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Executives

Drew Mackintosh – Vice President, Investor Relations

Chad Dreier – Chairman and Chief Executive Officer

Dave Fristoe – Senior Vice President and Controller

Larry Nicholson – President and Chief Operating Officer

Gordon A. Milne - Executive Vice President and Chief Financial Officer

Analysts

Joel Walker - FBN Securities

Michael Rehaut - J.P. Morgan

David Goldberg - UBS

Nishu Sood - Deutsche Bank

Wayne Cooperman - Cobalt Capital

[Unidentified Analyst] - Zelman & Associates

Alex Barron - Agency Trading Group

Josh Levin - Citigroup

Robert Stevenson - Fox-Pitt Kelton

Chris Hussey - Goldman Sachs

Carl Reichardt - Wachovia Securities

Megan McGrath - Barclays

James McCanless - FTN Midwest Securities Corp.

Timothy Jones - Wasserman & Associates

[Harry Gordon - Portman Partners]

Susan Berliner - J.P. Morgan

Daniel Oppenheim - Credit Suisse

Buck Horne - Raymond James

The Ryland Group, Inc. (RYL) Q3 2008 Earnings Call October 23, 2008 12:00 PM ET

Operator

Good day, ladies and gentlemen, and thank you for participating in The Ryland Group 2008 third quarter results conference call. The company will first share its prepared comments, followed by a question-and-answer session. We would like to remind that this call is being recorded.

At this time we would like to turn the call over to Drew Mackintosh, Vice President, Investor Relations. Mr. Mackintosh, please begin.

Drew Mackintosh

Thanks. Good morning, and welcome to Ryland's third quarter 2008 earnings conference call. Today's call is being transmitted live over the Internet and can be accessed through Ryland's Investor Relations section of the website at Ryland.com.

In a moment I will be turning over the conference call to Chad Dreier, Ryland's Chairman and Chief Executive Officer. Also joining us today are Larry Nicholson, President and Chief Operating Officer, Gordon Milne, Executive Vice President and Chief Financial Officer, and Dave Fristoe, Senior Vice President and Controller.

Before we begin, please be aware that certain statements in this conference call are forward-looking statements based on assumptions and uncertainties that include the completion and profitability of sales, changes in economic conditions, mortgage lending markets, costs, and pricing and interest rates, consumer confidence in general housing market conditions, and general economic, business and competitive factors, as well as the factors set forth in the company's press release. These factors and other may cause actual results to differ from the statements made in this call.

With that out of the way, I will now turn the call over to Chad Dreier.

Chad Dreier

Thanks, Drew. Good morning and thanks to everybody on the call for joining us today. I assume you've all had a chance to review the release that we issued after the close of the market yesterday.

Ryland reported a loss per share of $1.54 for the quarter ended September 30, 2008. To state the obvious, the business of selling homes remains challenging. Buyers are understandably cautious and the level of inventory in most markets is too high. The third quarter did little to clear up the uncertainty surrounding the housing market, and also, as a result of the events of the last three weeks, we're off to a weak start for the fourth quarter.

As a company, however, we were able to accomplish some of the goals we set for ourselves with respect to cash generation, overhead reduction, and reducing net debt. These achievements did not result in a profitable quarter, but they did put us in a position to survive and ultimately thrive as the homebuilding market evolves.

Here are some of the details of the quarter:

Revenues for the Homebuilding segment came in at $526 million, with land sales contributing $14 million to that total. This represents a 27% decline from the third quarter of 2007. Closings dropped 19% to 2,017 units, and the average closing price fell 11% year-over-year to $254,000 a house. Considering that we ended the period with 30% fewer communities than we had a the end of the third quarter of last year, closing were actually up on a per-community basis. Our divisions in Las Vegas, Phoenix, Jacksonville, Charleston and Tampa all had higher closings when compared to the same period last year.

We did experience a sequential decline from the second quarter in our average Homebuilding gross margins from 12.5% to 11.8% before impairments.

Sales incentives, which result in a lower average selling price, continued to cut into our profit margins.

We were able to lower our SG&A, both in dollar terms and as a percent of revenue. We took $27 million out of SG&A compared to the third quarter of last year, and as a percent of sales, SG&A was down from 12.3% to 11.6%. This number would have been even lower were it not for some charges related to severance costs and model abandonments. Considering the revenue declines we have experienced, this overhead reduction was no small feat, and I want to thank all of our employees for doing more with less.

The unit sales decline was about in line with the drop in our community count, down 32% to 1,284 units. On average, sales fared better in our Northern and Texas divisions as compared to our Southeastern and Western divisions. Cancellations are always higher as a percentage of sales in the second half of the year due to the seasonality of the business. Still, we were disappointed with the 39% cancellation rate we experienced in the period. A buyer's inability to sell an existing home and credit issues continue to remain as the two biggest obstacles behind most cancellations.

