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KB Home (NYSE:KBH)

Q4 2008 Earnings Call

January 9, 2009 11:30 am ET

Executives

Kelly Masuda – SVP & Treasurer

Jeffrey Mezger – President & CEO

William Hollinger – SVP & CAO

Analysts

Dan Oppenheim – Credit Suisse

Carl Reichardt – Wachovia Securities

Ivy Zelman – Zelman & Associates

Michael Rehaut - JPMorgan

David Goldberg – UBS Securities

Stephen East – Pali Research

Kenneth Zener – Macquarie Research

Megan Talbott McGrath – Barclay’s Capital

Nishu Sood – Deutsche Bank

Susan Berlinger – JPMorgan

Analyst – FTN Midwest

Joel Locker - FBN Securities

Operator

Good day everyone and welcome to the KB Home fourth quarter earnings conference call. (Operator Instructions) KB Home's discussion today may include certain predictions and other forward-looking statements.

These statements may cover market or economic conditions, KB Home's business and prospects, its future financial and operational performance and/or future actions or strategies and their expected results. They are based on management’s current expectations and projections about future events and business conditions but are not guarantees of future performance.

Due to a number of risks, assumptions, uncertainties and events outside its control, KB Home's actual results could differ materially from those expressed in, or implied by the forward-looking statements. Many of these risk factors are identified in the company’s periodic reports and other filings with the SEC, which the company urges you to read with care.

For opening remarks and introductions I would now like to turn the call over to KB Home’s President and Chief Executive Officer, Mr. Jeffrey Mezger; please go ahead sir.

Jeffrey Mezger

Good morning everyone and Happy New Year. Thank you for joining us today for a review of our fourth quarter and fiscal year 2008results.

This is our first call without Domenic Cecere, who has now officially retired. I would like to thank Domenic for all his contributions to KB Home. Here with me now are William Hollinger, our Senior Vice President and Chief Accounting Officer and Kelly Masuda, our Senior Vice President and Treasurer.

In a few moments I will turn the call over to William who will provide a more detailed overview of our financial results. We will then open it up for questions at the end of our prepared remarks.

I would like to start by offering some perspective on our performance, our strategy, and most importantly what we believe it takes to be a leader in current market conditions. As you have heard repeatedly from others in the industry the housing sector continues to confront unprecedented downturn pressures.

The pace of foreclosure activity is continuing to inflate housing inventories driving prices steadily lower. Overall economic weakness and job losses have prompted a historic decline in consumer confidence which discourages major purchases.

These conditions persist nationally with no visible signs of lessening in the near-term. Experts agree that a housing market recovery is essential to an overall economic recovery and we support any federal stimulus that can promote housing stabilization.

That is why we are playing an active role in the fix housing first coalition along with many others in the building and related industries. All that being said we are not relying on outside intervention as a cure-all for the current distress in the housing market.

It is our responsibility to continue improving our business to effectively compete and operate in any economic environment. So rather then fight the headwinds we are adapting to them. It has been said adversity does not build character, it reveals it. As a leadership team and as a company we are using this opportunity to reshape how we operate the homes we build, and the markets we serve.

While we cannot conjure up a better economy or increase consumer confidence we can continually make KB Home a stronger, more efficient, higher performing company.

In early 2006 we recognized that the housing market was changing and we were among the first builders to begin shifting focus from growth to inventory reduction and cash generation. Since then we have committed to a series of aggressive actions focused on generating and preserving cash, lowering our cost to build, gaining operational efficiencies and lowering overhead, developing innovative new home designs to compete with resales and foreclosures, and restoring profitability.

These actions favorably impacted our results throughout the year and particularly in the fourth quarter giving us forward momentum to build on as we enter 2009. For example, we ended the year with $1.3 billion in cash which exceeded our targets. Generating cash from operations and strengthening the balance sheet remains our primary focus and our enhanced liquidity positions us to navigate this downturn and capitalize on opportunities in 2009 and beyond.

While last quarter we communicated a goal of operating cash neutral for 2009 we are now upgrading that goal to being cash positive in 2009.

For the first time in five quarters we achieved positive operating income in the fourth quarter on a pre-impairment basis. As the housing market continued to decline throughout 2008 we constantly adjusted and refined our business with the goal of improving our results for the long-term.

The impact of these integrated actions became more apparent as we ended the year. We sharply reduced the cost to build from 2006 to 2007 and accelerated those reductions from 2007 to 2008. This enabled us to improve gross margin performance in 2008 despite a drop in the average selling price from $262,000 in 2007 to $236,000 in 2008.

We further improved operating efficiencies and significantly lowered overhead expenses year-over-year. This is an ongoing imperative as we continue resizing our business structure to a better alignment with today’s market realities without sacrificing our growth platform.

Lastly our transition to more affordable and flexible home designs that will compete more favorably with resales and foreclosures is now ahead of schedule. I will discuss that transition in more detail in a moment.

More then one person has expressed surprise to me that anyone is buying a home today given the unrelentingly negative atmosphere pervading this market. For most buyers however, a home purchase is not just a financial decision it is a highly personal decision that includes their desire for a more stable community, the pride that comes with home ownership, and so much more.

As foreclosures flood the markets and drive down prices, potential buyers increasingly see an opportunity to own at a very attractive entry point. In fact, some of the hardest hit regions like Las Vegas and Southern California, overall inventory has actually begun shrinking.

A December article in The New York Times said, this might be, “the buying opportunity of a lifetime for those who can qualify for a mortgage.” Given the substantial price declines mortgage rates around 5% and affordability around the highest level in 20 years, I think it is increasingly difficult to argue with this assessment.

First-time buyers in particular are responding to these opportunities. Not burdened by the need to sell a home first they are in a better position to buy a home today. Many of these buyers were priced out during the market frenzy of a few years ago. In addition FHA financing is still readily available.

We have strategically focused on reaching these buyers and in Q4 of 2008 the percentage of homes we delivered to first-time buyers stood at 66% of our total deliveries. This is almost a mirror image of where we stood just a few years ago when first-time buyers were less then 40% of our business.

We look to drive our percentage of first-time buyers even higher going forward. So from a strategic standpoint our objective is clear. We are attracting first-time buyers with a product that is price-competitive with resales and foreclosures.

