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Executives

Larry Mizel - Chairman and CEO

Chris Anderson - SVP and CFO

Analysts

Michael Rehaut - JPMorgan Chase

Nishu Sood - Deutsche Bank

Dan Oppenheim - Credit Suisse

Carl Reichardt - Wachovia

Joel Locker - FBN Securities

Josh Levin - Citi

Alex Barron - Agency Trading Group

Susan Berliner - JPMorgan

Alan Ratner - Zelman & Associates

Joshua Pollard - Goldman Sachs

Jim Wilson - JMP Securities

M.D.C. Holdings, Inc. (MDC) Q3 2008 Earnings Call October 31, 2008 10:00 AM ET

Operator

Welcome to M.D.C. Holdings 2008 third quarter earnings conference call. On the call with me today I have Larry Mizel, Chairman and Chief Executive Officer; and Chris Anderson, Senior Vice President and Chief Financial Officer.

At this time, all participants are in a listen-only mode. After finishing our prepared remarks, we will conduct a question-and-answer session. (Operator Instructions).

Please note that this conference is being recorded and will be available for replay. For information on how to access the replay, please visit our website at mdcholdings.com.

Before turning the call over to Larry, it should be noted that certain statements made during this conference call including those related to M.D.C.'s business, financial condition, results of operation, cash flows, strategies and prospects and responses to questions may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These statements involve known and unknown risks, uncertainties and other factors that may cause the company's actual results, performance or achievements to be materially different from the results, performance or achievements expressed or implied by the forward-looking statements.

These and other factors that could impact the company's actual performance are set forth in the company's 2007 Form 10-K and 2008 third quarter Form 10-Q. It should also be noted that SEC Regulation G requires that certain information accompany the use of non-GAAP financial measures. Any information required by Regulation G will be posted on our website.

And now, I will turn the call over to Mr. Mizel for opening remarks.

Larry Mizel

Good morning and welcome. During the third quarter, economic turmoil took center stage in our country and across the globe; highlighted by the failure of highly respected financial institutions and a decline in U.S. consumer confidence to an all-time low. While the government has responded with unprecedented legislation among other things to stabilize our economy, the outlook for short-term recovery is not promising. Of course, given the turmoil in the home building industry, we have been dealing with distressed market conditions for more than two years and as a consequence, our focus in the third quarter was little changed from what we have discussed with you in prior calls.

And so we remain focused on the preservation of our balance sheet strength during the quarter. To that end, we generated in excess of $100 million in operating cash flow largely through our efforts to reduce inventory balances.

Just in the past quarter, we decreased our total lot count including WIP lots by 13% which brought the total decline over the past year to 46%.

Our ability to reduce overhead also helped us to maintain our steady stream of operating cash flow.

For the third quarter, we decreased our general and administrative expenses by 33% over the same period last year as we continued to adjust our organizational structure to fit a smaller base of revenue.

We ended the quarter with $1.37 billion in cash and investments. While others in our industry have accumulated large cash balances as well, we are only one of two builders whose quarter end cash and investments exceeded total debt. And furthermore, our next debt maturity does not occur until 2012. Therefore, though many businesses across the country have struggled in the wake of tightening credit markets and overall market volatility, we believe that our capital structure currently provides us with adequate resources to pursue optimistic investments as we seek to capitalize on current market conditions.

Many of you are aware that our company currently has no joint ventures, no off-balance sheet financing, that our exposure to performance bonds and letters of credit related to land development activities is low with an estimated cost to complete of less than $50 million and that we focused almost exclusively on one type of product, single family detached homes.

This is a key advantage for our company because it means we are better able to focus on improving our business, going forward.

With unit volumes far below their peak, we believe that now is the time to apply the talents of some of our best and brightest people to initiatives that are designed to improve key aspects of our operating platform. In that spirit, we continue to move forward with our company-wide initiatives to streamline and improve our process and business practices, and at the same time, we remain dedicated to providing the best possible homebuying experience for our customers.

Ultimately, the successes we achieve in these areas should have a significant positive impact on our bottom line.

As most of you know, Chris Anderson is on the line with us, first time as our new CFO. I'd now turn the call over to Chris.

Chris Anderson

Thanks, Larry, and good morning, everyone. I'm excited to have the opportunity to speak with you on the call here for the first time. One quick housekeeping item; we did file our 10-Q this morning, so that information is out there for those of you who would like to look at the quarter in greater detail.

