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Executives

Robert Martin - VP of Finance and Business Development

Larry Mizel - Chairman and CEO

Chris Anderson - SVP and CFO

Analysts

Analyst for Michael Rehaut - JPMorgan

Joel [Locker] – No Company Listed

Nishu Sood - Deutsche Bank

Joshua Pollard - Goldman Sachs

Dan Oppenheim - Banc of America Securities

Josh Levin - Cit Investments

Carl Reichardt – Wells Fargo

Alex Baron - Agency Trading Group

Eric Landry - Morningstar

Jim Wilson - JMP Securities

Ivy Zelman - Zelman & Associates

Adam Rudiger - Wachovia Capital Markets

M.D.C. Holdings, Inc.(MDC) Q2 2009 Earnings Call July 31, 2009 12:30 PM ET

Operator

We are ready to begin the M.D.C. Holdings, Incorporated second quarter 2009 earnings call. I will now turn it over to Robert Martin, Vice President of Finance and Investor Relations. Sir you may begin.

Robert Martin

Thank you. Good morning ladies and gentlemen and welcome to M.D.C. Holdings’ 2009 second quarter earnings conference call. On the call with me today I have Larry Mizel, Chairman and Chief Executive Officer and Chris Anderson, Senior Vice President and Chief Financial Officer.

At this time all participants are in a listen only mode. After finishing our prepared remarks, we will conduct a question-and-answer session at which time we request that participants limit themselves to one question and one follow-up question. Please note that this conference is being recorded and will be available for replay. For information on how to access the replay please visit our website at mdcholdings.com.

Before turning the call over to Larry it should be noted that certain statements made during this conference call including those related to M.D.C's business; financial condition; results of operation; cash flows; strategies and prospects and responses to questions may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties and other factors that may cause the company's actual results, performance or achievements to be materially different from the results, performance or achievements expressed or implied by the forward-looking statements. These and other factors that could impact the company's actual performance are set forth in the company's 2009 second quarter Form 10-Q.

It should also be noted that SEC Regulation G requires that certain information accompany the use of non-GAAP financial measures. Any information required by Regulation G will be posted on our website. Now I will turn the call over to Mr. Mizel for opening remarks.

Larry Mizel

Good morning and welcome. During the second quarter difficult economic conditions persisted as evidenced by a national unemployment rate that now stands at its highest level in more than 25 years. However, the homebuilding industry shows some signs of life. After dropping to historic lows in the first quarter housing starts, permits and new home sales all rebounded in the second quarter.

For our company, quarterly net home orders increased year-over-year for the first time since the third quarter of 2005. Additionally, after booking significant inventory impairments in each of the last eleven quarters, impairments in the second quarter of 2009 were minimal, in large part due to the fact that our WIP and land balances have dropped to their lowest level in more than a decade.

We continued to focus our internal operations during the quarter through our company-wide initiative to reevaluate, transform and streamline our core business practices. A key focus for this initiative currently is the evaluation of our product offering. We are pleased to report that the smaller, more affordable homes that we introduced earlier this year in many of our markets have been well received by our buyers with a sales absorption pace exceeding the company’s average. We are excited to expand the ability of this new product in a large percentage of our active communities in the future as we look to return to a period of profitability and growth.

We have also reevaluated our strategy on unsold inventory. We continue to believe that finished unsold inventory negatively impacts our operating results and therefore we reduced our exposure to this type of inventory by more than 70% in the quarter alone. However, we also believe that the strategic production of unsold homes can be very effective if managed properly. Therefore, we built a limited supply of unsold inventory with the requirement that the construction of these new homes stop at the drywall stage so the buyers have an opportunity to personalize the homes with upgrades from one of our home galleries or design centers. We believe this strategy will help us turn our inventories more quickly while we maintain margins similar to those we receive for a built to order home.

While our low exposure to land is a positive in this unstable economic environment, we are looking forward to redeploying our capital into new investments. With our cash and investment balance of more than $1.6 billion at the end of the quarter, no borrowings outstanding on our home building line of credit and no senior debt maturities until 2012 we are well positioned to act on opportunities that arise.

We continue to actively pursue and evaluate a number of potential investments subjecting each to our rigorous and disciplined investment process and approving only those we believe will maximize our long-term value for our shareholders.

I will now turn the call over to Chris Anderson for more specific financial highlights of our 2009 second quarter.

Chris Anderson

Thank you Larry and good morning everyone. First off, as has been our practice for the last few quarters our 10Q has already been filed so there is significant detail available as you take a look at our quarterly results. We have also prepared slides to aid you in your review so I will jump into those now.

