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D.R. Horton Inc. (NYSE:DHI)

F4Q09 Earnings Call

November 20, 2009 10:00 am ET

Executives

Don Tomnitz – Chief Executive Officer

Stacey Dwyer – Executive Vice President and Treasurer

Bill Wheat – Executive Vice President, Chief Financial Officer

Analysts

Michael Rehaut – JP Morgan

Kenneth Zener – Macquarie Research Equities

Dan Oppenheim - Credit Suisse

Nishu Sood - Deutsche Bank

Joel Locker – FBN Securities

Analyst for David Goldberg - UBS

Joshua Pollard - Goldman Sachs

Josh Levin - Citi

Stephen East - Pali Research

Mike Widner - Stifel Nicolaus

Alex Barron - Agency Trading Group

Timothy Jones – Wasserman and Assoc.

Jay McCanless - FTN Equity

Jim Wilson - JMP Securities

Stephen Kim – Alpine Woods

Operator

Welcome everyone to the D.R. Horton America's Builder 2009 fiscal year end conference call. (Operator Instructions) Mr. Don Tomnitz, you may begin your conference.

Don Tomnitz

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

Stacey Dwyer

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

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

Don Tomnitz

Net sales orders for the fourth quarter were 5,008 homes, up 26% from the same quarter in the prior year. Fourth quarter sales were essentially flat with our June quarter which is better than the usual seasonal trend. Our average sales price on net sales orders in the quarter decreased approximately 4% from the year-ago quarter and 1% sequentially to $205,100.

Our cancellation rate was 27% in line with our June quarter but improved from 47% from the year-ago quarter. Our net sales were relatively even in each month throughout the fourth quarter and in October. However, we have seen our sales in November 20, 2009 slow both seasonally and in response to the original November 30th expiration date of the Federal Homebuyer Tax Credit. We expect our net sales to show a positive year-over-year comparison in our first quarter of fiscal 2010.

As I am sure you are all aware the Federal Homebuyer Tax Credit has been extended. To qualify for the tax credit homes must be under contract by April 30, 2010, and close by June 30, 2010. The tax credit has also been expanded with higher income limitations and a new $6,500 tax credit for existing home owners who have been in their homes for five years or more.

Our sales backlog increased 6% from the prior year and 4% sequentially to 5,628 homes or $1.1 billion. Our fourth quarter home sales revenues were $1.0 billion compared to $1.5 billion in the year-ago quarter. Our average closing price for the quarter decreased approximately 5% from the year-ago quarter to $210,100. Stacey?

Stacey Dwyer

Our gross profit margin on home sales revenue in the fourth quarter before inventory impairments and land option write offs was 12.5%, a 160 basis point increase from our home sales margin in the year-ago period. Approximately 300 basis points of the increase was due to the effects of prior inventory impairments on homes closed during the quarter, the average cost of our homes declined by more than our average sales prices and geographic mix shift. This increase was offset by 140 basis points due to an increase in our estimated warranty and litigation accruals. Bill?

Bill Wheat

During our fourth quarter impairment analysis we reviewed all projects in the company and determined the projects with a combined carrying value of $963.1 million had indicators of potential impairment. We evaluated these projects and determined that projects with a pre-impairment carrying value of $421.3 million were impaired.

We recorded inventory impairments of $174.9 million as a charge to cost of sales to reduce the carrying value of these impaired projects. Our West region incurred the largest portion of these charges. We refer to our projects which were evaluated and not impaired as our watch list, which represents those projects deemed to be the highest risk for future impairments. Our watch list is currently at $541.8 million with the largest concentrations in California, Texas, Illinois, Florida and Arizona.

The size of our watch list this quarter is 50% smaller than both last quarter’s balance and a year ago when it had a balance of $1.2 billion. During our fourth quarter we also recorded $17.7 million in write offs of earnest money deposits and pre-acquisition costs related to land option contracts we do not intend to pursue. Don?

Don Tomnitz

Home building SG&A expense for the quarter was $134.8 million, down $41 million or 23% from $175.8 million in the year-ago quarter. We have and will continue to actively manage our SG&A levels relative to our expected number of home closings.

We recorded $26.8 million in interest expense during the quarter. We will continue to recognize a portion of our interest incurred as interest expense as long as our home building debt levels exceed our active inventory.

Bill Wheat

Financial services pre-tax loss for the quarter was $2.9 million compared to pre-tax income of $6.9 million in the year-ago quarter. 89% of our mortgage company’s business was captive during the quarter. Our company-wide capture rate was approximately 65%. Our average FICO score was 723 and our average combined loan to value was 93%.

Our product mix in the quarter was essentially 100% agency eligible with government loans accounting for 64% of our volume. Stacey?

Stacey Dwyer

At September 30th we had a net income tax receivable of $293 million. We received $113 million of the receivable in October of 2009. The majority of the remaining income tax receivable is due to carry back of losses generated in fiscal 2009 that can be carried back against fiscal 2007 taxable income. We expect to receive an additional refund of approximately $150 million in fiscal 2010 and the remaining amount for federal and state items expected to be recovered in future years.

In addition to the income taxes receivable that were reflected on our balance sheet at September 30th, we expect to receive an additional tax refund related to the recent legislation which expands the NOL carry back up to five years. We are evaluating our options because we can choose to either carry back our remaining net operating loss from fiscal 2009 or carry back any taxable losses generated in fiscal 2010. The amount of additional refund we anticipate will be generated from choosing to carry back our full 2009 NOL is approximately $200 million. We are evaluating our business plan to determine which options would be more beneficial to us.

Our reported net loss for the quarter was $231.9 million or $0.73 per share compared to a net loss of $799.9 million or $2.53 per share in the prior-year quarter. Bill?

