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MDC Holdings Inc. (NYSE:MDC)

Q3 2009 Earnings Call

October 30, 2009 12:00 pm ET

Executives

Robert Martin – Vice President of Finance and Business Development

Larry Mizel – Chairman and Chief Executive Officer

Chris Anderson – Senior Vice President and Chief Financial Officer

Analysts

[Buck Horn – Raymond James]

Ivy Zelman – Zelman & Associates

Nishu Sood – Deutsche Bank

Joshua Pollard – Goldman Sachs

Josh Levin – Citi

Carl Reichardt – Wells Fargo Securities

Dan Oppenheim – Credit Suisse

Michael Rehaut – JP Morgan

James McCanless – FTN Equity Capital Markets

Jim Wilson – JMP Securities

Alex Baron – Agency Trading Group

[Joel Locker – FBN Securities]

Eric Landry – Morningstar

Operator

Welcome to MDC Holdings Inc. Third Quarter 2009 Earnings call. I will now turn it over to Bob Martin, Vice President of Finance and Business Development.

Robert Martin

Welcome to MDC Holdings 2009 Third Quarter Earnings conference call. On the call with me today I have Larry Mizel, Chairman and Chief Executive Officer, and Chris Anderson, Senior Vice President and Chief Financial Officer.

At this time, all participants are in a listen-only mode. After finishing our prepared remarks, we will conduct a question and answer session 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 MDC's business, financial condition, results of operation, cash flows, strategies, and prospects and response 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 third quarter Form 10-Q.

It should also be noted that SEC Regulation G requires that certain information accompany the use of non-GAAP financial measures. Any information required by Regulation G will be posted on our website.

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

Larry Mizel

During the third quarter, we saw some indications of improving business conditions for our industry. But these positive signs were largely overshadowed by issues at the forefront of the national economic picture, including continued deterioration in employment levels.

However, even as volatile and uncertain conditions persisted, we were encouraged by a year-over-year increase in our own net home orders for the second consecutive quarter. We believe that the improvement in our home orders was made possible by our companywide initiative to reevaluate, transform and streamline our core business practices.

During the third quarter, we continued to expand our offering of the small more affordable homes that we introduced earlier this year in an effort to better serve the changing needs of our customers. In addition, to improve affordability for our homebuyers, we initiated a sales program during the quarter which focused on providing low mortgage interest rates. We also positioned our inventory to allow buyers the opportunity to close on homes prior to the impeding expiration of the federal homebuyer's tax credit.

During the quarter, we strategically increased the number of unsold homes available for personalization by more than 40%, while we decreased our finished homes by more than 75%. We believe that this approach will help to improve our profitability as the margins we realize on unsold homes available for personalization significantly exceed those of finished inventory.

We generally stop construction on unsold units at the drywall stage. Once contraction is restarted, these homes can close within 45 days which allows us to directly compete with finished homes on the market. However, by holding the units at drywall we offer our buyers the opportunity to personalize the home in one of our home galleries.

After several years of relatively limited land acquisition activity, during the third quarter we secured control of almost 1,300 additional lots through direct acquisitions or option contracts in the third quarter. As always, we have underwritten these lots with great care using assumptions that we believe are appropriate given the current market conditions and submitting each to be reviewed and improved by our asset management committee.

We anticipate starting the construction of homes at each of these projects as soon as possible. Doing so should allow us to add additional home closings volume stating in 2010, which is a key focus as we strive to return to a period of growth and profitability. Even after we funded our acquisition activities, we ended the third quarter with $1.6 billion in cash and investments. Therefore, we are well positioned to continue making opportunistic investments as we build our land pipeline for the future.

I will now turn the call over to Chris Anderson for more specific financial highlights.

Chris Anderson

For your reference, as we've done in our previous quarters, we filed our 10-Q earlier this morning so there's significant detail available as you look at our quarterly results. I'll hit some of the major points with the rest of our slide presentation, and I'll start with orders.

As Larry mentioned, in the third quarter we received 1,016 net home orders, which was a 52% improvement over the same period last year and a 4% increase over the second quarter. Each of our segments showed improvement in orders year-over-year, but the most significant increase was in the mountain segment.

Within our segments, only California and Delaware Valley had a decrease in net orders and in both cases the decrease was caused by a decline in active subdivisions that exceeded the company average. For the company overall, active subdivision were down 35% year-over-year, including double-digit declines in every market. Our average monthly net orders in active subdivisions improved to 1.8 for the third quarter as compared with 0.8 in the quarter a year ago with improvements in every market.