We have created a Built to Order experience that enables buyers to truly customize their own home differentiating us from both resale and other builders and our goal is to build and deliver these homes profitably while maintaining our commitment to quality and customer satisfaction.

Our product transition began with an understanding that a one-size-fits-all approach would not work. Rather we look closely at our market surveys and community-specific data to determine the type of new product a KB Home community should offer.

This fact-based decision making is a fundamental principal of our KB [next] business model. Every submarket and every community is analyzed to optimize performance. For some communities it may be as simple as value engineering existing designs to reduce unnecessary costs while increasing quality and reliability.

For others it may also include reducing square footage and spec levels while providing the functionality needed to effectively compete with resales and foreclosures. These incremental changes have helped us to stay competitive as the market weakened but given the severity of the downturn we look to develop and execute and even bolder transformation.

We have begun introducing a new generation of innovative and more affordable home designs which we have branded the open series. These homes give buyers tremendous freedom to add or subtract bedrooms, multi use spaces, storage areas, and outdoor living spaces.

In many ways the open series represents the fullest expression of our Built to Order brand differentiation. We have moved beyond offering choice on basic items like flooring and countertops to offering choice on the size, placement, and number of rooms.

By maximizing choice we empower buyers during a time of uncertainty providing them more control and creating a home that accommodates both their style and their budget instead of asking them to choose between the two. We think the worst decision a homebuilder could make today is to continue building the same type of homes that were built near the peak and stay purely defensive while waiting for the housing market to rebound.

Last quarter I said we would be underway with this product transformation in 25% of our communities as we entered 2009. I am pleased to say that we are now ahead and in some regions, dramatically ahead, of this projection. KB Home is rapidly mobilizing around these new home designs with more then 50% of our targeted communities scheduling grand openings in the first half of 2009.

I’m very proud of how the KB Home team has responded to the challenged of introducing affordability and flexibility to the housing market. In less then six months not only have we been able to design and engineer an entirely new array of homes, we have also begun introducing them across the country.

An undertaking of this magnitude could only be accomplished through flawless execution of our KB next business model. While transitioning our product to be even more affordable we are not compromising the quality of the materials that go into our homes. Today’s homebuyers puts a premium on our 10-year limited warranty, energy efficient designs, and name brand features.

This gives buyers greater confidence in the quality and reliability of their home which further distinguishes a KB Home from a resale or foreclosure. We recognize that 2009 will likely bring continued deterioration in the average selling price in our markets. We are countering that by introducing the open series into our product mix.

As well as we have already done in reducing our direct costs, our objective is to reduce them by an additional 10% during the year to stay ahead of pricing pressures. We believe our efforts around direct cost reduction will enable us to offer lower priced product, while improving margins, and better aligning us with today’s buyer.

And we’re also able to produce these home much faster reducing our cycle times without compromising quality. As we continue right sizing our business we’re protecting our strategic growth platform. Today 10 divisions now oversee approximately 30 metro markets.

We continue to exit markets and consolidate our operations as necessary. But I want to emphasize that these decisions are less about choosing where we do not want to be today, and more about choosing the markets we do want to be in, now and when things stabilize.

The markets we are now in supported almost 29,000 KB Home deliveries at our peak in 2006 so our growth platform remains robust. One of our core strategies is to operate large businesses in the markets we serve. Many of the cities we are now in will be the first to rebound in a housing market recovery and we intend to regain scale where it is appropriate.

This will help accelerate our cost reduction strategy as we negotiate in bulk with local trades. We will also become the builder of choice for those with lots to sell and additionally a large market presence gives us more opportunity to leverage the KB Home brand and our clear differentiation from resale and foreclosure homes and from other builders.

We are also thinking creatively about how best to seize opportunities for land and lots in our markets without compromising our substantial liquidity. While 2009 will likely offer attractive land acquisition opportunities we intend to reload conservatively in a capital-sensitive manner.

Finished lots are now readily available in every market at attractive terms. We remain patient however as we do not believe lot prices have stabilized yet. When the time is right and where possible we will acquire lots on a rolling option basis. We are also exploring creating alliances with investors for land and lot opportunities where bulk purchases are required.

This investment strategy going forward will primarily focus on finished or substantially finished lots in markets in which we historically have had scale and brand recognition. We will only acquire lots that are aligned with our strategy at a price where we can be profitable and achieve acceptable returns.

While we operate in extraordinarily price-sensitive market, homes will never be a commodity product. Brand differentiation continues to matter in good times and in bad. In addition to our well-established Built to Order experience our commitment to energy efficiency, and environmental awareness is becoming an increasingly important differentiator.

Environmental programs and products are important to today’s homebuyers because they help lower the total cost of home ownership, buyers will also have a growing expectation that their homes will be built in an environmentally responsible manner.

Last year we committed to installing only Energy Star appliances in all of our homes and we’re the first national builder to do so. We are now taking that commitment to a higher level. Since January 1 all KB Homes built in new communities are fully Energy Star qualified.

Studies suggest that Energy Star qualified homes save as much as 45% on energy costs when compared to homes built as recently as in the 1990s. As part of our My Home My Earth initiative we also work with our vendors to offer a complete line of environmentally friendly, high value, low cost products in our studios.

Time and again when the long-term benefits of environmentally friendly options are really explained to our buyers they make that choice. It would be easy in this market to put our environmental programs on the back burner but in fact, we are accelerating them. We continue to benchmark our progress against the environmental commitments we made in our 2008 sustainability report and will issue an update later this year.

So, before I turn it over to William, let me recap where we stand today. KB Home heads into 2009 as a more efficient, [land like] company concentrated on key long-term growth markets. We continue our strong focus on generating cash and positioning the business to restore profitability.

At the heart of that strategy are innovative Built to Order designs that compete effectively with resales and foreclosures. We are driving down our cost to build so we can lessen the impact of declining home prices. We relentlessly push for operational efficiencies and further reductions in overhead levels.

Above all our employees are completely committed to our strategy and have a proven business model to guide their way. That is a powerful foundation for KB Home to build on. We are not counting on a federal housing stimulus or passively waiting for better times. Instead, we are going to execute against the opportunity that is right in front of us.

I’m confident we will be as successful in this regard, as we have been in repositioning this company over the past year.

Now I’d like to turn the call over to William who will recap our fourth quarter and fiscal year 2008 performance.