Bill Wheat

Our total inventory decreased by approximately $29 million excluding non-cash impairment charges during the quarter. Our homes in inventory at the end of September totaled 11,600 of which 1,100 were models. Of our total homes in inventory, 5,800 were speculative and 2,200 of these specs were completed. We plan to continue to manage both our total number of homes in inventory and our number of speculative homes in the coming quarters to match our demand. Don?

Don Tomnitz

Our land and lot acquisition spending remains limited and we continually reevaluate our land development plans based on current sales trends. We spent $377 million in fiscal 2009 on land and lot acquisitions and land development expenditures which was less than the $500 million guidance originally provided for fiscal 2009. Our spending on raw land and development costs will continue to be at very low levels. However, we have been actively contracting for finished lots which require less capital and can supplement our existing land positions and increase our current average gross margins. Our spending on finished lots will be largely dependent on our sales pace. Bill?

Bill Wheat

Our supply of owned land and lots at September 30, 2009 was approximately 89,500 lots, down 10% from a year ago. We plan to continue to adjust our owned land and lot supply in line with our expectations for future home sales and closings.

We control an additional 26,500 lots through option contracts which includes 8,100 lots for which we do not expect to exercise our option but the contract has not yet been terminated. Our net earnest money deposit balance is only $9.4 million at September 30th but it represents contracts that control 18,400 lots with a purchase price of $607 million. We have no unconsolidated joint ventures and we rarely use land bank arrangements so our deposits are typically a low percentage of the purchase price. Don?

Don Tomnitz

We generated approximately $39 million in operating cash flow in the quarter bringing our total for fiscal year 2009 to $1.1 billion. We have generated positive operating cash flow in the past 13 consecutive quarters for a total of $5.2 billion. We ended the quarter with approximately $1.9 billion of unrestricted home building cash and $55 million of restricted cash. Stacey?

Stacey Dwyer

In the current quarter we repurchased approximately $72 million of our outstanding notes for $72.4 million plus accrued interest which brings our debt repurchases for the fiscal year to approximately $380 million. At September 30th our homebuilding leverage ratio net of cash was 36.3%, a 730 basis point improvement from a year ago and well within our target operating range of less than 35%. Don?

Don Tomnitz

As we look forward to fiscal 2010 our industry continues to face many challenges; high, although moderating levels of both new and existing inventory, continued high levels of foreclosures, tight credit for our homebuyers, continued limitations of mortgage products available, low consumer confidence, increasing unemployment, continued pricing pressure in certain markets, the expiration of both the federal homebuyer tax credit and the government support of purchases of mortgage backed securities which could lead to higher interest rates.

These headwinds continue to impact our business both in our sales volumes and operating margins. However, this quarter we did see our first year-over-year increase in net sales since the March quarter of 2006. In addition, as we mentioned earlier our sales were essentially flat from the June quarter which is stronger than the usual seasonal trend.

Our cancellation rate of 27% was still above our historical range and was in line with our June quarter and significantly better than 47% a year ago. We expect the extension and expansion of the homebuyer tax credit to be beneficial to our business in the near-term.

D.R. Horton has a solid balance sheet to capitalize on the eventual housing recovery. During the quarter we generated an additional $39 million of operating cash flow to bring our total for the fiscal year to $1.1 billion, continued to reduce our inventory dollars, our number of completed specs and the percentage of our specs to total inventory. We continue to reduce our SG&A, homebuilding down $41 million and 23% year-over-year.

We will continue to reduce our owned lot position while we focus on option lot opportunities. Our current focus remains on targeting the entry-level buyer, managing our SG&A and continuing to negotiate lower construction costs.

As I look forward to where we are in this cycle I believe we have already passed two major milestones. One, our impairment charges and operating loss peaked in fiscal 2008. Two, our closings hit a volume bottom in 2009. We have added and will continue to add additional flags in most every market and are beginning to add employees in certain markets. We strongly believe our closings in 2010 will be greater than in 2009 and that we will continue this growth in the upcoming years.

Our entire company is focused on a return to profitability in 2010 and maintain this profitability thereafter; house by house and community by community. We want to thank all of our DHI team members who continue to outperform all of our peers. We are especially proud of our sales team which significantly out sold all of our competitors in the industry. Keep up the great work. D.R. Horton is leading the industry into the housing recovery.

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

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Michael Rehaut – JP Morgan.

Michael Rehaut – JP Morgan

My first question has to do with gross margins and then I have a second question on impairments. On the margins you kind of gave some break out there was 300 bps benefit if I understand this right and I apologize if I am not repeating it correctly, 300 bps benefit from prior impairments in geographic mix shift and then 140 bps from estimated…I guess the 300 bps…maybe you can just, I think maybe I’m not repeating it correctly. Can you just review the differences year-over-year?

Also, given the higher gross margins in the first half of 2009 was that primarily due to the larger charges you took in 2008 and how do you see gross margins going forward particularly as you look at your backlog today?

Bill Wheat

On the improvement in the margin in the quarter we discussed the year-over-year improvement and the 300 bps improvement is essentially core margin improvement which reflects the effects of prior impairments on our inventory. It also reflects reductions in our actual costs of construction relative to our sales price changes. That is really what is built into the 300 basis point improvement.

Offsetting that 300 basis point improvement is 140 basis points that reflects increases in the amount of our estimated warranty and litigation costs that we report in our accruals and estimate each quarter. Those are the primary factors on a year-over-year basis.

Stacey Dwyer

In terms of the margin differential in Q4 compared to the earlier quarters in 2009, if you go back and look at our average sales price in the first and second quarters on our deliveries we ran about $217,000 and $215,000 so from this time last year to where we currently are today we have seen some additional pressure on sales price and we have also redesigned some of our product to be more affordable.

