VIA EDGAR AND FACSIMILE
May 25, 2006
Mr. John M. Hartz
Securities and Exchange Commission
Division of Corporation Finance
100 F Street, N.E.
Washington, D.C. 20549
Mail Stop 7010
Dear Mr. Hartz:
We have prepared the following in response to your comment letter dated
April 20, 2006 with respect to the following:
Hovnanian Enterprises, Inc.
File Number: 1-8551
Form 10-K for the fiscal year ended October 31, 2005 and Form 10-Q for
the quarter ended January 31, 2006
The paragraphs that follow respond to the questions asked under each of
the respective headers in your letter. For convenience of reference,
the text of the comments in your letter has been reproduced in italics
herein.
We trust that you will find these responses acceptable, however, if you
have further questions or comments, please contact me at 732-747-7800.
Sincerely,
/S/J. LARRY SORSBY
J. Larry Sorsby
Executive Vice President and Chief Financial Officer
Form 10-K for the year ended October 31, 2005
General:
1. Where a comment below requests additional disclosures or other
revisions to be made, please show us in your response what the revisions
will look like. These revisions should be included in your future
filings, including your interim fillings where applicable.
Residential Development Activities, Page 7:
2. You disclosed that the number of new homes sales contracted
slightly in the West Region due to the timing of the opening of new
communities in 2005. In future filings, please provide more detail and
explain how the timing of opening new communities in 2005 differs from
that of the prior year. We also note the reduction in homes delivered,
net contracts signed and contract backlog in your West Region that
occurred subsequent to year-end as disclosed in the Form 10-Q report for
the first quarter of 2006. If the lower sales are due to multiple
factors, including overall market factors, you should expand these types
of discussions in future filings.
We will include a discussion of factors impacting sales and the
timing of the opening of new communities in future filings. Relevant
factors include: the availability of homes for sale in the current year
compared to the prior year, the number of communities that are open for
sale throughout the year, how long each community is open during the
year, the number and type of homes in each community, the number of lots
that are either delivered to us or developed internally to be made
available for sale and the regulatory environment.
Management's Discussion and Analysis of Financial Condition and Results
of Operations
Results of Operations, Page 17:
3. If material in future filings, please provide a comprehensive
discussion on the number of cancellations of home sales contracts by
region and in total and discuss trends in the level of home sales
cancellations in relation to historical levels. Please refer to Item
303(3) of Regulation S-K.
We have not discussed cancellation rates in prior filings with the
Commission because our rates of cancellation have historically been
relatively steady (plus or minus 3% quarter to quarter). In the first
and second quarters of 2006, we have seen an increase in cancellation
rates. Our future filings will include a discussion of relevant
cancellation rates, including in relation to historical levels.
Financial Statements
Consolidated Balance Sheet, Page F-3:
4. In future filings, please present restricted cash held in
escrow separately on the face of the balance sheet. Please refer to
Rule 5-02 of Regulation S-X.
In response to the Staff's comment, we will present restricted
cash held in escrow separately on face of the balance sheet. We note
that we currently show restricted cash held in escrow in Note 5 to the
financial statements.
Consolidated Statements of Cash Flows, Page F-7:
5. In future filings, do not include restricted cash in the cash
total in your statements of cash flows. Please refer to Rule 5-02 of
Regulation S-X.
In response to the Staff's comment, we will not include restricted
cash in the cash total in the statements of cash flows in future
filings.
6. Given the various acquisitions of homebuilders in recent
years, in future filings please disclose separately the amounts paid to
acquire homebuilding companies and the amounts paid to purchase
property, equipment and other fixed assets in net cash used in investing
activities. Please refer to SFAS 95.
SFAS 95, paragraph 17 lists the items that should be included in
cash outflows for investing activities. It separately lists in items
17b and 17c, payments to acquire equity instruments of other enterprises
and payments to acquire property, plant and equipment and other
productive assets, respectively. For each of the acquisitions in the
last three years, we acquired the assets and certain related liabilities
of the homebuilders and not the equity, therefore, we included these
purchases in the amounts paid for property, plant and equipment and
other productive assets. We chose to include in the description of that
line item "and acquisition of homebuilders" to help explain why the
amounts fluctuated from year to year.
We also note that none of these acquisitions have exceeded the
significance thresholds, individually or in the aggregate, for separate
financial statement disclosure required by Regulation S-X Article 3-05.