As Larry mentioned, for the first time in 15 quarters we achieved a year-over-year improvement in sales. In the second quarter we received 977 net home orders which were a 2% improvement over the same period last year and a 45% increase over the first quarter. The slight net order improvement was driven by significant increases in our Mountain and East segments offset by a substantial decline in our West segment. The declines we saw in the West were mostly attributable to significant decreases in active subdivisions.

Net orders per active subdivision improved to 1.6 for the second quarter of 2009 compared with 1.1 in the quarter a year ago. Our gross orders were down by about 27% for the quarter but this decline was more than offset by a decrease in cancelations. Our cancellation rate of 20% was much improved from 43% in the second quarter of 2008. If you look at it a little differently though, as a percentage of beginning backlog instead of a percentage of gross sales then the rate was actually up slightly from a year ago.

A couple of other items to note on this slide, first the smaller, more affordable homes that Larry talked about earlier are starting to have an impact on our results. They represented just under 10% of our gross home orders during the quarter and we are really just getting started with them. Second, the average price of the net home orders increased 2% year-over-year to roughly $296,000 primarily due to a higher mix of homes coming from markets priced higher than our average.

While the slow pace of home orders over the past year led to a year-over-year decline in our backlog the good news is that our backlog has increased by almost 80% from the beginning of the year including a 50% jump in the second quarter alone to a current level of 941 homes. Prior to 2009 we had experienced a sequential decrease in backlog for eight consecutive quarters so we are pleased with the direction we are headed. Our average price in backlog is also down from $331,000 at June 30, 2008 to $313,000 at June 30, 2009.

Moving on to inventory, this slide shows the trend over the past year for both our land and work in process with sequential declines every quarter for both categories. Overall, our inventory is down by more than 50% over the past 12 months and 11% in just the past quarter.

For both land and WIP our inventory is the lowest it has been in more than a decade. Looking at the land side of things, we decreased our lot count by 24% over the past 12 months and by about 6% for the quarter. The decline in the first quarter primarily was a result of transferring lots to our work in process inventory at the start of home construction in the normal course of business.

Land acquisition and sales were relatively insignificant. We were a net purchaser of lots with about 35 lots sold versus about 264 lots acquired. Of the roughly 6,700 lots we have remaining, about 750 are classified as held for sale meaning we have determined the best use for them is to sell them to an outside party. At the end of the quarter these lots had a book value of approximately $10 million with California having the largest concentration of these lots.

As we have noted on previous calls, the majority of lots we own are finished so there is not a lot of development money to be spent on these assets and we have continued to focus on keeping our exposure on the surety side down. At the end of the second quarter we had only $134 million in bonds outstanding which is down 9% since the end of the first quarter. We estimate the cost to complete land development under our outstanding bonds is less than $20 million.

We had approximately 1,400 work in process units at the end of the quarter, a decrease of about 50% from the same time last year. Sequentially there wasn’t much of a decrease in the quarter because we started a significant number of homes that we expect to close in the last half of the year. Our spec units declined significantly due to a drop in our finished spec count and I will give you a little bit more color on this topic on the next slide.

In addition, we have reduced our model county by almost 10% during the quarter in the interest of saving on selling costs and through the overall reduction in our subdivision count. Over the past year our model count is down 54%. The lots that we have under option only decreased by 13% during the quarter and year-over-year they are down 29% to roughly 2,000 lots at quarter end. For those lots, we have less than $10 million at risk.

In the second quarter our active subdivisions fell from 175 to 142 with the largest declines in Arizona and California. Over the past year our active subdivisions are down 37% from 227 at June 30, 2008 with about 2/3 of that decrease coming from Nevada, Arizona, California and Virginia.

This slide gives you a visual on one of the topics Larry covered earlier. You can see our strategy on unsold inventory at work here. Just in the second quarter we reduced our finished, unsold inventory by 72% to 82 homes at June 30. That is only about a week’s supply which is very manageable. We prefer not to let our specs get to the finished stage because they tend to be much less profitable for us than a home that has been personalized for its ultimate buyer.

On the other hand, we think the use of unsold inventory can be a very effective strategy if managed properly. Our experience tells us we can still maintain an attractive margin on an unsold home if we at least give the buyer a chance to personalize the home at one of our home galleries or design centers. So we built a limited supply of unsold homes that fit within this strategy. Construction on these units is typically halted after the drywall is installed until a buyer is identified and upgrade selections are made.

On this slide you can see the combined number of unsold homes and the foundation of frame categories actually increased in the second quarter after decreasing for each of the prior periods shown reflecting the implementation of our new strategy. We expect to invest additional capital in unsold inventory during the second half of the year.

Turning to the next slide we would be remiss if we didn’t include a slide here on our cash position. For the sixth consecutive quarter our cash and investments balance exceeded our total debt, in this case by 60% and on top of that we have just shy of $500 million of available borrowing capacity on our home building line of credit.