Moving back to our slides, as Larry mentioned, our cash flow continues to be a key focus for us. We've now generated operating cash flow for nine consecutive quarters, almost $1.5 billion in total, including the $106 million, we generated this quarter.

Year-to-date, we generated $429 million in cash, which includes $90 million of tax refunds we received in early February.

Over the last 12 months, we've generated $686 million in positive operating cash flow. We've accomplished this consistent cash flow mostly through a real reduction in our inventories.

This slide shows the trend over the past year for both our land and work in process lots, with sequential declines every quarter for each category.

Looking at the land side of things, our quarter end lot count is down 42% over the past year and 13% in just the past quarter. We've been able to steadily decrease our lot count by focusing on a couple of areas.

First, as has been the case for the past couple of years, by limiting our new land acquisitions which were less than $5 million in the past quarter. And second, by continuing to sell land parcels in selected areas across the country.

During the third quarter, we sold about 530 lots for approximately $16 million in proceeds. Most of these lots were in Arizona and Florida. While we actually recognized the small gain on these sales for book purposes, the tax loss associated with these sales was over $25 million, since these lots have been significantly impaired. So as a result, these sales should help us to maximize the NOL carryback refund that we expect to get from 2006, which could reach as high as $164 million.

Of the 7800 lots we have remaining, almost 1,000 are classified as held for sale, meaning we've determined that our highest and best use for them is to sell them to an outside party. At the end of the third quarter, these lots had a book value of approximately $17 million. 700 of these lots are in California and Arizona with the balance split between Virginia, Illinois and Florida.

I should also note that the vast majority of the lots that we own are finished, so there is not a lot of development money to be spent on these assets. And we've continued to focus on keeping our exposure on the surety side down. At the end of the third quarter, we had only $186 million in bonds outstanding, which is down 19%, since the end of the second quarter.

As we previously disclosed, we have less than 50 million of development work that's required to fulfill our obligations under those bonds.

For work in process, our lots are down to 2300 at the end of the quarter. That's a decrease of 17% during the quarter and 56% over the past year. Of these, only about 360 are completed homes that have not yet been sold as of the end of the quarter.

The lots we have under option actually didn't change much during the quarter but year-over-year they are down 31% to 2752 at the end of the quarter. And for those lots, we only have $11 million at risk, $10 million being deposits and $1 million being due diligence cost.

In the third quarter, active subdivisions fell from 227 to 211, similar to last quarter, the largest declines occurred in our western market with California, Nevada and Arizona at the top of the list.

The next slide really is key to the story of M.D.C. What you can see is that not only as our cash and investment balance grown by 88% over the past year to $1.37 billion, but it also now exceeds our total debt by 33%. And on top of that, we have about $530 million of available borrowing capacity. We believe that our balance sheet strength is at the top of our industry, which is certainly a key distinction as credit markets tighten, and overall economic conditions continue to decline.

Turning to some of our key operating metrics, you can see that the demand is still limited, when you look at the significant decline in our orders. In the third quarter, we received 667 net home orders, down 46% versus the same period last year. Every market showed a decline ranging from 13% in our Delaware Valley market to 65% down in Illinois.

A 27% decline in our average active subdivision count contributed significantly to the drop in new orders. But our orders are also down 25% on a same-store basis as net orders for subdivision dipped below one per month.

Our cancellation rate of 46% was down from 57% in the third quarter of 2007 but it's still relatively high in the industry and by our own historical standards. The most common reason for a cancellation during the quarter was financing issues. These lower net orders have contributed to a significant decline in our backlog which is now down to 1,127 homes.

Our average price in backlog is also down from 356,000 at the end of the quarter last year to 323,000 this year.

The next slide takes a look at our bottom line. Given the limited demand I talked about on the last slide, both our home closings and average selling price declined year-over-year for the third quarter and nine months periods. However, we were able to narrow our losses on a pre-tax basis and an after-tax basis year-over-year, due to a significant decline in impairments and SG&A. Our average price was down 9% to about $302,000 that's off $30,000 from where it was last year. All of our markets posted a decline with the biggest drops coming in Arizona and Nevada, and the smallest in Colorado. We actually saw a sequential increase in our average sales price for the first time, since the fourth quarter of 2006. But the improvement was really just the result of a slight mix shift away from some of our lower priced homes with Arizona, Nevada and Florida all representing a slightly lower percentage of closings.