Tough times like this call for an organization to rethink every aspect of the business, to find creative ways to save money, reduce overhead and operate more efficiently. Fortunately, Ryland's senior purchasing team has an average of 14 years experience negotiating agreements with vendors and suppliers in the industry. Few builders can match their tenure or expertise in the marketplace.

Our team's core philosophy is simple - conduct business with suppliers in an honest and ethical manner, leverage the size and scale of our operation to maximize volume discounts where possible, and ensure the best price via competitive bidding. We apply these principals not only to the direct materials that go into a house, but also to indirect purchasing categories such as telecommunications.

We have moved away from using turnkey solutions, which made sense when our business was growing, opting instead to bid out each step of the process to ensure the lowest price. For 2008 we expect to receive roughly $20 million in rebates from the people with which we do business.

Our divisions have also responded to challenging times by creating lower cost affordable alternatives like smaller floor plans, one-sided architecture and scaled back amenities. While we still believe in design centers as an effective way to increase revenue, we have reduced the number of choices we offer. All these initiatives contribute to a lower cost structure for Ryland.

As the industry has contracted, so has Ryland. We consolidated our Austin and San Antonio divisions, a move that will save us around $1 million over the next 12 months. Headcount at the end of the third quarter stood at 1,589, down more than 50% from our peak. We had 292 open communities at the end of September, 30% less than in the third quarter of 2007. The company has also taken $176 million out of standing inventory by reducing the number of spec units and model homes by 38% over the last year. We have demonstrated an ability to scale our business to appropriate levels through this downturn and will continue to do so.

Turning to the balance sheet, we ended the quarter with $345 million in cash, $784 million in debt and no borrowings on our bank revolver, resulting in a net debt-to-capital ratio of 36%. $56 million of this cash came from the liquidation of securities related to a terminated deferred comp plan. This money will be distributed to participants in the fourth quarter. The plan's termination will entitle Ryland to an additional estimated $12 million tax refund in early 2009.

Cash flow from operations in the third quarter was $101 million.

Lot count at the end of the period stood at 29,132 lots, with a breakdown of 80% owned, about 23,000 lots, and 20% optioned, about 6,000 lots. This represents a 36% decline in total lot count compared to last year.

We incurred $65 million in valuation adjustments in option-related write-offs. The bulk of the impairments were taken in our Washington, D.C., Austin and Minneapolis divisions.

With respect to land, we spent $60 million in the quarter on converting optioned land to owned and developing existing land. That brings our total land-related expenditures for the first nine months of the year to $185 million, which means that we will probably come in significantly below the $280 million that we had previously estimated for the full year. As a result, we expect to generate positive cash from operations in the fourth quarter and end the year with roughly $100 million more in cash than we had at the beginning of the year, after having reduced debt by $80 million and having paid $20 million in dividends.

We recorded a non-cash tax charge of $17 million for the valuation allowance related to our deferred tax assets in the third quarter. This brings our total tax valuation allowance to $216 million or over $5.00 per share. While this asset no longer shows up on our balance sheet, it represents a significant tax shield for the company once we return to profitability.

Moving to the Financial Services segment, we achieved another quarter of profitability, generating pre-tax profits of $6 million; 83% of our buyers opted to use our mortgage company to secure financing for their new home. The shift in government insured loans continues as 54% of the loans we originated in the third quarter were FHA or VA. Prime loans accounted for the rest. Our average FICO score was 712, and the average combined loan-to-value was 90%.

I've always believed that it's important to attract and retain the most talented and experienced leaders in the industry to ensure that Ryland stays ahead of the curve. To that end, we promoted Larry Nicholson to President of the company. Over the last year, Larry has done an exceptional job as Chief Operating Officer, managing the day-to-day operations of the business. He has a proven track record at the division, region and now national level, and I'm confident that Ryland will benefit from Larry's expanded role.

In conclusion, I am proud of how our company has executed in these tough times. The fact that we closed more homes on a per-community basis this quarter than we did last year is a testament to the hard work and dedication of our people in the field. Our cash balance has grown and it will continue to get better over the next two quarters as we generate more cash from operations and receive a substantial refund for taxes paid in prior years.

The keys to success in a cyclical industry such as homebuilding are one, stick to your operating philosophy, two, avoid too much leverage, and three, be poised to take advantage of opportunities coming out of the downturn. Ryland has stayed true to the first two keys, and I look forward to executing on the third.

I look forward to the day when the majority of our operational highlights no longer consist of our effectiveness in shrinking the company. Unfortunately, that is the environment we are in. Our challenge is to look through this downturn and determine where the opportunities will be. The future is bright for the homebuilders that survive this downturn, and we have the right people, systems and business model in place to be one of those builders.

That concludes our prepared remarks, and we'll now be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Joel Walker - FBN Securities.

Joel Walker - FBN Securities

I just wanted to talk to you about your material costs going forward. With the significant drop in commodities in the last month, do you think that will hit more in the fourth quarter or is that something that will hit more in 2009?

