KB Home F2Q10 (Qtr End 05/31/10) Earnings Call Transcript

| About: KB Home (KBH)


F2Q10 (Qtr End 05/31/10) Earnings Call Transcript

June 25, 2010 11:30 am ET


Jeff Mezger – President and CEO

Bill Hollinger – SVP and Chief Accounting Officer

Jeff Kaminski – EVP and CFO

Kelly Masuda – SVP and Treasurer


Michael Rehaut – JP Morgan

Dan Oppenheim – Credit Suisse

Ivy Zelman – Zelman & Associates

Stephen East – Ticonderoga

Joshua Pollard – Goldman Sachs

Jonathan Ellis – Bank of America/Merrill Lynch

Michael Smith [ph] – JMP Securities

David Goldberg – UBS

Rob Hansen – Deutsche Bank

Buck Home – Raymond James

Mike Widner – Stifel Nicolaus


Good day everyone and welcome to the KB Home’s second quarter earnings conference call. Today’s conference call is being recorded and webcast on KB Home’s Web site at kbhome.com. The recording will be available via telephone replay until midnight on July 5th by calling 719-457-0820 or 888-203-1112 and using the replay pass code of 3914926.

KB Home’s discussion today may include certain predictions and other forward-looking statements that reflect management’s current expectations or forecast of market and economic conditions and of the Company’s business activities, prospects, strategies and financial and operational results.

These statements are not guarantees of future performance and due to a number of risks, uncertainties and other factors outside its control, KB Home’s actual results could materially be different from those expressed in or implied by the forward-looking statements. Many of these risk factors are identified in KB Home’s filings with the SEC, which the Company urges you to read with care.

KB Home’s comments today may also include non-GAAP financial measures as defined in Regulation G. The reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures and other Regulation G required information is provided in the Company’s earnings release, which is posted on the “Investor Relations” page of the Company’s Web site under “Recent Releases” and through the “Financial Information News Releases” link on the right hand side of the page.

And now, it is my pleasure to turn the conference over to Mr. Jeff Mezger. Please go ahead, sir.

Jeff Mezger

Thank you, Kelsey. Good morning, everyone. Thank you for joining us today for a discussion of our second quarter 2010 results. With me this morning are Bill Hollinger, our Senior Vice President and Chief Accounting Officer; and Kelly Masuda, our Senior Vice President and Treasurer.

I’d also like to welcome Jeff Kaminski, our Executive Vice President and Chief Financial Officer, who joined the KB Home team earlier this month. We are very pleased to have Jeff with us and we look forward to the value he will add in the years ahead.

I will begin with an overview of today’s housing market environment followed by a summary of KB Home’s operating strategy within this context. Next, I will provide a review of our second quarter results along with our actions to grow revenues and improve our business results going forward. Finally, I will comment on our outlook and competitive position for the remainder of 2010 and beyond.

A combination of both positive and negative factors continues to impact the housing market. On the positive side, affordability remains at incredible levels. By taking advantage of lower prices and historically, low interest rates, home buyers, especially, first time buyers, are finding they can now afford to buy the home they want in their preferred location.

In fact, as a result of today’s low prices and interest rates, mortgage payments on a median priced home have dropped below 20% of median household income. This is the lowest level on record dating back to 1971 according to the State of the Nation’s Housing report released last week by the Joint Center for Housing Studies of Harvard University. This extraordinary housing affordability has helped to spur activity, clear inventory and even stabilize prices in many areas.

At the same time, however, the disappointing employment report in May, served as a reminder that all is not yet well in the larger economy. Additionally, the month of May proved to be particularly challenging for the housing industry.

The Commerce Department reported this week that new home sales in May were at record lows, resulting primarily from the expiration of the Federal home buyer tax credit on April 30. The confluence of these indicators and events has produced an overall market that lacks much needed stability.

We are undoubtedly in a better position than we were a year ago and housing is on the road to recovery, but the recovery remains uneven, while the market is, in many ways, still finding balance. As we continued to move past the tax credit period, we know that demand will eventually come back and return to levels consistent with household growth.

Before I share the results of the second quarter, I will quickly summarize where we see our Company’s future within this environment. Utilizing our KBnxt Built to Order business model, KB Home has been executing a consistent strategy of operating our business as efficiently as possible and maintaining a healthy and liquid balance sheet, while transforming our operations and product offerings.