Bill Wheat

As far as where we are today and our expectations for margin as you recall especially in the second quarter and third quarter this year we had some pressure on our margin as we reduced our completed spec count and our age completed spec count. That is having a lesser effect now so that is certainly one positive impact on our core margins this quarter and we would expect that improvement to continue. So we would expect to see some incremental improvement in margin as each quarter moves forward. We are not in a position to talk specific amounts but we do expect incremental improvement.

Michael Rehaut – JP Morgan

Before I hit on the impairment question the 140 bps from increased warranty and litigation accruals, I know you have talked about that in the past if I remember correctly. Is that something you expect to moderate or is there some sort of catch up where you wouldn’t necessarily have that same type of impact going forward?

Don Tomnitz

I believe as our closings have continued to trend downward over the past 3-4 years, clearly our tail on our warranty is shortening so we would anticipate that to moderate moving forward.

Bill Wheat

There are two major components to that. Our ongoing warranty expense typically occurs within a 2-3 year period after the home closes. So that tail is dramatically shorter. Other matters which we estimate, or are largely based on just estimations of potential future exposure have a longer tail and so we continue to revise those estimates just based on what we see in the marketplace. At some point that tail will start to decline further as well.

Michael Rehaut – JP Morgan

On the impairment and then I will get back in the queue, I think the number that came out maybe was higher than our estimate and higher than I think others, the way I am looking at it more is that towards the year-end and towards the back half of the last couple of years there has been a larger impairment and as far as I understand it to some degree it also has to do with perhaps a more aggressive scrubbing of the books at year-end or a more aggressive review.

The increase in impairments is also a little bit different than some other builders have reported where it has been more sequentially stable particularly given the more stabilizing price environment. I was wondering was this just some certain communities you really just tried to work through or address more finally or were there certain price declines in the quarter that triggered it? Maybe give some color on the reasons for the increase.

Don Tomnitz

I guess the first thing I would comment on is our disclosures which we have consistently disclosed each quarter over the past 2-3 years regarding our watch list. Our watch list has been our best indicator we can provide to investors regarding forward visibility on potential impairments. As you know it has been very difficult to predict exact amounts but we have attempted to provide good visibility. That watch list in terms of absolute volume has remained very high, even last quarter that watch list remained at a level of $1.2 billion.

So that was our best indication that we expected to still see some substantial impairments on a forward-looking basis through last quarter. Clearly some impairments came through this quarter but as we discussed in our prepared statements our watch list is far lower now at September 30th forward looking into fiscal 2010 at $541 million, less than half of the previous balance.

As far as the patterns over the past years and this year in terms of having more impairments in the second half of the year. Primarily that is not because our review is any different in terms of aggressiveness on a quarter-to-quarter basis. What it really has to do with is our market knowledge at those points in time. In the first half of our fiscal year, that is at the end of December and the end of March that is the slower time of year. At the end of December we will have just reported our earnings a month earlier. We are at a slow time of the year. You really don’t know a whole lot more about what the market really says 30 days later.

At the end of March typically you are very early in the selling season it is very hard to make definitive conclusions on what the market is doing to our projects at the end of March. By the time you get to June and by the time you get to September you are well into the selling season and beyond the selling season and the dust has settled. So we know a whole lot more about the market and we also know with much more certainty what our operating plans for all of our individual projects will be going into the fiscal year and so that process and that improved knowledge I think has contributed to a higher level of impairments in our third quarter and our fourth quarter.

So from that standpoint that would be our basic explanation of that pattern.

Operator

The next question comes from the line of Kenneth Zener – Macquarie Research Equities.

Kenneth Zener – Macquarie Research Equities

One of the things that other builders that have more land or shorter land is that gross margins should be lower with shorter landed builders. I wonder if you could just comment on that based on their blending in land?

Don Tomnitz

Why don’t you state your question again. I’m not sure I understood.

Kenneth Zener – Macquarie Research Equities

The margins, your gross margins being lower because of the legacy land you have versus perhaps shorter landed builders which are acquiring land. Within that context obviously comes up as last quarter as an aggressive buyer of land which we actually don’t see in terms of your increasing lot count. One, gross margin. Two, what you see out there in terms of land deals.

Don Tomnitz

Let me answer the second half and let Stacey answer the first half. We are not aggressive purchasers of land. We are aggressive purchasers of lot option contracts and as we have stated we have over $600 million worth of option contracts with only about $9 million of earnest money. So yes we would tie up the world if we could but we are not putting much earnest money up against those future purchases. Stacey?

Stacey Dwyer

We do see higher margins in the lot option contracts that we are putting into production today. We have not seen a significant impact from that in our current margins because of our mix is still heavier in terms of the legacy land we have owned. That is one of our goals for next year. As Don mentioned we are actually contracting for land. We want to get more flags in the air and we want to continue to blend in those option contracts with our existing land and that is part of what would contribute to the margin improvements Bill referenced earlier.

Kenneth Zener – Macquarie Research Equities

Do you think it can get to 25% of your closings next year or how would you characterize that based on what business you are contracting today?

Stacey Dwyer

It will be totally dependent on sales. If we see continued good sales pace and there are opportunities to bring online, it is going to approach 25%. But if we see our sales slowdown we are not going to be bringing as many new projects on line and it wouldn’t be 25% of sales.

Kenneth Zener – Macquarie Research Equities

Relative to your units under construction which actually rose for the first time into the fourth quarter relative to the third quarter you have increased it roughly 700 units. Historically you have said that is the best indicator of your times two, so essentially 11,000 times two, 22,000 units for your forward year deliveries. Would you still stand by that characterization?

Don Tomnitz

I think you can do the math. These are unusual times. I will stand by what we clearly said earlier that in 2010 we will close more units than we did in 2009.