Although the thresholds of Article 3-05 do not apply directly to the
SFAS 95 discussion of disclosing the amounts paid to acquire
homebuilding companies, we believe that because the amounts were not
significant for Article 3-05 purposes they could properly be combined
with the amounts paid to purchase property, plant and equipment.
7. You disclosed that investments in unconsolidated homebuilding
and land development joint ventures totaled over $1.1 billion in 2005
and that they had increased from $212 million in the prior year in
footnote 18. In future filings, please disclose separately the cash
flows associated with investments in unconsolidated subsidiaries and
cash flows associated with distributions of capital from unconsolidated
subsidiaries in your statements of cash flows. Please refer to SFAS 95.
Footnote 18 provides condensed balance sheets and income
statements for our joint ventures as if they were consolidated. The
amounts referenced in your comment are the total assets of the joint
ventures in which we have investments as of October 31, 2005 and 2004
and not our investment in these joint ventures. Our investments in
these joint ventures were $187.2 million and $40.8 million as of October
31, 2005 and 2004, respectively, as shown on our consolidated balance
sheets and stated in the paragraph following the balance sheet tables in
footnote 18. In future filings, we will separately disclose the
investment in unconsolidated joint ventures and the returns of capital
from unconsolidated subsidiaries as required by SFAS 95, paragraphs 16
and 17.
Note 1. Basis of Presentation and Segment Information, Page F-8:
8. We note significant regional information in both your Business
section and MD&A. Please provide a comprehensive analysis explaining
how you have defined your reportable segments. For example, we assume
that your operating segments are at a lower level for purposes of
managing your business and that you have aggregated certain operating
segments. We may have further comment.
As the Staff's comment assumes, our homebuilding operating
segments are at a lower level than the regional information provided in
the Business section and MD&A. We provide this regional information to
enhance our Business and MD&A disclosure.
SFAS 131 defines an operating segment as a component of an
enterprise:
a. That engages in business activities from which it may earn
revenues and incur expenses
b. Whose operating results are regularly reviewed by the enterprise's
chief operating decision maker to make decisions about resources
to be allocated to the segment and assess its performance, and
c. For which discrete financial information is available.
Based on this definition, each one of our communities is an
operating segment, because the chief operating decision maker determines
resource allocation and analyzes performance at the discrete community
level. In addition, our financial services business is an operating
segment, because it is managed and operated separately from the
homebuilding communities, and we report it as such. However, under
paragraphs 18 and 19 of SFAS 131, we aggregate our communities into one
operating segment ("homebuilding") for financial reporting purposes
because none of the communities meet any of the quantitative thresholds
in paragraph 18:
a. 10% or more of the combined revenue of all operating segments
b. 10% or more of the combined reported profit of all operating
segments
c. 10% or more of the combined assets of all the operating segments.
Also, in accordance with paragraph 19, the combined segments
(individual communities) share a majority of the aggregation criteria in
paragraph 17. Specifically, with respect to each of the aggregation
criteria:
a. The nature of the products and services - In each of these
communities we design, construct and market single family or
multi-family homes. While tailored to appeal to specific market
tastes for the respective community, we develop lots and build and
sell homes to United States' consumers. We develop our plans on a
project by project basis, utilizing our expertise to develop a
plan that we believe will allow the project to deliver returns
consistent with our overall business strategy of maximizing the
total return on equity over the long term. The criteria used to
assess project viability and determine project approval are the
same across all projects.
b. The nature of the production process - The skills, methodologies
and production processes used in developing land and building
homes in each of the communities are very similar to identical
across all communities.
c. The type or class of customer for their products and services - We
sell our product to homeowners in the United States. While
communities may target different price ranges for these homes, we
believe that our customers are similar in that this will be one of
the most significant purchases in their lives, and therefore the
relative significance to each customer is the same.
d. The methods used to distribute their products or provide their
services - In connection with sales, we establish sales centers
and models and undertake marketing initiatives to raise awareness
of the communities. This is a process consistently applied, with
slight community specific modifications, across all communities.
e. If applicable, the nature of the regulatory environment - Banking
relationships and lending facilities are consistent in nature and
type across all communities as most are generated centrally by
Corporate. In addition, Corporate also obtains insurance on a
centralized basis. Each of the communities is impacted by their
local municipalities and utilities, but these local requirements
are comparable across all communities.