This integrated strategy started several years ago and remains in place today. At the first signs of the downturn, we set a course to build and preserve cash, streamline our operations to cut costs and reduce our inventory.

We also developed the Open Series innovative Line of Homes to lower our cost to build and compete effectively with resales and foreclosures. Because of these actions, we have continuously improved our business as evidenced by our second quarter results.

We narrowed our net loss for the eighth consecutive quarter, improved our year-over-year gross margins for the seventh consecutive quarter, while strategically lowering the price point of our product offerings and maintained ample liquidity.

In fact, year-over-year deliveries in our second quarter increased for the first time in more than three years. While we are encouraged with these results, we recognize that we still have more work to do and the KB Home team is energized to achieve our objectives. We believe we have the right strategy in place to grow our business and return to profitability in the current environment.

We are positioned in the most attractive product segments, targeting first time, move up and active adult buyers within the most dynamic geographic areas. When you combine our strong market position with solid and predictable per community sales rates, improving margins and an increase in community count, a normalized profit picture comes into view. Moreover, as our top-line grows, we are committed to additional cost reduction measures in order to further leverage SG&A and expand our operating margins.

When we look specifically at the selling environment in the quarter just ended, it is difficult to read too much into it or even analyze it in the context of where we are in these economic times because of the extraordinary impact of the home buyer tax credit and its expiration on the entire quarter.

We knew that the tax credit would result in stronger demand, follow by a drop-off in May. What we saw in May, which is historically one of our better selling months of the entire year, was that home buyers who missed the deadline seem to step out of the market entirely and put their home buying plans on hold for the time being. As a result, post-tax credit traffic levels and sales were significantly impacted.

At the beginning of the quarter, we had strategically started a limited number of spec homes in select markets to take advantage of the tax credit. But by April, we had sold the majority of these and our Built to Order homes were at a disadvantage because they could not close in time to qualify.

The tax credit represented a temporary disruption to the marketplace in which the consumer ultimately favors the value and choice that our Built to Order model provides. As the market resets following the government stimulus, we are confident our Built to Order approach is the right one to compete in the current housing market.

This anomaly combined with fewer communities and a generally weak economy resulted in the negative year-over-year order comparison we experienced. We generated 2,244 net orders in the second quarter of 2010 versus 2,910 orders in the same period last year, a decrease of approximately 23%.

Having said that, net orders were up 17% sequentially from the first quarter and our overall net sales per community in the second quarter remain solid. It is still too early in the third quarter to determine where demand will go from here.

In the short term, the market is bouncing along the bottom, but is only a matter of when, not if, things are going to improve. In recognizing the pull-forward effect of the tax credit, we are now working diligently to refill our pipeline of potential buyers in order to set up our fourth quarter deliveries and gain momentum into 2011.

The second quarter of 2010 marked the first time in 14 quarters we have seen a year-over-year increase in the number of homes delivered and we ended the quarter with a backlog of 3,175 homes. Higher year-over-year delivery should continue into the third quarter due to our compressed cycle times, higher levels of backlog conversion and tax credit sales closing by the end of this month.

On a side note, as the June 30th closing deadline approaches, we have not experienced mortgage or construction delays in our targeted closing, contrary to some reports in the media about the industry in general.

Our optimism for our approach to competing successfully in today’s housing market is based on the data we are seeing at our individual communities. Indeed, KB Home sales on a per community basis have been and continue to be among the highest in the industry. The broad array of new home deigns from the Open Series are appealing to a range of home buyers, whether they are first time, move up or active adult buyers.

The Built to Order floor plans, flex to incorporate expanded living spaces, higher bedroom counts and numerous other design choices that are tailored to each buyers wants, needs and budget.

This customization combined with the energy efficiency, 10-year limited warranty and compelling price points are just some of the numerous advantages of these new homes when compared to our largest competitor resale homes.

We now have six quarters of favorable customer response from the Open Series and continue to expand our offerings of these designs across all our markets.

Each region is unique and it’s settling at its own pace. Some are performing well, while others are taking more time. But even in this unpredictable environment, our current sales results on a per community basis give us confidence in our growth strategy, as we work to increase our community count across our regions.

Our community count was down 7% year-over-year in our second quarter and we anticipate that the third quarter of 2010 will also be down compared to the same period last year.