Our gross orders were up about 8% for the quarter, which is the first year-over-year increase that we've had since the third quarter of 2005. Our cancellation rate of 23% was half of the 46% in the third quarter of 2008. And the rate also decreased, if you look at the cancellations as percentage of beginning backlog, to 33% as compared with 36% a year ago.

The average price of the net home orders decreased 2% year-over-year to roughly $268,000. It's not a big change, but the number is influenced by cancellations. If you look at just the average price of our gross home orders, the year-over-year decline is about 7%.

As Larry mentioned earlier, the smaller more affordable homes we started selling earlier this year are starting to have a definite impact on our results. It represented just over 20% of our gross home orders during the quarter, with individual markets as high as 50%. Also, we had some great success this quarter in generating sales through a nationwide sales promotion during which we offered incentives including attractive interest rates and positioned inventory to allow certain buyers the opportunity to take advantage of the federal tax credit.

Moving on, on the strength of our orders for the first time since the fourth quarter of 2005, the units in our backlog increased year-over-year by about 15%. For just the quarter, backlog jumped 38% to our current level of 1,298 homes. Our average price in backlog is down 9% from $323,000 last year to $295,000 at the end of this quarter.

Moving on to inventory, this slide shows the trend over the last 12 months for both our land and work-in-process inventory. While inventory overall was down 37% over the year, it's up 2% in the past quarter due to an increase in the number of homes we have under construction as we prepare for fourth quarter closings.

Looking at the land side of things, we decreased our lot count by 19% over the past 12 months and by about 7% for the quarter. The decline in the third quarter primarily was the result of transferring lots to our work-in-process inventory at the start of home construction in the normal course of business, partially offset by a net acquisition of approximately 650 lots during the quarter.

You can see on the income statement that we had about $9.4 million in land sales during the quarter, but all of these sales actually relate to acquisitions we've done during the quarter. Situations where we only wanted part of a land parcel that was offered in bulk and therefore we simultaneously sold some of the lots to a third party buyer as we closed.

Of the 6,264 lots we have remaining, about 680 are classified as held for sale, meaning that we've determined that 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 $6 million, with California having the largest concentration of those lots. As we've noted previously, our active subdivisions are down 35% from 211 in September 30, 2008 to 137 today. And in the third quarter, our active subdivisions fell slightly from 142 last quarter.

The next slide gives you a picture of our unsold home inventory, which tells a compelling story about our strategy. As we mentioned last quarter, we believe that the use of unsold inventory can be a very effective strategy if managed properly. Our experience tells us that a home that's been personalized for its ultimate buyer at one of our home galleries or design centers is much more profitable than a home that is sold after it is finished.

So, we've concentrated on building a supply of unsold homes that fit with this strategy while reducing our exposure to unsold finished homes. On the slide, you can see that the combined number of unsold homes in the foundation and frame categories, which we call unsold homes available for personalization, increased by 42% in the third quarter, while we reduced our finished unsold inventory by 77%.

As Larry mentioned earlier, while this strategy is a good tool for our operations, it's also a great thing for our buyers. We typically stop an unsold home at drywall and at that point they can close in about 45 days once we restart, which competes nicely against finished homes on the market. However, by stopping construction at drywall, we do give our buyers the opportunity to personalize their homes at one of our home galleries or design centers, which is a fantastic selling point.

Turning to this next slide, on land acquisition, this is a new slide for us this quarter and I think it gives you a great picture of how our land acquisition efforts have progressed over the past five quarters. We put almost 1,300 additional lots into our control in the third quarter, including about 500 through direct purchases and 800 through option contracts. That's clearly a big increase over any of the previous four quarters that you see here.

In addition, we acquired about 150 lots through option contracts that were already in place at the beginning of the quarter. As always, we continue to underwrite all of our land acquisitions cautiously with every deal requiring the approval of our asset management committee.

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

Total revenue for the third quarter fell 44% to $203 million, mostly due to a 41% decrease in home closings. In addition, the average closing price was down 6%, $283,000 in the third quarter, down almost $18,000 from where it was last year. All of our markets are down except for Virginia and Delaware Valley, with the biggest drops coming in Nevada, Utah and Jacksonville. In Virginia and Delaware Valley the increase was mostly a function of selling larger homes.

