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D.R. Horton Inc. (DHI

F2Q09 (Qtr End 03/31/09) Earnings Call

May 5, 2009 10:00 am ET

Executives

Don Tomnitz - President and Chief Executive Officer

Bill Wheat - Executive Vice President and Chief Financial Officer

Stacey Dwyer - Executive Vice President and Treasurer

Analysts

Michael Rehaut - JPMorgan

Megan McGrath - Barclays Capital

Dan Oppenheim - Credit Suisse

Nishu Sood - Deutsche Bank

Kenneth Zener - Macquarie

Joshua Pollard - Goldman Sachs

David Goldberg - UBS

Stephen East - Pali Capital

Joel Locker - FBN Securities

Mike Widner - Stifel Nicolaus

Stephen Kim - Alpine

Josh Levin - Citi

Timothy Jones - Wasserman & Associates

Carl Reichardt - Wachovia Capital Markets

Alex Barron - Agency Trading Group

Gerald Buchanan - Babson Capital

Jay McCanless - FTN Midwest

Nick - Fox-Pitt Kelton

Jim Wilson - JMP Securities

Susan Berliner - JPMorgan Securities

Operator

Good morning. At this time, I would like to welcome everyone to the D.R. Horton, America's Builder second quarter 2009 conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. (Operator Instructions).

Thank you. Mr. Tomnitz, you may begin you call.

Don Tomnitz

Thank you and good morning. Joining me this morning are Bill Wheat, Executive Vice President and Chief Financial Officer, and Stacey Dwyer, Executive Vice President and Treasurer. Before we get started, Stacey.

Stacey Dwyer

Some comments made on this call may constitute forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995, although D.R. Horton believes any such statements are based on reasonable assumptions, there is no assurance that actual outcomes will not be materially different. All forward-looking statements are based upon information available to D.R. Horton on the date of this conference call, and D.R. Horton does not undertake any obligation to publicly update or revise any forward-looking statements.

Additional information about issues that could lead to material changes in performance is contained in D.R. Horton's annual report on Form 10-K and the most recent Form 10-Q, both of which were filed with the Securities and Exchange Commission. Don?

Don Tomnitz

Net sales orders for the second quarter were 4,160 homes, a seasonal increase of 50% from our December quarter. D.R. Horton continues to outsell everyone else in the industry. Our industry-leading sales of over 7,500 units in the year-ago quarter were a tough comp, as they represented a 77% sequential increase from last year's first quarter, the strongest sequential performance of the group last year.

As a data point, our average increase in net sales from Q1 to Q2 since 2003 has been about 48%, which approximates our current yearly and quarterly sequential performance. Our average sales price on net sales orders in the quarter decreased approximately 8% from the year-ago quarter to $203,000, but was flat sequentially compared to our December quarter.

Our second quarter home sales revenue were $770.7 million, 3,585 homes, compared to $1.6 billion, 6,719 homes in the year-ago quarter. Our average closing price for the quarter was $215,000, compared to $237,800 in the year-ago quarter.

Stacey?

Stacey Dwyer

Our gross margin profit on home sales revenue in the second quarter before inventory impairments and land option write-offs was 13.3%. This was a 390 basis point increase from our home sales margin in the year-ago period. Approximately, 240 basis points of the margin increase was due to the average cost of our homes declining by more than our average selling prices, geographic mix shift, and the effects of prior inventory impairments on homes closed during the quarter.

Also, contributing a 140 basis point to the margin increase was a decrease in the amortization of capitalized interest and property taxes as a percentage of home sales revenue, resulting from reductions in our interest and property taxes incurred and capitalized over the last year.

Our gross profit margin declined from our December quarter, due to a greater proportion of speculative homes closed in the March quarter, and an increase in the number of older specs closed, which had a higher cost structure. Also in the December quarter, our gross margins benefited from a reduction in our estimated cost to complete certain development projects, and we did not have a similar benefit in the March quarter. Bill?

Bill Wheat

During our second quarter impairment analysis, we reviewed all projects in the company, and determined that projects with a combined carrying value of $1.4 billion had indicators of potential impairment. We evaluated these projects and determined that projects with a pre-impairment carrying value of $143 million were impaired. We recorded inventory impairments of $45 million as a charge of cost to sales to reduce the carrying value of these impaired projects.

Over 50% of these charges related to projects in our west region. Of the remaining $1.3 billion of evaluated projects, which were not impaired, the majority are located in Florida, Illinois, California, and Texas.

We also recorded $3.1 million in write-offs of earnest money deposits and pre-acquisition costs, related to land option contracts that we do not intend to pursue. Don?

Don Tomnitz

Homebuilding SG&A expense for the quarter was $126.9 million, compared to $208.3 million in the year-ago quarter, a reduction of $81 million or 39%. We have and we will continue to actively manage our SG&A levels, relative to our expected number of home closings. Bill?

Bill Wheat

We recorded $23.1 million in interest expense during the quarter. As we continued to reduce our residential inventory and our development activity, our active inventory declined relative to our homebuilding debt levels this quarter, so we expensed more of our homebuilding interest incurred.

Financial Services pre-tax loss for the quarter was $12.4 million, compared to pre-tax income of $11.9 million in the year-ago quarter. Due to additional repurchase requests during the quarter, we increased our estimates for losses on loans that we expect to repurchase in the future, due to limited recourse provisions regarding borrower misrepresentations. We also increased the reserve for expected future mortgage reinsurance losses.

76% of our mortgage business was captive during the quarter. Our company-wide capture rate was approximately 69%. Our average FICO score was 717 and our average combined loan-to-value was 91%.

Our product mix in the quarter was essentially 100% percent agency eligible, with government loans accounting for 66% of our volume. Stacey?

Stacey Dwyer

As previously announced, we received a Federal income tax refund of $621.7 million in December of 2008. We expect to receive the remainder of our net income tax receivable, currently estimated to be [$55 million] in our fourth fiscal quarter. Our net remaining tax assets of $213.5 million are expected to be realized primarily through net operating loss carry-backs to tax year 2007 based on projected tax losses to be incurred in fiscal 2009.

We expect this will result in an additional tax refund in fiscal 2010. Our reported net loss for the quarter was $108.6 million or $0.34 a share, compared to a net loss of $1.3 billion or $4.14 per share in the prior year quarter. Don?