Stacey Dwyer

One other anomaly for this year was the expiration of the original tax credit in November of 2009. We usually see a seasonal pattern where we have our absolute strongest closings in our September month. This year it has changed a little bit so we are actually a little heavier with inventory and a little heavier with backlog at September than we typically would have been because of the real push for seasonal closings has moved from September now to November. That is one of the reasons you see the inventory staying a little higher in September.

Don Tomnitz

We think we will see the same thing in our third quarter because basically we are going to be seeing with the tax credit more people pushing their closings or we will have a bigger number of closings for June 30th.

Operator

The next question comes from the line of Dan Oppenheim - Credit Suisse.

Dan Oppenheim - Credit Suisse

In the past you have talked about, rightly so, about how you don’t build homes for practice and a focus on net income. I am wondering about the operating cash flow. A comment recently about how you see more closings in the fiscal first quarter. Do you have any goals for what you would like for cash flow for fiscal 2010 or at least for the first quarter of 2010?

Don Tomnitz

We are planning on having positive operating cash flow in 2010. I think that will come from a couple of places. One of the places we believe it will strongly come from is from profitability. So that is what we are focusing on in 2010.

Bill Wheat

Clearly we do have income tax receivables that we expect to come in. We have already received $113 million in our first quarter. We expect approximately another $150 million which is reflected in our income tax receivable on our balance sheet. Then as we stated with the expanded carry back of the NOL for five years that will mean an additional $200 million. If you look at the current quarter and a quarter in which our inventory stayed relatively flat and we were not profitable, we still had positive operating cash flow with no tax refund so we are operating at or around breakeven cash flow on an operating basis now even with no profits.

Dan Oppenheim - Credit Suisse

Secondly, I was wondering on the comments you made about the closings pushed to November it seems like you probably had I would think 60 days from contract signing to closing. You probably had a lot of the orders for fiscal fourth quarter coming in the of September. How lumpy was the quarter in terms of the timing of the orders and what is your thought as far as how much of a pull forward from the first quarter in terms of orders?

Stacey Dwyer

We mentioned in our conference call we actually saw our net sales throughout the fourth quarter were relatively flat across each of the months. We saw October relatively flat with the volume we saw in those months in the fourth quarter. We have seen November slow down a little bit. That is probably both seasonal and in response to the original expiration at November 30th for the tax credit.

Operator

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

Nishu Sood - Deutsche Bank

I also wanted to follow-up on the question on cash flow. You have close to $2 billion in cash. You just mentioned you would like to be cash flow positive including the tax refunds for 2010. That obviously reflects a kind of conservative outlook and you have to see how things go, how they recover. What would you need to see, and assuming the land opportunities are out there, what would you need to see before you begin to say alright we are sitting on a lot of cash and there are a lot of opportunities out there, let’s really go out there and tie up a lot of land as we grow back to more normalized environment?

Don Tomnitz

First of all I don’t know what a lot of cash is but I think the $2 billion in cash is not as much cash as we would like and clearly we are continuing to focus on cash generation. Second, D.R. Horton and I have been together for 26 years. This is our third downturn together and as we had our board of directors meeting yesterday I can assure everyone that we are focusing on a land light business model. So to the extent we are focusing on increasing our volume, which we are. We are doing that by clearly by rolling option, lot option contracts to the extent we buy any land we have a very tight parameter on how quickly we want that money back from that investment and I assure you it doesn’t go 2-3 years out.

We want to turn our land very quickly so we are not going to be doing on a go-forward basis any projects that have sizes that are too big for us to get our money back within a year or 18 month timeframe.

Nishu Sood - Deutsche Bank

That raises a question going forward if you are going to be pursuing a land light model. Obviously there is a good amount of raw land or less developed land on your own balance sheet that you would need to put capital into at some stage. What, as a kind of operating model, as D.R. Horton deals with the sellers of land in the market, who would you prefer to be doing that development going forward? Is it going to require then more partnering? You have obviously traditionally shied away from joint ventures and land banking arrangements. So to kind of maintain the size of D.R. Horton someone else is going that development. Who is going to be doing in the future?

Don Tomnitz

First of all we are going to clearly stick to our business model of not having any joint ventures nor any partners of that sort; certainly financial partners. Secondly, to answer your question there are an excess number of developers out there who are available in each of our markets to develop those lots. Clearly I believe we are better off to consistently make a gross margin on home building and maintain that in the good times and the bad times so to the extent that there are opportunities for the lot prices to be higher we would be willing to let the developer make a little bit more money on the development and sell the lots to us on an option basis at a higher price so we can continue to maintain our consistent home building margin and not take on the risk of land ownership.

Nishu Sood - Deutsche Bank

The other assets balance increased quite a bit. I was just wondering what drove that.

Bill Wheat

This quarter and we will be filing our 10-K within the next day or so, there is a revision in the classification of estimated insurance receivables on our balance sheet. In the past that has been netted against other liabilities and at year-end that has been revised to be shown as an asset on the balance sheet. The impact of that at September 30, 2009 is $235 million. We have revised the prior year balance and the prior-year impact is $241 million so that is essentially an increase in other assets and an increase in other liabilities.

Operator

The next question comes from the line of Joel Locker – FBN Securities.

Joel Locker – FBN Securities

The interest expense it declined in the last few quarters before this one. It just kind of surprised me that it jumped up a little bit. I just wanted to see what you thought going forward if it was going to continue to come back down or it might stay elevated for awhile?

Bill Wheat

You are talking about the home building interest expense?

Joel Locker – FBN Securities

Yes the interest expense that came through the income statement. It declined like 25.6 to 23.1 to 20.3 then back up to 26.8.

Stacey Dwyer

There are probably a couple of different things happening there. We had issued $500 million of convertible debt in May that did carry low interest coupon of 2% but that was an incremental debt in our fourth quarter. The other thing we continually evaluate is in terms of what we can capitalize we look at our active inventory compared to our notes balance and any changes in that ratio could increase or decrease our interest expense in any given quarter.