The next slide takes a look at our bottom line. This story is much the same as the last few quarters. Both our home closings and average selling price declined year-over-year for the second quarter but we were able to narrow our losses on a pre-tax basis and on an after-tax basis and an after tax basis due to a significant decline in impairments and SG&A.

Total revenue for the second quarter fell 52% to $195 million, mostly due to a 49% decrease in home closings. In addition, the average closing price was down 6% to $279,000 in the second quarter. That is down about $17,000 from where it was last year. All of our markets were down except for California with the biggest drops coming in Nevada, Maryland, Utah and Arizona. In California the increase was a function of selling larger homes, not a price appreciation.

Looking at gross margin, overall for the company we were at 18% in the second quarter which was up 630 basis points from last year and up 260 basis points from the first quarter. I will give you a little bit more detail on that in a moment. We also have a slide later on for impairments as well but the story is fairly simple. In the second quarter 2009 impairments were minimal. Only about $1.2 million. We decreased our SG&A expense year-over-year by about $26 million, a 33% drop. If you annualize that reduction that would be about $100 million per year in savings.

Financial service profits were up for the quarter primarily due to a decrease in G&A costs that more than offset a decline in revenue. On the corporate side we shifted from an $8 million loss to a $24 million loss in the second quarter. A couple of things drove this decline. First, similar to the past two quarters we recognized significant interest expense at the corporate level outside of what runs through our cost of sales because we couldn’t capitalize the full amount of interest incurred relative to our senior notes.

The amount for the current period was about $10 million while minimal interest was expensed in the corporate segment last year. Second, we earned almost $6 million less interest income during the quarter as higher cash balances did not offset much lower rates of return on our investments. We have interest charges coming through in a couple of different places on our income statement so we put a bullet on the bottom here to tie it all together.

When you add together the home builder piece which runs through cost of sales, the corporate piece which you can see on the base of our income statement, the total was about $19 million. Then subtract our interest income which you also see on the face of our income statement and you get to a net interest expense for the year of about $16 million. Arguably we can make some changes to our capital structure to bring this net interest number down but right now we are more interested in preserving the financial flexibility we have to pursue opportunistic investments.

Overall, our pre-tax loss for the second quarter was $19 million, down from $102 million in the same period last year and our net loss for the quarter was $30 million as compared to $101 million in the 2008 second quarter. As you can see, we actually had an income tax charge in the second quarter of about $11 million despite the fact that we had a pre-tax loss. This occurred primarily because we recorded a $10 million 2006 alternative minimum tax liability associated with the 2008 net operating loss carry back.

Overall we recognized an $18 million valuation allowance against our deferred tax assets compared with the $43 million we booked during the same period last year. As of June 30, 2009 our total valuation allowance is $327 million which is a full reserve of our deferred tax assets.

Now looking a little bit closer at our home gross margin, this slide shows our trend since the second quarter of 2008. On both a pre and after-interest basis, margins improved in the first quarter both year-over-year and sequentially. Interest continued to have a significant impact at 470 basis points. However, the interest impact was similar for both the second quarter of last year and the first quarter of this year so it doesn’t have a big impact on the change in margins year-over-year or sequentially.

Looking at things before the interest impact, shown on the green bar on the slide, our gross margins are up by 660 basis points from the same quarter last year. There is a twofold explanation for the improvement. First, our warranty adjustment for Q2 2009 versus Q2 last year increased the percentage by about 300 basis points.

Second, as we have mentioned in prior quarters the improvement in margins is largely a function of the significant amount of impairments we have taken in the past so what you see here is a result of our inventories having been appropriately valued to market conditions over the past 11 quarters. Looking at the sequential trend, compared with the first quarter our pre-interest home gross margin increased by 250 basis points. Again, the improvement was driven by a lower basis in land because of prior impairments and the warranty adjustment.

Now, if you take out both interest and the warranty adjustment in all periods the gross margin is 16% in the second 2009 up from 13.4% in the second quarter of 2008 but slightly down from 18% in the first quarter of 2009. So we are still seeing some volatility and part of that is the impact of finished unsold homes and model sales that we recognized in the second quarter.

About 58% of the closings in Q2 were from finished specs or models which typically generate a significantly lower margin than dirt sales or homes that can still be personalized. As the percentage of finished unsold homes and models decreases in our mix of closings, we should be able to provide you with a better picture of what normalized margins look like.

Turning now to selling expenses, we have reduced these expenses by nearly 60% year-over-year. The decrease in commissions is really just a function of the decrease we have seen in home sales revenue but the reduction in marketing expenses is a result of our efforts to reduce the expenses we incur related to model homes.