As we endeavor to open more communities, we have been closing out approximately the same number, bringing our average community count for the year down slightly from 2009. With our strategic land investment over the past three quarters however, we expect year-over-year community count growth in 2011 for the first time in a number of years.

To support our community count and top-line growth, in the second quarter, we secured approximately 4,300 owned and controlled lots that met our financial and strategic guidelines.

We are seeing more deal flow and remain disciplined in our investment parameters favoring options over outright purchases with the latter being reserved only for finished lots in top locations that we know we can bring to market quickly and generate attractive returns. In many cases, we are able to go from closing on the lots to delivering homes in approximately six months.

Future investment activity will continue to be subject to our stringent underwriting criteria, which include sensitivity to current market conditions.

The majority of lots secured in the second quarter were located in Texas, California and Las Vegas. For example, we secured finished lots in Northwest Houston, near one of our very successful existing communities that is approaching sell-out. This acquisition will create continuity in that proven neighborhood.

We were able to open this new community quickly and efficiently by selling the same product out of our existing Open Series models and we’ll generate deliveries as early as the fourth quarter of 2010.

We also recently announced an exciting land deal on Southern California with the Lewis Group of Companies, with whom KB Home shares a more than 20-year working relationship. This phase take-down purchase involve 664 home sites in two prime master plan communities located in the Inland Empire, one of the best selling areas of the country.

In all, as a result of this transaction, eight new communities featuring the Open Series product and targeting first time and move up buyers will open for sale late in 2010 and begin delivering homes in early 2011.

In Las Vegas, we acquired finished lots in seven communities in the second quarter, all in highly desirable locations, with attractive price points and solid margins.

One example is our Remington community, in which we acquired the lots in the second quarter, we’ll open models in the third quarter and we’ll have first deliveries in the fourth quarter. This underscores the very local nature of housing, which explains how we can operate successfully in a city as hard hit as Las Vegas by offering the right product, at the right price point, in the right locations within that market.

These examples illustrate our strategy of securing finished lots in great locations that meet our return hurdles, fit well with our popular Open Series product line and can quickly be turned into revenue producing communities.

At the end of the second quarter, we owned or controlled almost 40,000 lots, a more than 2,500 lot increase over the end of the first quarter of 2010. This represents a four-year supply and the first quarter-to-quarter sequential lot count increase in four years.

Additionally, approximately $1.2 billion of our $1.7 billion in inventory is related to homes sold and in backlog and finished or nearly finished lots. Our land position allows us to continue to be nimble and opportunistic in today’s market.

Turning to our financial results, we again narrowed our net loss for the quarter to $31 million, a 61% improvement over the prior year’s period net loss of $78 million. On a per share basis, we posted a net loss of $0.40 for the quarter versus $1.03 a year ago.

We reduced our quarterly net loss significantly, despite our revenues decreasing about 3% on a year-over-year basis to $374 million.

We had no asset impairment or land option contract abandonment charges in the second quarter of 2010 compared to almost $50 million in the same quarter last year.

We delivered 1,782 homes in the quarter, a slight increase compared to the second quarter of 2009. This reflected increases of 49% in our Southwest region and 5% in our Central region, partly offset by decreases of 12% in both the West Coast and Southeast region.

The average selling price for the quarter of $207,900 was down 4% from a year ago, but included increases of 3% in our West Coast region and 6% in our Central region. Our second quarter average selling price increased 5% from the first quarter of 2010 and was up sequentially in three regions of our four regions.

Margins held up well throughout the quarter, enabling us to mark our seventh straight quarter of year-over-year margin improvement. Our housing gross margin in the quarter was 17.7%, a nearly 16 percentage point increase over 2009.

Excluding impairment and abandonment charges from the prior year, our second quarter housing gross margin was up 500 basis points on a year-over-year basis. This track record reflects our comprehensive work over the past few years in transforming our business and product offerings.

We continue to expect our housing gross margin for the full year 2010 to be higher than in 2009.

Reducing our selling, general and administrative expense ratio continues to be a top priority. At $83 million or 22.4% of housing revenues, these expenses remained elevated in the quarter compared to $73 million or 19.1% of housing revenues in the year earlier quarter, primarily due to increased legal costs and higher advertising expenses related to expanded marketing efforts and opening new communities.