Joel Locker – FBN Securities

I guess your active inventory seems like it has been kind of holding steady and with the buyback of the debt I would expect that to kind of at least stay flattish, maybe in the low 20’s or so.

Bill Wheat

It has been slightly declining relative to our overall debt level. When we have been having expense a bit more on the overall interest incurred.

Joel Locker – FBN Securities

A follow-up question, your backlog conversion was actually lower in the fourth quarter than it was in the third quarter for the first time in probably over a decade if not ever. Do you expect that might have been an inflection point on your conversion rate or it will start declining because your backlog is actually growing or not declining year-over-year as it was?

Stacey Dwyer

We have seen very high conversion rates in the backlog in the March and June quarters. We did see that moderate a little bit in September. I think that kind of ties back into what we were talking about a little earlier with the tax credit expiration, moving the urgency of a closing from our September quarter which traditionally would have one of our highest conversion rates to actually now the month of November.

In terms of the conversion rate going forward it will truly depend on the mix of our spec business versus our to-be-built homes closed in any given quarter.

Bill Wheat

And the new tax credit closing by April 30th and having to close by June 30th that is going to drive closings into that third quarter.

Operator

The next question comes from the line of David Goldberg – UBS.

Analyst for David Goldberg - UBS

You noted you expect your closings to be up in fiscal 2010. As you look forward can you give us some idea of how much growth you think the current liquidity can support? Is there a way for us to sort of think about that in terms of land spending, working capital investments, how much you could handle without having to access the capital markets?

Bill Wheat

I guess first regarding our liquidity as Don talked about with regard to our strict guidelines on any spending on land and getting our cash back more quickly to the extent we are able to sustain that model, that is not going to necessarily require a significant additional capital. So with our cash balance and our modest debt maturities in the next couple of years we would expect to be able to really handle any growth the market is going to give us. I think our growth would be dependent largely on what the market is overall and what opportunities we have to continue to add additional flags on a lot option basis. I don’t think we are going to be limited by our liquidity in the next couple of years.

Analyst for David Goldberg – UBS

Can you give us a sense of how you think about investing in the business relative to maybe buying back more debt or the possibility of maybe easing up on that?

Bill Wheat

We have been relatively consistent in repurchasing our debt each quarter, taking advantage of market opportunities that are there at a fairly reasonable pace. We would expect some activity to continue there. Overall as Don has talked about there are still a number of headwinds in front of us operationally in the business so we are still very cautious as we look forward to next year in terms of knowing what the market is going to bring to us. So we are going to maintain sufficient levels of liquidity on the balance sheet and then we will choose to start incrementally investing.

Don Tomnitz

Based upon our option model basically our investment back in the business is focused really on our vertical construction so as we continue to add new flags, the bottom line is what we are investing in is the vertical construction and those new flags.

Operator

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

Joshua Pollard - Goldman Sachs

On the expanded and extended tax credit, we sort of expected October to sort of be flat for you relative to September but now you are seeing a bit of a November slow down. When do you expect the tax credit to actually start being beneficial to your orders?

Don Tomnitz

I think as the traditional selling season starts which is always around Super bowl weekend, we believe that will have some significant impact. Once people get finished with the holidays and get into after the Super bowl when we traditionally have had our traditional selling season.

Joshua Pollard - Goldman Sachs

On your specs it looks like that picked up a little bit. Can you talk about what percentage of your orders came from spec in the quarter or what percentage of some of the deliveries you are trying to get out by November 30th are coming from your spec inventory?

Stacey Dwyer

The number I can give you is then number of homes that were sold and closed in the same quarter. 41% for us this quarter. In terms of what we will deliver in November I’m not sure that any of us have any kind of clear information to give you on that right now.

Don Tomnitz

We have the information, we are just not going to give it to you. I would say to you on our specs one of the things that has led us to where we believe we are clearly leading the industry in this recovery is by virtue of the fact we are maintaining specs in our communities because the buyers we have because once they are qualified they want to buy and close very quickly so we believe we will continue to maintain a reasonable spec count in each one of our communities.

Joshua Pollard - Goldman Sachs

Are you actually kicking the construction engine back into gear ahead of sort of the April ending of the tax credit so you can deliver by June?

Don Tomnitz

We are clearly focused on selling all of the homes we can by the expiration of the April 30th tax credit so we are maintaining inventory levels which we think will meet the demand that is going to be generated by that tax credit, yes.

Bill Wheat

We are also at the same time continuing to manage it community by community based on the demand we are seeing. So we keep our spec count and inventory levels in line.

Don Tomnitz

Just to let you know our spec count we reduced our specs and at the same time if you take a look at what our specs are that are completed in greater than six months that is only 800 units of inventory. The ones that were completed greater than a year are like 400 or so. We really do not have an aged spec problem and we focus on moving through those completed specs as quickly as possible.

Joshua Pollard - Goldman Sachs

On your cash flow, the seasonality there was a little off. It seems like seasonality on everything was off. Orders were up more than expected. Deliveries down more than you had seasonally expected. Do you think that is the same issue on your cash flow and could you talk about how much of your cash flow you would have expected to see in a normal September quarter that may come through in your December quarter?

Bill Wheat

Absolutely. As we have said the pattern is different this year with the tax credit impacting timing as far as closing goes. Yes, some of our cash flows I think did move into the first quarter. So I think that will positively impact cash flow in the first quarter. As we move forward we hope to continue to generate positive cash flow. As far as what it would have been versus what it is, that is difficult to say. We don’t know exactly what the full impact of the tax credit is but clearly it has moved the seasonal trend.

Don Tomnitz

I want to remind everybody I think we projected we would have about $1 billion of free cash flow at the beginning of 2009 and we delivered $1.1 billion and we are telling people we will have positive cash flow in 2010 and we will deliver that.