Over the past year the 54% decline in our model home count has outpaced our 37% decline in active subdivisions as we have re-evaluated the number of models we need in each community or move to sell homes in multiple communities using a single set of models. And we continue to closely control the merchandising spend we put into each of our homes. The amortization of these costs was down by almost 80% in the second quarter compared to the same period a year ago.

Moving on to G&A expenses, we are down 14% for the second quarter as compared with last year’s second quarter. We have done this through primarily significant adjustments to our employee headcount which is down by approximately 36% from last year. We are certainly conscious our G&A expenses have increased in relation to our revenues. This has occurred partly because of the speed of the decline of revenues but is also because we have made a commitment to reevaluate, transform and streamline our core business practices. In addition, we want to be sure to keep a core team in place to help us return to growth as conditions improve.

That doesn’t mean we are done with our focus on G&A. We will continue to make hard choices especially if we see further declines for the industry. We remain committed to the long-term needs of the company.

On our final slide here we have an update on impairments for you. This shows the history of our impairments since the beginning, starting in the third quarter of 2006. As I mentioned previously impairments in the second quarter 2009 were minimal but we did book a small amount in our Virginia market covering just 56 lots in two subdivisions. We anticipate that our impairment levels will remain low going forward given our low exposure to land inventory.

Now to emphasize the message you heard from Larry earlier we are excited to see the opportunities the market has in store for us but we are going to be disciplined to make sure we are making the right decisions keeping in mind our ultimate goal of creating long-term value for our shareholders. In the meantime we are pleased with the progress we have made internally to prepare our company for an eventual turnaround.

As always, I want to thank our M.D.C. team from across the country for the work they do every day to put our company at the top of the homebuilding industry. I would also like to thank everyone on the call for their continued support and interest. At this point in time we will open the line for any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Analyst for Michael Rehaut – JPMorgan.

Analyst for Michael Rehaut - JPMorgan

A question on the gross margins. Given you have likely impaired your land down to appropriate levels and given where your backlog is today what should we be expecting for margins for the foreseeable future? Kind of stable around this 18% level or are you thinking about down sequentially?

Chris Anderson

I think as we have said when you back out some of these other adjustments you can see the volatility from last year’s Q2 to this year and even a bounce that we had in Q1. It is a little hard for us to predict exactly what is going to happen going forward. I think the one message that we would reiterate is what we have done with our inventory. As we have reduced the amount of finished, unsold inventory and as we shift to see a higher mix of unsold inventory that will hold at drywall or dirt sales then if that should have a positive effect for us on our mix.

Analyst for Michael Rehaut - JPMorgan

Nice job on the completed spec reduction. If you could give a break out of where that was geographically and then going forward, for your new strategy where are you targeting the new spec inventory? Is that kind of broad based or is that targeted in specific geographic locations?

Chris Anderson

I’m not sure we have provided a breakdown of that finished unit level inventory. We are down to 82 at June 30 which is a pretty minimal amount. When I think about going forward it is really across the board in all of our divisions. We are focused on unsold inventory that our buyers will be able to personalize and our dirt sales.

Analyst for Michael Rehaut - JPMorgan

Do you have a margin differential between those spec homes versus traditional build to order homes or is there pretty much no differential anymore?

Chris Anderson

No, we would say we are still seeing a difference I think I can’t remember if I said that or if Larry said that. We would expect to see a better margin performance in our unsold inventory that is held and allowed personalization versus our finished inventory.

Operator

The next question comes from the line of Joel [Locker] – No Company Listed.

Joel [Locker] – No Company Listed

Curious on the land side what you are seeing. Obviously you haven’t seen a lot in the second quarter but is anything starting to open up or at least the bid/ask spread starting to narrow a little bit?

Larry Mizel

There is a sequential increase of assets that are being marketed and the spread is still there between the bid/ask but eventually the financial institutions and others are beginning a slow process of putting these assets on the market for sale. I expect over the next period of time the adjustment and realization of values will come to the market and we will be able to be very active.

Joel [Locker] – No Company Listed

Have you thought of maybe a more creative way of maybe purchasing delinquent notes from the banks on certain land parcels you find attractive? You have to be kind of getting frustrated right now based on what you thought might come through the pipeline maybe 6-9 months ago.

Larry Mizel

I would say we are very disciplined, not frustrated.

Joel [Locker] – No Company Listed

You are definitely disciplined. I’m just saying that you would have thought you would have seen some deals, or bigger deals that were attractive by now.

Larry Mizel

We came to view that if we bought it last month we over paid. So that gives you an impression of the market place for raw land or finished lots and those that are willing to take it through foreclosure to restructure, those opportunities continue to be available and we evaluate whatever is proposed to us and we will continue to do so with an open mind.