On last quarter’s earnings call, we mentioned that legal costs would continue to have an adverse impact on our SG&A into the second quarter. Despite these additional expenses, we may progress in reducing the year-over-year gap in our SG&A ratio to 3.3 percentage points in the second quarter from 7.4 percentage points in the first quarter of 2010.

For the full year, we are still targeting an SG&A ratio in the 18.5% range. We expect this ratio to improve further in 2011, primarily as a result of our anticipated top-line revenue growth, driven by an increase in the number of homes delivered.

Our balance sheet remains healthy and liquid and we ended the second quarter with approximately $1.1 billion in cash. Our cash balance decreased during the quarter, mainly reflecting our investment in land opportunities across our regions and the repayment of debt. We still expect to end the year with a cash balance in excess of $1 billion.

As many of you have asked, I would like to give you an update on the status of the SEC’s investigation, which is still in process. While we cannot speak on behalf of the SEC and cannot be certain as to the scope of its review, the information request we have received from the SEC relate to our impairments of communities and joint venture investments.

We have a robust, disciplined, fast driven process to evaluate our inventories and investments in joint ventures for potential impairments. And we remain confident in our consolidated financial statements. Of course, we will continue to cooperate with the SEC and cannot predict the outcome of its review.

Before I summarize our longer-term outlook for the Company, I would like to share our progress in the quarter related to our “My Home. My Earth.” environmental program.

Our commitment to becoming a leading environmentally-friendly national company is far more than a brand initiative. It can be seen in every aspect of our business, from lowering our costs by reducing waste and increasing operational efficiencies to differentiating our homes to compete effectively with resale homes in the marketplace. It is the right thing to do not just for the earth, but also for our business and our customers.

We recently partnered with the U.S. Environmental Protection Agency to be the first national homebuilder to participate in its new WaterSense for new homes water efficiency program. According to EPA, WaterSense new homes use 20% less water than conventional new homes and can save home owners more than 10,000 gallons of water each year.

KB Home is already a leader in building all of our communities to ENERGY STAR guidelines and we believe that just as EPA’s ENERGY STAR program has raised awareness of energy efficiency among consumers, the WaterSense program will do the same for water consumption.

KB Home is proud of its position as one of the greenest production home builders in the U.S. Our earth-friendly homes conserve natural resources and lower monthly utility bills without raising the price of the home for our buyers and without materially impacting our cost to build. This distinction is not only important to us, but to our home buyers and serves as a great differentiator compared to a resale or foreclosure home.

Historically, the spring selling season sets up our fourth quarter deliveries and full year results. As we look at 2010, however, the extraordinary circumstances of the tax credit dynamics have added another element of uncertainty to the mix.

We continue to sell for fourth quarter deliveries, as our reduced build times are setting up stronger than ever backlog conversions and allowing us to lengthen our selling season further into the year. In fact, many divisions will sell Built to Order homes in August that will deliver in the fourth quarter.

Having said that, a lack of predictability in the overall sales environment will likely impact our full-year deliveries and could potentially extend our outlook for profitability by a quarter or two.

Given the current environment and in light of the fact that orders in the second quarter were off, we now anticipate full-year 2010 deliveries to be in the range of 8,000 units to 8,500 units. Regardless of whether we cross the threshold of profitability during 2010 or shortly thereafter, our strategic vision for 2011 and our clear path in how we can get there remain unchanged.

As we look ahead, we believe our success at the community level is creating a strong platform for increased momentum coming out of 2010 and a trajectory for top-line growth in 2011. In fact, our projections call for community count growth of over 25% in 2011.

To get there, we are following a straightforward path based on the fact that our Open Series product line is selling more predictably and new communities are achieving healthy margins.

As we underwrite new land deals at today’s home prices and establish a solid sales pace with our well received new product offerings, we are getting the expected results on a per community basis.

We must now continue expanding our community count through strategic land acquisition, while relentlessly cutting incremental costs in our business to further leverage our overhead and sales pace.

While the tax credit dynamics disrupted the gradual recovery process, the market will stabilize. It is just a matter of when. Long-term demographics, household formation and population growth continue to signify a positive course ahead for the home building industry.

Even the low end estimates in the Harvard study put household growth at about $1.25 million annually over the next 10 years. This is on par with the pace from 1995 through 2005 and should support average housing completions, manufacture home placements of over 1.7 million units per year over the coming decade.