Looking at gross margin overall for the company we were at 18.9% in the third quarter, which was up 360 basis points from last year and up 90 basis points from the second quarter. I'll 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. For the second quarter in a row, impairments were minimal with only about $1.2 million recorded. Looking at our SG&A, we decreased our SG&A expense year-over-year by about $27 million, a 46% drop. On an annualized basis, that would be about $108 million in savings.

Looking at financial services, our segment shifted to a $4.3 million loss this quarter, down by almost $8 million for the same quarter a year ago. The decrease is primarily due to an increase in G&A expense of $5 million, 6.5 of which is associated with an increase on our loan loss reserves as compared with what we booked a year ago. And we also experienced a decrease in the gain on sale of mortgage loans, broker origination fees and insurance revenue of $2 million.

Now I want to give you a little bit more color on our low modest reserve. As it's been noted in industry reports, mortgage performance continued to deteriorate in the third quarter as evidenced by significant year-over-year increases in delinquency rates. Additionally, foreclosures and foreclosures in process have increased substantially.

Similarly, our mortgage company, Home American Mortgage, has experienced an increase in the number and magnitude of demands to repurchase previously sold mortgage loans. Accordingly, Home American increased its estimated loan loss reserve by $7.3 million during the 2009 third quarter, compared with the reserve increase of only $800,000 booked in the third quarter last year. As noted above, the increase is included as a component of G&A on our income statement.

Now, on the corporate side our loss increased to $27 million in the third quarter, as compared with a $21 million loss a year ago. A couple of things drove this decline. First, we earned almost $6 million less in interest income during the quarter as higher cash balances did not offset much lower rates returned on our investments.

Second, corporate G&A was up slightly in large part due to a $2.6 million write-off of prepaid finance costs associated with the reduction of the commitment under our home building line of credit. Overall, our pre-tax loss for the third quarter was $32 million, down from $117 million in the same period last year. And our net loss for the quarter was $32 million compared with $118 million in 2008 third quarter.

We also recognize a $12 million valuation allowance against our deferred tax assets in the third quarter compared with the $61 million we booked during the same period last year. As of September 30, our total valuation allowance is $339 million, which is a full reserve of our net deferred tax asset.

Now looking a little bit closer to our home gross margin, this slide shows a trend since the third quarter of 2008. On an after interest basis, margins improved in the third quarter both year-over-year and sequentially and just continued to have a significant impact at 380 basis points, which is 100 basis points higher than the third quarter last year but 90 basis points lower than Q2 of '09.

Looking at things before the interest impact, shown as the green bar on this slide, our gross margins are up by 360 basis points in the same quarter last year. There's a twofold explanation for the improvement. First, a warranty adjustment in Q3 increased the margin by about 590 basis points, as compared with an increase of only 100 basis points in the third quarter of '08. Second, as we've mentioned in prior quarters, the improvement margin is largely a function of the significant amount of impairments we've taken in the past.

So, what you see is a result of our inventories having been appropriately valued at market conditions over the past 12 quarters. Looking at the sequential trend, compared with the second quarter, our pre-inches gross margins were unchanged. We took similar warranty adjustments in both quarters, resulting in an elevated margin level for both periods.

Now, if you take out both interest and the warranty adjustments in all periods, the gross margin is 16.9% in the third quarter of '09, which is about even with 17.2% in the third quarter of '08 and 16.8% in the third quarter of '09. So even though we've seen price declines over the past year, our gross margin has held steady when you remove some of these reconciling items.

Now turning to selling expenses, we reduced these expenses by nearly 47% year-over-year. The decrease in commissions is really just a function of the decrease we've seen in home sales revenue, but the reduction of marketing expenses is the result of our efforts to reduce the expenses we incur related to model homes.

Over the past year, the 50% decline in our model home count has outpaced our 35% decline in active subdivisions as we reevaluate 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 merchandise expenses that we put in each of our homes. The amortization of these costs was down almost 35% in the third quarter compared to the same period a year ago.

Now moving on to G&A expense, we're down 8% if compared with last year's third quarter. But keep in mind the G&A for the third quarter is running a bit higher than the past couple of quarters for a couple of reasons. First, as I mentioned before, the $7.3 million reserve for mortgage loan losses is a part of G&A as is the $2.6 million charge we took as part of reducing our home building line of credit.