Don Tomnitz

Our overall inventory decreased by approximately $210 million, excluding non-cash impairment charges during the quarter. We reduced our total homes in inventory to approximately 10,300, down slightly from December. We also reduced the absolute number of speculative homes in inventory by 11%, to approximately 5,500 and reduced our completed specs by 9% to 3,000. We plan to continue to adjust both our total number of homes in inventory and our number of speculative homes in the coming quarters to match future demand.

Our land and lot acquisition spending remains limited and we continually reevaluate our land development plans based on current sales trends. We expect to spend less than $500 million in fiscal 2009 on land and lot acquisition and land development expenditures. Bill?

Bill Wheat

Our supply of owned land and lots at March 31, 2009 was approximately 95,000 lots, down 33% from year ago, and represents a 4.6 year supply based on trailing 12 months closings. Approximately 30% of our owned lots are finished. We plan to continue to adjust our owned land and lots supply in line with our expectations for future home sales and closings.

We control an additional 23,000 lots through option contracts, which does include 6,200 lots for which we do not expect to exercise our option, but the contract has not yet been terminated. Our net earnest money deposit balance at March 31st was approximately $18.7 million on a net remaining purchase price of $464.8 million.

We have no unconsolidated joint ventures, and we rarely use land bank arrangements, so our deposits are typically a low percentage of the purchase price. Don?

Don Tomnitz

We generated a $161 million in operating cash flow in the quarter, and we have generated a positive cash flow in each of the past 11 consecutive quarters for a total of $5.1 billion. We plan to generate positive operating cash flow for fiscal 2009, in addition to any income tax refunds. Even after utilizing $535 million to repay debt during the quarter, we reported a $1.5 billion cash balance at March 31st. Stacey?

Stacey Dwyer

During the second quarter, we repaid the outstanding principal amount on our 5% and 8% senior notes of $460 million, which became due on January 15th and February 1, 2009 respectively. Also in the quarter, we repurchased $77.8 million of our outstanding notes with maturities beyond 2009 for $75.3 million plus accrued interest. As of March 31, we had $382 million remaining on our debt repurchase authorization.

Subsequent to March 31st, we repurchased a total of $25.2 million of our outstanding notes for a total purchase price of $23.7 million plus accrued interest. At March 31st, our homebuilding leverage ratio net of cash was 34.3%, well within our target operating range of less than 45%. We had no cash borrowings outstanding on our revolving credit facility at quarter end and we are in compliance with all of our covenants at March 31st.

We recently gave notice of termination to our bank group and we expect the credit agreement governing our revolving credit facility to be terminated effective May 11, 2009. With our substantial cash balance and our expected future cash position, we did not anticipate a need to borrow from the facility through its maturity in December 2011. Additionally in terminating this agreement will save us over $300 million annually in [non-used] fees. Don?

Don Tomnitz

In conclusion, our industry continues to face many challenges, high levels of both new and existing inventory, increasing foreclosures, tight credit for our homebuyers, low consumer confidence, increasing unemployment, and continued pricing pressure. These headwinds continue to impact our sales.

However, our industry leading sales were up 50% sequentially from the December quarter and our cancelation rate improved to 30%. More recently, April sales were down only 18% from a year ago. D.R. Horton is in a solid position to weather this downturn, and is in a strong position to capitalize on the eventual housing recovery.

During the quarter, we generated an additional $161 million of operating cash flow, resulting in $5.1 billion over the past 11 quarters. We repaid over $500 million in debt, which reduced our homebuilding debt balance 16% from December and still ended the quarter with $1.5 billion in cash. We improved our leverage to 34.3%, the lowest it has been since September 30, 2005.

We continue to reduce our inventory, both in absolute dollars and number of homes under construction, total specs and completed specs. We continue to reduce our SG&A, down $81 million or 39% year-over-year.

D.R. Horton will continue to pursue a land-like business model. Our focus remains on repositioning our product and targeting the entry level buyer, aggressively reducing our SG&A costs and continue to negotiate lower construction costs, as we position DHI to return to profitability as soon as possible.

Once again, D.R. and I wish to thank all our DHI team members, who consistently outperform and continue to outperform all our other competitors. You know your missions going forward. We only ask that you execute this plan and continue to outperform all your competitors.

This concludes our prepared remarks and we will host any questions you have now.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Michael Rehaut from JPMorgan, your line is open.

Michael Rehaut - JPMorgan

First question just with April orders, I was wondering if you could give us a little bit of perspective from a comp situation, month by month perhaps, if the April comp was easier or if it wasn't if you had taken any actions, vis-à-vis price or promotions to improve the order rate given that 2Q at least against my estimate or against perhaps some others was a little bit below where we thought you would come in?

Bill Wheat

Stacey, can give you the percentage number. To answer your second part of your question, we continue to have marketing programs in various parts of the country, depending on what our inventory levels are and our demand levels are in various markets

To answer your question directly, we didn't have any more or any less marketing programs in the second quarter versus the first quarter, nor in April versus the second quarter. Stacey?

Stacey Dwyer

Yes, and then last year in fiscal year 2008, our second quarter was clearly our highest sales volume quarter with 7,500 homes compared to about 5,500 homes in the June quarter. Rather than speaking specifically to April, I think that gives you kind of a relative feel for how the trends played out there.

Looking back more historically, we would not expect to see that kind of differential between our second quarter and third quarter, because there have actually been times in the past where our third quarter has been a little stronger than our second quarter in terms of units.

Michael Rehaut - JPMorgan

But as far as month-to-month, one month within the year ago third quarter wasn't materially different, April very much different than May or June?

Bill Wheat

Yes, Mike, both month-to-month and really looking at Q2 and Q3 historically, Q3 sales both in total and on a month-to-month basis, historically have stayed at an absolute volume level, that's relatively consistent with Q2. Last year was an anomaly in which you saw a 77% increase in Q2 versus Q1, and then we saw a substantial decrease from Q2 to Q3 last year.

So really Q2 a year ago really stands out as an outlier in terms of the sequential increase, and it's really outside of the historical seasonal patterns.

Operator

Your next question comes from Megan McGrath from Barclays Capital, your line is open.