Based on the above, we believe that our operating segments
(individual communities) can be aggregated into a single "homebuilding"
operating segment for reporting purposes, in accordance with paragraphs
18 and 19 of SFAS 131.
9. In future filings, please disclose your accounting policy and
the factors that you consider in determining whether or not to
consolidate joint ventures where you are the manager of the joint
venture.
In future filings we will add disclosure to Note 2 - Summary of
Significant Accounting Policies and to the critical accounting policies
discussed in the MD&A, to expand on the discussion currently included in
Note 18 regarding the factors that we consider in determining whether or
not to consolidate joint ventures where we are the manager of the joint
venture. We anticipate that the additional disclosure will be as
follows:
"Our ownership interest in joint ventures varies but is generally
less than or equal to 50 percent. In determining whether or not
we must consolidate joint ventures, where we are the managing
member of the joint venture, we consider the guidance in EITF 04-5
in assessing whether the other partners have specific rights to
overcome the presumption of control by us as the manger of the
joint venture. In most cases, the presumption is overcome because
the joint venture agreements require that both partners agree on
establishing the operating and capital decisions of the
partnership, including budgets, in the ordinary course of
business."
10. In future filings, please provide enterprise-wide product-
line disclosures for each group of similar product as required by
paragraph 37 of the SFAS 131. This disclosure should include revenues
from the single-family detached homes, attached townhouses and
condominiums, mid-rise and high-rise condominiums and planned
residential developments described under Business Overview. Paragraph
101 of SFAS 131 states that enterprise-wide disclosures are appropriate
for all enterprises if a range of products and services are offered.
Paragraph 37 of SFAS 131 requires an enterprise to report the
revenues from external customers for each product and service or each
group of similar products and services unless it is impracticable to do
so. We believe we currently do this by providing revenues from Sale of
Homes, Land Sales, and Financial Services all separately on the face of
the income statement. Sale of Homes revenues include all revenues from
the homes delivered in our different communities. Communities can have
different types of homes, single-family, town-homes, condominiums, etc.;
however we believe that these are similar products (a residence for the
customer) and should be grouped. Land sales are disclosed separately
because those are a different customer type, generally another builder
or land developer. Finally, financial services revenue relates to our
financial services products (mortgage origination and title services)
and is provided separately. Therefore, we respectfully submit to the
Staff that we believe our current disclosure complies with the
requirements of paragraph 37 of SFAS 131.
Note 2. Summary of Significant Accounting Policies, Page F-8:
11. In future filings, disclose your revenue recognition policy
for attached condominiums, townhouses and mid-to-high-rise condominiums.
Please refer to SFAS 66.
We make the distinction between products with a construction cycle
less than 12 months or more than 12 months based on our interpretation
of SFAS 66.
The Decision Tree in Appendix F of SFAS 66 references Paragraph 20
of SFAS 66 with respect to the question of whether we are constructing
condos, office buildings, etc. Paragraph 20 states, "The deposit method
of accounting described in paragraphs 65-67 shall be used until a sale
has been consummated. .... However, because of the length of the
construction period of office buildings, apartments, condominiums,
shopping centers, and similar structures, such sales and the related
income may be recognized during the process of construction, subject to
the criteria in Paragraphs 41 and 42."
It is our interpretation that SFAS 66, Paragraph 20, allows
percentage of completion accounting for buildings with a long
construction time. Based on SOP 81-1, long term contracts that require
percentage of completion are generally projects that are longer than one
year. Therefore, we use a 12 month construction time threshold as the
first consideration for percentage of completion accounting. If the
construction time is less than 12 months we recognize revenue when the
title is conveyed to the buyer, adequate cash payment has been received
and there is no continued involvement. If the construction time is
longer than 12 months then we further consider Paragraph 37 in
determining if all the criteria are met to require percentage of
completion accounting.
In future filings, we will enhance our significant accounting
policy titled "Income Recognition from Home and Land Sales" to be more
descriptive of our current accounting treatment for attached
condominiums, townhouses and mid-to-high-rise condominiums. We
anticipate that the revised disclosure will be as follows:
"The Company is primarily engaged in the development,
construction, marketing and sale of residential single-family and
multi-family homes where the planned construction cycle is less
than 12 months. For these homes, in accordance with SFAS 66,
revenue is recognized when title is conveyed to the buyer,
adequate cash payment has been received and there is no continued
involvement.