Joel [Locker] – No Company Listed

California, I guess you are down to probably $1.5 million of land under development there. Are you just not seeing anything that [pencils] there? It looks like you are almost out of land there.

Larry Mizel

I was waiting for the governor to get things straight. California has its own unique circumstances and I read there is 38 million people that live there so I assume they will sort it out and we will sort out the real estate opportunities there as things stabilize.

Operator

The next question comes from the line of Nishu Sood - Deutsche Bank.

Nishu Sood - Deutsche Bank

I wanted to follow-up on the question on the land purchases. I think it is safe to characterize that some of your peers are shifting more towards the green light perspective on certain types of deals, small deals and finished lots and good locations. Whereas you might be characterized as still being more at an amber light. Now the simple answer to that is obviously that the numbers in your pro formas are still a lot lower than what the sellers are asking. There is also what you are seeing out there in the market and as a result of that what you are plugging into your model. I want to just get a general sense of if there are any indicators or what sort of fundamental shift are you waiting for before you are going to shift more to a green light perspective?

Larry Mizel

First of all, we have a bright green light on anything that is priced in line with our assumptions. So we are not amber. We are at bright green. I think an element that is becoming pretty transparent is that the banks have major non-performing loans and I read something recently it was over $60 billion in the first quarter that their REO was only $11 billion which shows the foreclosure pipeline remains full and the banks have yet to dispose of these distressed assets. This is ADC loans. This is just an observation that I think probably tells all of us that the government is just figuring out how to deal with the banks. If you have a financial institution that they are going to close if you realize the losses that are embedded in your balance sheet and you are out of business you keep hoping something good is going to happen.

We continue to see a larger flow of proposed transactions and we hope to continue to transact. It is very important that reality be in the forefront and reality is that the price point and the values on a prospective basis of product that is selling is at a substantially lower level than what it has been in the past. You have to put that into your calculations of what you expect out of these assets that you are looking at.

Nishu Sood - Deutsche Bank

What I’m hearing you say then, essentially if I can paraphrase, is the increase in supply will bring the ask down as opposed to some set of fundamental conditions let’s say on pricing or orders which is likely to bring the bid up? So the former is more likely than the latter?

Larry Mizel

I think you are right on the money.

Nishu Sood - Deutsche Bank

Some of the other builders have been letting go of their lines of credit. I just want to get your thoughts on that. Your liquidity position is arguably among the strongest in the industry. How are you looking at the line and the need to keep it through its expiration?

Larry Mizel

I think we continue to evaluate all of the financial nuances and we are aware of the various views involved with that. We will evaluate it as deemed appropriate.

Operator

The next question comes from the line of Joshua Pollard - Goldman Sachs.

Joshua Pollard - Goldman Sachs

Another question on land as it is the topic de jour. Are you seeing banks willing to take land option deals? In other words, offer you options? The thought process is that they have the land improperly marked and you have discussed that earlier. They can’t take the capital hit by quickly transferring ownership on the landowner books. Are they instead trying to earn their way out as opposed to quickly transferring ownership they just wait it out by optioning the land out to home builders? Are you starting to see some of that coming to the market or are you still only seeing cash deals from banks?

Larry Mizel

I think we see both. A bank that is financially strong and the assets are properly valued it is easier for them to achieve more money by doing an option transaction because you get a higher return. Those institutions you might think it in reverse that the stronger ones would be inclined to drive for cash. It deals with the accounting. If the banks have truly scrubbed their balance sheet and marked these assets it is to an advantage to sell it for cash but it is also to advantage to actually receive more total dollars by having more of a rolling option program. So it really deals with the individual financial institution depending on where they are in the process of marking it to the net realizable value or present value proceeds versus and ultimate dollars recovered.

As you look at investments and IRR Has one calculation but total dollars received is another. I think really it is specific by financial institutions. Additionally, some of the larger financial institutions have a multitude of assets that they have to develop a strategy on what they are going to do. The government is getting close to giving clarity of a theme of what they want them to do but you have a public profile of regulators and then you have regulators on the ground that are actually doing the work. You might call it the career people. The career people are being proper and conservative and dealing with how the banks should mark it.

Sometimes the public profile is trying to make it a softer image. The reality is the banks are working on it and those that have strength and discipline and capital are dealing with it more quickly. So the simple answer is not simple. It is really not only asset specific but it is financial institution specific. That is what gives both the opportunity and the problem for the bank and the developer. It goes in both directions.

Joshua Pollard - Goldman Sachs

I guess you are softly referring to the PPIP in your comments. Is there any update there so they may be in which financial institutions could participate? Are you still having conversations with the FDIC and those financial institutions?