William Hollinger

Thank you Jeffrey and good morning everyone. This morning I will take you through some of the highlights of our fourth quarter financial results, our financial position, and our recent sales activity.

In the fourth quarter of 2008 we generated a net loss of $307 million or $3.96 per diluted share compared to a net loss of $773 million or $9.99 per diluted share for the year earlier quarter. The fourth quarter net loss in each year resulted from significant non-cash charges taken for asset impairments and abandonments and valuation allowances on our deferred tax assets.

Although we delivered half as many homes and recorded significantly less revenues in the 2008 fourth quarter our bottom line financial results improved from the year earlier quarter. This improvement was the result of a decrease in our asset valuation and abandonment charges and better operating performance as evidenced by our higher housing gross margin.

Our 2008 fourth quarter included pre-tax non-cash charges of $309 million for the asset impairments and abandonments compared to $403 million of similar charges recognized in the year earlier quarter representing a year-over-year decrease of $94 million.

Additionally in the fourth quarter we took an after-tax charge of $99 million to record a valuation allowance against our deferred tax assets. This was substantially lower then the $514 million charge taken in the 2007 fourth quarter. Excluding the asset impairment and abandonment charges and deferred tax asset valuation allowances we would have reported net income of approximately $12 million in the 2008 fourth quarter and $3 million in the 2007 fourth quarter.

About $132 million or 50% of our inventory and joint venture and impairments and abandonments taken in the quarter were in our South Coast region while $74 million or 28% were in the South East region. These two regions also experienced the largest declines in average selling prices in the quarter.

The charges were $29 million in our South West and $31 million in our Central region with each amount representing 11% of the quarter’s impairments and abandonments. The inventory valuation adjustments were necessitated by the continued deterioration in the housing markets and in the general economy, both which put strong downward pressure on home prices.

We believe this intense pricing pressure will continue into 2009. Overall inventory levels remain elevated and already weak demand for new housing is now further hampered by rising unemployment, declining consumer confidence, and tight credit conditions. To the extent these obstacles weaken prices further in the months to come, we are likely to experience additional asset impairments.

However we believe that the majority of inventory related charges are now behind us. In addition we took a goodwill impairment charge of $43 million in the 2008 fourth quarter associated with our South East region. At the end of our fiscal year we had no remaining goodwill company wide.

Our 2008 fourth quarter homebuilding revenues of $916 million decreased from the year earlier quarter primarily due to lower housing revenues. Fourth quarter housing revenues were $909 million down 55% year-over-year reflecting a 52% decline in the number of homes we delivered and a 6% drop in our average selling price.

We delivered fewer homes in the 2008 fourth quarter mainly as a result of our reduced community count and our lower backlog levels in the wake of the persistent housing market downturn. With regard to our 2008 fourth quarter average selling price, our Central region posted a year-over-year increase of 10% primarily due to a change in product mix.

Our remaining three regions experienced year-over-year decreases with the largest decline occurring in our South East region where the average selling price fell 17%. In general these lower average selling prices reflected continued pricing pressure in our housing markets across the company coupled with our strategy to introduce more affordable, value engineered homes designed to appeal to today’s first time buyers.

Our homebuilding business generated an operating loss of $241 million in the fourth quarter of 2008. That included charges of $206 million for inventory impairments and abandonments and $43 million for goodwill impairment. A year ago our homebuilding operations generated a fourth quarter operating loss of $332 million including $306 million of similar inventory related charges.

Excluding the asset impairment and abandonment charges our homebuilding business generated operating income of $8 million in the fourth quarter of 2008 compared to an operating loss of $26 million in the fourth quarter of 2007. Our housing gross margin included inventory valuation adjustments and abandonment charges was a negative 8.6% in the fourth quarter of 2008.

That compared to a negative 4.3% in the year earlier quarter. Excluding all inventory related charges our housing gross margin improved year-over-year by 3.8 percentage points to 13.9% from 10.1% as well as on a sequential basis increasing from 9.6% in the third quarter of 2008 and 8.7% in the second quarter of 2008.

We made further progress in reducing our overhead costs in 2008 fourth quarter. Our selling, general and administrative expenses or SG&A, totaled $121 million in the fourth quarter, down $108 million or 47% from a year ago. As a percentage of housing revenues these expenses fell to 13.3% in the fourth quarter of 2008 from 19.9% in the third quarter of 2008.

While the fourth quarter 2008 ratio remained above the 11.3% we posted a year ago due to a lower revenue base the actions we have taken to reduce costs and bring our SG&A into better alignment with current revenue levels are becoming evident in our financial results.

During the 2008 fourth quarter we took the difficult step of reducing our workforce further. We have reduced our headcount substantially since the beginning of 2008 and anticipate the benefits of these reductions to become more evident in 2009.

Going forward as long as market conditions require it, cost reductions will remain a major focus for us in every area of our business. As we mentioned on previous calls our cost reduction initiatives in 2008 including exiting underperforming markets, strategically consolidating certain operating divisions and reducing our workforce.

Our consolidation strategy focused on maintaining strong primary divisions with smaller satellite business units to help service a wide area. One of the important goals of this strategy is to preserve solid regional market platforms from which we can build and grow as conditions improve.

In essence we want to preserve our base and have an expandable operating presence in all the markets that contributed to our peak year results of about 29,000 deliveries. Now let me turn to the subject of interest expense.

During the fourth quarter of 2008 the amount of our assets qualifying for interest capitalization fell below our debt level as a result of both significant inventory reductions and our suspension of land development in certain communities.

Consequently we recorded $2.6 million of interest expense for the period. In last year’s fourth quarter all of our interest was capitalized and therefore we had no interest expense. We anticipate recording interest expense throughout 2009.

Our equity and loss of [inaudible] joint ventures totaled $61 million in the fourth quarter of 2008 including $60 million of impairment charges taken mostly in our West Coast and South East regions. That compared to an $89 million loss in the year earlier quarter including $98 million of impairment charges.

We continue to reduce our joint venture count. During the 2008 fourth quarter we reduced our number of joint ventures by five compared to the third quarter. As of November 30, 2008 we had 25 unconsolidated joint ventures which was a decrease of 29% from the 35 at fiscal year end 2007.