And within California, our closing shifted to higher end product, which resulted in a significant increase in average selling price over the second quarter, even as that market continue to struggle.

Touching on gross margins quickly and we'll come back to that in just a moment. Overall for the company, we were at 15.3% in the third quarter, which is up 120 basis points from last year and up 360 basis points from the second quarter. We decreased our SG&A expense year-over-year by $46 million, a 36% drop. Even more significant was the decrease in impairments for the quarter.

The third quarter of 2007 was a peak in impairments for us at $249 million and this quarter the charge fell to only $95 million. Offsetting that, our closings were down 43% with double-digit declines in every market led by Utah and Arizona.

Financial Services profits were down for the quarter, primarily due to lower insurance revenues collected from our subcontractors as construction activity continues to decrease.

Looking at the mortgage company, we also saw lower gains on sales of mortgage loans as our overall volume decreased, but we more than offset that decline with decreases in G&A. So the mortgage company on a stand-alone basis actually increased its profits over last year.

On the corporate side, we shifted from a small gain to a $9 million loss in the third quarter. A few things really drove this decline. First, we recognized $10 million in interest expense this quarter outside of what runs through our cost of sales. Looking at that charge on a very basic level, in the third quarter we saw the inventory in our books drop below the total amount of our senior notes for the first time in recent history. And as a result, we could no longer capitalize full amount of interest incurred related to those senior notes. So $10 million had to be expensed immediately at a corporate level.

Second, in the third quarter of 2007, we recognized an $8 million gain on the sale of an aircraft and that wasn't there for us this quarter. And finally, as we discussed in prior quarters, the supervisory fee that we charged to our other segments was lower in the third quarter versus the same period last year.

Overall, our pretax loss for the third quarter was $117 million down from $251 million last year, on revenues of $361 million versus $687 million in the prior year. Our net loss for the quarter was $118 million as compared with $155 million in 2007 third quarter. As you might have noticed, we actually booked a small provision for an income taxes, during the quarter despite our significant pretax loss.

The reason is that we recognized a $61 million valuation allowance against our deferred tax assets, which basically eliminated the benefit from income taxes that you might have expected to see. We've taken such a valuation allowance in each quarter since the fourth quarter of 2007.

Now back to margins. This slide shows our trends since the third quarter of 2007. We report gross margins on an after interest basis but we've also shown it on our pre-interest basis here, just to give you a sense for the significant impact of interest over the past year. The amount of interest that we now attach to each dollar of inventory is much higher than in years past, given the substantial decline in our inventories over the past two years and therefore, it's coming through as interest to cost of sales at a much higher rate, even after we directly expensed some of the interest incurred this quarter.

Even looking at things before the interest impact, the green bar on the slide, our gross margins are up by about 200 basis points from the same quarter last year and from the second quarter. But the improvement in margins is really just a function of the significant amount of impairments we've taken in the past. Had we not taken any impairments, in past periods, our gross margin would have been negative in the third quarter.

As a final thought on this slide, as we mentioned last quarter, the impact of spec sales continues to weigh on our margins. For a few quarters now, we have seen that buyers are really looking for quick move-in homes and of course they are looking for a good bargain to close in this kind of a market.

About 65% of our closings in this quarter were on specs and those specs typically generate a lower margin than a dirt sale, where the buyer can choose everything he or she wants in the house from the start.

Looking at our G&A expenses, we are down 33% as compared with last year. We've done this primarily through significant adjustments in our operating structure with both operating divisions and employee headcount down around 40%.

As you may have read in our press release, we made the decision to exit our Illinois operation during the quarter. Unfortunately, since Illinois is one of our newer markets, we have not been able to grow to a level of volume that truly justifies our overhead expenses and we know it that will be difficult to grow our operations there in the near term given the tough economic environment, we've seen across the country. So it made sense to wind down our operations at this point.

As we move forward, we'll continue to adjust our operating structure, if market conditions continue to deteriorate. Also for the quarter, our marketing expenses are down 34% from the prior year and our commissions are down 49%. You can see that our G&A expenses went up as compared with the second quarter. As we disclosed in our second quarter 10-Q, part of the increase relates to credits to G&A that we made in the second quarter, but were not repeated in the third quarter.