Larry Mizel

They only announced it in the last week or two. I think it is very, very premature. Discipline in this business isn’t days or weeks. It is months and sometimes it is years. There is a story you can buy in ten minutes that which you can’t sell in a lifetime that is worth remembering.

Joshua Pollard - Goldman Sachs

Additionally, a quick question for Chris. A couple of different financing options out there for you with so much cash. I wouldn’t expect you to use $1 billion on land in the next couple of months. Repurchases of debt, significant investments with money managers relative to some of your peers and even if you are feeling really good share repurchases. Could you rank the attractiveness of some of those options?

Chris Anderson

We evaluate everything at all times. I would say that is accurate. In fact I talk to Larry every morning. We have looked at all those and one thing we have done is we have looked out and said what do we look like over the next 5 years under several different scenarios or land acquisition, auction, what does our capital structure need to look like under a few difference scenarios. What that said to us is we want to preserve that flexibility because the opportunities, as Larry talked about on land, things are changing and they continue to change.

Larry Mizel

I would say we are focused on not the short-term but we are focused on what we are going to look like over the next five years. We believe on a prospective long term basis it is a great opportunity for us. We want to maximize that and that is what we are doing day to day.

Operator

The next question comes from the line of Dan Oppenheim - Banc of America Securities.

Dan Oppenheim - Banc of America Securities

As we think about the margins and such there is significant warranty reserve reduction this quarter and also in the first quarter. Should we expect more of that coming through the remainder of this year or do you think that is generally out of the way at this point?

Chris Anderson

We always will make that assessment in the quarter and we are going to book things on what we see at that time. We took all of our known inputs and that is what created that reduction. The positive trend is that our payment experience has been trending down. So, we will continue to trend down. I have not made the future predictions. We just are going to take that look and apply our accounting on a consistent basis.

Dan Oppenheim - Banc of America Securities

Thinking about SG&A the comments were that you looked at the long term needs of the company. Thinking about the comps in land if it is difficult for land to meet the hurdle and such so you won’t likely have land coming to you in 2010. Or land available for building then. Should we assume SG&A is likely to remain at elevated levels as a percent of revenue through next year?

Chris Anderson

I wouldn’t say it is going to be down 15% but it is a whole business model so we are focused not just on the SG&A dollars or percent. We are focused on the top line, what we need to do from a product, pricing and location for growing our top line. Given the changes even in our markets with competition we think that it is one lever that we are actually exercising pretty hard and you saw some of that in our order numbers for this quarter. We are working that. We will work the margin pieces and we will continue to work efficiencies in our G&A spending.

Operator

The next question comes from the line of Josh Levin - Cit Investments.

Josh Levin - Cit Investments

I wanted to ask what was the rationale to changing your spec strategy now. Was there something that happened about the timing that you decided to build more spec?

Larry Mizel

I think we focused clearly on both new product and a strategy that higher gross profit margin and this is an opportunity for us to create more velocity, gross profits and therefore the higher specs that you saw at year-end last year were really almost all old inventory and old models. So it is kind of like most retail businesses. You have to get rid of last year’s merchandise, bring in new models, new product, in some cases new people, new process, new procedures. Where we believe we are building a model that we can achieve similar gross profit margins by going to drywall hold where the consumer can come in and pick all the finishes and they will be selected at the design center instead of at the sales site. This is a much more profitable structure for us since we have design centers in all of our markets.

Josh Levin - Cit Investments

If the home buyer cash credit expires as scheduled in November do you think it will impact demand for homes?

Larry Mizel

I assume it will have some impact. Our management approach is not relying on the tax credit being there or not being there. We take whatever consumer comes in the door and whatever the circumstances are that is what we are going to deal with as we always have.

Operator

The next question comes from the line of Carl Reichardt – Wells Fargo.

Carl Reichardt – Wells Fargo

I had a pragmatic question I guess about the spec and taking it to drywall stage. If I am a customer do I have the option of rolling in a loft or converting a den to a bedroom if I have dry walled in? Of course my rough electrics behind the walls. Are those options not available to me and aren’t those good margin options?

Larry Mizel

The margin options I think as you do your field work and I know you do you will see the options that are usually done at the construction site are really backed into the gross profit margin in the basic house. Therefore, we are focusing on those items that will up sell the product through the design center gross profits which are usually at least double what the base home is. There might be a few items one couldn’t do but on the other hand our new product is designed with maximum design flexibility and therefore few items one could select we might not be able to do but the overwhelming majority of the consumers find that the product we are developing really fits their needs completely.

Carl Reichardt – Wells Fargo

You said, just to clarify, the margins on what you sell through the design center are double what you get on the core box. Will you have a rough idea and is this changing what percentage of the selling price of your homes consist of design center chosen options?