A home is not an ordinary purchase. It is a milestone. And the primary reasons for buying a new home remain the life events that are constant in our society. Events such as a marriage, a new baby or an empty nest. Moreover, buying a home is always about affordability and desirability and buyers are still finding both at KB Home communities across the country.

While some challenges and uncertainties persist in the short-term, the intrinsic demand for housing in America is undeniable and our long-term growth strategy to capitalize on this demand is on track.

I’ve been in this business long enough to know that good companies come out of these cycles even stronger and better able to take advantage of the tremendous opportunities that the recovering market will present.

We are closing in our goal of restoring profitability and I’d like to thank our employees for their hard work and accomplishments. As we continue to execute our proven strategy and KBnxt Built to Order business model within the context of a gradual market recovery, KB Home is in an excellent position to gain market share and achieve substantial future growth.

Now, we will open it up for your questions.

Question-and-Answer Session


Thank you, Mr. Mezger. (Operator instructions). We’ll go first to Michael Rehaut with JP Morgan.

Michael Rehaut – JP Morgan

Thanks. Good morning, everyone. First question, I just wanted to drill down a little bit on the differences in gross margin and also SG&A and appreciate some of the commentary you provided Jeff on the SG&A in particular, but kind of a two parter, I guess, on the gross margin can you review kind of some of the puts and takes as to the sequential decline when you exclude the charges from first quarter to second quarter of about 110 bps and what you expect to see in the back half for the year?

And then also with the SG&A, kind of the second part of the question, you certainly have some wood to chop in the second half in terms of the ratio to get to 18.5%. And I was wondering if you can give us a little more granularity in terms of what cost you expect to pull out of the picture in the back half?

Jeff Mezger

Mike, I’ll speak to the gross margin side and then I’ll ask Bill to give you the response on SG&A. On gross margin, as I shared in our prepared comments, we did have our seventh consecutive quarter of gross margin improvement. In fact, over last year it was 500 basis points and 17.7%. The slight decline from first quarter resulted from two things really. Product mix a little bit and buyer closing costs increased due to some of our first time buyers needed the cash to close.

On a per unit basis the dollar margin per unit was the same, but due to the two things I mentioned, it is down 1%. And as we go forward and you look at our business, margins will range where they’re at to tick up slightly, depending on mix and the better way for us to grow margin is through top-line and units. Bill, do you want to cover SG&A?

Bill Hollinger

Yes, Jeff. Notwithstanding the levels of our SG&A in the quarter, keep in mind though; we do have a relentless focus on reducing our SG&A expenses and percentage. And so we do believe at these elevated levels, they will improve as the year unfolds and as we move into 2011.

It’s important to keep in mind that at our current low revenue levels, the changes in expenses can have a dramatic impact on our SG&A percentage. If you recall last year, we had a much flatter trajectory in our SG&A percentage, in that we started the year of last year at 20.1%, we ended the year at, I think for a full year of 17.2%.

We’re starting this year at 27.5% and as you saw in the second quarter, we’ve brought it down already 510 basis points to the 22.4%. We see that gap continuing to narrow into the third quarter, as we end or as we hope to target the 18.5% at the end of the year. So you’ll just see a much steeper decline in our ratio and one coming much more into a normalized level I guess.

Michael Rehaut – JP Morgan

Specifically, I guess when you kind of highlighted the legal costs, are some of those going to pull back or do you have identifiable dollars on that line that you expect to decrease?

Bill Hollinger

Yes. We are expecting going forward that the legal costs should abate.

Michael Rehaut – JP Morgan

Okay. Second question, if I could, on just order trend throughout the quarter and as we sit here in June, you kind of alluded to the fact that you pulled back on spec a little bit or you sold out sooner than you expected during the second quarter. I was wondering if you could just give us a sense of month-to-month order trends on a year-over-year basis. Yesterday, Lennar saw that June improved a little bit for them on an orders basis, also a traffic basis. I was wondering if you could provide any color to that, this month that we are in right now as well.

Jeff Mezger

Mike, I couldn’t tell you what the monthly comp is year-over-year, but we also don’t want to get into the specifics of the month-to-month track during the quarter. As I shared in the prepared comments, May was off significantly post-tax credit. Getting back to our strategy and how we set up our business, heading into this tax credit expiration, we remained a pre-sold builder. We’re firmly committed to our business model.