Our financial services business generated pre-tax income of $7 million in the fourth quarter of 2008 versus $12 million in the fourth quarter of 2007. Earnings from financial services declined in the quarter primarily due to fewer loan originations from our joint venture which in turn reflected the lower number of homes we delivered.

The joint venture had a retention rate of 81% in the 2008 fourth quarter compared to 79% in the year earlier quarter. The average FICO score of borrowers was 704 which was nearly unchanged from the 2007 fourth quarter. The average loan to value ratio of 92% was the same in the fourth quarter of 2008 and 2007.

Our product mix in the 2008 fourth quarter was essentially 99% agency eligible versus 90% in the year earlier quarter. Government loans accounted for 70% of our volume in the current quarter compared to 27% in the 2007 fourth quarter.

Turning to income taxes our fourth quarter results included a $99 million charge to record a valuation allowance against deferred tax assets generated during the period. While allowance is a non-cash item it impacted our balance sheet and book value.

As of November 30, 2008 we had $880 million of deferred tax assets offset by a valuation allowance of $879 million. The amount of this valuation allowance is significant relative to our current equity and would have had a meaningful impact on our book value per share and leverage ratio should it be realized.

Also our receivables at fiscal year end 2008 included $221 million of federal income taxes that we expect will be refunded to us in February. This amount was included in deferred tax assets in prior quarters.

Now let me discuss a few items relating to our balance sheet. We ended 2008 with cash and cash equivalents of $1.3 billion. We generated $311 million of positive operating cash flow during the 208 fourth quarter which drove our fiscal year end cash balance above the $1 billion mark we had previously targeted.

Over the past three years our continuing operations have generated nearly $1.6 billion of cash. This figure excluded the sale of our French business. Looking forward we are focused on producing positive operating cash flows for the 2009 fiscal year. We anticipate our cash flows in the first half of 2009 to be negative to neutral as we rollout our new value engineered product followed by positive cash flows in the second half of the year.

During the 2008 fourth quarter our Board of Directors reduced the quarterly dividend on our common stock to $0.6.25 per share from the $0.25 per share previously paid. The decrease brings our dividend in line with our historical yield while continuing our practice of paying quarterly dividends to our stockholders for more then 20 years.

This reduction is also aligned with our goals of maintaining a strong financial position and preparing for future opportunities both of which are expected to create long-term stockholder value. In addition the reduction will improve our cash flows by approximately $60 million annually.

Our inventories totaled $2.1 billion at November 30, 2008. During the fourth quarter we reduced our inventory balance by $316 million or 12% excluding inventory impairments and abandonments and other non-cash items. We also cut our overall lot count by 11% to 40,000 at fiscal year end 2008 from 52,700 lots three months earlier.

Of that total we own about 35,500 and control approximately 11,500 via land option contracts. Our year-end inventory level was 75% lower then our peak level of 186,300 in the first quarter of 2006 and 28% lower then the 65,700 lots we owned or controlled at fiscal year end 2007.

We ended the year with a supply of just under four years based on [trailing] 12 month deliveries. Over the past few quarters we have significantly streamlined our land position through building and closing homes opportunistically selling land and exiting underperforming markets.

We have also curtailed land purchases and remain highly selective in our investments in order to preserve cash until our markets improve. Our number of homes in production at the end of the quarter was down almost 86% from the peak we reached in the second quarter of 2006 and was down 55% from the fourth quarter of 2007.

We currently have 2,544 homes in production with 29% or 7,744 homes unsold. We had approximately 543 finished unsold homes in inventory at fiscal year end. While currently above historical levels we expect both the number of unsold homes and related percentages to return to more levels as we convert these homes into revenues in the first half of 2009.

Our total debt stood at $1.9 billion at November 30, 2008 down $220 million from the balance at November 30, 2007. This reduction was due to the early extinguishment of all $300 million of our 7 ¾% senior subordinated notes in the third quarter of 2008. We had no cash borrowings outstanding under our unsecured revolving credit facility at fiscal year end 2008.

After the end of our year we redeemed our $200 million of 8 5/8% senior subordinated notes at their scheduled maturing on December 15, 2008. Our remaining $1.6 billion of senior notes are well laddered with maturities extending through the year 2018. Our next maturity is August, 2011.

As of the end of the fourth quarter of 2008 our debt net of cash totaled $691 million. This represents a decrease of $146 million compared to $837 million a year earlier. Our net debt to total capital ratio was approximately 45% at fiscal year end 2008 compared to 31% at fiscal year end 2007. The increase was due primarily to losses we have incurred as a result of inventory valuation and abandonment charges and deferred tax asset valuation allowances recorded in 2008 which reduced our equity.

On a pro forma basis excluding the deferred tax asset valuation allowance our net debt to total capital would have been 29% at November 30, 2008. Our liquidity at November 30, 2008 exceeded $1.8 billion. This included $1.3 billion of cash and cash equivalents and the amount available under our bank revolving credit facility. We believe we have ample liquidity and financial flexibility to navigate the current environment and capitalize on opportunities as they arise.

As we anticipate generating positive cash flows in 2009 we do not expect to borrow against our bank revolving credit agreement. As of November 30, 2008 we had approximately $178 million invested in 25 unconsolidated joint ventures. That amount is down 40% from $297 million one year ago and 29% from $250 million at the end of 2008 third quarter.

Our investments in these unconsolidated joint ventures continue to shrink due to impairments renegotiation with partners and opportunistic buyouts. We made tremendous progress in 2008 in reducing both the number of joint ventures and the total amount of our joint venture investments and we intend to continue working on reducing these investments further in 2009.

The debt of our unconsolidated joint ventures totaled $871 million at November 30, 2008 representing a decrease of about 43% from [inaudible] at both August 31, 2008 and November 30, 2007. All in all 2008 was a difficult time for us and the homebuilding industry. For the second year in a row we confronted deteriorating housing markets and were forced to adjust our operations to address the highly challenging conditions.

But consideration those conditions we also made important progress on several financial fronts. We improved our margins excluding impairments and abandonments, reduced our selling, general and administrative expenses, and continued to build on a strong cash position while maintaining our financial flexibility.

We also greatly reduced our inventory levels and joint venture investments. Next I will turn to net orders which totaled 1,296 new homes in the fourth quarter of 2008, down 50% from 2,574 net orders in the year earlier period. This was largely due to our reduced community count which decreased 37% from a year ago.