If you take out those two items we're running right around the level we have been for the past few quarters, which is a significant drop from a year ago. We've done this primarily through significant adjustments to our employee headcount which is down by approximately 20% from last year.

On our final slide here we have an update on impairments for you. This shows the history of our impairment since the beginning, starting in the third quarter of '06. As I mentioned previously, impairments from the third quarter of '09 were minimal but we did book a small amount in our Colorado, Florida and Nevada markets covering just 61 lots in these three subdivisions. We anticipate that our impairment levels will remain low going forward given our low exposure to land inventory.

To sum up, we're encouraged by what we've been able to accomplish during the third quarter, including the increase in our homeowners and the additions to our land pipeline. We know we still have work to do in order to bring MDC back to a period of profitability and growth and many obstacles still exist on the road to recovery for our industry and the economy overall. We are intensely focused in the fourth quarter on these initiatives we believe will allow us to progress towards our ultimate goal of creating long-term value for our shareholders.

As always, I want to thank our MDC team from across the country for the tremendous work they do every day to put our company at the top of the home building industry. I would also like to thank everyone on the call for their continued support and interest.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of [Buck Horn – Raymond James].

[Buck Horn – Raymond James]

I was wondering if you could talk a little bit about the reserves a little bit further, specifically on the warranty side. Several quarters in a row now where we've seen benefits from the warranty reserves. Maybe you can help explain exactly what's going on, and is this basically going to end anytime soon? Are we going to see continued benefits to the gross margin from warranty reserves coming back?

And then on loan loss reserve from the Financial Services Division, I'm just wondering what the risk is necessarily or why does such a large reserve need to be taken given how much of your originations are government insured or their conforming products. I'm wondering what the major risks are there.

Chris Anderson

Buck, this is Chris. I'll give you a couple points on the warranty piece. There were two things that impacted warranty reserves this time. One was actually just a settlement of some prior construction defects in Nevada. That was about $7 million of the $10 million in warranty adjustments. So the ongoing revenue adjustments that you've seen over the last few quarters were really only about 2.6, the 7 was a distinct item that happened as a result of resolving some construction defects from several years back.

And will that continue? I think what we've seen is our warranty payment experience is what informs us of what we think our expected expenditures will be going forward. We think that we've done a good job on improving the quality of our homes and improving our customer experience over the last several years and I think it's – I'm not going to project out what I think is going to happen to that, but we've seen a downward trend in our warranty payment experience and that's what's been driving it up.

On the loan loss reserve, we have watched this carefully and the loan loss reserve primarily relates to loans that were underwritten and originated in prior years, not the most recent 12 to 18 months. So they're really related to older loans that ultimately have made their way through all of the foreclosure process and have now come back in the form of demands.

As we disclosed in our 10-Q, we carefully evaluate that and take all of the inputs that we have to make the best estimate that we have and we think at this point that's our best estimate for our exposure on loans previously sold.

Operator

Your next question comes from Ivy Zelman – Zelman & Associates.

[Alan] for Ivy Zelman – Zelman & Associates

It's actually Alan on for Ivy. Chris, I was hoping to dig in a little bit deeper there on some of your comments about the gross margin, kind of stripping out the interest and the warranty noise. It looks like gross margin actually declined on a core basis a couple hundred bips versus the second quarter.

And I know you guys have done a great job of kind of taking your medicine on the impairments upfront and you've obviously been posting some pretty strong margins. But that's kind of counter to what we've seen from some of your other peers and that the third quarter results so far have sort of demonstrated a nice pickup on the margin and some of that is catch-up but some of that is also some stabilization we are seeing on price.

So I guess the question is looking forward kind of directionally, would you expect there to be a lot more upside there assuming prices continue to stabilize, or are you actually experiencing a little bit of a negative mix shift now that maybe some of the newer deals that you are underwriting aren't quite up to the level that you're seeing from some of the impaired assets coming through.

Chris Anderson

A couple of responses. One, it's difficult to do comparisons to the other builders because of the large impact that impairments have and you have different companies. I know what our approach has been to impairments and we feel like we took those largely early, you can see what that term looks for us. So when I look at our margins as I did in my comments, I look at sequentially and year-over-year. When I adjust out interest and the warranty adjustments I am at about 16.9% margins for Q3, 17.2% for Q2 and 16.9% last year.