Joshua Pollard - Goldman Sachs

Your community count, what was it in the fourth quarter?

Stacey Dwyer

We have not historically given a community count. We have talked a little bit in terms of directionally. Really what we have seen year-over-year is toward the end of fiscal 2009 we were actually getting some new flags flying. They didn’t contribute a lot to our sales but we have seen an increase in our active selling communities.

Joshua Pollard - Goldman Sachs

A sequential increase quarter-over-quarter or sequential increase year-over-year?

Stacey Dwyer

Quarter-over-quarter.

Bill Wheat

June to September we have seen an increase with a limited impact overall on our metrics. On a year-over-year basis in terms of overall communities that are actively selling, I think we are still slightly down versus year-ago levels.

Operator

The next question comes from the line of Josh Levin – Citi.

Josh Levin - Citi

You mentioned I think you were talking about increased accruals for warranty and litigation. Can you just elaborate what does that exactly relate to?

Bill Wheat

As we disclose in all of our filings we estimate what our future liability may be related to warranty expenses and any other claims we may have related to our products which usually comes in the form of litigation in the ordinary course of business. Our warranty liability typically comes through within 2-3 years following the closing of the home. So as our tail of closed homes in the past starts to come down that will start to moderate. The tail in terms of estimated liabilities for other product issues is a longer tail. We simply look at overall claims activity. We look at overall closings activity. We look at our insurance policies in terms of the coverage that we have on our insurance for such claims and adjust those balances really on a quarterly basis. Those balances have consistently increased as our tail has increased over the years. So the difference in the quarterly volume and the quarterly margin is reflective of that normal adjustment.

Josh Levin - Citi

It is November. We are all sitting here trying to figure out how good or bad the spring selling season is going to be. As you sit there and try to plan for the spring selling season what do you think is the single most important factor that is going to determine how good or bad the spring selling season is going to be?

Don Tomnitz

The thing that drives our business the most is job creation and then solid unemployment. If we look at the macroeconomic environment it is not good for us. If you look at where we are positioned I believe we are properly positioned to capitalize on bringing entry level buyers out of their apartments into a single family home and we have focused on that very, very sharply over the last three years. We are fighting the headwinds and we think we are very well positioned within the industry but until the unemployment number starts to drop and there are jobs created then we are going to have a tough time.

We basically are continuing to focus on capturing market share in each one of our markets because we are competing almost exclusively with under-capitalized builders both the public ones and the private ones, so we feel like we are clearly in a strong position to continue to sign up growing option contracts, not have to borrow a nickel from anyone, any bank, to build our vertical construction which makes us an incredibly strong purchaser of lots from a developer or from a bank.

Operator

The next question comes from the line of Stephen East - Pali Research.

Stephen East - Pali Research

Could you help a bit reconcile what you have been talking about, you said you spent about $377 million on land development this year. Quarter-over-quarter inventory was only down about $19 million before charges. Lots were only down about 1,000 lots that were owned. So I would have expected that implies that you spent like $300 million or so, $250-300 million on either going vertical or acquiring or developing. Could you just sort of shed some light on that?

Bill Wheat

In the quarter our overall inventory did stay relatively flat. It was slightly down. Our homes in inventory was slightly up so it was a slight use of cash on homes. We generated some cash by incrementally working down our net owned lot count during the quarter. As we are spending cash on finished lot deals, as we are taking down finished lots off of option contract as we raise these new flags yes there are some cash outflows for finished lots. But net/net we still reduced our inventory slightly and we would expect to generate additional cash flow as we see more closings come into October and November.

Stephen East - Pali Research

Would the lion’s share of the cash spend in the quarter have gone to the lots or would it have gone to increasing the vertical dollars?

Bill Wheat

The vast majority of the spending for both this quarter and the year are all in finished lot purchases. Overall, our spending is on vertical.

Stephen East - Pali Research

You talked some about the conversion rate. We all touched on that. I am hearing some builders were under staffed and are starting to have to hire project supers, etc. on the conversion rate. Are you all seeing any of that? Was that an issue where you will probably be bringing people on or do you think you have the right human capital structure going on right now?

Bill Wheat

As we add flags we are adding a few superintendants and obviously adding sales people. We are not adding any back office staff. We believe we have the proper staffing to carry on our back office efficiently. Those are the only people we are bringing on. In many instances we are bringing on a new flag we are trying to load up our superintendant with another project before we hire another superintendant.

So our hiring is limited but from a positive perspective, at least from my positive perspective, it is great to be bringing on a few people as opposed to be laying people off. We see our business growing.

Stephen East - Pali Research

The economics of fee building, is that attractive to you at all? Do you have any interest in doing it or are you doing it?

Don Tomnitz

No sir and no sir.

Operator

The next question comes from the line of Mike Widner - Stifel Nicolaus.

Mike Widner - Stifel Nicolaus

I am wondering if you could elaborate a bit more on the cancellation rate and whether you are seeing anything change there. Specifically the reason I ask with your focus on spec homes and fairly rapid delivery and the first time buyer tax credit for most of the quarter was expected to come to an end I just would have expected the cancellation rates to be coming down. I saw a slight increase quarter-over-quarter and so I was just wondering if you could talk a little about what you are seeing from the buyers there?

Bill Wheat

I think the cancellation rate has continued to stay relatively flat simply because the underwriting guidelines continue to be tweaked and increased slightly I think that is what maintained our can rate where it is.

Don Tomnitz

I think it is reflective of the economic weakness as well as the weakness in employment right now. You are having changes in people’s lives right now as they lose jobs. I think that is having some impact as well.

Mike Widner - Stifel Nicolaus

If I am interpreting that right the cancellations are still being driven primarily by credit availability and people that want to buy a home failing to qualify for a loan? That is driving the can rate as opposed to I changed my mind, found a better offer, etc.?