Megan McGrath - Barclays Capital

Good morning, just wanted to follow-up on your spec homes. Just wondering how you would characterize your success in reducing your spec count this quarter, given that you highlighted it last quarter as a priority?

Bill Wheat

Well, frankly, we are adjusting our inventory levels to our demand in the field, and we did reduce our spec count last quarter. We have reduced it again this quarter. However, what really marked this quarter was, is that we sold a larger percentage of our completed specs, our older specs in the quarter, which had higher costs in them.

Hence we were proud to have a reduction in our completed specs, because we had some older specs as I said that had higher costs in them. So, clearly a good move in the second quarter versus the first quarter.

Stacey Dwyer

Our absolute decrease in our specs, Megan, was not as great as the decrease in our completed specs and really the competed specs are the numbers that we want to focus on, and continue to bring down.

Don Tomnitz

Because the new specs that we are starting today have a lower cost structure, and certainly have a more predictable margin in today's environment than those old specs with higher cost structures.

Bill Wheat

However along those same lines, we continue to maintain an adequate number of specs in each one of our subdivisions and each one of our divisions because there is one thing that we see very clearly and we've seen it for some considerable period of time over a year and that is our buyers are showing up in our subdivisions either having sold their home or they've got the down payment, they're ready to move into a home within a 30-day period, 60-day period max, and do not want to wait for the home to be constructed to close.

Megan McGrath - Barclays Capital

Okay, that's helpful, and just a quick follow-up on your order trends in the quarter, your cancellation rate got much better, although your net order trends got a little bit worse, so just curious how you would interpret that? Are you getting fewer but better buyers? What would you attribute to that?

Stacey Dwyer

Megan, I think, what we would focus on is the absolute number of sales, trends are somewhat reliant on the comparison to the prior year, and as we talked about, our prior year comparison was a little bit of an outlier for us. So to post a 50% sequential increase, which is inline with what we have historically done from Q1 to Q2, actually makes us feel pretty good about the sales this quarter.

Don Tomnitz

And not to be too overly competitive, but 4,165 units sold in the quarter far exceeded anything that has been reported in the industry to-date.

Bill Wheat

I would add one other encouraging sign, is we did have a lower can rate this quarter. It was 30% versus 38% the previous quarter. As you know that can move around quite a bit from quarter-to-quarter, so this does not necessarily establish a trend, but it certainly was encouraging to be back down at 30% on the can rate.

Don Tomnitz

Our can rate was consistent throughout the months of the quarter.

Operator

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

Dan Oppenheim - Credit Suisse

Thanks very much. Was wondering if you could talk a little bit about what you are doing in terms of west and southwest. I think in the past you talked about how you're able to compete effectively against foreclosures there. Those were the weakest areas in terms of the orders this quarter. How would you describe what you are doing there, the homes that you are building, and how you are trying to deal with that issue?

Don Tomnitz

We're doing about three different things. One, we are reworking our lot costs in those communities, obviously one of the ways we are as we've impaired our lots in certain of those communities to become more competitive. Secondly, we are continuing to drive down our construction costs in each one of those markets. Thirdly, we are very focused on providing a new product, which we are bringing out across the country in various divisions, where we are focusing on smaller, more scaled down houses, so we can compete with that entry level buyer.

Last, but not least, is the fact that we are pricing our product to be competitive with foreclosures and those are four bullet point plan that we have got in each one of those markets.

Dan Oppenheim - Credit Suisse

In terms of that pricing competitively, in the smaller homes, if you could just tell us when you say you have gotten those homes, so those homes are out in the month of March, when we should see the impact, and also have you been more promotional here during April based on the numbers that you had during the second quarter?

Don Tomnitz

Well, to answer your question, we have got that product out in Seattle and Portland, where I just came from as well as in California. We have that product out in Texas as well as in Albuquerque, and then in the state of Florida, as well as Denver. And once again, I will emphasize we didn't have any greater or less promotions in April for the second quarter, than what we have historically had in the previous quarters. Each one of our markets we are dealing with on an individual basis, and having sales programs that meet our sales needs in those markets at a specific point in time.

Operator

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

Nishu Sood - Deutsche Bank

First I was wondering if we could get some more color on the elimination of the revolver. I understand that you will be incurring obviously some savings, $3 million, but one way you might look at the environment right now, is that builders generally are holding liquidity and that $3 million is actually a pretty small price to pay compared to what some builders are paying out there to improve their liquidity.

So, I was wondering if there's some other elements you were looking at maybe escaping some of the restrictive covenants, or just some more further color on that?

Bill Wheat

Thanks, Nishu. I will address the liquidity issue first. As we looked at our facility, and we looked at mainly one of the primary aspects in terms of liquidity was the limitation under our borrowing base. As of this quarter, our borrowing base limitation was at $275 million and so it was a relatively limited ability to borrow under the facility or to be able to incur additional debt.

So with that limitation in front of us, that was certainly a factor in our decision, because in terms of wanting to have flexibility going forward in our business, we would like to have a bit more flexibility in our ability to borrow or incur additional debt.

And in terms of our overall cash position, we felt confident in terms of our cash position where we expect our cash to be going forward, such that we did not expect a need to use this facility regardless over the next three years. Then certainly costs were a consideration to have a facility in which we did not expect to use it over the remaining maturity of the facility and to continue to pay over $3 million in fees was certainly a drag on our operation in terms of our cost structure.

So in terms of liquidity and in terms of restrictions on our ability to be flexible on our capital structure, we felt it was the best decision to terminate the facility at this time. Our covenants, as you can see and we have filed our 10-Q, we were well in compliance on all of our covenants, and we are really in no danger of tripping any of those covenants in the short term. So it's really more of a decision around our liquidity, our flexibility, and our costs.

Don Tomnitz

I would like to add a couple of things, one is that what we have seen executed by our competitors in the industry, specifically the doubling in most instances of the non-used fee resulting in a total commitment fee equivalent to what the initial revolver amount was. As well as securitizing a portion of the interest, I would say to you one thing, D.R. Horton is a strong company. We are in a strong position, because our people have put us in a strong position. We are not about to roll over and do a deal that doesn't make any sense to us, both economically, liquidity, or financially.