So I look at that and I think about the price degradation from for the top line and the average selling price and I'm pretty happy and think that some of the improvements we've done on purchasing and in our product and cost have helped us offset the price erosion that we've seen.

Related to future margins, if we've taken a position we're not going to comment on what the projection will be on margins. But we feel like we've made a lot of progress on our product and pricing and the value and the mix of our product and think that at 16.9% margin, holding that when the price declines, I'm pretty happy about that.

[Alan] for Ivy Zelman – Zelman & Associates

I guess if I could sneak in one second one just on the land acquisition, the perks that you made in the quarter, can you give any more color just related to maybe some geographies where some of those lots were isolated. I would assume that the vast majority are finished so do a lot of them tie into your 2010 closings plan and if not maybe just give a little bit of color on kind of what the duration of those lots might look like.

Chris Anderson

Well, we're focused on acquiring finished lots so those were finished lots and they are to be closed or homes to be started and closed in 2010 so they are definitely a part of 2010 plan.

[Alan] for Ivy Zelman – Zelman & Associates

And were they kind of focused on any specific geography or spread pretty evenly across your market.

Chris Anderson

We're focused on every one of our markets where we are and positioning ourselves to improve and increase our position.

Operator

Your next question comes from Nishu Sood – Deutsche Bank.

Nishu Sood – Deutsche Bank

Actually what I wanted to follow up on that last question on the land purchases. As we see the builders generally begin to pickup their land purchases, the experiences to date what we've been hearing is kind of diverse. Some people have been quite aggressive and some people have been arguing that the opportunities are a little bit more limited. Now looking at MDC's tradition of being quite conservative and cautious, and obviously that's reflected, for example, even in the way you describe the conditions in the third quarter.

I would expect MDC to traditionally be towards kind of more conservative side, so with 1,300 lots that you've taken control of, that's on the kind of higher end of the spectrum from what we've heard from some of the builders. So just wanted to get your sense of how you relate what you're seeing out there in the market to the land purchase activities that we've seen from you in the third quarter.

Larry Mizel

I would say that we're focused on expanding the land purchase opportunities across all the markets. Highly scrutinized, underwritten, and focused on where they fit and as our prior policies have been we look for acquiring assets that we can utilize within 24 months of getting a building permit, and that's what we're doing.

We think that there's probably more availability that is attractively priced coming to the market and through those builders that are able to transact in a efficient manner. We believe that the patience that we've had over the last three or four years will be properly rewarded.

Chris Anderson

One other comment on that if you look at our presentation, the breakdown of those 1,300 are about 750 are option, about 500 are actually acquisitions. So we're pretty conscience of our direction in what we want to do and our strategy.

Nishu Sood – Deutsche Bank

Larry, is there going to be a qualitative difference you think in terms of how the different builders approach the market depending upon their degree of legacy assets that they have to deal with? In other words, you have less legacy assets to deal with as you enter the land market here looking ahead to future recovery. How does that show up in differences in terms of your negotiating stance perhaps, or what sorts of opportunities you look at or even how the sellers out there might react to the different bidders?

Larry Mizel

I would say that most of the other large builders in the country have capital. They're able to transact if they wish to and it seems to be an indication several of them are acquiring some land. I think a material difference would be as you see our balance sheet we have a nominal amount prior of assets. And we should be able to see going forward a better inventory turn because our inventory will be turning with current assets versus legacy assets.

Operator

Your next question comes from Joshua Pollard – Goldman Sachs.

Joshua Pollard – Goldman Sachs

Larry, you always tell your team not to hurt the core infrastructure in an effort to cut costs, and this relates directly to your G&A cost. With that said when you put that together with your land acquisition what are you doing in your land acquisition strategy to really try and get some leverage off the current cost structure that you already have?

Larry Mizel

Our land acquisition strategy is we are continuing to emphasize in I think almost every market and our acquisition teams and we're on a selective basis adding people to the land group as we perceive the opportunities for us, and I really can't measure what the other person may or may not do or going to be present.

And as I've commented over the last year or so, we have spent and we are spending capital on improvement of information process procedures, a broadly defined training, upgrading sales personnel, new product introduction, and the land component part I think I had commented maybe a year ago and someone said well, when are you going to start buying and I said well, read the Q.

And so we've been a little bit more transparent, which I think you could comfortably interpret meaning that we're becoming more comfortable with where we are as a company. And I think the public disclosures by the government seem to indicate some of the indicators are improving, but for us specifically we've seen an improved tone in the marketplace for our products specifically.