In addition, the Company is developing, several high-rise/mid-rise
projects that will take more than 12 months to complete. If these
projects qualify, revenues are recognized using the percentage of
completion method of accounting during the construction period in
accordance with SFAS 66. Under the provisions of SFAS 66,
revenues and costs are to be recognized when construction is
beyond the preliminary stage, the buyer is committed to the extent
of having a sufficient deposit that the buyer cannot require be
refunded except for non-delivery of the home, sufficient units in
the project have been sold to ensure that the property will not be
converted to rental property, the sales prices are collectible and
the aggregate sales proceeds and the total cost of the project can
be reasonably estimated. Under the percentage of completion
method, revenues of individual projects are recognized on the
individual project's aggregate value of homes for which buyers
have signed binding agreements of sale multiplied by the
percentage of the actual construction costs incurred to total
estimated construction costs. Total estimated revenues and
construction costs are reviewed periodically and any impact on
revenues and costs recognized is applied prospectively. If the
homes sold in a high-rise/mid-rise project do not qualify for
percentage of completion accounting during the construction
period, then the revenues are recognized when these criteria are
met for each home when title is conveyed to the buyer, adequate
cash payment has been received and there is no continued
involvement with respect to that home."
12. In future filings, please disclose separately the allowance
for doubtful accounts and notes receivable either in the balance sheet,
the footnotes to the financial statements or in the Valuation and
Qualifying Accounts Schedule in accordance with Rules 5-02 and 5-04 of
Regulation S-X.
We do not disclose an allowance for doubtful accounts or notes
receivable, because we do not have an allowance for either. Customers
either finance their home purchases through mortgages or pay fully in
cash. Therefore, because we receive the entire sales price in cash upon
delivery of homes at closing, we do not have traditional receivables and
are not at risk for the collectibility of the sale price.
Insurance Deductible Reserves, Page F-9:
13. You disclosed that you increased significantly your general
liability insurance and workers compensation deductibles per occurrence
in 2005 and that in 2006 the deductibles per occurrence will increase
further to $20 million for bodily injury and property damage, $20
million for product defects and $1 million for worker's compensation.
You also disclosed that you introduced an insurance program to your
subcontractors whereby they will pay you insurance premiums and you will
assume the liability associated with work they perform on your homes.
Given the increasing risks that you are self-insuring and your exposure
to loss under your recently introduced insurance program for your
subcontractors, please disclose the following:
Your basis for estimating unpaid claims, claim adjustment expenses
and incurred but not reported claims reserves for the various risks that
you are assuming. Please also disclose if these insurance reserves
include provisions for inflation, claims handling, other administrative
expenses and legal fees.
The amount of insurance claims paid over the last three years.
Your revenue recognition policy under the insurance program that
you offer your subcontractors. Please also tell us how you are
classifying the income earned from your insurance program in your income
statement.
In future filings, we will include a discussion of the following:
We engage a third party actuary that uses our historical warranty
data to estimate our unpaid claims, claim adjustment expenses and
incurred but not reported claims reserves for the risks that we are
assuming under the general liability and workers compensation programs.
The estimates include provisions for inflation, claims handling and
legal fees.
Insurance claims paid by the insurance carriers were $8.8 million,
$222 thousand, and $376 thousand for the years ended October 31, 2005,
2004 and 2003, respectively.
For the information of the Staff in response to the request in
last bullet point of the comment, we apply amounts received from
subcontractors as a reduction to the cost of their services, and that
reduction flows through cost of sales with the related inventory. To
explain, our subcontractor work is covered by our General Liability
policy. Therefore, we require that subcontractors that do not have
their own suitable insurance reimburse us for being covered by our
General Liability policy. Prior to 2006, we recorded the amounts paid
by these subcontractors as an addition to our reserves and assessed our
total reserves based on the third party actuarial study. Based on any
excess or shortfall we reduced or increased insurance expense.
Beginning in 2006, because we now have an aggregate cap of $20 million
on our exposure and we reserve for this full exposure as part of our own
General Liability reserve, we apply amounts received from subcontractors
as a reduction to the cost of their services, and that reduction flows
through cost of sales with the related inventory.
Intangible Assets, Page F-10:
14. You disclosed that in May 2004 you changed the brand name of
a real estate company acquired in 2002 to K. Hovnanian Homes. Due to
the change in the brand name you reclassified $50 million from goodwill
and indefinite life intangible assets to definite life intangible assets
that you are amortizing over more than four years. Please explain in
more detail the following:
Why the original brand name was classified as an indefinite life
intangible;
Why the name change would result in a reclassification of goodwill
to definite life intangibles;
Provide support for the realization of the definite life
intangible related to the previous brand.