Chad Dreier

I think we'd see it in 2009. We're pretty comfortable we've got all our pricing locked in through the rest of 2008. We did that earlier, so we don't believe we'll see any of it until 2009.

Joel Walker - FBN Securities

And do you think in the first half of 2009 or maybe not, delayed to the second half? Do you have locks in place in the first and second quarters?

Chad Dreier

It varies by product. I mean, we have some stuff that's locked through mid-year next year, so it's hard to say when it'll actually happen. But we're pretty comfortable that we'll start seeing it some time in the first quarter.

Joel Walker - FBN Securities

D.J., what percentage of that was in the third quarter for closings?

Dave Fristoe

It was about the same as it was for the first half of the year, like in the 20% range. But, you know, it's gone. We don't deal with it anymore.

Operator

Your next question comes from Michael Rehaut - J.P. Morgan.

Michael Rehaut - J.P. Morgan

First question just on the environment. We're heard that things have softened throughout the quarter, particularly into September. Looking into the fourth quarter and people are trying to, I guess, tie up a backlog and see what they can do going into '09. What are you seeing in terms of competitiveness on price? We've heard a little bit of inelasticity, but at the same time demand is falling off even further and, while there may be some inelasticity, at the same time builders are rejiggering their product and trying to put out a lower ASP product. So how do you see yourselves falling out amid those types of trends and ideas that are starting to take place?

Chad Dreier

Well, I don't think we'd be any different than any other builders, trying to rejigger, to use a technical word, both our product and - we continue to really, I guess, teach, for lack of a better word, our salespeople to, if we get a buyer in that's really interested, to make sure we don't lose him or her, and we're still intending to use significant incentives.

And our goal for the fourth quarter is to do - part of what you said is to get every house that's already in backlog closed before the end of the year to generate the cash and two, to get every sale we can get to generate a backlog going into 2009.

It's highly competitive. All the builders are doing the same thing. We're all fighting for a smaller market. The economic conditions are challenging. For one, I'll be happy when the election's over, no matter who wins. I think that will eliminate some uncertainty in the marketplace. And we all hope that the credit crisis or whatever you want to call it on Wall Street continues to stabilize, and once that stabilizes, I think those are the bigger issues as to whether or not a buyer wants to buy a house.

Michael Rehaut - J.P. Morgan

Another question I have on cash flow generation, we've started to hear that - you know, a couple of builders that have reported already - that they'd be happy just to be cash flow neutral and that there is a chance to be negative in '09 given further decline in the backlogs and perhaps more limited ability to restrict land spend.

Can you give us any kind of initial thoughts in terms of, for Ryland, would it be safe to, at minimum, assume that cash flow generation would be down? Do you have any thoughts in terms of if it can be negative in '09? What are the levers place that you might still have to prevent negative cash flow for '09?

Chad Dreier

Well, you know, first of all, who really knows what in '09's going to happen? If you use today's economy, it'll be a tough year. I'd like to think it'll be marginally better.

But the one good thing we have going for us, we should get a significant tax refund - I don't know about the first quarter, but early in the year - and we think that'll be around $100 million. So for us, that's a pretty big number, and that will make up for a lot of other potential issues.

I'd like to think we'll be cash flow positive, and we won't know until we see what kind of backlog we have going into the year and how the year turns out for 2009.

Michael Rehaut - J.P. Morgan

What was your land spend in '07 and what do you expect it to be in '08?

Chad Dreier

Well, I don't know what it is for '07. I imagine that's just a matter of record. I think we said  what number are we using for '08?

Dave Fristoe

Well, nine months into the year we've spent $185 million on land expenditures and land development. I can get back with you.

Michael Rehaut - J.P. Morgan

Will that come down any further in '09?

Chad Dreier

It could. It should. We'll see.

Operator

Your next question comes from David Goldberg - UBS.

David Goldberg - UBS

I guess the first question I had is about Texas and Chad, you mentioned that it was a little bit better market relative to what's going on in the rest of the country. I guess maybe it's a little bit theoretical, but are you guys concerned about, given what's going on in the economy  also maybe what's going on with energy prices and oil prices - Texas taking a leg down from here? And if so, do you think the exposure is such that it's going to cause a significant decline as you move forward?

Chad Dreier

Well, that is pretty theoretical. While energy prices have come down, I think they only went up for the last six months or nine months. And I don't know, at $65 or $67 or whatever, they're kind of about where they were a year ago, I think. And I think if you're an oil company, $67 a barrel is still a pretty good deal, so I still think you're going to see Texas - and in our case Houston, you know, has more of the direct energy - so I wouldn't feel too awful concerned about that, and in fact I guess I'm a good enough American to think that a lower energy price is probably better for the economy.

The second part of the thing is, you know, Texas in general and, I guess, the markets in specific, never really had a huge run up in price. So to use your phrase, another leg down, I wouldn't be as concerned about it as I would have been in Chicago or Florida or California or something like that.