Specifically, during the second quarter, we saw a $3.6 million benefit related to legal expense as a result of resolving construction defect claims, the cost of which are now expected to be paid by third-party insurance carriers and a $3.5 million benefit related to a reduction in warranty reserves that were established through G&A during prior reporting periods.

On our final slide, we have an update on impairments for you. This shows the history of our impairments since the beginning starting in the third quarter of 2006. Looking at our most recent quarter, we are up slightly from the second quarter, but we are down 64% from the peak level of impairments that we saw a year ago.

The West markets continue to see the majority of our impairments and on an absolute basis, the West has booked a relatively constant impairment number for each of the three quarters in 2008. Due to the extent of the impairments, we booked in the segment combined with the liquidation of inventory we achieved through land sales, we only have about $52 million in land in the West now, including less than $1 million in California.

Also for the second straight quarter, our Mountain segment contributed quite a bit to the impairment total mostly in Utah from declines that started a little later in this downturn than they did in most of the other markets.

Overall, we impaired 3500 lots and 150 subdivisions that includes 441 lots in eight subdivisions that are held for future sale, $63 million of the impairment related to our land account, $21 million related to our work in process, and $7 million related to a held-for-sale assets.

After reducing our lots owned by 10% during the quarter and recording the additional impairment, our land inventory now stands at just 150 million. We want to thank our M.D.C. team from across the country, they’ve done a fantastic job, even as we’ve had some difficult choices to do and make in today's environment.

At this time, we'll open our line for any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instruction). Your first question comes from Michael Rehaut from JPMorgan Chase. Your line is open.

Michael Rehaut - JPMorgan Chase

Thanks, good morning everyone. First question I had was just if in regional color. Obviously, all the markets essentially that you are in remain pretty weak but are there any markets that stand out in terms of either pricing. Maybe, if you can just talk about which markets you feel are the weakest in terms of price and which on a relative basis perhaps you are a little bit more hopeful on?

Larry Mizel

Michael, I would say it's generally consistent throughout the country, applied in both the positive and the negative.

Michael Rehaut - JPMorgan Chase

Okay.

Chris Anderson

One additional comment, Michael, is if you look at some of the information in our Q, you can look at what has happened with pricing over three-months comparatives and nine-months comparatives and Colorado has actually shown pretty stable from a price standpoint. And some of these markets are little bit in different cycles, Utah showing a pretty significant decline recently versus some of the other markets that have had a bigger decline earlier in the cycle.

Michael Rehaut - JPMorgan Chase

Okay. Thanks for that. Second question, as you guys continue to strengthen your balance sheet, there has been a lot of I guess guesswork, Larry, on the sales side and buy side in terms of when you might be tempted to take a more constructive look on land. Are you starting to nibble in any areas or are you tempted at all? Are you starting to either have more engaged discussions with counterparties? And if so, are there certain areas that you could, geographically where that might be?

Larry Mizel

I would say that it would be a reasonable view that our land group and all the markets, we are receiving information from just about every source whether it's private builders, lenders, competitors. There is billions of dollars of assets for sale and we expect to increase our exposure when the pricing justifies it. But we are open for business, anybody has anything, they want to show us, we are glad to look at it, we are glad to work on it.

And as you see sequential deterioration of the market, then the level of that we would have an interest in transacting continues to move, but we are very much focused and we are active in exploring different types of relationships on different assets. And I think that our patience, we started in 2005 adjusting our business plan, so we can be here to focus on our internal operations, our customer experience and most important, focus on the market conditions.

And each of the markets will be a little bit different but each of the markets that we are in has opportunities and they are just not at a level that we believe we want to transact at this time.

Operator

Your next question comes from of Nishu Sood from Deutsche Bank. Your line is open.

Nishu Sood - Deutsche Bank

Thanks, good morning, guys.

Larry Mizel

Good morning.

Nishu Sood - Deutsche Bank

First question I wanted to ask was about your decisions on your land sales. In the trade-off, you are constantly evaluating whether to monetize your land by building through it or going out into the market and selling it. The last few quarters, you have gone the sales route more and more.

So I wanted to understand whether that was a function of the bid or the ask? In other words, are you bringing your prices down now to where you are finding some bids out there in the market or are the bids coming up? And I also wanted to get your perspective on how that might evolve going forward here in on a recession as demand continues to sink?