As we looked back on what happened with the last tax credit, we were totally at a disadvantage because we had no inventory to take advantage of the deadline and it did hurt our sales. Post-tax credit last year there was definitely a low in sales just like you are seeing now.

As we look forward to this tax credit expiration, we did put some limited inventory on the ground in markets with price stability where the community targeted first-time buyers. And what was interesting for us is a big chunk of those spec starts actually sold as the foundations were being poured and the buyer still had the opportunity to go to the studio and make all of their selections other than the floor plan and the exterior elevation. But we did not have a huge spec inventory out there.

What we did start recovered and then as April unfolded, our buyers could no longer once again take advantage of the tax credit because we couldn’t get the home built by the end of June. So we were once again at a competitive disadvantage. So the tax credit, while it absolutely helps to clear inventory and it did recreate some incentive for our consumer, it also created a disruption to our business model.

And now that we’re moving past the tax credit period, we’re looking forward to things getting to a more stabilized supply and demand environment where the strengths of our business model can once again emerge.

On the June sales front, we’re not going to give any color on that either because it’s too early in the month. And as things bump along, we don’t want to overreact to one week or two week activity. We’ll share more color at the end of our third quarter.


Our next question will come from Dan Oppenheim with Credit Suisse.

Dan Oppenheim – Credit Suisse

Great. Thanks very much. Jeff, just wondering if you can just talk a little bit more, you spend a lot of time talking about the growth strategy and the demands going to return. We understand that it’s something we can all look at for the past few years. But I guess given the declining trends in May and what seem to be still weak conditions in June, how is that you’re responding to the current market and adjusting your plans? I understand you don’t want to alter the long-term strategy, but what do you do differently here at the end of June than you would have done if we’d seen strength in the market?

Jeff Mezger

Are you referring, Dan, to our investment strategy or our sales strategy?

Dan Oppenheim – Credit Suisse

Both, whether you will alter the land purchases and also what do you think about in terms of sales?

Jeff Mezger

Okay. As I mentioned in my prepared comments, our biggest competitor is resale and resale pricing is fairly stable. So in most of the markets we’re in, it’s fairly stable. In some cases, it’s actually been ticking up for many months like in California.

We’re all watchful and everybody has their own crystal ball on what’s going to happen post-tax credit environment here, but we look at each community specifically. We’re competing with resales in that market and we’ll take whatever steps we need to balance a sales rate with a margin, with the asset and the investment there. So we’re not doing anything dramatic as a result of what happened to our May sales. We’ll be a watchful and deal with each community based on the dynamics in that location.

On the investment side, again, the communities that I used as examples and we could have picked more, they’re all priced very competitive with resales. They’re all selling at price points comparable to product that’s already been selling for many months in those location. So we’re comfortable with our underwriting and our investment decision. Wherever the selling environment takes us and whatever happens to supply and demand in that location would influence our investment strategy going forward, but we’re chasing 5 million resale units. So there are a lot of places we can go to compete in and continue to grow the business.

Dan Oppenheim – Credit Suisse

Great, thanks. I guess if you can talk a little bit more in terms of the comments on the closings also SG&A. The guidance for SG&A assumes I guess a significant improvement in terms of closing for back half of the year. What are the assumptions in terms of when demand does return? And then also on SG&A, how significant was the improvement in SG&A that occurred unfortunately based on the decline in stock price during the quarter? I imagine that was probably a couple of hundred basis points.

Jeff Mezger

I can let Bill speak to that side, Dan. But, again as I shared in my comments, we’re continuing to see great progress in compressing our cycle times. In fact for the quarter, our average build time was 86 days. You’ve covered us for quite some time, so you know that in the old days “Our business model was a six-month cycle time.” We’re now down in many divisions running below four months because of the simpler product to build and the sub base we have in our business model.

So we are able to sell deeper into the year and still hit our deliveries for the year. So I’ve given you the range of units for the year and assuming we hit that range and that’s where we’re targeting right now, we’ll hit the SG&A ratio that we guided to. We’ll continue to chip away at our costs while we push the top-line and we’re expecting higher conversions because of a shorter cycle time going forward.


Moving on to Ivy Zelman with Zelman & Associates.