Bill Wheat

That being said, we still have very good relationships with our banks. They have been supportive through the years. It is a tough banking environment right now clearly, but we will continue to maintain good relationships with our banks, and would expect to have future conversations with them in another environment, about future facilities. But for right now for the short to medium term, we feel like we are in good position with our liquidity and with the access that we have to additional liquidity outside the banks.

Operator

Your next question comes from Kenneth Zener from Macquarie, your line is open.

Kenneth Zener - Macquarie

I wonder if you guys could comment on the community counts that you guys, the change they expect now towards year end, relative to the communities that you guys are reporting in the Q as well as kind of the order rates per community, for instance, the Southwest really had a nice spike-up.

Stacey Dwyer

What we have been seeing consistently for the last three to four years is a continued downtrend in our open communities. We would expect to see that continue in the near term unless demand recovers. And basically, future decisions on the trends for those will be dependent on demand. If we see an increase in demand or if there are options available, communities where we can open and hit a different price point, and hit a lower price point, then we may choose to open some new communities, but for the short term, the trend is probably going to be slightly down.

Kenneth Zener - Macquarie

Right, and I guess if you look at it from the orders per community, could you comment on that? For example, the southwest increased rather dramatically and I expect that is in part to the extent that you've reduced the spec count that was sitting in places like Phoenix. Could you comment on that orders per community and your guys' outlook?

Don Tomnitz

We do continue to work on our spec position. And that is really across our markets. And so that is certainly contributing to the sales. But I don't think that we would make any statements that absorption per community, that there has been anything outside of expectations.

Operator

Your next question comes from Joshua Pollard from Goldman Sachs, your line is open.

Joshua Pollard - Goldman Sachs

I have a couple of quick questions. The first is on your capital structure, things are strong, but a couple of your competitors have tapped the debt capital markets. And just wondered with you guys cutting your revolver, which you did have some additional debt restrictions, are you guys considering that at this point?

Don Tomnitz

Well, as you know we cannot comment on that. We have all of the opportunities available to us, but clearly, we cannot comment on this at this time.

Joshua Pollard - Goldman Sachs

I have another question. There is speculation that D.R. Horton desires to be the biggest builder at any cost and with the most recent transaction between two of your peers, I was just wondering where you guys sit and what you think about that comment?

Don Tomnitz

Well first, I have been with Don Horton for 25 years and we have always focused on the bottom line more than the top line and specifically on growth. We have been a profitable company for many years, up until the last year as we have gone through this downturn. Our focus is clearly to continue to be the best and most profitable builder.

However, we do believe that volume is an important part of our scenario. We are not going to go do a deal with someone, just so we that can say we are the largest builder at this point in time. And I think if you look at the numbers of the entities that you may be referring to relative to our sales, as of last December, those combined entities versus our sales, they were combined 66 sales ahead of us. And I would only say they better start selling, because at this pace we should end up as the largest builder this year.

Operator

Your next question comes from David Goldberg from UBS, your line is open.

David Goldberg - UBS

First question is really about the financial services business and the change in terms of the limited recourse provision, and if you could just walk us through how that calculation is done and maybe just give us some more color with that about when those loans were originated? Is it over a period of time and now you are changing some of your provisions? Or maybe just talk about how that calculation was done?

Stacey Dwyer

Sure, basically we approached that reserve the way we approached most of our other reserves, like warranty. We would have historical information and based on claims that have come in on volumes of business that we had originated in the past, we make estimates for reserves. And what we saw this quarter was an increase in repurchase requests, which changed our experience factor in that calculation, and so you saw an increase in reserve for that. Also this quarter you saw an increase in the reserve on the reinsurance program. And basically we are dependent on the third parties to whom we sold those mortgages to provide us with [performance] information.

As we got updated information throughout the quarter, we decided that we also needed to increase those reserves. So that is all based on actual experience reported, and then extrapolating that experience over the tail of the production that we have written.

David Goldberg - UBS

So assuming that you are properly reserved now, as you move forward, we shouldn't see that repeat, in terms of having take larger reserves or anything like that unless the (inaudible) changes?

Stacey Dwyer

Yes, that's correct. If we see a difference in what is actually coming in, then we would continue to update our evaluation of our continuing exposure.

Don Tomnitz

Just as an operator's perspective, from my perspective, our mortgage company has originated billions of loans over the last 10 years, and the reserves we have taken and the losses we have taken have been very minimal. So bottom line is, I think that our mortgage company does an excellent job, underwriting mortgages and the related risk associated with it.

Operator

Your next question comes from Stephen East from Pali Capital, your line is open.

Stephen East - Pali Capital

If I could follow up on David's question just really quickly, do you expect asking a little bit differently looking forward, do you expect reserve increases to continue? I mean I realize they do a quarter by quarter, but as you all look at the business, do you expect it to continue because I don't know the age of your loans, et cetera, in the mix?

Bill Wheat

Stephen, we look at our entire history of production in doing this estimate and we have seen a slight shift in the pattern of requests recently, primarily around provisions around borrower misrepresentations on certain loans. So, as long as the pattern remains consistent with what we are now seeing, we would not expect to have major adjustments to the reserves because we have taken that into account. It would take a change in the pattern and a change in the expectations of that pattern of requests, in order to cause any incremental change in those reserves.

Don Tomnitz

I would say two other things. One, the time period since we originated those loans relative to today, a lot of those buyers have made payments for an extended period of time, so therefore the fraud contention is not really applicable in a lot of those instances.

The other is that our early payment default has really shortened, so basically we have got very little exposure on the EPD.

Bill Wheat

The way I look at this, this reserve is more similar to our warranty reserve, in which we are looking at our entire tale of history, and making adjustments to the estimates as we see changes in trends, which is very different than our inventory impairment process, which is a very discrete process on a project by project basis, in which we have to analyze each individual project, which can result in much more volatile changes in the impairment estimates relative to this reserve.

Stephen East - Pali Capital

Then two other questions, typically give an aged inventory, if you could do that? And then looking at your SG&A, quarter-over-quarter the dollar volume was about flat, even though sales were down. Could you explain one, what was going on? Two, what we should expect moving forward?