Larry Mizel

As you can see, our total land assets have diminished substantially. So, our aggregate inventory of lands and even work in process is in an alignment of where we are going. The motivation really is individual analysis by subdivision not just globally but by subdivision, it's affected both by market conditions in that subdivision specific and also the alternative opportunities of tax planning.

As you know for the builders, the carry back expires as far as cash refund for those of us that are on a calendar at the end of this year. So a cash refund has a bearing. The evaluation of a build-out is in the factor since most of our land is what you would consider well located. We are in a position to evaluate both keeping it and selling it and there is no easy formula but our analysis is subdivision at a time versus market in general.

And it has been affected by tax considerations but as we go forward, we are really evaluating how we can best position our enterprise to be most opportunistic predicated on whatever the market conditions, we believe are going to take place.

Nishu Sood - Deutsche Bank

That's very helpful. Second question, land opportunities that are going to come up with the recession, it might be a while before these opportunities come up. By then your infrastructure, your staff on the ground to take advantage of these opportunities, I imagine its going to be pretty thinned out. So, what would be the game plan then to go out and re-staff to manage these opportunities, to work with outside joint ventures? And also I know I can't ask a third question, so I just wanted to ask if you've taken any provisions for expected losses on the unsettled trades at the reserve fund?

Larry Mizel

I will answer the last one by calling your attention to the most current footnote in our Q that is a couple hours old. So you can get a full explanation that the SEC is really dealing with the liquidation of the assets. And at this point versus me adding color, just read the item in the Q and you will see that we feel very comfortable, which is included in the same question of course.

As to what are we going to do on the ground and where are we going? If you look back on my comments, I made some pretty specific comments that we are dedicating some of our most gifted staff to initiatives that deal with information process and procedure in order to prepare for the recovery. And I'm not making a prediction because none of us know when "there is a recovery".

But your question is on point in the sense that we are focused on how we are going to run the enterprise, what efficiencies we can build into systems through technology and we have a lot of effort and we are spending significant dollars currently that are being expensed in preparing the enterprise and the platform to be a very efficient operator going forward.

Operator

Your next question comes from Dan Oppenheim from Credit Suisse. Your line is open.

Dan Oppenheim - Credit Suisse

Thanks very much. I was wondering if you can talk a little bit about the land investment that is in Colorado. If we look at the $254 million of land overall, how much of that is sitting in Colorado? I was just thinking about the number of lots you have there relative to order trends as of late?

Larry Mizel

I think there is a schedule in the press release where you can get accurate by the numbers of how many lots we have in Colorado.

Dan Oppenheim - Credit Suisse

It's got number of lots. I was wondering sort of the investment in terms of the.

Chris Anderson

The value, Dan, it's about $100 million out of our $250 million is in Colorado.

Dan Oppenheim - Credit Suisse

Okay.

Larry Mizel

To add a little color, Dan, we expect Denver, since it had the least upside as far as being active after the 2001 adjustment, that we are very optimistic that when the market changes, that Colorado will be a key point of opportunity for us. Most of the other builders have given up.

Dan Oppenheim - Credit Suisse

Okay. And then secondly, I'm wondering about the cancellation rate. Is that consistent across the markets and the regions you are dealing with and what are you doing to or doing anything differently now to prevent cancellations, given this current environment here?

Chris Anderson

I think we've included some information on the cancellation rates. But where we have seen it a little bit higher in some of these markets, where we've had first-time homebuyers. So, out in the West, most of our market is first-time homebuyers and they've been a little bit more challenged with the mortgage financing issues.

Back in the East in our mid-Atlantic markets where we have a little bit more of a diversified customer, their rate is a little bit lower. But as we said earlier, the number one reason for this cancellation rate right now is financing issues.

Operator

Your next question comes from Carl Reichardt from Wachovia. Your line is open.

Carl Reichardt - Wachovia

Good morning, guys. How are you?

Larry Mizel

Good morning, Carl.

Carl Reichardt - Wachovia

I actually got one of my questions already but Larry, I'm curious how you perceive foreclosure activity impacting your sales rates since we've seen some improvement in turnover in Central California and parts of other places? I'm curious if your perspective is that's negatively impacting you or that's more investor business not impacting you?