The original brand name was classified as an indefinite life
intangible because at the time of acquisition we did not have any
intention of discontinuing its use in its operating market. However, in
May 2004, we made the decision to transition to the KHovnanian trade
name by using KHovnanian at new communities and the original brand name
at the existing communities that were already being marketed with that
name. This decision resulted in reclassification from "goodwill and
indefinite life intangibles" (which were combined on one line item on
the balance sheet) to definite life intangibles.
To support the realization of the definite life intangible related
to the original brand name, we rely on the pretax profit from the
applicable communities using the original brand name, which is projected
to be $130 million and $65 million for 2006 and 2007, respectively.
These future profits are forecasted to be well in excess of the book
value at October 31, 2005 of $19.4 million.
Accounting for Derivative Instruments and Hedging Activities, Page F-12:
15. Under Customer Financing you disclosed that you sell mortgage
loans in pools or individually and against forward commitments to
institutional investors. In future filings, expand Footnote 6 to
describe the methods and assumptions used to estimate their fair value,
any associated hedging strategies and the net gains or losses recognized
in earnings during the period. Please refer to SFAS 133, SFAS 149 and
SAB Topic 5DD.
As the Staff notes, we disclose in Customer Financing that we sell
mortgage loans in pools or individually or against forward commitments
to institutional investors.
In Note 2 to the financial statements (F-13) we state that 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.
Also, in Note 6, we disclose more detailed information on the
mortgages held for sale at the period end.
In future filings, we will expand the disclosure in Note 6 to
present the information described above together in one location in the
financial statements, and, if material, we will include the net gains or
losses recognized in earnings during the period in that disclosure.
Note 17. Variable Interest Entities, Page F-21:
16. We note that most of your cash and letters of credit to
purchase land and lots are not consolidated. We assume this is because
you either do not consider them to be VIEs, and/or you do not consider
yourself to be the primary beneficiary. Please expand your disclosures
to provide an overall understanding as to how you interpret an option
for land or lots to be a VIE. For example, disclose what you consider
to be a significant nonrefundable option fee, and how that impacts your
interpretation. Also expand your disclosures to explain the conditions
under which you are not considered the primary beneficiary, both in
technical terms and how the nature of the option economically results in
that determination. Please refer to FIN 46 (R).
Note 17 states that we have concluded that whenever we option land
or lots from an entity and pay a non-refundable deposit, a VIE is
created in accordance with FIN 46R, paragraph 5 (b), because the equity
holders in the selling entity are not obligated to absorb the expected
losses up to the amount of our deposit, and they do not have the right
to receive expected residual returns of the entity if they occur,
because our option has put a ceiling on the price the seller can get for
the land.
Further as we state in our disclosure, for every option agreement
with a significant nonrefundable option fee (we currently define
significant as greater than $100,000 because we have determined that in
the aggregate the VIEs related to deposits of this size or less are
immaterial) we complete the financial analysis to determine the primary
beneficiary of the entity based on which party will absorb the majority
of the expected losses, or receive the majority of the residual returns.
We compute the expected losses and residual returns based on the
probability of future cash flows as outlined in FIN 46R. If we are
deemed to be the primary beneficiary of the VIE, we will consolidate it
on our balance sheet.
Typically, the determining factor in whether or not we are the
primary beneficiary is the deposit amount as a percentage of the total
purchase price, because it determines the amount of the first risk of
loss we take on the contract. The higher this percentage deposit, the
more likely we are to be the primary beneficiary. Other important
criteria that impact the outcome of the analysis, are the probability of
getting the property through the approval process for residential homes,
because this impacts the ultimate value of the property, as well as who
is the responsible party (seller or buyer) for funding the approval
process and development work that will take place prior to the decision
to exercise the option.
In future filings, we will expand our current disclosure to
include what we consider to be a significant nonrefundable option fee
and a discussion of the information in the preceding paragraph.
As you requested, the company hereby acknowledges:
the company is responsible for the adequacy and accuracy of the
disclosure in its filings;
staff comments or changes to disclosure in response to staff comments
do not foreclose the Commission from taking any action with respect
to the filings; and
the company may not assert staff comments as a defense in any
proceeding initiated by the Commission or any person under the
federal securities laws of the United States.