Don Tomnitz

Well, specifically on the east inventory, our number of units that have been completed for a period greater than the year and remain unsold, are 515. That is down from the previous quarter. I remind everyone as we have reduced our models dramatically and continue to reduce our number of models dramatically in the company. By definition, a model moves into the unsold classification, once it's closed and those models are always a year or greater aged. So bottom line is of that 515 a pretty substantial number of those are models that had been put in inventory just recently.

Bill Wheat

Stephen, in terms of SG&A, of course, we did see a substantial reduction in our SG&A on a year-over-year basis, down $81 million. When we do look at SG&A on a sequential basis, we were relatively flat, slightly down from Q1 to Q2 on our reported SG&A. However, on a cash basis, our SG&A expenses continued to decline and they did decline in Q2 to a greater extent than the reported number.

There are a couple of factors for that, which muted the impact there. Some of our executive compensation plans are tied to our performance relative to our peers and they are also impacted by our stock price. With the increase on the stock price and the continuing relative improvement in our company's performance relative to our peers, some of those accruals were increased during the quarter. They were more valuable today than they were at the end of December.

In addition, we do have a liability on our books related to our deferred compensation plan, which is largely based to the performance in the stock market. In Q2, the value in that fund declined to a lesser extent than it did in the December quarter. So relative to Q1 to Q2, there was actually an increase in the reported expense.

Operator

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

Joel Locker - FBN Securities

Just wanted to get a little further breakdown of your lots; I guess there are 95,000 owned. I just wondered, how many of them went into the WIP area, and how many under development, how many for land held for development?

Stacey Dwyer

Just at a top level, that does not include our homes under construction. The homes under construction is about 10,300 homes, and that is tied directly to our residential inventory line. The owned lots of about 95,000 would agree to the two categories of land and lots under development and land held for sale.

Joel Locker - FBN Securities

And how many, do you have a breakdown between those two of the 95,000?

Stacey Dwyer

I don't, do you on the 95,000?

Bill Wheat

I don't have that right here. I don't have a lot count on that immediately.

Joel Locker - FBN Securities

I may have missed this previously in the call, of the 95,000 lots, how many were finished?

Bill Wheat

About 30% of those 95,000 lots are finished today.

Operator

Your next question comes from Mike Widner from Stifel Nicolaus, your line is open.

Mike Widner - Stifel Nicolaus

Just wanted to ask you, you guys have pretty good geographical diversity. So, I was wondering if you could provide some additional color on traffic patterns and what you are seeing from competitive inventory out there from existing homes and foreclosures? So where are we seeing the strongest and where are we maybe seeing the weakest areas?

Don Tomnitz

Well, I think Las Vegas continues to be the weakest area, although we have had two successful sales events, one last quarter and one we are in the process of another one this quarter. But obviously the job losses in Las Vegas and the general decline in visitors to the Las Vegas market has not helped that housing market and it is one fraught with a lot of foreclosures. I think secondly Phoenix continues to be on the decline. There are a lot of job losses continuing to take place in the Phoenix market and sales prices continue to trend downward in the Phoenix market.

As I get down on the west, where I just came from, if you take a look at Seattle and Portland, our sales are doing well in those markets, simply because of the fact that we have repositioned our product, and we have got a smaller product in both those markets, and are able to build those in subdivisions where there are larger homes. So we have got a good competitive value for the buyer.

In California, I'm seeing some stabilization in California. We have some good sales out there over the course of the past, certainly in March and February. Our sales have increased in those areas. Also in that market we have a more competitive product, and as I said before, we have impaired our lots in that market, so now we are competitively priced with the foreclosures.

I think Florida, clearly Florida still is weak and Texas was not as strong as it was in the past, although Texas is still very profitable for us. Chicago and the Midwest so to speak, in Minneapolis, both of those markets continue to be weak, certainly in the northeast and New Jersey and DC markets, those markets are weak.

Generally speaking, some of our greater successes have been in Albuquerque, where we have got a really good, well-priced small, entry level product, which we are selling a lot of. In our Houston market, we are beginning to reposition ourselves well there, and our sales are increasing there as well. San Antonio continues to be strong for us.

Lastly I would like to say is really that whole Mobile, Baton Rouge market, Mobile Alabama, and northwest Florida as well as Mobile are two strong markets for us. Not any real strength I would say in the larger markets that obviously drove the homebuilding business. Specifically being California, Arizona, Nevada, and Florida, those markets are still weak and showing signs of life with the exception of Las Vegas.

Mike Widner - Stifel Nicolaus

Great, thanks if I could just follow up on that. Maybe one way to characterize that, and tell me if I am wrong here. There are contrasting views on whether the areas that let us down are going to be the ones to lead us out or going to be the last ones to lead us out, just because of the quality of the buyers that led us up in the bubble and the quality of the loans and the excess inventory.

So is it fair to say that the areas that let us down are still some of the most challenged areas and where you are seeing the greatest recovery right now is sort of in the secondary markets?

Don Tomnitz

Yes.

Operator

Your next question come from Stephen Kim from Alpine, your line is open.

Stephen Kim - Alpine

I wanted to start off with a follow up on the SG&A question that Steve East asked, could you quantify, Bill, the combination of the executive comp issue and the deferred comp issue in the quarter in dollars?

Bill Wheat

Right on the executive comp issue the accrual actually increased by greater than $5 million during the quarter, in terms of the change in the accrual. On the deferred comp plan what flowed through the P&L in the first quarter versus the second quarter, there was a difference of about $5 million in that change.

Stephen Kim - Alpine

Okay.

Bill Wheat

Both of those. You don't add the two together. You are talking about a sequential change, a difference in excess of $10 million.

Stephen Kim - Alpine

Got it, perfect. Secondly with respect to the deal that was done recently or announced between Pulte and Centex, I assume that if a major builder and practically your next door neighbor was being sold, you probably had a chance to take a look at that. I was curious as to whether you could shed any light on what about the combination between yourselves and Centex, looked less appealing than let's say I guess what Pulte perceived.

In your mind is it that the timing was wrong? Was there an issue of culture that perhaps was not a great fit? Or did you think that this is not really the time to be looking at combinations with other public builders, because there may be some better opportunities in let's say land deals, or distressed assets coming from banks? I just wondered if you could shed a little light on your thinking around that?