Larry Mizel

Well, I think every home that's foreclosed upon creates a housing unit that someone has the opportunity to buy and the short sale phenomenon that the banks are forced to do is definitely competition. The market is affected by foreclosures. The opportunity that is evolving and I don't want to even say after the election, I think probably later in the day, all of the attention in Congress, besides chasing the banks that got any money is all going to be talking about lending.

And lending and helping existing homeowners is very important, whether they restructure their debt or whatever they are going to do. We are now going to see our government activities go from the financial side to the housing side. I would expect that there will be multiple pieces of legislation that deal with existing homeowners that are in trouble, those that are past the point of help. We are expecting to see presented a substantial tax credit for not only new homes but maybe existing homebuyers.

I think you are going to see a movement for reduction of interest rates for mortgages to help unclog the marketplace. I see that the 30-year average rate came out, at least what I saw today, was up to 6.46% and I think that we believe that Congress is going to look at a way to probably bring it down by 150 basis points. They are using a little bit of the example of the story of the early 70s, when they had a buy-down of rates and investment tax credit.

And if you adjust that for where we are today in life, I think a substantial tax credit benefiting all homeowners that are buying and a reduction of interest rates, even if these programs are only good for a year, you will re-create and help put a floor on value and we needs the consumer confidence to come back into play.

There's a lot of people that would like to buy homes, but between having confidence to buy and the ability to get an affordable mortgage, it's an overhang which, of course, tied into your question on foreclosures and the effect of them.

So one of the key effects of just additional inventory, but I am very confident that we will work through those foreclosures, the marketplace. And as you can see, the new home starts continue to go down to a current history low, which means that ultimately, you will wake up at the other end of the tunnel, wherever that might be, with probably a little bit of shortage of new product because of the inability for the private builder really to go forward since generally speaking, the value of his existing home is less than what his unpaid debt is.

So it's kind of a combination of factors, but I think the market is dealing with the issues and I feel very comfortable that Congress will deal with the housing issue, is the next major issue dealing with our economy.

Carl Reichardt - Wachovia

I appreciate the color. Thank you, Larry.

Operator

Your next question comes from Joel Locker from FBN Securities. Your line is open.

Joel Locker - FBN Securities

Good job on the gross margins, actually it seems like most of them are impairments. But anyway, last three quarters you are in the 11% range and now you are up to 15%. I was just wondering if you thought that you could continue to improve the margins at least on the gross margin side.

Larry Mizel

As you know, we don't give forward guidance of any kind, Joel. I think we tried to be pretty transparent on what is in our margins for the last few quarters. So, I don't think we will comment on what we think maybe they are going forward.

Joel Locker - FBN Securities

I understand. Just if you maybe could tell me what the difference is between the build to order and the specs on the gross margin side, or what you have been seeing at least the last quarter or two?

Chris Anderson

I think we've shared that in the prior quarter where the build to order or pre-sold home has several point advantage over the spec home. We said that our mix is about 65% spec homes versus dirt sales and certainly we want to influence that mix and go more towards that pre-sold home because we think that there is several point advantage in that.

Operator

Your next question comes from Josh Levin from Citi. Your line is open.

Josh Levin - Citi

Good morning, guys. First question, where do you think we are in the impairment cycle or how comfortable are you with your current book value?

Larry Mizel

I think we are extremely comfortable with our current book value. If you look at our properly conservative approach to accounting starting early in the cycle, you see the size of our aggregate assets that are pre-existing this cycle, you should have enough information to determine where it might stand.

Josh Levin - Citi

Okay. And then next question, Larry, you have a very straightforward and simple business model. And given the balance sheet strength and the flexibility that affords you, do see any strategic changes in how you run the business? Do you think, you might increase your land supply beyond the traditional two years, if you saw some really great deals? Or could you imagine partnering up with some of private capital we've heard about? Or is it just going to be business as usual going forward?

Larry Mizel

I don't think it is reasonable to assume that the world is the same now as it has been in the past. And I would say that we are very open to evaluating, really all opportunities. We found that where we are and what we do, has worked very, very well to prepare the company to have opportunistic exposure. And we have an open mind for whatever might come our way.

Operator

Your next question comes from Alex Barron from Agency Trading Group. Your line is open.

Alex Barron - Agency Trading Group

Thank you and good morning. My first question had to do with impairments. I guess it's like a two-part question. One was, what was the benefit from previous impairments to gross margins this quarter? And also wanted to know what percentage of all your communities have been impaired at least once?