David Goldberg - UBS

I was wondering, Chad, you mentioned the increased use of incentives and how that impacts the gross margin in the quarter. Can you give us some quantification around what the number's going to look like from an incentive standpoint?

Chad Dreier

Well, we're still running in the 15% range.

David Goldberg - UBS

And is it similar, is it incentives or is it price mostly at this point?

Chad Dreier

I would say it's mostly incentives but, you know, I mean, every house is different. But by and large, if you use 15% and sort of an all in number, you're going to get pretty close.

Operator

Your next question comes from Nishu Sood - Deutsche Bank.

Nishu Sood - Deutsche Bank

I wanted to get some more details on the termination of the deferred compensation plan. So if I'm understanding it correctly, you got $50-some million from the sale of securities, but that cash is going to be disbursed in the fourth quarter?

Chad Dreier

Correct. You know, basically it was a deferred comp plan for over the RSOP limits or whatever it was. And it'd been in place for as long as I can remember being in the company, which, I might add, is 15 years next month. And as a result of the whole tax world, you know, this year we can go back to 2007 because we can carry our losses back two years. Starting in January, you know, it goes to - well, I guess we can go back to 2006 and starting in January we can't. You know, in 2007 we had a loss. So basically anything we can convert to a real transaction by the end of the year we can deduct as a tax deduction.

On deferred comp, like a lot of things, the company doesn't get a deduction until it's actually paid, so we terminated the program, paid the money out and the company will get a tax deduction of that $50-odd million when we file that tax return that I talked about in February or March.

And so if you use 30x% on the $50x million, you get the $12 or $13 million that I talked about.

Nishu Sood - Deutsche Bank

And you said that your cash balance at the end of the year is going to be about $100 million more, I believe, than last year.

Chad Dreier

Yes.

Nishu Sood - Deutsche Bank

That puts you level with where you are now, but obviously you're going to have a $50 million outflow, so does that mean your operating cash flow is only going to be $50 million in the fourth quarter?

Chad Dreier

Well, only is - you know, I'd be ecstatic if we only had $50 million. That's a lot of money for Ryland.

Nishu Sood - Deutsche Bank

Right, right. No, I'm just comparing it - obviously you're going to have all the year end closings and you generated, what, I think $100 million this quarter, so I was just trying to get a sense of -

Dave Fristoe

There's also a few debt repayments in the fourth quarter and the dividend. And so, I mean, it's a little better than that number.

Nishu Sood - Deutsche Bank

Have any of your divisional guys been out recently price shopping against nearby or comparable foreclosures? I just wanted to get a sense - pricing has been coming down pretty fast on the foreclosure side of things, so I wanted to get a sense of where you stand on your pricing versus the foreclosures on a kind of very specific local basis.

Chad Dreier

Well, first of all I would tell you if every guy that's working for us doesn't know what is going on in his market, he or she shouldn't be working for us. So the answer is they better damn well know what's going on.

We have had several instances where we'll sell a house for, let's just use a round number, $250,000, and a foreclosure happens four miles away at $240,000 or something, and that's a problem for us in the appraisal process. So it would be naïve to say that doesn't happen. It has happened, but I wouldn't call it an overwhelming catastrophe.

Nishu Sood - Deutsche Bank

So generally they're still above on a comparable basis?

Chad Dreier

Yes, I would say so. Hey, a new home is always going to be better than a foreclosure.

Operator

Your next question comes from Wayne Cooperman - Cobalt Capital.

Wayne Cooperman - Cobalt Capital

A question on gross margins. Has everything that you're running through the P&L been impaired already, and what has to happen so we can get the gross margins to a level where we're generating a real operating profit?

Chad Dreier

I would say 50% to 60% of the stuff we're running through has been impaired. There's still lots of, you know, like one of the earlier questions about Texas, we haven't had many impairments in Texas so anything that runs through hasn't had an impairment.

If you use the concept of - what I said on incentives was in the ballpark of 15%, and if you got back to, quote, normal, whatever that is, and you had 5% incentives, basically by definition your margins would be 10 points higher. So if I said 11.8% or whatever we said, you'd be at 21%-ish Which, you know, I think, in the long run we'd take and you could run a pretty decent business with.

And I think I've said this on the last couple of call. As an industry in general and as a company in specific, we need to get to the point where we at least get some equilibrium in the market and we can sell houses without having to give away so many incentives.

Wayne Cooperman - Cobalt Capital

Can you buy land in the market at today's prices and earn, you know, your high teens gross margin?

Chad Dreier

I would say not. I mean, we haven't seen any deal. I have to tell you, we're not looking like every day, but we haven't seen many of those transactions by either us or any of our colleagues or really any of the land funds either.

Operator

Your next question comes from [Unidentified Analyst] - Zelman & Associates.

Unidentified Analyst - Zelman & Associates

My question just kind of is around the revolver. I realize you guys are just using it for letters of credit now, but what would be the most stringent covenant? Is it still the debt-to-cap requirement?

