Wednesday, September 14, 2011

Capital Structure Arbitrage Idea (HOV, HOVNP)

I can't believe that basically all the homebuilders survived the crash without having to file for bankruptcy or completely wipe out the equity. Granted, they had to restructure by raising massive amounts of equity and exchanging debt for new equity.

Anyway, realization is dawning once again that residential real estate is still troubled due to massive inventory overhang, especially all the houses that are the wrong type (too big) or built in the wrong places. The SPDR homebuilder ETF (XHB) is down 17 percent year to date.

I notice that the more troubled homebuilders are developing mispricings in their capital structures. For example, the Hovnanian preferred stock (HOVNP) trades at 12 cents on the dollar. That's a market value of 15 million for the 125 million in face value of preferred, which is a deficit of 110 million. Yet the company has a market capitalization of 140 million. That is a pretty glaring inconsistency.

Equity investors are wildly optimistic (as we saw with the worthless stock inefficiency) and therefore a company's common stock price is usually not as realistic a reflection of enterprise value as the prices of more senior securities. I think the most likely outcome with HOV is that both the common stock and the preferred go to zero. That is certainly what the preferred stock and bond prices suggest.

The one downside to a long HOVNP short HOV trade is that the preferred dividend is not only suspended, but also is not cumulative. That means that the dividends are not accruing, although the common stock cannot receive distributions until the preferred dividends are reinstated.


John said...

Just trying to learn here: without a dividend, what is a possible advantage to a long HOVNP, short HOV trade? What would be the best possible scenario?

CP said...

The best possible scenario would be the common stock going to zero and the preferred getting a recovery equal to its current trading price.