Chris Anderson

The impact of margins is about $69 million for the current quarter and that's in the schedules that were in the press release. And about 80% of the lots that were impaired had been previously impaired.

Alex Barron - Agency Trading Group

Okay. Thanks. My other question, I was looking at your schedule of land options and it looks like in a couple of markets, I think it was Arizona, Nevada and Maryland, your land options went up slightly versus last quarter. I was wondering, if those were tentative attractive land deals you found early in the quarter? And now do you reconcile those increases versus your comments in the press release that you didn't want to keep buying any more land for now?

Chris Anderson

I think, Alex, you need to look at that in context with the lots owned. For example in Arizona where you see a year-over-year slight increase in lots under option, you see our lots owned down by like 70%. So some of those are contractual and some of those are in subdivisions that we want to be in. And as we look at that mix, you can't just look at the options only. You need to look at the market and the combination together.

Alex Barron - Agency Trading Group

But why would the options be going up? I guess, I could understand them going down if you had to do takedowns.

Chris Anderson

Right, but in some cases there are some subdivisions where we've added a few subdivisions. And as we have said, our strategy is really to be land light and where we do enter into any subdivisions, these are going to be soft rolling options.

Operator

Your next question comes from Susan Berliner from JPMorgan. Your line is open.

Susan Berliner - JPMorgan

Good morning. I apologize, I got knocked off the call. So, I don't know if you covered this. But I guess, I was just looking through the 10-Q and saw your bank line and I guess a reduction right now and the commitment amount due to the coverage and leverage and I was wondering if you could go over, do you have to go back to the banks now for an amendment? And also if you could go over the current interest cost.

Larry Mizel

It is a ratcheting formula that goes both up and down. And as you can see in the disclosures in the Q, we really give you a little color on how it works, so you should look at that and it will be helpful in dealing with it.

Susan Berliner - JPMorgan

So I guess just to follow up on that, do you have to get the coverage back up above two times to get the commitment back to where it was?

Larry Mizel

If you wanted to go all the way back, you would have to ratchet it all the way up with additional coverage, as you commented. With the degree of liquidity that we have, we are not focused very intensely on that as an area that is other than just operational.

Operator

Your next question comes from Ivy Zelman from Zelman & Associates. Your line is open.

Alan Ratner - Zelman & Associates

Good morning, guys, it's actually Alan Ratner on for Ivy. I was wondering if I look at your footprint of owned lots, could you give us some type of estimate on what percentage of those lots have been written down to zero? And maybe give some regional color in terms of where a lot of those lots are located?

Larry Mizel

I don't think, we can give that to you.

Alan Ratner - Zelman & Associates

Okay. Then can I just confirm a number. I believe, Chris said earlier on the call that there was one million of land remaining in California on the books. Was that correct?

Chris Anderson

That is. It's actually a little bit less than that, Alan, and there is a breakdown in the Q that shows all of that.

Operator

Your next question comes from Chris Hussey from Goldman Sachs. Your line is open.

Joshua Pollard - Goldman Sachs

This is Joshua Pollard on for Chris. Larry, you said that you had an open mind to what may come your way in terms of land. But I'm wondering what your preference may be? Is there a preference for raw land or finished? Is there a preference to be tied up in joint venture or have financial partners? That's my first question, my second question is, how small are you guys willing to get with your current business before you guys decide to make an investment of some sort into land or into other types of businesses? Thank you.

Larry Mizel

Our land preference is pretty simple. We would like to put up no money. We like to buy it really cheap. We would like to have a rolling option and we'd like the lots to be fully finished with no exposure and I'd like to pay for the lot after I build and sell the home currently. Those are the preferences, reality as you know, we are really seeing markets where people were taking a nominal down payment and nominal could be from a few thousand dollars to 3% or 5% and maybe as long as a couple years with no mandatory takedowns.

Virtually everything that has come through that seems interesting are fully finished lots and I would say comfortably it is a buyers market and the buyers are few and far between. We are keeping an active dialogue with land sellers, people that ultimately will be selling their land that haven't adjusted to the marketplace.

Since we are in a continued deterioration of the market, the seller's expectations of land are continuing to improve as far as our view is but it has a lagging period. Those sellers and you can see from public disclosures of other public builders that what they needed to do to sell in some bulk but the smaller sellers still are slow.