Dave Fristoe

Yes, minimum consolidated net worth is the one we follow the most, I guess the one we've had amended a couple of times now.

Unidentified Analyst - Zelman & Associates

And where is that right now?

Dave Fristoe

At the end of the third quarter we had a little over $150 million of room.

Unidentified Analyst - Zelman & Associates

And what is the current debt-to-cap threshold that you have to stay under?

Dave Fristoe

We've got a lot of room under that one, and we've got a cushion of $365 million there.

Unidentified Analyst - Zelman & Associates

Who knows how it plays out in '09, as you said, Chad, but if you guys have to go back to the banks for an amendment, do you have the ability under your public indentures to secure the line if you had to?

Dave Fristoe

I don't know. Can we look at that and get back to you?

Unidentified Analyst - Zelman & Associates

Sure.

Operator

Your next question comes from Alex Barron - Agency Trading Group.

Alex Barron - Agency Trading Group

I wanted to ask you, I was kind of looking at the trend in the inventories over the last couple of quarters, just kind of looking at the year-over-year number as well as the trend in the backlog, and I'm getting that it's somewhere down in the 40% range, 38% range in dollars, but then when I look at the accounts payable, it doesn't seem to be down in the same percentage. It's more down like 18%. So I was trying to figure out what you guys think accounts for the disconnect there?

Chad Dreier

Well, I think we actually had this discussion the other day. And Dave can correct me if I'm wrong, but I think you're comparing a December 31 balance of '07 to a September 30 balance. And, you know, usually - I'll let you give the more specific.

Alex Barron - Agency Trading Group

No, I was looking at September over September. You can look at any of the previous quarters.

Dave Fristoe

Sure. But there is a difference between year end and September. That's part of it. The other is it just has to do with timing of runs, what's going on, how much development you're doing, how much construction, where you are in that construction, so we're getting our specs down, but we may have started them later in the quarter. There's some differences there that are reflected in AP, but over the long run it'll be in line.

Alex Barron - Agency Trading Group

My other question is - I'm not sure if maybe you mentioned it at the beginning; I might have missed it - are you guys expecting any tax refund or planning or selling any land to get tax refund from '06 taxes?

Chad Dreier

Yes, we did have a discussion on that earlier. We said we think, you know - and I'm couching it conservatively hopefully so I don't get slammed on this - we're looking, we think, for about a $100 million refund in the early part of next year.

Alex Barron - Agency Trading Group

And in any of the markets or communities that you're in have you reached at point at which you think it makes more sense to just shut it down because it just doesn't make any sense to keep cutting prices any further and just sell it off?

Chad Dreier

Yes, we actually are having that discussion. We haven't made any of those decisions yet, but we're having that discussion.

Operator

Your next question comes from Josh Levin - Citigroup.

Josh Levin - Citigroup

What are you thoughts on your current dividend?

Chad Dreier

We actually have had that discussion as well. And there's a Board meeting in early December, and that'll be on the agenda then.

Josh Levin - Citigroup

You said you were eliminating some customer choices in the design center, and I know that customization is an important driver for margins. How do you balance reducing your costs by eliminating choices without sacrificing too much incremental revenue that you would have gotten from customization?

Chad Dreier

Well, you know, I'm not an expert in the retail world, but sometimes if you give your buyers too much choice you never get an answer. We've gone to a pretty detailed study; if you offer 10 different kinds of carpet or something, it turns out 80% of the people use two or three selections and you spend a lot of money to carry the other 8. So we're probably going  I'm making this a hypothetical - we're going from 10 selections to 5, and you're covering 95% of the buyers. So we don't think we lose any buyer customization, to use your word, but we eliminate lots of extra space and cost to carry the other X items.

Josh Levin - Citigroup

I know you don't usually talk about the current quarter, but you mentioned that the fourth quarter's off to a weak start. Are you seeing the can tick up or are you expecting it to tick up this quarter?

Chad Dreier

Well, I think the problem with that is - and you know this is another I'm the old guy; I've always thought can rates should be as a percentage of backlog and not as a percent of current sales. I mean, if you read into my comments that October has had a weak start, that means people aren't exactly out buying lots of houses. So if you have a couple cancellations, your percentage is high.

So as a percentage of backlog, I don't think it's significantly different but, you know, traffic and sales, I think by terms were difficult.

Operator

Your next question comes from Robert Stevenson - Fox-Pitt Kelton.

Robert Stevenson - Fox-Pitt Kelton

In terms of the can rate, the big jump, did you see that in terms of people not being able to get qualified for mortgages, so a lot of the can increase happened at the beginning of the purchase, or were people significantly - a lot more people bailing at closing?

Chad Dreier

Well, I don't think we're seeing as many people bail at closing. I mean, that was a pretty big phenomena there in '07, but I don't think that's the issue. I think it's still people trying to - they can't sell their house so, you know, that comes later in the process. But on the credit deal, we try to get that pretty well up in the front of the process.