Chris Anderson

I didn’t hear Larry say they were double. We would expect that as we are successful with our product that would take up a bigger piece of our revenue on that home.

Larry Mizel

In the past in prior years where we probably had more consistency we believe it added at least 200 basis points to the gross profit margin of the product in the Design Center because Design Center items which is wall covering, floor covering, cabinets and other products that we are now providing have a different mark up than the basic home. This is the business model that we believe because we are able to deliver a new home personalized in 30-45 days from drywall hold which would be about the same that you could do on a finished home and also it competes very aggressively with someone who needs a dirt start.

We are still in a market where people who own homes want to sell their homes, get paid or sell their homes and know where they are before they buy the new one. They want quicker deliveries and we are able to provide that by doing this.

Operator

The next question comes from the line of Alex Baron - Agency Trading Group.

Alex Baron - Agency Trading Group

I wanted to ask you, you talked a little bit about the SG&A but not looking at the commissions and the marketing which obviously have come down, the other two line items which I guess are more corporate, are you basically at the point where you would be kind of cutting into bone if you keep cutting further? Are there more opportunities where we could see more of these dollars come down so you can start achieving a level of profitability at the operating margin pretty soon?

Chris Anderson

If you look at just numbers overall and what has happened to our company year-over-year at the peak there were over 4,000 people. A significant reduction happened to about 1,600 people last year at this time. Even since last year at this time there was a reduction of about 600 people. We are continuing to look at how do we do things more efficiently. How do we leverage people better. What activities do we need to focus on. What things really drive value and what don’t. We will continue to do that forever. We are looking at all pieces of it.

Alex Baron - Agency Trading Group

My other question is a slightly different subject. I saw that you started picking up a few option deals in a few markets. I’m wondering what kind of IRR or gross margin you are building into those deals? I also noticed in your backlog it seems Chicago kind of went to zero backlog. Are you exiting that market or you are just kind of moth-balling it for now?

Chris Anderson

We actually exited Chicago and have been really just selling the last of our homes there. The other piece is those are kind of normal course of business for us. We are building homes and in some cases when the right location at the right price is there we are going to pick up the option or pick up the land.

Operator

The next question comes from the line of Eric Landry – Morningstar.

Eric Landry - Morningstar

I guess I am a little concerned you have been proactive throughout more so than any other builder yet the amount of activity I am picking up is most of these land auctions may mute that benefit. In other words you have worked so hard and are in what I would call the cat bird seat but the fact there is so much capital out there it may not be as good a situation as I had originally thought. Any comments on that?

Larry Mizel

You bet. The nice thing with others with capital they create opportunity because those that pick up some of these parcels of land, usually the second phone call is to us. Like, guess what, we bought this. What do you think? We look forward to working with our competitors, speculators, the land bankers, whoever is out there buying assets or has them we have an open door and I think over the next period of time it will turn out to work very well for us because we are a user of product and we have the resources and in 2005 we were the first ones to go to reduced assets.

We didn’t do a lot of things over the last five years and I believe our track record and our vision is really clear. Whether it takes a quarter to two quarters or a year or two years we know exactly where we are, where we are going and we look forward to working with everybody that ends up owning these lots because ultimately someone has to build a house on it to create a liquidity event. There is room for everyone.

Eric Landry - Morningstar

Would you hazard to maybe size the opportunity here relative to 1991 or 1990?

Larry Mizel

I wish my memory was that good. It is different this time. Every cycle, we have done this for about 40 years, and every cycle has its own nuances. I think that during different cycles sometimes real estate was in trouble. Sometimes it was residential. Then it was commercial. Then the energy business was in and out of trouble. This time it seems like many of the industries are in trouble. Different segments of the economy have been in trouble. If you look at the worldwide situation there has been so much in the trillions of dollars throughout the world thrown at this issue, residential housing was the first segment of the economy maybe in many parts of the world that got in trouble.

I do not believe housing will lead the economies of the world out of the current recession but I do believe in the United States that basic housing, single family detached, owner occupied, affordable will have a lot of opportunities over the next period of time. That is what we are really good at. That is what we are going to focus on. It does take time and discipline and we have both.

Operator

The next question comes from the line of Jim Wilson - JMP Securities.

Jim Wilson - JMP Securities

I think all I really have left to ask is really about the gross margins and Chris if you could give any more color on difference by geography or levels of improvement or any relative change. I’m just trying to figure out if there are any varying patterns you are seeing and how profitable or less profitable some regions of the country are for you.