Our transition to new value engineered product which disrupted sales at certain communities and the unprecedented weakness in new housing demand. The year-over-year net order comparison showed improvement in the 2008 fourth quarter from the third quarter of 2008 when year-over-year new orders were down 66%.

Our fourth quarter net orders typically drop off from the third quarter as we enter the slower selling season. However in the fourth quarter of 2008 we saw no such [demonition] in our net orders as they were roughly flat with the third quarter. In fact, within the fourth quarter of 2008 we gained positive momentum with our net orders increasing each month as the quarter progressed.

Our order cancellations as a percentage of gross orders improved to 46% in the fourth quarter of 2008 from 51% in the third quarter of 2008 and 58% in the fourth quarter of 2007. Cancellations as a percentage of beginning backlog were 23% in the fourth quarter of 2008 compared to 22% in the third quarter of 2008 and 30% in the year earlier quarter.

While our cancellations rates were volatile during 2008 we ended the year with these rates moving toward more normal levels, a trend we hope will continue in 2009. As a percentage of beginning backlog our fourth quarter 2008 cancellation rate was one of the lowest rates we have had in the past three years. As Jeffrey mentioned earlier during the last two quarters we have been transitioning to the open series, a new more affordable product line.

These value-engineered homes are better suited to the needs of today’s first time homebuyer and are more cost effective to build. The ongoing transition process effected order results in both quarters with some communities temporarily shut down and a lag in orders from the other communities where current products were being discontinued.

We expect to have more communities fully transitioned to the open series in 2009 which we believe will have a positive impact on net orders going forward. We had 263 active selling communities in the fourth quarter of 2008 down 37% from 418 in the fourth quarter of 2007. Our community count was lower across all of our regions. The decreases ranging from a low of 29% in our West Coast region to a high of 46% in the Central region.

In 2009 we expect to have an average community count of approximately 170 for the year which is about 29% lower then the average for 2008. Accordingly we expect to operate at reduced volumes for the foreseeable future as we continue to place our highest priority on improving our financial operating results and generating positive cash flows. But we will also continue to review conditions for improvement and stand ready to adjust our community counts as appropriate to maximize our performance in each region.

In closing given the uncertainty clouding the housing markets and our current backlog levels our visibility into 2009 is limited. There will be more tough times in the housing markets and the economy in general. However we have positioned our business to operate effectively throughout this downturn and our committed to continuing to improve our financial results.

We will remain alert to the potential new opportunities and believe we are well positioned to capitalize on those opportunities as they emerge.

Now let me turn the call back to Jeffrey who will provide some closing comments.

Jeffrey Mezger

Thanks William, before we take your questions I want to take this opportunity to thank the entire KB Home team. They rose to the occasion in 2008 and I know that they are ready to do even greater things in 2009.

I’m continually energized by their enthusiasm in the face of a very difficult housing market. I do not want to minimize the challenge we face or the unpredictability of the macroeconomic environment. Housing market volatility will continue but our strong cash position, lack of any near-term debt maturities, and above all our proven KB next business model give us a competitive edge in 2009 and beyond.

Much of the hard work to strength our balance sheet and reposition our business has been completed. We believe we have a strategy and business model that enable us to operate successfully under any condition and we are putting that to the test.

Our goals of generating cash, gaining operational efficiencies, reducing overhead, lowering our cost to build, and introducing new products are part of an integrated strategy to restore profitability. The open series array of home designs are intended to compete head on with resales and foreclosures.

Our ability to price them competitively and deliver them profitably is made possible only by our ability to lower direct costs. We are operating with a keen sense of urgency across KB Home to introduce these homes in our communities because we believe they will accelerate our return to profitability.

We should begin to see the impact of our new products on our financial results in the second half of this year. While this product transition unfolds our top priority remains generating cash. A healthy balance sheet is absolutely essential in this economic environment. That is why I am so pleased with our ability to exceed our 2008 cash target and that we can upgrade our goal from operating cash neutral in 2009 to operating cash positive in 2009.

So, we have an aggressive agenda for 2009 which I think shapes up to be one of the most significant years in KB Home’s history. We will concentrate on the business factors that are within our control to improve our overall performance and we will do what we must to protect and enhance shareholder value and ensure KB Home emerges from the downturn stronger then ever.

I look forward to the challenge of helping KB Home fulfill its potential and to sharing our progress with all of you throughout the year. Thank you and now we will open up the line to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Dan Oppenheim – Credit Suisse

Dan Oppenheim – Credit Suisse

You mentioned that 50% of the targeted communities with the new product offering are schedule to open in the first half, could you clarify how much of your total communities that will be and then also last quarter you talked about how the sales trends in those communities where you had already opened them were seeing two sales per week, could you comment about the trends you saw in the fourth quarter in those communities relative to your other communities.

Jeffrey Mezger

The reason that I clarified it as 50% of the targeted communities is that there are several locations in states like California where we don’t have the ability to change to a new product series because the product is approved with the map. Those are the communities where I’ve been referring to the value engineering, lowering spec levels, doing whatever we can to cut our cost.

But it can’t go to this new product which is significantly more affordable to build and to offer to the consumer. We’re continuing to open these products around the system now however most of them are opened in December with a full grand opening here in January. So I can’t share with you the December results because we don’t share numbers within the quarter however we are seeing favorable positive sales where we’re opening these communities where they are outperforming their previous product or other communities we have open in the area.

Dan Oppenheim – Credit Suisse

Could you talk at all about how should we think about the margins on these products. Have you taken enough cost out where we can see kind of maintaining margins or should we think about lower margins on these going forward.

Jeffrey Mezger

Well certainly the intent is to elevate margins. We’ve been able to lower our cost, we are lowering the price of the product as well so its more affordable and more competitive with the resale and foreclosures. However we’re not lowering the price to the extent that we’re lowering our costs so at this time we’re actually seeing margin improvement as we introduce this new product.

It was one of the components in why our margins were up incrementally in the fourth quarter because we’ve been able to lower our cost to build. We’ll give you more guidance on that as we go forward after we open up in the first quarter but our expectation is that margins will be enhanced with this product not reduced.