Robert Stevenson - Fox-Pitt Kelton

And then have you guys started seeing any material improvement on prices for oil-based materials?

Dave Fristoe

Improvement? Too early yet.

Operator

Your next question comes from Chris Hussey - Goldman Sachs.

Chris Hussey - Goldman Sachs

Any comment on the down payment assistance program post-October 1? Have you seen any material drop off in sales in those communities where that was more prevalent?

Chad Dreier

Well, you know, I forget when that law passed - I don't know, July or whatever. We knew it was going away in October, and I think Larry could be more specific, but we shut it down pretty quick and we're really only using it into August and September on our spec sales. We knew it was going away and kind of glided down with that. It's the real world. It's sort of like it's not there, so now you don't have it to sell and we just - that's how we deal with it.

Chris Hussey - Goldman Sachs

And can you characterize how many finished specs you have out there now at this point?

Chad Dreier

Yes, we could. I might need a minute.

Dave Fristoe

Finished or total? We've got total 715.

Chad Dreier

Finished around 200.

Chris Hussey - Goldman Sachs

And are you finding that the margins on those specs are materially lower than the rest of your business?

Chad Dreier

Hey, our margins are so crappy everywhere, it doesn't make much difference.

Chris Hussey - Goldman Sachs

Lastly, on the finished lot side, how would you characterize your land inventory at this point? How much of that is finished, that doesn't require a whole lot of investment.

Dave Fristoe

Owned, it's about 75%, so I assume finished would be, you know, because there's a mix in there, would be even higher, so maybe in the mid-80s to 90% range.

Chris Hussey - Goldman Sachs

And then last is sort of a theoretical question in anticipation of like your step number three, which is taking advantage of this thing once you start coming out it, as you assess what's happened in the downturn, how big a division do you need to be successful in this business? Are you going to be able to be as ubiquitous in terms of the number of communities that you're developing? Are you going to have to tone that down and become a little bit more local to make sense of this going forward?

Chad Dreier

That's a good question, and I have spent a lot of time thinking about the business model. I still think a division, which for us would be a city, needs to do about 300 units a year to really take care of all of the issues it takes to be a public builder, etc., etc., etc. And if you get to 500, you're making a pretty good, decent return, and anything over 500 is really wonderful.

So one of my bitches with communities is, you know, if you've got to 300 units, would you rather have 12 communities that are doing 25 each or 6 that are doing 50? I'd rather have 6 that are doing 50. And so the real question's going to be, if we ever get to whatever we call normal again, will you be able to get a sale a week and get 50 units out of a community.

And just like in the old days, even in the good times, some cities are more - you can do that easier in some cities than other. In Texas, it's pretty easy. In some of the Midwest, it's not so easy.

So I still think the basic business model works, and I think one of the advantages we're going to have coming out of the downturn, whenever it is, is that you're going to see a lot less of the smaller private builders. The banks are hardly - well, they're not even polite to us, and we don't owe them any money. They're not really dealing with the smaller guys, so you're going to see a lot more of the smaller private guys gone and that's a double-edged sword. It'll be plus and minus.

But today I still feel the business model is okay. We'll keep evaluating that and, you know, if we get to February and the world's different again, we'll have to take another look at it.

Operator

Your next question comes from Carl Reichardt - Wachovia Securities.

Carl Reichardt - Wachovia Securities

Of the finished lots that you have, how many of those are either in or tied to communities that you've got open now roughly do you think?

Dave Fristoe

I wouldn't have that stat. We'd have to get back to you on that.

Carl Reichardt - Wachovia Securities

Do you guys have the basis point impact from previous impairments that went through gross margin this quarter?

Dave Fristoe

$53 million.

Operator

Your next question comes from Megan McGrath - Barclays.

Megan McGrath - Barclays

Just a really quick follow up on your spec count. A couple of builders have taken opposite tacts in terms of their feeling about spec, some saying they want to keep some on the books in terms of people needing to buy a home quickly, some saying they want to get rid of as many as possible. Where are you in terms of your feeling around your spec count and are you keeping any specs open for folks who are needing really quick sales?

Chad Dreier

Well, what we're trying to do is have about half of them finished so we can accommodate those people that do walk in and need a house timely. But we're trying to maintain our twofer community, which we've pretty much stuck to, so half are finished and half are not finished and we'll continue to go along those lines.

Megan McGrath - Barclays

For next quarter in terms of the $12 million tax refund that you're expecting from that reversal, does that mean it's going to flow through the income statement as a loss next quarter?

Dave Fristoe

No.

Operator

(Operator Instructions) Your next question comes from James McCanless - FTN Midwest Securities Corp.

James McCanless - FTN Midwest Securities Corp.

I wanted to ask about potential purchase opportunities from the banks that can sell foreclosed properties. What's the latest on those? Any falling by the banks?

Chad Dreier

Well, we weren't seeing much. With all due respect to the banks, it kind of takes them awhile to get that machine moving, so we haven't seen much of that yet. I'm guessing that will come in the first part of 2009.