Don Tomnitz

First of all, yes, we see virtually every deal that comes to the market and we did see that deal. I don't want to speak for either Pulte or Centex. I would rather speak for D.R. Horton. Our focus is on continuing to generate increased liquidity, continuing to adjust our inventory levels, to meet the demands in our respective markets. We are continuing to right-size our organization. We right now have about 2,900 employees. I think if you do the math on the combined entity, they have almost over three times that number of employees. They have sold in the December quarter only 66 more units than we. So I think that is a competitive challenge that they face.

We also are focused on an asset-like business model. We clearly are not focused on buying land. We are focusing on how we can build on other people's lots as we go forward. We are also focused dramatically on trying to reduce our debt as quickly as possible relative to our cash position, and maintaining a minimum amount of cash on our balance sheet.

So generally speaking, the real focus has been we felt like the asset-like, generating cash, having as little debt as we possibly can, and continuing to right-size our organization, was a lot more important than taking on land and lots from some other organization, that we would have a difficult time valuing.

Operator

Your next question comes from Josh Levin from Citi.

Josh Levin - Citi

You said in the past that Horton has really tried to qualify every potential buyer that it could for a mortgage. I wonder relative to the number of people who wanted to buy a Horton home this past quarter, how many of those potential buyers were you able to qualify for a mortgage, relative to what you would have expected? Was it more or less, the same?

Stacey Dwyer

I would say it's probably about in the same area, especially since you saw our cancellation rate continue to adjust downward a little bit to 30%. I think the expectations of people walking in the door today are very unlike what the mortgage market is, so they know they are going to be required to have an adequate down payment. They generally know that they are going to be required to have a good credit score. The other thing that we are offering to help people qualify is we do have a Homebuyers Club, and we will enroll people in that and actually help them work to clean up their credit, so that they can qualify for a mortgage. So with all of those different dynamics, I would say it is about what we would expect right now.

Josh Levin - Citi

You talked about your newer product, less expensive, smaller, how are the margins on that going to compare to the margins on your other products?

Don Tomnitz

Higher, clearly we have done in the divisions we have the smaller products rolled out. There are obviously a lot of subcontractors who are looking for work. There are not many of any of our competitors with very much vertical construction in all of our markets. So to the extent that we are actually starting homes as we are, in a number of our markets, we are getting competitive bids.

The second part of that equation is, as we build a smaller product in a lot of instances that has been on new subdivisions that we have opened, that we are either buying from third party developers, or from banks. We don't feel we know that without a doubt, that that new product has a higher gross margin than our existing product.

Stacey Dwyer

That is also hitting the right price points in the markets right now, because most of those are going to be aimed at the first time home buyers, and they don't have the obstacle of selling their homes.

Operator

Your next question comes from Timothy Jones from Wasserman & Associates, your line is open.

Timothy Jones - Wasserman & Associates

The first question is, could you give me the numbers on the reserve taken from the loan borrowers having problems on prior loans and the reinsurance losses?

Bill Wheat

In terms of the total reserve that we have on our books today related to --

Timothy Jones - Wasserman & Associates

How much is it related to the $12.4 million loss in the quarter?

Bill Wheat

Right, we had a total increase in recourse expense this quarter on borrowers who had our loans of about $16 million this quarter, in terms of recourse. The reinsurance increase in that reserve, let me just pull the exact amount here.

Stacey Dwyer

From December it was about $5 million or $6 million, I am not sure of the quarterly number.

Timothy Jones - Wasserman & Associates

It was $21 the million increase in total from the December figure?

Stacey Dwyer

In the reserve?

Bill Wheat

Including the reinsurance. That is a separate item.

Timothy Jones - Wasserman & Associates

The other thing is, why was your impairment so low given the fact, let's just take that $20 million out that you took. You lost $55 million pretax before impairments. So let's give you the $20 million back will give you $35 million versus a $6 million loss in the first quarter. Why weren't your impairments larger given that fact?

Bill Wheat

Tim, as we looked at our impairment analysis this quarter we look at it on a project by project basis. So it is based on what we are doing in there, and what we are doing going forward. But if you step back and look at a high level, and you look at the primary factors and the change in the margin from the first quarter to the second quarter, from in excess of 15% to in the 13% range. One of the primary factors was the fact that we moved through a greater proportion of our old aged speculative homes at lower margins this quarter.

So those homes moved through at a lower margin, but we no longer have them. So that does not really impact our impairment analysis, as we have fewer old age spec homes in our inventory going forward. So that fact didn't really impact it. Also as we pointed out in our script, there were some items in the first quarter. That were land development estimate adjustments. That were a benefit to us in the first quarter. That did not recur in the second quarter.

So in terms of that, that would have no impact on the impairment analysis either. So really both of those factors really would have no impact on the impairments. We are simply looking at our business today. Our ASP was only down slightly sequentially. So it is really only a marginal change in our ASP, and then as we look at our business going forward we will continue to evaluate it.

It will be the forward market conditions that would perhaps adjust the impairment analysis.

Don Tomnitz

Tim, to be more specific from my perspective, because I backed into this number trying to figure out the differential also between the loss this quarter versus last quarter, and there are two numbers that are big numbers to me. One was the additional $10 million worth of accruals that Bill spoke to earlier, and also in one of our regions we were down about $20 million in pretax income, so to speak, in those regions. So if you add up those numbers that is pretty much the differential between our Q1 and Q2.

Bill Wheat

Don is talking to our South Central region, where we were profitable by in excess of $20 million in the first quarter. We are still profitable there, but it is much lower than that this quarter. It did not necessarily generate impairments, we are still profitable. It did impact our overall profitability from Q1 to Q2.

Operator

Your next question comes from Carl Reichardt from Wachovia Capital Markets.

Carl Reichardt - Wachovia Capital Markets

I have a question, of the 95,000 lots the 70% or so that aren't finished, when you guys look at potentially bringing them to market, whenever you think you will. I mean could you bring them to market today at margins you consider reasonable, based on current pricing and current costs to develop? If you couldn't, how far off are you with today's pricing from actually being able to do that?