Ivy Zelman – Zelman & Associates

Good morning, everybody. I think just to follow on Dan’s comments recognizing that you don’t have a crystal ball, but I think your confidence in holding margin going into the back half of the year, improving margins, having a hard time digesting that, given the weakness we’re seeing in order trends currently. I know builders talk about low levels of inventory in new homes, but as you pointed out, Jeff, you’re really competing against existing homes. And we recognize that you have to sell houses in order to cover G&A and to obviously generate revenue.

So how you feel as confident as you do that you won’t need to accelerate incentives in order whether it would be closing costs as you experienced in this second quarter with respect to more people needing the down payment that you needed the fund to close or closing costs I mean. I just want to understand where your confidence comes from?

And I’m also kind of perplexed that you’re using the Joint Center long-term housing forecast to talk about what’s going on, given that today we’ve got so much excess inventory in the market from an existing home standpoint, as well as a lack of formations, households peaks for today that’s actually almost non-existent.

So hopefully, you’re not running your business on Joint Center and can you give us more of a understanding of how you actually think about opening new communities, how many new communities will you open in 3Q and 4Q or how many would you postpone possibly if for whatever reason demand doesn’t pick up without government providing stimulus as they’ve done through the past year? So I’m a little confused and concerned.

Jeff Mezger

You just asked like 15 questions, Ivy. But I’ll try to answer as many as I can recall from what you just rattled off. We’re using the Harvard data to illustrate that in the long run this is still a very vibrant industry. And some of the lack of household growth right now that was actually shared at the Harvard Board meeting is people that are customarily home buyers are staying in the nest, where people are actually getting married, but not moving out from underneath the parent umbrella because of uncertainty or lack of confidence in their job or whatever. So household growth is still occurring and population and demographics are going to drive our industry in the long run. So that’s what I was sharing before.

At the same time, this is a very local business and I walked through a couple of examples here of communities where we are selling well in those areas today and we are reinvesting to have more lots and to continue or open new communities in those specific submarkets. In those cases if there was a lull in sales for a while, we’re still going to open the community, because it’s positioned extremely well relative to resale.

I don’t recall that I guided margins up for the rest of the year. We ranged them because it’s our business model range of gross margin is 18% to 20%. I think you and I have actually talked about normalized margins in our industry over the years as kind of a normalized range. Everybody has a crystal ball and everybody’s got a different view on whether the May drop in activity is one month, three months, five months. Everybody’s going to have a different opinion. But everybody agrees it’s going to come back. It’s too early in this thing. Just like when the last tax credit expired there was this lull and then it slowly rebuilt. And we think that’s the trajectory that you’ll see as the economy gets on firmer ground.

Now, if the markets were to go south, we’re going to have to do some things that could impact our margin. So I’m not saying that it’s going up. I’m not saying it’s going down. I’m saying we’ll react to whatever market conditions we face at that time.


We’ll now hear from Stephen East with Ticonderoga.

Stephen East – Ticonderoga

Thank you. If we could go back to the SG&A a little bit, last quarter you said about $12 million was from non-business. I think the phrase you used was non-business expense and legal and the long-term cash comp, etc., what was it this quarter?

Jeff Kaminski

I don’t think we really want to get into the detail. Again, I think what you need to take away from this is that we are focused on the SG&A. We will bring it down. We think it will more normalize as we get into the second half. And again, we think it will be at about 18.5% by the time we end the year, which is really up only about roughly a 1.5% from where we were last year, not the 740 basis points that we were in the first quarter or the 500 basis points that we were in the second quarter. So again, I think we really want to focus on more where this is headed, not where it is that we are.

Jeff Mezger

As we shared, Stephen, we are always looking at ways to cut cost and we’ll chip around the edges. We’ve guided that the cost will ease through the second half of the year and at the same time, we expect the leverage from more top line to lower the ratio. That’s why we’re comfortable guiding at the 18.5 right now.

Stephen East – Ticonderoga

Okay. I appreciate that you typically don’t want to talk about it month-over-month and I think generally that’s a good policy. But given that this quarter did have the expiration of the tax credit, all of us are trying to understand for all builders what May really look like year-over-year and what that means as we sort of climb out of this hole. So if there’s any more color you could give on May and how much it fell off year-over-year.

And also then on the gross margin, you talked about product mix pushing it down, your gross margins come down two quarters in a row. So I want to understand, is there something going on that from a product mix standpoint that will continue or what should we expect moving forward there?

