraph. We have been deemed to have provided subordinated financial support, which refers to variable interests that will absorb some or all of an entity’s expected theoretical losses if they occur. For each VIE created with a significant nonrefundable option fee, we will compute expected losses and residual returns based on the probability of future cash flows as outlined in FIN 46. If we are deemed to be the primary beneficiary of the VIE we will consolidate it on our balance sheet. The fair value of the VIE’s inventory will be reported as “Consolidated Inventory Not Owned - Variable Interest Entities”.
Management believes FIN 46 was not clearly thought out for application in the homebuilding industry for land and lot options. Under FIN 46, we can have an option and put down a small deposit as a percentage of the purchase price and still have to consolidate the entity. Our exposure to loss as a result of our involvement with the VIE is only the deposit,
not it’s total assets consolidated on the balance sheet. In certain cases we will have to place inventory on our balance sheet the VIE has optioned to other developers. In addition, if the VIE has creditors, it’s debt will be placed on our balance sheet even though the creditors have no recourse against our Company. Based on these observations we believe consolidating VIE’s based on land and lot option deposits does not reflect the economic realities or risks of owning and developing land.
At October 31, 2003, we consolidated VIE’s created from February 1, 2003 to October 31, 2003 as a result of our option to purchase land or lots from the selling entities. We paid cash or issued letters of credit deposits to these eleven VIE’s totaling $13 million. Our option deposits represent our maximum exposure to loss. The fair value of the property owned by the VIE’s was $100.3 million of which $6.2 million was not optioned to our Company. Since we could not get the remainder of the selling entities to provide us with any financial information, the fair value of the optioned property less our cash deposits and liabilities from inventory not owned, which totaled $90.3 million, was reported on the balance sheet as “Minority interest from inventory not owned”. Creditors of these VIE’s have no recourse against our Company.
We will continue to secure land and lots using options. Including the deposits with the eleven VIE’s above, at October 31, 2003 we have total cash and letters of credit deposits amounting to approximately $168.6 million to purchase land and lots with a total purchase price of $2.3 billion. Not all our deposits are with VIE’s. The maximum exposure to loss is limited to the deposits although some deposits are refundable at our request or refundable if certain conditions are not met.
On January 23, 2001, we acquired a Southeast Region homebuilder for a total purchase price of $87.4 million, of which $38.5 million was paid in cash and 6,352,900 shares of our Class A Common Stock valued at $44.9 million were issued and option issued to their employees with an intrinsic value of $3.4 million were converted to 738,785 of our options. At the date of acquisition we paid off approximately $57.0 million of their third party debt.
On January 10, 2002, we acquired a California homebuilder for a total purchase price of $196.5 million, of which $151.6 million was paid in cash and 2,208,738 shares of Class A Common Stock were issued. At the date of acquisition we also paid off approximately $88.0 million of their third party debt. During the second quarter ended April 30, 2003, we exercised the right to retire at no cost 749,359 Class A Common Stock shares that were held by the selling principal under the terms of the acquisition. The total purchase price amounted to $90.4 million over book value, of which $22.8 million was added to inventory to reflect fair value, $18.5 million was paid for two option agreements, a two year consultant’s agreement, and a three year right of first refusal agreement, and the balance recorded as a tradename, which is recorded as an indefinite life intangible asset.
A condensed balance sheet (including the effects of purchase accounting adjustments) as of the acquisition date is as follows (dollars in thousands):
Our Southeast and California acquisitions were accounted for as purchases with the results of operations of these entities included in our Consolidated Financial Statements as of the date of the acquisitions. The purchase price was allocated based on estimated fair value of the assets and liabilities at the date of the acquisitions. An intangible asset equal to the excess purchase price over the fair value of the net assets of $12.8 million and $49.8 million for our Southeast Region and California acquisitions, respectively, were recorded as goodwill and a tradename, which is an indefinite life intangible asset on the Consolidated Balance Sheet. The goodwill from our Southeast Region acquisition was being amortized on a straight line basis over a period of ten years during fiscal 2001. On November 1, 2001 we adopted Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets”. Indefinite life intangible assets are not amortized. As a result of adopting SFAS No. 142, we no longer amortize goodwill or indefinite life intangibles, but instead assess them periodically for impairment. We performed a fair value analysis as of October 31, 2003 and 2002 and determined that no impairment of goodwill or intangibles existed.