Joshua Pollard – Goldman Sachs

Along that same line, can you talk about you're incentives to sell homes as those numbers as a percentage of the price of the home gone down? Can you quantify that over call it the last two or three quarters?

Larry Mizel

I would say that they're trending down slowly. And this is all, as you know, is specific market adjustment predicated on really subdivision by subdivision because each of the projects has different challenges. But we believe that as the market firms up you'll see further reduction of incentives which of course will enhance the gross profits.

Operator

Your next question comes from Josh Levin – Citi.

Josh Levine – Citi

Larry, you talked about how you positioned inventory to take advantage of the homebuyer tax credit. How much of a net orders this quarter would you guess were driven by the tax credit, would you say it's a lot, a little, or somewhere in between?

Larry Mizel

Somewhere in between.

Josh Levine – Citi

I shouldn't have left that open for you, can narrow it down a little bit? I mean do you think a fair amount of demand was pulled forward? Where do think your orders might have been without the tax credit?

Larry Mizel

We were pleased to see that the percentage was not as large as one could have expected, and of course having said that and reading what's coming out of Congress, I think it's like the car program there's a lull immediately afterwards. And we'll see over the next couple months actually what took place versus theoretically, but I think what it really did was create some enthusiasm in the market, created some urgency.

But that should not lead one to the conclusion that the overwhelming sales were only because of the credit because many of the people didn't qualify for it, and they knew at the time of contracting that the homes that they were contracting for would not be available by the end of November. So consequently we felt good that the momentum created was helpful in the broad spectrum.

Josh Levine – Citi

On the land market, when some of your competitors talk about the land or the lots they're buying, they said they're only going to buy lots with say an 18% or 20% minimum gross margin. Would you think about buying land that gives you lower gross margins, say 15% but offers much higher IRRs because you can use options and not have to tie up much capital?

Larry Mizel

I'd say we'd be very flexible because as we all know everything's done on a risk adjusted basis and a lower gross with a little or no risk and a high IRR as you commented, I think you're focused appropriately.

Operator

Your next question comes from Carl Reichardt – Wells Fargo Securities.

Carl Reichardt – Wells Fargo Securities

I have two questions to start with just on the assumptions you're using on your pro forma for your current acquisitions. Can you give me a general sense of what you're expecting in terms of pricing and then what you'd expect to happen to your direct construction costs?

Larry Mizel

No.

Carl Reichardt – Wells Fargo Securities

A little more detail than no.

Larry Mizel

You always ask good the question but I would say that the performance that we're seeing is in line with our goals of the new acquisitions that the gross profit margins are we're not looking to transact on diminished margins. We're hoping to transact on inline margins and I think the prior question dealing with IRR probably as we focus on our inventory turns because of having the ability to do that, it should result in substantially better performance on those assets.

Carl Reichardt – Wells Fargo Securities

The reason I ask is if land shrinks as a percentage of your overall input costs, but you're wrong on your pricing assumption on your directs and they're a higher portion of your cost base, especially on quick turn stuff. I wonder whether or not the pro forma's are right or wrong, so that's why I asked the question.

But let me ask a different one. On the stop at drywall plan that you guys have been using, what amount of time is there between the stop and then the restart typically for a customer who's choosing colors and upgrades between the stop the drywall and restart. How much does that add to your cycle time?

Larry Mizel

We think that it will add a more likely – in today's market it might not add anything because there's a strong demand for the product and we're able to deliver it in 30 or 45 days, so it's not like we're in a big hurry and then we just stop. Everything is measured even the drywall hold ratio of pre-sales to drywall hold is a controlled factor. And as you can see from the information, it's almost hard to believe that there's only 17 finished homes in the whole company.

And so the strategy of the drywall hold as we've previously discussed in prior periods, the gross profit margin on those items that are in the design center are materially greater than the gross profit in the basic home and this allows us to increase our overall gross. But I guess the best part is the homebuyer is actually able, as we call it, is able to personalize what they're buying.

And we believe that this is more responsive to their desires and consequently the design centers that we have developed have continued to, not only do well, but our procedures are being better integrated and I think it will help us overall in our gross profit margins without a deterioration to the inventory turn.

Operator

Your next question comes from Dan Oppenheim – Credit Suisse.