James McCanless - FTN Midwest Securities Corp.

And then another question, more theoretical, for '09. If you're reducing the amount of skews that you're offering in the design center and potentially going to a smaller footprint overall, does that mean that incentives could potentially go down as a percentage of sales next year or how are you all thinking about that?

Chad Dreier

Well, I would think incentives as a percent of sales has more to do with the purchasing power, buyer supply/demand side than it does the size of the house.

James McCanless - FTN Midwest Securities Corp.

So the incentives, in other words, you wouldn't need to keep a larger amount of options on hand to help sell the house and maybe save some gross margin or no?

Chad Dreier

I don't think so, but I'm sure we'll be doing another call in January and April and we'll follow up.

Operator

Your next question comes from Timothy Jones - Wasserman & Associates.

Timothy Jones - Wasserman & Associates

Did you say that you took $53 million from prior impairments through the income statement in the third quarter?

Chad Dreier

Yes.

Timothy Jones - Wasserman & Associates

And what was that in the prior quarter, sequential quarter? In other words, I'm trying to get to the decline in your gross margin from 12.5% to 11.8%.

Dave Fristoe

Right. I don't have the prior [inaudible] handy, but it's 109 year-to-date.

Timothy Jones - Wasserman & Associates

So could you go into a little more - a lot of builders aren't actually showing an improvement  not all of them, believe me - sequentially in the gross margins, maybe more this prior impaired stuff coming through, and yet yours went down from 12.5% to 11.8%. Can you give me a little more flavor on that?

Chad Dreier

Probably not, no. I mean, you've got 2,000 units you've got to go through and analyze them all, and this is that and that's that. I mean, you know, it's -

Timothy Jones - Wasserman & Associates

I mean, there's got to be one or two major things that are causing it, though.

Chad Dreier

No, I don't really think so, to be honest. Hey, we wish it was the other way, but it's 0.7 of a point and we'll take another look at it. We'll see if we can come up with something, and I'll have Dave or Drew give you a call.

Timothy Jones - Wasserman & Associates

The other question is, to make what you said, of your 80% owned lots, you said 75% of that 80% are finished. Is that correct?

Chad Dreier

Yes.

Timothy Jones - Wasserman & Associates

And then you had the 6,000, probably most of those optioned lots, are finished. You say it's roughly 85 of the total. Is that correct?

Chad Dreier

I don't know that we said they were on the optioned.

Timothy Jones - Wasserman & Associates

It's going to be the 85 to 90 number, and I didn't know what that -

Dave Fristoe

No, we were talking about finished lots.

Chad Dreier

We were just talking about finished. I don't think we made a comment on options, and I don't know that I would know off the top of my head.

Dave Fristoe

It's about 50% on the options.

Chad Dreier

50% on the options are finished.

Timothy Jones - Wasserman & Associates

And 75% on the owned.

Chad Dreier

Yes.

Operator

Your next question comes from [Harry Gordon - Portman Partners].

Harry Gordon - Portman Partners

A question about competition from the smaller builders. Are you seeing any particular change in their activity? Are they starting to get foreclosed? Are they liquidating and more competitive? How would you characterize it?

Chad Dreier

Well, I think Larry might know more than I do, but it seems like every week you read about another builder filing Chapter 11 or announcing they're going out of business. In almost every city you see that reasonably often.

Harry Gordon - Portman Partners

Does that take awhile to actually benefit you? When they say they're liquidating, do they have another six months of sales or clearance?

Chad Dreier

Well, you know, I mean, the answer's probably yes. What I was referring to is, you know, when we came out of this downturn and went back to whatever normal is, I thought we'd have less competition from those guys. So, yes, that'll take six months, a year, 18. You know, each one's different.

Harry Gordon - Portman Partners

As we speak you haven't seen much yet, much benefit?

Chad Dreier

Hey, you know, you saw the numbers. We haven't had much benefit of anything here for awhile.

Operator

Your next question comes from Susan Berliner - J.P. Morgan.

Susan Berliner - J.P. Morgan

I was wondering if you could talk about surety bonds. I guess with municipalities hurting I was wondering if you're seeing any of them being a little bit more aggressive on perhaps spending more or are you hearing anything from other builders?

Chad Dreier

No. I mean, we're not seeing any change in it. Obviously, we think we have good relations with those municipalities, and we haven't seen a problem.

Susan Berliner - J.P. Morgan

Can you talk a little bit about incentives? I don't think you gave a rate this quarter, and I guess what kind of incentives do you think are effective in this market right now?

Chad Dreier

Well, I'm going to chide you for not being on the whole call because we've said twice our incentives are in the neighborhood of 15%.

The second half of the question is are they effective? I think that's what I heard. You know, one of the other fellows asked earlier, mentioned inelasticity. I mean, right now everything's pretty inelastic, and if you have 15 as an average, obviously some are lower and some are higher. In some cities they work better than not. And actually we really - that's a house by house deal in each city.