The following unaudited pro forma financial data for the years ended October 31, 2002 and 2001 has been prepared as if the acquisition of the Southeast Region homebuilder on January 23, 2001 and the acquisition of a California homebuilder on January 10, 2002 had occurred on November 1, 2000. Unaudited pro forma financial data is presented for information purposes only and may not be indicative of the actual amounts had the events occurred on the dates listed above, nor does it purport to represent future periods.
On November 1, 2002, and December 31, 2002, we acquired two Houston homebuilding companies. On April 9, 2003, we acquired a build-on-your-own lot homebuilder in Ohio, and on August 8, 2003, we acquired a homebuilder in Phoenix, Arizona. Our aggregate net cash purchase price, including payment of third party debt, for our fiscal 2003 acquisitions was approximately $186.4 million. In connection with the December 31, 2002 and April 9, 2003 acquisitions, we have definite life intangible assets equal to the excess purchase price over the fair value of the net assets of $65.4 million. It is our policy to obtain appraisals of acquisition intangibles. We have received the appraisal for the December 31, 2002 acquisition and are awaiting the appraisal for the April 9, 2003 acqusition. Until appraisals are received we estimate intangible values for amortization calculations. We are amortizing our definite life intangibles over a period of three to seven years (see Note 2). All 2003 acquisitions provide for other payments to be made, generally dependent upon achievement of certain future operating and return objectives.
19.
Unaudited Summarized Consolidated Quarterly Information
Summarized quarterly financial information for the years ended October 31, 2003 and 2002 is as follows:
20.
Financial Information of Subsidiary Issuer and Subsidiary Guarantors
Hovnanian Enterprises, Inc., the parent company (the “Parent”) is the issuer of publicly traded common stock. One of its wholly-owned subsidiaries, K. Hovnanian Enterprises, Inc., (the “Subsidiary Issuer”) acts as a finance entity that as of October 31, 2003 had issued and outstanding approximately $300 million Senior Subordinated Notes, $390 million face value Senior Notes, a Term Loan with an outstanding balance of $115 million, and a Revolving Credit Agreement with no outstanding balance. The Senior Subordinated Notes, Senior Notes, the Revolving Credit Agreement, and the Term Loan are fully and unconditionally guaranteed by the Parent.
In addition to the Parent, each of the wholly-owned subsidiaries of the Parent other than the Subsidiary Issuer (collectively the “Guarantor Subsidiaries”), with the exception of various subsidiaries formerly engaged in the issuance of collateralized mortgage obligations, a mortgage lending subsidiary, a subsidiary engaged in homebuilding activity in Poland, our Title subsidiaries, and joint ventures (collectively the “Non-guarantor Subsidiaries”), have guaranteed fully and unconditionally, on a joint and several basis, the obligation of the Subsidiary Issuer to pay principal and interest under the Senior Notes, Senior Subordinated Notes, the Term Loan and the Agreement.
In lieu of providing separate audited financial statements for the Guarantor Subsidiaries we have included the accompanying consolidated condensed financial statements. Management does not believe that separate financial statements of the Guarantor Subsidiaries are material to investors. Therefore, separate financial statements and other disclosures concerning the Guarantor Subsidiaries are not presented.
The following consolidating condensed financial information presents the results of operations, financial position and cash flows of (i) the Parent (ii) the Subsidiary Issuer (iii) the Guarantor Subsidiaries of the Parent (iv) the Non-guarantor Subsidiaries of the Parent and (v) the eliminations to arrive at the information for Hovnanian Enterprises, Inc. on a consolidated basis.
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidating Condensed Balance Sheet
October 31, 2003
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidating Condensed Balance Sheet
October 31, 2002
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidating Condensed Statement of Income
Twelve Months Ended October 31, 2003
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidating Condensed Statement of Income
Twelve Months Ended October 31, 2002
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidating Condensed Statement of Income
Twelve Months Ended October 31, 2001
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidating Condensed Statement of Cash Flows
Twelve Months Ended October 31, 2003
Consolidating Condensed Statement of Cash Flows
Twelve Months Ended October 31, 2002
Hovnanian Enterprises, Inc. and Subsidiaries
Consolidating Condensed Statement of Cash Flows
Twelve Months Ended October 31, 2001
During November 2003, we purchased a Florida based homebuilder.