Bill Wheat

Carl, when we look at our overall land positions, and where they are valued today on our balance sheet, post impairment all of our assets that we would look at would be valued at reasonable margins going forward. The real evaluation for us as we look on an individual project basis is what are we going to have to spend in order to bring it to market. So in cases where land is partially developed and there is a limited amount of cash outflow to bring it to a finished lot state that is a more favorable scenario. If it is totally undeveloped and there is significant development dollars necessary to bring it to market, then that project would be less favorable to bring to market. But clearly a great opportunity right now is in terms of the ability to be able to bring finished lots to market, either through auction contracts or through those that we already own today.

Don Tomnitz

As a follow up to that, I would tell you that there are subdivisions where we are not bringing them to market today, because we believe that in the future that there will be more valuable, i.e. higher gross margins in those subdivisions a year or two or three out, than what they would be today.

Carl Reichardt - Wachovia Capital Markets

One thing we talked about in the past was historically Horton had relatively small numbers of lots per community and that had increased substantially in the '04, '05 timeframe. How comfortable are you now, given your open base of 802 communities that you have got relatively few lots in those stores left to work through? Or do you still think you have an excess of lots per store, which may take some time to get through? By the way, I would also be curious as to what your comp to the 802 communities is from last year? I have end of September and this quarter, but not last year?

Bill Wheat

Carl, let me be clear on the 802 and what that means, that is a disclosure in our 10-Q, which simply represents the number of communities that we have evaluated for our impairment process. So that include all communities, those that we are actively selling, those in which we own lots, and those in which we may just own land and we are not actively selling or will be actively selling for quite some time.

So it is a data point, and you can compare versus a previous period, but it does not really represent what we are actively selling in. As you can see in our disclosure, in our Q we did drop from 841 at September to 802 in March, so we are down about 5% over the last six month period. I don't have off hand the last year's number here in front of me. I wouldn't expect a change to have been that much different with the exception of the large land sales that we did in September. So the impact of that will probably be a bit larger from March of last year to September.

Operator

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

Alex Barron - Agency Trading Group

Wanted to ask you, did you give I don't think I heard it, the benefit to gross margin from previous impairments?

Bill Wheat

We have not. We have that here.

Stacey Dwyer

The previous impairment release was $79 million this quarter. On home sales, yes.

Alex Barron - Agency Trading Group

I wanted to also ask with regards to the reserve taken on the financial services, how many loans were involved that you had to purchase back?

Stacey Dwyer

Alex, the reserves would not be based on loans. It would be based on dollar volumes. So we really don't have a loan amount that we have tried to estimate.

Bill Wheat

Alex, to be clear on this reserve, it is an estimate. Some component of it relates to actual loans that have been requested, but a large portion of the reserve is really an estimate for future requests that may come to us, based on our history and based on what we are seeing today. So there is an element that is essentially incurred but not reported estimate, similar to an insurance reserve or a warranty reserve. So it is really not all tied to specific loans that have been identified to us today.

Operator

Your next question comes from [Gerald Buchanan] from Babson Capital.

Gerald Buchanan - Babson Capital

I have a follow-on question regarding the new product. Is there any sense for what percentage of sales this new product constitutes?

Bill Wheat

Not currently.

Gerald Buchanan - Babson Capital

When you talk about the competitive pricing for the new product as well as existing homes, for the new product are you looking to price to par with foreclosures and shorts?

Don Tomnitz

Well it depends upon the market, and clearly what we are looking to do is to produce the most profitable product that we can out there. As we evaluate our business model as we design the product and certainly it has the intent of being pari passu or close to being pari passu with the foreclosures in the market place.

Stacey Dwyer

Right and if you look at the list prices you would actually probably see some difference between the list price of a new home and a foreclosure. We would also be looking at, as a builder we would typically pay the closing costs of the home buyer. So that is not an out of pocket cost they have on the new home that they would on a foreclosure. A foreclosure is generally going to need some level of repair. Obviously a new home is ready to move into. There are tax incentives for first time homebuyers out there, and in California, those are very specific to new homes. In California, that is actually another competitive advantage we have against the foreclosures.

Gerald Buchanan - Babson Capital

With your existing homes that you say you are pricing competitively. Again is that on a per market basis? Are you repricing too foreclosures, what do you mean by competitive?

Don Tomnitz

Well, the issue in the market, competitive means everyone out there is trying to sell a home, whether it be a new home builder, an existing home builder, or a foreclosure. We do extensive market studies, our divisions, and our sales people do extensive market studies in each one of their locations, to determine where they need to be, in order to sell and close as many units as we can profitably close in those markets.

Operator

Your next question comes from Jay McCanless, FTN Equity.

Jay McCanless - FTN Midwest

Quick question on the gross margin improvement we have seen in the last couple of quarters. Are the inputs to that materials, labor, et cetera, still staying within the ranges that you all projected at the beginning of the year? How confident are you all in gross margins continuing to look better than the previous year?

Don Tomnitz

Let me be the optimist, as we continue to drive down our cost in a number of these markets that just came out of Seattle, Portland, and California. The entire state of California, our decreases in costs have been, in my opinion, very dramatic. So as a result I believe that we will continue to be able to achieve those kind of cost reductions. It is not only on a, per square foot basis, but it is just on a house basis as we continue to build a smaller product, which is going the attract the people who are living in an apartment, who have an affordable payment, that they can qualify for the home.

Bill Wheat

Of course the other side of the equation there on confidence and margin, it comes down to our average selling price. While we are still seeing year-over-year declines in the average selling price, we are seeing the pace of that decline soften a bit. We were only down 1% from the first quarter to the second quarter. Part of that is actually mix, as we are downsizing our homes. So relatively flat in terms of ASP, if that trend holds then I would not expect to see any significant changes in margin and clearly that would remain at a higher level than last year. That is all dependent on market conditions obviously.

Don Tomnitz

I would say the other part of that equation is that as we continue to sign up new lots from banks and from developers, those lots are at a competitive price list that we are only going to go execute those contracts and build on those lots. If we can pro forma our gross margin that is acceptable to us which is trying to get back into my old belief that gross margins on the homebuilding industry, take out the peaks and the valleys, are somewhere between 18% and 22%. So that is our goal moving forward, as we execute new contracts, is to execute contracts where we can produce a unit, and close it and generate an 18% to 22% gross margin.