Dan Oppenheim – Credit Suisse

Talking about what happened after the tax credit you described it as a lull that occurred after Cash for Clunkers and similar things happening in housing. Can you elaborate in terms of what that low is that you're seeing here in October, especially at the end of the month it would be difficult to be signing contracts and having closings for November 30?

Larry Mizel

Well, first of all we usually don't comment on current activities other than the fact that I think overall there has been a lull, one. Two, we're able to – anyone we contract with since we have available inventory at drywall hold we can certainly get those homes done by the end of the year, and so that's what we will be focused on.

Dan Oppenheim – Credit Suisse

Secondly, wondering about land supply. Having just 721 lots in California right now. In the past that's been a market of focus, a region of focus. Do you have any goals in terms of the land purchases over the next year within the geographic region?

Larry Mizel

I would say that you should look to us to focus on all the regions of the country and California has I think 38 million people and they've had plenty of challenges in their budget, their economy, but there are places in California that we believe we can execute and do it profitably and do it with low risk and that's what we're working on and you should assume there will be further activity on our part in California.

Operator

Your next question comes from Michael Rehaut – JP Morgan.

Michael Rehaut – JP Morgan

First question just on trying to get a little more color if possible on the demand as it's played out during the quarter and post-quarter. Certainly the talk of town a little bit today I think on questions around the sustainability of sales pace as the sales tax expires. So let me just get a sense of how the order growth progressed on a year-over-year basis throughout the quarter and what you're seeing post the 3Q?

Larry Mizel

I can comment a little bit on third quarter concurrent with the government's emphasis. We also had one of our most successful marketing programs initiated, which was very successful as it was concurrent with the government program. The rollout of what's going to happen in the fourth quarter is premature. I think for everyone, at least this morning, it sounded like we're going to have an extension of the tax credit planned, which I think will be good.

But I'd like to refer back to a prior comment that those persons buying in the third quarter that the focus was not singularly on the tax credit because homes were contracted to be delivered between the contract time and later than the end of November. So I believe that there is a base demand and we can't measure it until we have a little more experience in some hindsight of what's taking place in the market after these last week or two.

Michael Rehaut – JP Morgan

In terms of the incentive visa vie the lower mortgage rate or points off the closing, on an overall basis when you look at this kind of feature in the sales program with that including the total amount of incentive that you're offering on the homes that you sold during the period. Would that be a net increase on a total level of incentives on the homes sold relative to 2Q or 1Q?

Larry Mizel

Not really because when we look at that it ends up being a mix between the incentives that are offered so make it more mix to the incentives on a rate and a little bit less on a closing cost or we may change some other incentive. So I wouldn't' say that caused us to balloon up. We are very conscious about margins on sales.

Operator

Your next question comes from James McCanless – FTN Equity.

James McCanless – FTN Equity Capital Markets

I wanted to ask first if there was any impact from the 77% reduction in finished specs on the gross margins and if so could you quantify it?

Larry Mizel

We have not quantified that and disclose that. I mean we are certainly conscious of that and as we've said margins on finished are significantly lower than margins on our drywall hold product.

James McCanless – FTN Equity Capital Markets

Second question and talking hypothetically about the credit as the latest iteration seems to be out there. The $6,500 I think maximum for move up buyers is that something that number one you all think might pass? And number two if it does do you think you would get even more aggressive on building some of these drywall specks since those move up customers would seem to fit in your wheelhouse?

Larry Mizel

I would say until anybody knows what the laws going to be it would be just speculating of how we react to it, and we'd probably also want to see how the market itself reacts. Sometimes you find that the buyers aren't nearly as sophisticated on the nuance of the programs so everything that's taking place is not program oriented.

So we'll see what happens in Congress I guess next week and then we'll see how the public responds, but we're actively operating assuming that there is no extension to the tax credit that it expired in November and that's the way we run our business. And if it happens to be reinstated in some form or another that's just a bonus.

Operator

Your next question comes from Jim Wilson – JMP Securities.

Jim Wilson - JMP Securities

I was wondering on the new lot acquisitions if you could give us a little color on timing of the community rollouts and if you can contrast what you expect in the way of margins versus your existing business?

Larry Mizel

I would say you should anticipate the community rollouts to be starting 2010 and, as I said previously, our underwriting requires that as a general guideline it's a 24-month absorption predicated on current absorption rates and the margins one would expect to be generally in line with what we're seeing subject of course to market conditions.