Operator

Your next question comes from the line of Carl Reichardt – Wachovia Securities

Carl Reichardt – Wachovia Securities

As you’re looking at expanding community count in the next quarter or two, what kind of impact is that going to have from an SG&A perspective just given that you’ve been shrinking so much, I’m not surprised to see SG&A down as much as it was this quarter but going forward could you give a sense of if you’ll be able to maintain this kind of a level or seasonally you’ll go higher.

Jeffrey Mezger

On a year-over-year track we expect our SG&A to be lower in 2009 then it was in 2008. Again in the fourth quarter we took a lot of steps whether it was headcount reduction that William mentioned, the consolidation of divisions in an effort to lower overhead and there’s always a time, I call it the tail on the comet where it takes a while for the expenses to wash through.

We expect to see our overhead continue to actually go down in 2009 while retaining this growth platform.

Operator

Your next question comes from the line of Ivy Zelman – Zelman & Associates

Ivy Zelman – Zelman & Associates

Could just clarify some of your comments on the 2009 cash flow. I realize, maybe start off with whether the tax refund is included in those comments but you’ve got backlog down over 60%, home prices will probably be lower, and you’re shrinking your communities by upwards of 30% so I’m just trying to understand the levers there that you’re are pulling to feel confident in being cash flow positive.

Jeffrey Mezger

We paid off the December debt, the $200 million. We do expect the tax refund here in the first quarter in February so that will offset the debt reduction. Past that what we’re seeing is as we continue to scale our business to the current revenue it reduces the cash consumption for overhead and we’re also lowering our expectation for land spend in 2009. With the size of the business and the lots we control we don’t have to buy any lots to hit our 2009 plan.

We’ll continue to reduce inventory with the lower overhead spend and an actual improvement in margin as this new product rolls out so we expect now that we’ll be cash flow positive for the year.

Ivy Zelman – Zelman & Associates

And just to clarify that does include the refund.

Jeffrey Mezger

It does.

Ivy Zelman – Zelman & Associates

On the product are you able to change the density of the product in some of these areas where you’re also changing the floor plan?

Jeffrey Mezger

In some cases we are. As you can imagine in the heated pace of 2004, 2005 or 2006 the focus was on get the community open and there were occasions where we mapped parcels for product that did not max density. We’re now going back in to those situations and remapping to a higher density and the cities are responding very favorably to this move.

But that takes time and that’s not as big a driver in 2009 as just retooling product on the same size lot that we already have in our portfolio.

Ivy Zelman – Zelman & Associates

Are you saying SG&A in absolute dollars certainly will be down but will you be able to offset the deleveraging of the top line as well so that as a percentage of sales you expect it to be lower?

Jeffrey Mezger

Certainly that’s our goal. It will depend frankly on how sales evolve through the year with this new product. As we shared we dropped our SG&A $100 million year-over-year in the fourth quarter so there was a significant reduction and we intend to keep chiseling away at it and do whatever we can to lower the SG&A.

Operator

Your next question comes from the line of Michael Rehaut - JPMorgan

Michael Rehaut - JPMorgan

Just on the gross margin I was wondering if you could give a little more granularity. Certainly you mentioned that some of the rollout of the new communities or the product reformulation and the lower costs have helped, is it, what percent of communities that is flowing into that 13.9 ex charges gross margin number and also if possible to give the benefit from prior impairments, what it was this quarter and last quarter in terms of how that’s also influencing the margins.

Jeffrey Mezger

Its very difficult to identify for a quarter what percentage was X, Y or Z of the factors. There’s a lot of factors that play into why our margins were up. Its not so much this open series rollout as it was a lot of the efforts we made in 2008 just through lowering our cost and lowering our spec level that finally played out at the end of the year because our directs were down and are part of it.

As you may recall earlier in the year we slowed down sales intentionally to try to raise margins. That played into it a little bit. And then we delivered more in the fourth quarter so that would have played into it a little bit and in part its mix because we were closing out communities and your margins are lower on the last view versus your ongoing.

William Hollinger

As we’ve said in the past, we think it’s a bit difficult to ascertain what the actual impact is in terms of dollars on our gross margins but having said that in terms of the units, we believe that about 70% of the units we delivered in this quarter compared to about 25% in the fourth quarter of a year ago were units that had impairments taken.

Michael Rehaut - JPMorgan

So just to understand in terms of the gross margins, because you’ve had up until this quarter four consecutive quarters of between roughly 9 and 10% and in September I think you were talking about a post impairment gross margin for the communities in a 9 to 11% range. And so certainly you’ve had some success with the cost reductions and product reformulation but looking forward do you see this type of 13, 14% margin sustainable. Do you see it actually improving or expanding due to the fact that more communities will be rolled out this way and are you also taking into account further pressure in home prices as all indicators are that the environment is still pretty challenging in general.

Jeffrey Mezger

Keep in mind also the comment that we made that we’ve done the heavy lifting on repositioning our balance sheet and creating dry powder and over the last two years there were times that we were moving product through at a lower price and a lower margin due to our focus on generating cash.

We now have the dry powder in a war chest to run this business and be opportunistic. My sense is just with that change in strategy you’ll see margin improvement. As I said a lot of what you saw in the fourth quarter was the fruit from efforts through [2009] whether it was pricing and pacing, whether it was our direct cost, the scale or the impairments that have been flowing through. While we gave you the percent of deliveries we don’t go back and track was that an impairment from 2006, 2007 or 2008, we just know that the lot was impaired to that amount.

Going forward a lot of the margin will be a direct reflection of where the market is. We expect prices to go down. That’s why we’re pushing to bring in a whole new product line at significantly lower cost to build then even the lower levels that we achieved in the fourth quarter of 2008. So we’re anticipating price going down, we’re doing everything we can to restore profitability and I don’t think you’ll see margins down where they were in Q2 or Q3, but we also aren’t ready to tell you where they’ll be until we’ve opened all this product up and see what the market will give us.

Operator

Your next question comes from the line of David Goldberg – UBS Securities

David Goldberg – UBS Securities

You mentioned that you’re expecting prices to go down as you look forward and what I’m trying to get an idea of is if I have it correctly, you are pricing the new product to really be more competitive with foreclosures and more inline with foreclosures, albeit a smaller product obviously, how would you respond next year if foreclosure pricing starts to fall. Strategically does that mean redesigning the product again or does it mean that at some point you’re just not going to make smaller homes and if you’re priced above the foreclosure levels that that’s kind of what it is.