Jay McCanless - FTN Midwest

The other question that I had is, are the absorptions that you are seeing so far even into the new quarter we started and also the selling prices holding up to what you had originally expected, and what level of forecasting can you give us on impairments, if any? Or what you are thinking about those at this point?

Don Tomnitz

I will answer the first part of that question and what I see on the new contracts that we are entering into and building homes on is that we are maintaining our pro forma margins on those products. So as we are able to introduce more and more of those new products at the lower [lot] cost into our mix, then our margins will continue to increase.

Bill Wheat

Jay we are not in the business of forecasting the level of impairments. That being said, when you look at the absolute value of inventory that is on our balance sheet today versus a year ago and we continue to decline. There is simply less potential for substantial impairments, similar to what you saw a year ago in our balance sheet today. We still disclose what we call our watch list. There still is $1.3 billion of inventory that we are watching. Of course we evaluated $1.4 billion of inventory this quarter and impaired only about 124 of it for an impairment charge of $45 million. So it is something that we watch closely. Could impairments be higher than this quarter in a forward quarter? Yes. Could they be less than they were in this quarter? Yes, they could, because the potential simply isn't as great as it was this time a year ago.

Operator

Your next question comes from Rob Stevenson from Fox-Pitt Kelton, your line is open.

Nick - Fox-Pitt Kelton

This is actually Nick on for Rob. Quick question on the tax credits, do you guys have any numbers on what percent of your buyers are actually utilizing the national or the California tax credits?

Stacey Dwyer

On the first-time home buyers, the way we are tracking our first-time home buyers is that is more than 50% of our business. I am not sure all of that is driven by the tax credit though a lot of that is repositioning our product. We have always focused on the first time and then the first-time home buyer. I don't have any specific numbers for California though.

Don Tomnitz

No but as I actually through California over the course of two weeks, I can tell you that the $8,000 Federal income tax credit is strong, but also the $10,000 state of California is definitely strong. So both of those are definitely driving our business in California currently.

Stacey Dwyer

Yes in California, that went into effect March 1st. So that would have only impacted a small amount of our sales last quarter, and actually a fewer percentage of our closings. As we look forward to next quarter that is going to be basically 100% of California's volumes, simply because it is all new home sales, assuming that people choose to apply for that credit.

Don Tomnitz

As I mentioned earlier, our sales in California are doing much better than what they were doing a quarter ago, sequentially they are doing much better.

Nick - Fox-Pitt Kelton

One other question is on the backlog. How should we think about that? Because on a per unit basis it looks like it was down to around 210,000, which was down from say 222 in the 12/31 quarter, I mean I am wondering on the margin side, how should we think about those homes? What sort of margin might be in those homes?

Don Tomnitz

I think the best way to answer that question is, one as we continue to drop our sales prices, both to meet demand in the market place, as well as entering into these new contracts, where we are buying lots at a less expensive price and being able to produce a more affordable product with a less expensive lot and a smaller product. Our sales prices will continue to trend down.

Simply because as we reposition the company into a bigger and bigger percentage of first-time home buyers. Like Stacey said, we have always been about 40% first-time home buyers. Well clearly, we are moving to a percentage greater that that, so as we continue to increase that percentage of first-time home buyer product, our ASPs will continue to come down, and I think that is a good thing. The margin on those is going to be reflective of today.

We have taken all the impairments that we should take. As a result those by definition, those margins and that product are certainly above 12% to 13%. The new lots that we are buying as I mentioned to you before were pro forma in rolling option deals on the smaller product of 18% to 22%. So I think those factors in of themselves, irrespective of the ASP declining, our margins should be going up.

Operator

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

Jim Wilson - JMP Securities

I guess, my really only remaining question, land strategy and whether, I mean obviously you want to stay asset light, but would you consider any of these kind of JVs that competitors have announced? Or anything that you can talk about that you are thinking of strategically to take advantage of the opportunities that are surely going to be upcoming, the rest of this year and next year?

Don Tomnitz

On the land side we are abiding by the KISS principle, we are trying to keep it simple. To answer your question directly on the JVs, absolutely not. Or any kind of other funky financing arrangement. We are really focused on one thing, working our way through our existing lots and secondly, continuing to add subdivisions in markets where we are able to purchase on a rolling option basis, lots where we can produce an entry level product.

Jim Wilson - JMP Securities

Definitely, obviously in that scenario any other, you might easily argue any other outside financing or new bank lines, or anything you really feel probably won't be necessary and might not be necessary for the course of the future?

Bill Wheat

We don't. Jim. We are in great shape with our liquidity today, and we continue to watch the markets, so that is where we are.

Operator

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

Susan Berliner - JPMorgan Securities

Jim just got one of my questions. My other one was in regards to your leverage target I think the Q still identified it as net debt to cap below 45. But it sounds to me like you are really focusing on reducing leverage. So I wondering in the near-term, are you expecting it to go a lot lower than that continuing?

Bill Wheat

We know overall our target does remain the same, keeping it below 45. Obviously, we are at the low end of our historic range at about 34%. Today given that the market is still challenging, really you can't have too much cash and you can't have too low a leverage. So we will continue to manage that, balancing or liquidity needs versus our ability to reduce our debt load versus the capital that we want to have in place to fund our operations and take advantage of opportunities that come. So I wouldn't put a prediction out there as to which direction the leverage may go in the short-term. Just suffice it to say that, we have plenty of cushion below our target. We will continue to value opportunities to repurchase debt, as we have been. We have had a good flow of ability to repurchase debt over the last few quarters.

Don Tomnitz

At very attractive prices.

Bill Wheat

Yes, good prices, good discounts and we have been focused on our shorter term maturities to date.

Operator

At this time, I will turn it back over to Mr. Tomnitz for any closing remarks.

Don Tomnitz

Thank you. We appreciate you joining our Q2 conference call. Are there additional questions? No. All right. Once again, we would like to extend our appreciation to all of our D.R. Horton team members. We produced again a good quarter in a tough market. As I said before, Don Horton and I have spent a lot of time in the field with each of you, and you clearly know your mission. You have out executed the competition all along and we only ask you to go out and continue to adjust yourself to the changes in mission from time to time and continue to out execute the competition. Thank you very much.

Operator

Thank you, this concludes today's D.R. Horton America's Builder second quarter 2009 conference call. You may now disconnect your lines.

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