Don Tomnitz

That is correct.

Mike Widner - Stifel Nicolaus

One quick follow-up on that, you mentioned that 60% of the loans in the quarter were government I believe. I wonder if you could talk a little about LTV trends and if we are seeing a substantial reliance on the 90+ financing available through the FHA?

Stacey Dwyer

We have seen our cumulative loan to value stay in the low 90% range. That has really been consistent for us. I think we ran between 89-92% for the last 6-7 years. So basically people are taking advantage of the mortgage products that are available to them and for people who can qualify for the FHA in terms of price points if they can close a loan with 3.5% down that is a product they are choosing to use.

Operator

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

Alex Barron - Agency Trading Group

As you look into the next six months to take advantage of the extended tax credit, do you anticipate increasing the number of specs more actively to try and capture as many of those buyers by June 30th?

Don Tomnitz

I believe our unit inventory relative to our projected closings for the fiscal year certainly is in a good, solid position. I would not anticipate our spec inventory increasing dramatically. We are “speced” out right.

Alex Barron - Agency Trading Group

Given your comments that you expect more closings next year, I was looking at the trend in the operating cash flow this year and it seems to have declined every quarter. Do you anticipate cash flow might be negative in the first half and then positive in the second half?

Bill Wheat

I think what you have seen in terms of the declining sequential cash flows is we have slowed our liquidation of our balance sheet. That has been a large driver of our cash flows but as we move into fiscal 2010 and we focus on profitability our hope ad our goal is that our cash flows shift from the liquidation of our balance sheet towards profitability and we start to generate some cash flows from profitability. Obviously we will continue to manage our balance sheet based on the sales demand we see. If sales slowdown we will reduce inventory levels and flow cash from that level. If sales increase hopefully we will see some profitability from cash flows but we may also invest further in our balance sheet which could drive negative cash flow. So we are really not providing absolute guidance. Any guidance we provide on cash flows is all contingent on what we see in the sales environment next year.

Operator

The next question comes from the line of Timothy Jones – Wasserman and Assoc.

Timothy Jones – Wasserman and Assoc.

You gave the homes under construction I think was 11,006. The models and the specs. Can you give me the same numbers for last year at this time?

Bill Wheat

Last year our total homes under construction were around 12,400. Our model homes a year ago were around 1,500. Our total specs were around 6,900 of which about 3,100 were complete a year ago.

Timothy Jones – Wasserman and Assoc.

The 11,600 historically you thought you would under normal times deliver about twice that number. Does that historical relationship seem reasonable?

Don Tomnitz

Based upon my previous answer I would say I would let everyone do the math. This year it is a different market than what it was on a historical basis. Clearly we are positioned to do two times that. We will have to see how the market cooperates with us.

Timothy Jones – Wasserman and Assoc.

Where is that $110 million of deferred tax receivables on the balance sheet? I have a deferred tax equal to zero on my balance sheet.

Bill Wheat

Move up one line to the income tax receivable balance. What we saw this quarter is as we finished our year and we firmed up exactly what our taxable loss would be, the balance that was in the deferred income tax line moved up to income tax receivables. You see the increase in that balance is $293 million so it just moved up a line.

Timothy Jones – Wasserman and Assoc.

That is both the $110 million and the $200 million or not?

Stacey Dwyer

That is going to be the $113 million we have already received in October. The additional $150 million we expect to receive on federal income taxes. The $200 million from the recent legislation change is not reflected anywhere on our balance sheet because that is not going to be in receivables right now.

Timothy Jones – Wasserman and Assoc.

Will it be on in the first quarter?

Bill Wheat

It will be on in the first quarter. The legislation changed during the first quarter and so we are not able to retroactively apply a change in the law back to the fourth quarter so that will be a first quarter event.

Operator

The next question comes from the line of Jay McCanless - FTN Equity.

Jay McCanless - FTN Equity

I wanted to continue the tax question. Hypothetically if you decided in fiscal 2010 to aggressively liquidate specs and land inventory to loss, what is the maximum federal tax refund you believe you could gain from that?

Bill Wheat

Maximum would be our entire inventory balance I guess. Right now the amount we have stated as the incremental $200 million that is the full amount of our entire net operating loss for tax purposes we have available to us. That is the minimum we have but it also fully captures our full net operating loss. What a forward projected loss could be into the future that is really not necessarily predictable. You would have to factor in reductions in home inventory, reductions in land inventory and that is something we are evaluating right now before we finally make our decision on how we are going to apply the carry back.

Jay McCanless - FTN Equity

I am confused. I thought the $200 million was on fiscal 2009 results. Shouldn’t you also be able to take a loss in fiscal 2010 and potentially recoup previous taxes paid?

Bill Wheat

The law does not allow us to use both years. We have to choose between either our fiscal 2009 or fiscal 2010. So we could wait a year and make the decision then but we have a substantial amount available to us today. We would have to see a taxable loss of a substantially larger amount than we have today to increase that overall refund.

Jay McCanless - FTN Equity

What should we expect for percentage growth in your community counts in fiscal 2010?

Don Tomnitz

We really don’t give community counts. It is difficult to assess. In each one of our markets our land acquisition people and our division presidents are focused on tying up every deal that makes economic sense to us. In some markets there are a lot of deals we can tie up and in other markets there are very few. Typically speaking I would be surprised in each one of our markets if we didn’t add 10 or so new flags over the course of 12-18 months.

Bill Wheat

Then you will roll off some of those projects so there is always a netting effect as well.

Operator

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

Jim Wilson - JMP Securities

Could you give a little bit of color on what you have seen with end markets or some of your better performing volume markets and some of your worst? Maybe you could give the same kind of color from a pricing standpoint?