Jeffrey Mezger

We’re always going to be pushing the envelope on our product to cater to the realities of the market at that time, but go back to the reference I made in my script where foreclosures are large in Southern Cal yet inventories are going down. Prices are at a level now where there’s a lot of buyers out there. It’s the affordability opportunity they haven’t seen in many, many years in Southern Cal and that’s why sales volumes are up a couple hundred percent on the resale basis year-over-year.

So prices have now reset at a lower level where inventory is clearing very quickly and our intent with this product is to target that price level because that seems to be where the market is stabilizing.

David Goldberg – UBS Securities

If we could go back to the free cash flow guidance you mentioned that sales in the newer community were outpacing either the product that had been there before or comparable, comparable to that older product in the same market, and I’m wondering when you look forward to your free cash flow and the guidance and being free cash flow in fiscal 2009, does that assume that that same sales pace outperformance against the older product that stay consistent, i.e. if you were selling two homes a month on the older product and now maybe you’re selling three, does that spread stay consistent when you look at sales moving forward.

Jeffrey Mezger

We’re always conservative in our forward look and our guidance to you people and its my expectation, if you think about it for a moment, again go back to Southern Cal, if a year ago we were selling 3,000 square foot homes for $400,000 and its now a 1,500 foot home for $250,000 you’re going to sell more houses. Its just a function of the price point so there’s probably some additional absorption included but when we build our business planning we assume current sales rates.

Operator

Your next question comes from the line of Stephen East – Pali Research

Stephen East – Pali Research

Around sustainability, is your operating margin that we saw this quarter is that sustainable as you go through 2009 with this new product and your cash flow generation on a per house basis, that was nearly 35% of average selling price. Are those two metrics sustainable moving through 2009.

Jeffrey Mezger

Well 35% of revenue is typically what your lot cost would be on an average around the system so we’re not buying a lot of lots today. I guess that’s your cash generation so we are, I don’t think you’ll see that kind of positive cash flow quarter over quarter because it was a larger delivery quarter but as the year unfolds, we again, we’re targeting to have positive cash flow for the year. I don’t know that I can give you a per unit because there’s a lot of things that go into that mix.

Stephen East – Pali Research

On the margin side, you think that’s sustainable or is that a growing thing as the open series takes hold.

Jeffrey Mezger

It will improve through the year because our volumes will pick up as we continue to roll out this product and reopen many of the communities we kind of paused on while we were retooling.

Stephen East – Pali Research

Any update on [Enspirada] and the Vegas market in general.

Kelly Masuda

There’s a lawsuit filed so we can’t comment on [Enspirada] much beyond that. We can say though that both the bank syndicate and the consortium have hired restructuring advisors and we have been actively discussing potential solutions.

Stephen East – Pali Research

Where can we find the series now and is your rollout timeframe, will you be totally rolled out in six months on it.

Jeffrey Mezger

On existing products, that’s our goal. Whenever these markets settle and we acquire additional lots at a lower basis we will be rolling out this product. That’s the product we’re targeting on the new acquisitions as well but its system wide. We’re rolling it out right now in Florida, in the Carolinas, in Texas, in Arizona and we’re seeing incredible savings on the directs.

I can actually share with you, in the past we talked just about Southern California and we’ve now opened up in Tuscan and to illustrate the magnitude of this product that used to build, we opened some models last week in Tuscan where a 1,700 foot home that built for $89,000 now builds for $63,000. So we dropped our directs $26,000 on the same size home.

It’s a significant game changer in terms of the cost to produce your product.

Operator

Your next question comes from the line of Kenneth Zener – Macquarie Research

Kenneth Zener – Macquarie Research

Just following up on that Tuscan example, the $89 to $63, could you give us the break down between the direct meaning the labor as opposed to the materials that you’re buying on a per square foot.

Jeffrey Mezger

I don’t have those numbers with me but materials are 60% of your budget, I don’t know. There’s both material and labor savings I can tell you that. Its on both sides. My hunch is the proportionate ratio will be the same its just all coming down as we identify all the different ways you can value engineer a more efficient product.

Kenneth Zener – Macquarie Research

Can you talk about your, because you expect to lower direct cost, the sustainability of that in light of the fact that other builders also will be getting material costs, that’s just being a net neutral for the industry as opposed to a benefit to your margins.

Jeffrey Mezger

My challenge there would be the savings here are not because commodity prices moved down. This is actual hard savings that are within the design of the product and I think as the markets stabilize this will be one of the differentiators between the top performers and the lesser performers is how good are they at bringing product to the market at an affordable number.

We think we do that extremely well.

Operator

Your next question comes from the line of Megan Talbott McGrath – Barclay’s Capital

Megan Talbott McGrath – Barclay’s Capital

I want to follow-up on what you were talking about in the beginning about where your projects are geographically, it sounds like you’re much more comfortable now with where you’re located, is that a fair interpretation or do you expect to continue to exit any markets.

Jeffrey Mezger

Two years ago I was comfortable with where we were at that time as well and we keep reacting to these markets as they’re shifting. Its very fluid out there. If you look at the markets we exited the majority of them we had only been in for a few years. They weren’t big businesses, they weren’t profit contributors necessarily to our overall results and we’ve elected strategically to revert back to focus on the large metropolitan areas where we have a brand, we have a franchise and we have a history of performing at a high level.

If you look at the total as I shared in my comments, the markets we’re in today generated 29,000 deliveries in 2006. So we still have a significant growth platform from our current level of business and they are all in markets that we think long-term have great prospects and solid economies.

Megan Talbott McGrath – Barclay’s Capital

You talked about how you saw sequential improvement throughout the quarter, one of the things we’ve been hearing is that all of this talk around stimulus packages and potential mortgage rate buy downs could be keeping some buyers out of the market as they wait to see if they can get a better deal, have you heard that from any of your customers.

Jeffrey Mezger

I think there’s a general nature and tendency in today’s consumer to take their time and make sure that they’re making the right decision. We normally don’t share what goes on sequentially in a quarter and I asked William to highlight that in that I’ve heard a lot of feedback where people were concerned our sales would stop because the DPA programs went away.