Jim Wilson - JMP Securities

I guess maybe this goes without saying but you would consider everything you've required so far to sort of be of A quality in terms of location?

Larry Mizel

We certainly expect so.

Operator

Your next question comes from Alex Baron – Agency Trading Group.

Alex Baron - Agency Trading Group

If this five-year NOL thing gets passed I was wondering what you guys think is the immediate impact that you might be able to monetize from that?

Larry Mizel

We haven't calculated it for a couple hours. We haven't made a comment on the impact of it but at least in the form it was in yesterday, I think it's substantial amount of money but I'm not sure today. Chris?

Chris Anderson

Alex, we actually do a breakdown of our deferred tax asset. It's footnote 15 in our 10-Q and I think that would give you some feeling for what our numbers look like for NOL amounts. And right now our NOL is at $86 million as of the end of September.

Alex Baron - Agency Trading Group

The other question was I was wondering if going forward once you guys do become profitable can you give us a sense of how the accounting's going to work from a GAAP standpoint in terms of what would happen to your deferred tax asset? Does it get reversed all at once or is it over time how does that work?

Larry Mizel

I think that is still to be determined. So that question is still open and we'd like to get to the answer of that by profitably as soon as we can. It's an excellent question the accounting industry, not just for home builders, but for other companies that have impaired their deferred tax asset.

And I don't think that the major accounting firms have written a position that is firm because the circumstances continue to change, but I would guess that there'll be more transparency from the accounting groups, the major accounting firms over the next 30 days because that it is an opportunity that will be needing to be dealt with.

Operator

Your next question comes from [Joel Locker – FBN Securities].

[Joel Locker – FBN Securities]

Just a question on community count, I guess it's declined about 10% sequentially for the last six quarters and just where do you see it at maybe the end of the fourth quarter and the end of the first quarter of 2010.

Chris Anderson

Well, we have not made a projection and we won't make a projection exactly on where we think that'll be. I think the best indication is our chart that we have in our presentation that we're actively pursuing the addition of new lots and new subdivisions. But as Larry mentioned, some of those take a little bit of time to get online for some closures to happen.

[Joel Locker – FBN Securities]

Just another question about obviously you've been conservative when it comes to your cash balance of $1.6 billion or so, but I'm just wondering if you were starting to look at cash as almost more risky than buying land based on what the Fed and the central bankers are doing with the money supply. I know you always kind of look at from the top down the whole industry and kind of wanted to get your thoughts on that.

Larry Mizel

Well, I think if you had no cash you would probably think that it was pretty risky to have no cash. And having a reasonable amount – we're a home builder and we expect to focus on building our business and as the opportunities come forward, we consider we're in a position to transact.

And so I consider it a major asset having liquidity in order to participate in what I believe will be a continuation, at least at this level or maybe even greater, in the sales rate of new homes because were expecting that new home sales on national basis does not necessarily increase on a substantial way but that we will grow in our market share in each of the market we're in, and over the next few quarters it will become even more transparent. Our market share in those markets were we are currently located we have an opportunity to increase it substantially.

Operator

Your next question comes from Eric Landry – Morningstar

Eric Landry – Morningstar

I was wondering with regards to the increase in new land put under contract, was that a function of your, so to speak, your hit rate going up or was there a lot more activity in the quarter or how did that work?

Larry Mizel

We are aggressively focused on acquiring more land and we have a large pipeline going to due diligence, which is a very, very rigorous process. And as you see from our comments, each asset that we acquired is appropriately evaluated and underwritten and we look forward to opportunistically accelerating that part of our business in preparation for gross and profitability going forward.

Eric Landry – Morningstar

Has the competition increased, decreased or can't even tell at this point over the past say nine months for land?

Larry Mizel

I'd say for A land that is finished, it has increased substantially. That most land that is fully finished in A locations in quality markets there's more than one buyer and that's good. That means that the market in the industry is getting healthier and during good times and great times we've done well competing aggressively in a good market and I'm glad to see that there's signs of it coming back. We're very optimistic.

Operator

There are no further questions at this time.

Larry Mizel

Thank you very much. Chris and I appreciate everyone's participation. We look forward to speaking with you after the end of the quarter.

Chris Anderson

Thanks, everybody.

Operator

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

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Source: MDC Holdings Inc. Q3 2009 Earnings Call Transcript
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