Don Tomnitz

I don’t want to get into the A, B, C, D, F scenario but our strong markets clearly are all of our markets in Texas which include San Antonio, Houston, Dallas Fort Worth, Austin, Killeen. Those markets performed well for us last year and they are improving significantly in 2010 over 2009. The other market that is doing extremely well for us is Seattle. I would call strengthening markets we see are Southern Cal, Atlanta to a certain extent. Weaker markets clearly Las Vegas, Chicago, Hawaii and to a lesser extent Florida and Phoenix.

Jim Wilson - JMP Securities

Your comments would imply really to the volume and pricing picture for each of those cities?

Don Tomnitz

Yes.

Operator

The next question comes from the line of Stephen Kim – Alpine Woods.

Stephen Kim – Alpine Woods

I have a question regarding your options. It looks to me like you entered about 6,100 new land options or options for that amount of units. I wanted to get a sense for whether you think that kind of addition to your land bank in the form of options is likely to accelerate a we go into the fourth quarter based on what you see currently? I was curious as to what you think the average price increase you have to pay…how much higher the purchase price is for those options than they would have been if you had opted to pay cash?

Don Tomnitz

The second part of your question is that just wouldn’t be an option for us. We are just not paying cash for virtually anything today. Until the market begins to clearly stabilize I think you would be ill advised to do that because one of the things clearly that a rolling option contract affords you is the opportunity to adjust the purchase price if the market does soften. I don’t really have a feel for that because that is just not something we are focused on.

Our ability to do it going forward, clearly we believe in calendar year 2010 there will be increasing opportunities for builders like Horton who have a strong cash position and a strong positioning of our markets, one of the things we continue to do is maintain our big footprint across the US so we anticipate in calendar year 2010 continuing to add at an escalating rate the number of contracts and flags we have in just the second half of calendar 2009.

Stephen Kim – Alpine Woods

Let me ask the second part of my question a slightly different way. When you are evaluating what prices, sort of strike prices you are willing to accept on these land options, are you assuming if prices and hard costs stay relatively the same as where they are now you could make a gross margin close to 20% when you are doing your feasibility analysis or are you targeting a margin a little lower than that? Can you just give us a sense for what kind of margins are baked into your sort of feasibility analysis on these lot options?

Don Tomnitz

Typically 18-20%.

Operator

The next question comes from the line of Michael Rehaut – JP Morgan.

Michael Rehaut – JP Morgan

When you were talking before about community count improving sequentially, would you see that trend continuing to increase given the lots you have been tying up recently and if so when would that necessarily result in a year-over-year increase if you keep the current pace of improvement steady that you saw this past quarter?

Don Tomnitz

We should have more flags open at the end of calendar year 2010 than we have at the end of 2009. As I just mentioned to Steve a few moments ago, we believe that for builders like Horton with a strong cash position, no requirement to borrow money from anyone, we are a strong buyer from developers as well as banks and we believe more lot option deals will become available from the banking institutions in calendar year 2010 than what we experienced in 2009.

Michael Rehaut – JP Morgan

The option lots you have this quarter can you give us an idea of the percentage that was tied up in the last three months and over the last six months?

Don Tomnitz

I can give you a general number. I would say well over 200 option deals have been tied up in the last six months. [Inaudible]

Michael Rehaut – JP Morgan

What would that be in terms of number of lots?

Bill Wheat

The typical deal is somewhere between 50-100 lots.

Operator

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

Alex Barron - Agency Trading Group

Do you have the number of the dollars benefit to gross margin from previous impairments for this quarter and also last quarter if available?

Stacey Dwyer

The number for this quarter is $134.8 million.

Bill Wheat

$134 million on homes for this quarter. Are you asking for the June quarter of 2009?

Alex Barron - Agency Trading Group

Yes.

Bill Wheat

Last quarter on homes was $112 million.

Alex Barron - Agency Trading Group

Did you quantify or measure somehow how many people or what percentage of your closings took advantage of the tax credit this quarter?

Stacey Dwyer

We don’t have access to that information because people apply for the tax refund after they close their homes. That is not part of the closing process or the sales process.

Operator

The next question comes from the line of Timothy Jones – Wasserman and Assoc.

Timothy Jones – Wasserman and Assoc.

You talk about going to more and more finished lots. What did your land held for development, raw land, increased $30 million and accounts for about 25% of your total land inventory.

Bill Wheat

It is about $30 million over the year, relatively flat with what it was in the third quarter. There were some projects earlier in fiscal 2009 we determined we did not intend to go and develop in the next 12-18 months. So we early in fiscal 2009 reclassified some projects into this category. That project list has remained relatively constant the last couple of quarters.

Stacey Dwyer

Those would not be new land purchases.

Timothy Jones – Wasserman and Assoc.

It is not new land purchases?

Stacey Dwyer

It is not new land purchases.

Bill Wheat

Existing projects that we classified as land held.

Timothy Jones – Wasserman and Assoc.

You talked about November being seasonally slow. I don’t know if I caught it, did you say anything about October? I know you said you expect first quarter vertical orders to be up but did you say anything about October?

Bill Wheat

October held up seasonably strong we believe impacted largely by the tax credit being available through November and our availability of having some spec homes for those buyers.

Operator

There are no further questions. Mr. Tomnitz I will turn it back over to you for closing remarks.

Don Tomnitz

Thank you. I would like to thank all of our employees for 2009 and most importantly everything everyone has done in this company since September of 2006. I was standing in Stacey Dwyer’s office and we were calling one of our regional presidents about the lack of sales. It has been a very long three years. We think we have properly positioned Horton going forward and we believe that we can take advantage of our strong position in the industry to grow this company once again and return to profitability. Our motto is onward and upward. Thank you very much. Good bye.

Operator

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

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Source: D.R. Horton Inc. F4Q09 (Qtr End 09/30/09) Earnings Call Transcript
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