And DPA went away on October 1 and we actually saw sales momentum not lessening after DPA went away so that’s why I asked William to raise it. I think we’re seeing around the system people visiting five, six, seven times before they make the purchase decision versus one time or two times a couple of years ago.

They’re being diligent, they’re doing their homework. I’ve not heard they’re waiting for a tax credit. I do think if the stimulus package included a credit or the subsidized rate that we’re trying to get I think it will get more people off the fence but in many of our markets it’s a very compelling time to buy if people have the conviction for home ownership.

William Hollinger

And interest rates or mortgage rates are at a 37-year low and affordability is at the highest level it has been in 20 years so it’s a pretty good time to buy a house.

Megan Talbott McGrath – Barclay’s Capital

On the cash flow when you talk about negative cash flow in the first half of the year, are you talking operating cash flow or total net cash flow.

William Hollinger

We’re talking operating cash flow.

Megan Talbott McGrath – Barclay’s Capital

So that includes the tax refund, still negative.

Jeffrey Mezger

It will be because that’s offsetting the debt we just paid off in December.

Megan Talbott McGrath – Barclay’s Capital

But that wouldn’t be in the operating cash flow line.

William Hollinger

Yes that is correct. That’s geography, I’d have to look at that that way. Because you’re right. The payment down of the debt will be done in the financing activities in the collection of the receivables up under operating.

Operator

Your next question comes from the line of Nishu Sood – Deutsche Bank

Nishu Sood – Deutsche Bank

Regarding the $220 million refund that you’re going to be getting soon, since you didn’t have the big land sales that helped some of the other builders claw back their previous taxes paid, I would imagine that that was mostly the marked down land that you were delivering under your closings, so is that the correct way to understand it and numerically would that imply then if we just take a 35% tax rate roughly that on your closings you were delivering land that had been marked down roughly $500 million or so, is that the correct way to look at it.

William Hollinger

Your first question yes, it is correct that we had no real big land sale losses that generated in the big receivable, this is really coming from just the delivery of previously impaired projects and so that is correct. Obviously you know taxes are very complicated but what we’re saying is I think that what we would say is just that same kind of situation going forward that our tax year losses for 2009 and 2010 would be more or less the same kind of impact, nothing big and dramatic but more of a flow through kind of basis.

Jeffrey Mezger

We did drop our inventory levels 11% outside of impairment so that’s also the cash that came back in.

Nishu Sood – Deutsche Bank

The five year window that’s being proposed extends the amount of time over which you’d be able to claw back taxes, would that have any effect on your behavior. Obviously you’ve chosen not to do the major land sales but there are other tactics that you could use like accelerating closings at the end of a fiscal year. So if it does get extended will that come into your calculus on how you deliver units for the next couple of years.

Jeffrey Mezger

I don’t think it will. It’s a proposal, its got a lot of moving parts, its got a lot of complexity to it. We’re certainly hopeful that the government does something here to help stimulate the economy and stabilize home ownership but we’re going to run the business and its unclear to us, we’ve been trying to understand the proposal and what it would mean for us but I don’t think it would drive any different behavior then we’ve outlined today.

Operator

Your next question comes from the line of Susan Berlinger – JPMorgan

Susan Berlinger – JPMorgan

On joint ventures it seems to me that you’re overall debt increased slightly from last quarter about $61 million while your joint venture investments dropped more so and I’m just trying to figure out what went on there.

William Hollinger

We terminated our unwound five joint ventures during the quarter which included opportunistically buying out two partners so that’s where you saw the debt come on a consolidated basis.

Susan Berlinger – JPMorgan

Will we see a notable drop when you put out your Q in terms of how much debt is associated with the joint ventures.

William Hollinger

Yes, and we said that remember we said that our debt was $1.5 billion on the joint venture, the combined joint ventures and right now we disclosed that its around $800 million so yes, it dropped by about $700 million.

Jeffrey Mezger

It is our expectation that you’ll see continued reduction in our JV investment and activity. We’ll continue to unwind these in 2009.

Operator

Your next question comes from the line of Analyst – FTN Midwest

Analyst – FTN Midwest

On the open series pricing, how stable has that been and have you been able to hold prices, do you think you’ll be able to hold them going forward.

Jeffrey Mezger

It will be a community specific issue. Where we’ve opened it we’ve strategically targeted to be competitive with the foreclosures at this time so if foreclosure and resale prices hold, we’ll be able to hold. If the markets deteriorate and prices go down we’ll have to come up with steps to remain competitive and move the product.

Analyst – FTN Midwest

What is the average dollar value of incentives that going into your closings now and how does that compare to last year.

Jeffrey Mezger

We really don’t share that.

William Hollinger

We don’t have that number and it’s a definition within the industry that everyone defines it differently. What we’ve seen is that the incentives and the way that we track it has not materially changed sequentially through the year or comparatively against last year.

Operator

Your next question comes from the line of Joel Locker - FBN Securities

Joel Locker - FBN Securities

Regarding SG&A, can you just give specific between overhead, corporate, and selling expenses and if there were any severance cost or lease termination costs in the $121 million number.

William Hollinger

Yes, there were. We haven’t quantified it because there were a lot of things going on in the quarter but just to give you a sense though as we mentioned in the script we reduced our workforce within the quarter by about 11% but so there’s more then just severance but there were other things, as we said, exiting other markets and so forth so there were some but we haven’t really aggregated all of that.

Joel Locker - FBN Securities

Do you have what percentage may be corporate though other then overhead.

Jeffrey Mezger

We really don’t break those out. The reason that its hard to identify is as I said earlier, there’s a tail to this comet so if we decide to leave Atlanta like we did and we’ll book the one-time charges and then something else comes up that you didn’t consider or you’re going to get out of an office lease in December and it takes until February, whatever it is, there’s a lot of little costs that keep cropping up for a while on a diminishing basis and we did in the fourth quarter we did consolidate seven divisions so there were one-time costs that we incurred and there will be some costs of those wind downs going forward but it will continue to diminish and go away and stabilize over time.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Jeffrey Mezger

I’d like to thank everyone for attending the call. We look forward to sharing our update on our new product and the market as 2009 unfolds and hope to talk to you again soon. Have a great day.

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Source: KB Home F4Q08 (Qtr End 11/30/08) Earnings Call Transcript
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