I mean, generally speaking, I think you'd say if they weren't we'd have a lot more sales, both as an industry and a company, and we don't. So right now I think - and I think Larry and the rest of the guys around the table would agree - buyer uncertainty or uncertain economic conditions probably trumps incentives.

Operator

Your next question comes from Daniel Oppenheim - Credit Suisse.

Daniel Oppenheim - Credit Suisse

I was wondering if you can talk a little bit about the impairment in the Austin market? You talked about some prices holding up. With that, was it a few communities? Just any color on that there in Austin.

Chad Dreier

It's just one project, one community. Three product types in the community.

Daniel Oppenheim - Credit Suisse

Then secondly I'm just wondering since maybe you opened the can of worms by talking about community counts overall, but if we were to think about it based on the regions, where were the order trends that you saw sort of consistent with rising orders per community - across all regions or what sort of variety do you see there?

Chad Dreier

Actually, you know, Dan, I think in the call I said something, but maybe I'm wrong on that. Well, what we've said is sales fared better in Northern, which would be the Mid-Atlantic and the Midwest and Texas, and lower in the Southeast, which would be Florida and the Carolinas, and the West, which would be Phoenix.

Daniel Oppenheim - Credit Suisse

That's per community you're referring to?

Chad Dreier

Well, you know, I guess, because we said the drop in sales in communities was about the same, so I guess you'd have to say that.

Operator

Your next question comes from Buck Horne - Raymond James.

Buck Horne - Raymond James

I was just wondering if you could talk about can you rezone or reposition some of the lots in your communities to maybe downsize some of them, make them more feasible to support smaller and more affordable homes? What percentage of your neighborhoods might you be able to kind of rezone or reconfigure your lot sizes?

Chad Dreier

You know, that's one of those great, theoretical, easy questions in a classroom that's really difficult to do in the field. I don't even think you could do it in a California or Maryland or something like that, where it takes five years to get a permit. By the time you got the permit, you are locked into whatever you got. Texas, it's a little easier, but Texas is still a, hey, bigger is better market.

So I wouldn't say you can do that that much. Usually what you need to do is say, we have a new phase or a new takedown or just buy a new acquisition or something. So I wouldn't say that is very practical and it doesn't happen very fast.

Buck Horne - Raymond James

And maybe can you also talk about just how your repositioning your floor plans, design and really where do you envision your kind of target price point moving towards in this market to meet affordability for the buyer?

Chad Dreier

Well, I mean, under today's conditions, lower is better on the price, so we're trying to take what you'd call the sexy stuff out of the house. To the first part of your question, I would say, you know, the houses would be - I don't want to use the world more plain, but simpler and, if somebody wanted crown molding or something, they could buy that in the design center. So you're seeing stuff that maybe a couple of years ago we would have included in the base house we're taking out and putting that into an option.

Operator

Your last question comes from Alex Barron - Agency Trading Group.

Alex Barron - Agency Trading Group

Given that there's more foreclosures these days, sometimes inside even builder communities, have you guys it's starting to affect appraisals?

Chad Dreier

Yes, I mentioned earlier we have seen that in several instances. And that's a challenge and a problem and we need to work through it on each community as it comes up.

Alex Barron - Agency Trading Group

My second was on this Kyle Canyon. I guess there was a story a couple of days ago on Bloomberg saying that Wachovia was trying to recover the money on the loan.

Chad Dreier

Yes. Hey, actually, I'm going to give Dan Oppenheim, who was on the call a minute ago, from Credit Suisse, he wrote a very nice two-page - I guess one-page summary of his version on the Wachovia thing and the exposure to the builders. My general counsel would yell at me for commenting on litigation so I won't comment on litigation, but I think if you read Dan's report it'd give you a pretty good answer.

Alex Barron - Agency Trading Group

Can you comment on at least what you guys have already written down against that project?

Dave Fristoe

Well, we wrote our equity off two quarters ago on it. The bank's going after the completion guarantee. You kind of need to read something on that to see what the magnitude of that is, but you've got to remember, we've only got 3.3% of that project. I think the bank's asked for $365 million or something, so at worst it's a $10 million issue, but we don't think it's that much. So we can't comment on it.

Alex Barron - Agency Trading Group

Yes, I think the numbers are small for you guys. I was just wondering if you had only provisioned for the equity.

Dave Fristoe

Yes, we've written the equity off some time ago.

Operator

Thank you. There are no further questions in queue at this time.

Chad Dreier

All right. Hey, well, we appreciate everybody's interest, and we're going to go back to work and try to get a lot more accomplished in the fourth quarter and we'll look forward to talking to everybody in January. And I hope everybody has a nice holiday season. Thanks. Bye, bye.

Operator

Ladies and gentlemen, this does conclude today's conference. We again thank you for your participation. You may all log off and disconnect at this time. Good day.

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Source: The Ryland Group, Inc. Q3 2008 Earnings Call Transcript
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