Most of them all have bank debt. The banks have not been active in liquidating their assets, I think since the banks are looking for the recapitalization and the big banks all took the money, I describe it as follows that the losses we have seen in the financial system, I call it are from the top down and the losses from the credit side are from the bottom up into the banks.

Those losses have not been realized and/or recognized that I am sure as the regulators and the auditors go through, the banks will adjust their reserves for the value of these assets and after they adjust their reserves, they will be in a position then that we can transact with them because they will have written the lots down to a reasonable level that make sense. Until they do that, they are just kind of stuck between trying to determine how they are going to deal with the borrower, how they are going to deal with the regulator, and how they are going to deal with their own capital needs.

As we can see, it is sorting itself out pretty quickly, but the ultimate answers as far as the ability to do transactions, I assume will be later down the cycle, probably some time next year. As to the size of an enterprise, we will make our enterprise that which the market allows and we will aggressively adjust to what is necessary focusing on what is good business judgment.

As I previously commented, we are working on and spending money for trying to improve our information process and procedures and our customers' experience. And what we are spending our time and effort on besides current business is looking forward to future business. And I believe that will be a value to the company at some future time.

Operator

Your next question comes from Jim Wilson from JMP Securities. Your line is open.

Jim Wilson - JMP Securities

Thanks, good morning, Chris. Good morning, Larry. I was wondering, obviously you have moved out of Texas. It looks like you've moved out of Illinois. I was wondering if you could give some thoughts on Florida? You still have, obviously a reasonable number of subdivisions, but is that one where you would be looking to stay, looking for opportunity in the future or can you say at this point?

Larry Mizel

I would say we are active in Jacksonville and we've got a few things left over in Tampa. But we expect to have Jacksonville as a good area.

Jim Wilson - JMP Securities

Okay, so probably just stay there. And one thing maybe general thoughts, I don't know if it's different by region. How active have you been in trying to reduce square footage of homes on lots and has that been successful or relatively successful?

Larry Mizel

I would say that we are trying to have an open mind and a clean piece of paper. The evaluation of reducing home size is active. The development of new product with smaller square footage is active on our part and we will adjust to whatever the market and the consumer require. So we are moving as quickly as we can to make sure that the product we have is the right product for the right market.

Operator

Your next question comes from Michael Rehaut from JPMorgan Chase. Your line is open.

Michael Rehaut - JPMorgan Chase

Thanks. Actually all my questions were answered. Thank you.

Operator

Your next question comes from Alex Barron from Agency Trading Group. Your line is open.

Alex Barron - Agency Trading Group

Thanks. I was going over that table that you mentioned where you give the values of the land. I guess if I'm doing this calculation correctly, it seems like your lots in California are valued at $800 per lot. I guess that said, I'm kind of wondering is there any plans to exit California and am I reading this correctly?

Chris Anderson

You are looking at just land and that's a pretty accurate read. There is another 80 million or so, if you look on the 96 million in the breakdown on the other table showing value of homes that are in inventory. So you have to look at both of those together again. But on the future for California, you can see it in our results, we have definitely been scaling that back and reducing our overall exposure to California. It will be pretty minimal going forward.

Alex Barron - Agency Trading Group

I wanted to ask you on those, when you show your lot count, the 873 lots in California. Does that include the homes that are under construction? Is that part of the 96 million or are those separate that aren't counted in this lot count?

Chris Anderson

They are separate.

Operator

And at this time, there are no further questions in the queue.

Larry Mizel

I would like to thank everyone for participating. I was reading a quote that came from a columnist, and I'm just going to read the quote because I think it's an interesting way to finish the call. This is from [Robert Cogen]. He said any projection that America with a 21% of the global economy last year is in decline is too pessimistic. Although the United States is suffering through a financial crisis, so is every other economy.

If the past is any guide, the adaptable American economy will be one of the first to come out of a recession and many actually will find the position in the global economy enhanced. I would just like to say it was an interesting quote and I think it applies to the housing industry. Thank you all very much.

Chris Anderson

Thanks.

Operator

We would like to thank you again for joining our call today. We look forward to having the opportunity to speak with you in a few months, following the announcement of our 2008 fourth quarter results. You may now disconnect.

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Source: M.D.C. Holdings, Inc. Q3 2008 Earnings Call Transcript
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