Chris Anderson

In our Q you actually can see the breakdown of our margins by the major groups, West, East, Mountain and other. When you look at that and actually think through it and analyze it what you see is the significant impact of impairments on those results. The West was the most heavily impaired and in our most recent Q out of our regions have the highest gross margin. You actually kind of get into some unusual comparisons. One of the things we have done is I have looked recently at all of our subdivisions and I want to see what the contribution margin is on homes in those subdivisions X lend. Kind of looking at that you get into some interesting compares when you try and include all of these prior period impairments from 5, 8 or 10 quarters ago.

We have the breakdown in the Q for you. We have a description of what the percentages are. You can see the West has a significant margin in this quarter of 26.5%. Mountain has 8.5%. East is 14.5%. Really Jacksonville, Florida is 10.8%.

Operator

The next question comes from the line of Ivy Zelman - Zelman & Associates.

Ivy Zelman - Zelman & Associates

I think what I would like to ask and talk about is the fact your company today has gotten lean and mean. I think we looked at your closings and you are back to the number of lots you own is back to the 1983 level. It is clear you are ready for action. My question pertains to action. If you were to see a significant rebound in demand for housing, what do you think the realistic ramp up would be in terms of units in terms of your capacity and staffing and relationships you have with respect to getting the utilization rate up to a level that would be achievable? Can you grow at 20% if demand was growing at 20%? If demand grew at 50% would you be unable to grow at that pace with demand?

Larry Mizel

I think restructured to grow as quick as demand. Remember the moving field of dreams. We are dressed, ready to go and we are in a position to take whatever growth comes in the market place and are excited and looking forward to it.

Ivy Zelman - Zelman & Associates

You don’t think there is a human capital constraint where you find yourself where you don’t have ten years experienced professionals because you have unfortunately had to reduce headcount that it might mitigate your ability to keep pace given the small position you are relatively in today compared to others that think they have an advantage because of their human capital they have maintained or just their staffing has not been reduced as sharply as yours? You do not see that as a competitive disadvantage?

Larry Mizel

No. I would say we have the best management team at all levels that we have had since we have been in business. The business model of what we are looking at in the future has an expectation of substantial growth as the market allows. The human capital will not be an issue. We are well prepared to react quickly.

Ivy Zelman - Zelman & Associates

When you look at your sales today and you think about the number of units you are selling and the G&A per unit and you realize the selling component will be somewhat likely variable with your volume in terms of cost for those units, if you were to think today you reduced G&A pretty substantially per unit, is there more to go? Another 5%? You can only grow profitability so much from cost cutting before you really rely on volume. Where would you say you are in that position today in terms of the magnitude left to go and assuming there is a point of overturn where you will have to get volume to grow the bottom line?

Larry Mizel

One of the elements that is mixed into what we have in G&A is expenditures in time and effort for the future that if you were only dealing with the present and you wanted to be lean and mean we have gone from 4,300 people down to a little over 1,000 and if we were looking for short-term pleasure I’m sure we could have a substantial reduction of G&A and I’m speaking G&A non-related to the variable of the sales. We have publicly said for I’m sure at least a year or longer that we are rebuilding and structuring our company for the future. There is a price you pay which is being expensed on a current basis as appropriate for being prepared for the future. That is a business judgment we have made. I feel highly confident that in the future we will look back and you will say Larry it was painful you spent that money when things were not as robust as they are now but it looks as though it worked out well for you. That is the business risk and the judgment we have undertaken.

Operator

The next question comes from the line of Adam Rudiger - Wachovia Capital Markets.

Adam Rudiger - Wachovia Capital Markets

I wanted to ask you about the Illinois exit and if you could talk about some of your thought processes in the exit. What were some of the factors in your decision that you considered to help make that decision?

Larry Mizel

Because we are done in Illinois. We really shut down last year. We publicly announced over a year ago we were exiting. We didn’t see that this was a market we needed to be in over the next few years. In this industry sometimes you go into markets and we thought it was the appropriate time to exit Illinois and it turned out to be accurate.

Adam Rudiger - Wachovia Capital Markets

I think you have 140 lots or so there. Is your plan to just sell those? Not build on them, just held for sale?

Larry Mizel

141 I think.

Adam Rudiger - Wachovia Capital Markets

My memory is obviously not very good, but can you talk about what at the time your decisions or thought processes that go into deciding to stay in a market or not?

Larry Mizel

Just market conditions and the market conditions in Illinois we didn’t see it fit into our strategic, shorter term strategy. Therefore we reduced and closed the division. It has been in this mode for over a year.

Operator

There are no further questions at this time. Mr. Martin I will turn the call back over to you.

Robert Martin

Thank you. We appreciate you joining us on the call and look forward to seeing everyone after our third quarter earnings release.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: M.D.C. Holdings, Inc. Q2 2009 Earnings Call Transcript
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