Bill Hollinger

I think our growth on a product mix, it’s not just product mix; it could be product mix and it could be geographic mix, timing of communities, making delivery. I think the point is, is that, if you look at our gross profit contribution on a per unit basis, it is flat sequentially and up more than $9,000 year-over-year.


And we now hear from Joshua Pollard with Goldman Sachs.

Joshua Pollard – Goldman Sachs

Hey, guys. A quick question on your strategy. You are, as far as I can tell, solely building homes to order and over the two most recent upticks in housing that’s led to some under penetration on the new home side. My thought process is interest rates are likely to rise as an economic and housing recovery stage. So do you think that the time that it takes or the time that consumers want to actually get a home delivered has shortened at least for a couple of years and it may be worthwhile to revisit the strategy to build homes that are not to order?

Jeff Mezger

Josh, I think you and I have actually talked about this. I shared on my prepared comments that we will be selling homes in late August that close in November, that are sold, the buyer goes to the studio, we get the loan approval, then we start the home and we will close it in November. So, it’s a 95-day, 105-day, 120-day turn. You’ve heard the horror stories of consumers getting frustrated trying to buy short sales, foreclosures. I think the normal resale cycle is 45 days to 60 days. And in these foreclosures the short sales is well longer than that. So we actually think we are very competitive now. And would you wait an extra 30 days to get your own custom home versus go through the headaches of foreclosure or resale? So we think what we’ve done strategically is absolutely the right place to be.

Joshua Pollard – Goldman Sachs

Understood. The other question I had is could you actually quantify what you’re looking for community count growth in 2011? And if you would be willing to give a trajectory for the second half of 2010, that’d be helpful as well? Thank you.

Bill Hollinger

Josh, I think for the remainder of 2010, we think community count will be slightly down in Q3. For the year, it’ll be slightly down which implies some growth in Q4. And as we said in our prepared remarks, we’re projecting community count growth of 25% in 2011.


Our next question will come from Jonathan Ellis with Bank of America/Merrill Lynch.

Jonathan Ellis – Bank of America/Merrill Lynch

Thank you. The first question I wanted to ask about the profitability guidance that you offered up and I’m wondering just to help get some framework around that. Any guidance you can give with respect to what percentage of homes would need to be sold through the Open Series product line and/or percentage of homes sold on new or recent land purchases in order to meet that profitability target?

Jeff Mezger

Jonathan, I’ll have Kelly respond on the Open Series percentage, but on the market, again, this tax credit has created an interesting disruption in our normal business flow. In that, you have this deadline now in June, where we will have a spike in deliveries in June that we normally don’t see. And as we go forward through the balance of this year, we shared our deliveries will be up in Q3.

Our fourth quarter deliveries are going to be tied frankly in part to how sales materialize over the next eight weeks to 10 weeks. So as we shared in our comments, we’re approaching profitability. You can see it, but there’s a variable now of what happened to the market and what happens with our delivery sequence. Having said all that, we still think we’re positioned at a gross margin and with the top-line growth we’re positioning for next year that will be profitable.

Kelly Masuda

Jon, as far as the Open Series, it’s represented more than 50% of our deliveries for the last four quarters. So I think part of our profitability equation is related to two things. One is the Open Series is becoming a bigger portion of our delivery. Secondly, as we start rolling out new communities on new land with Open Series, we expect to move close to the normalized margins.

Jonathan Ellis – Bank of America/Merrill Lynch

Great. My second question, just in terms of the order declines, particularly, in the California market, in the context of the tax credit that California has in place right now. Can you just talk about what you saw specifically on the West Coast market this past quarter? Did the state tax credit seem to provide any stability in May or was just a function of so many macro factors that led to the slowdown in orders in the West Coast?

Jeff Mezger

Jonathan, any time the government offers a tax credit incentive, to me in part, it’s a message to the consumer that now is a good time to buy a house. And that’s always helpful with the consumer psyche. When you compare this year’s tax credit in California to last year’s, last year has worked extremely well. This year’s has been much more muted and that the payback this time around is over three years, whereas last year it was received right back in the same year. And for our consumer in California, we’re not seeing it as a primary motivator. Now, prior to April, if they were a Federal tax credit buyer and a State tax credit beneficiary, I think it would be a positive impact, but it hasn’t been a real driver before or after April 30.


Our next question will come from Michael Smith [ph] with JMP Securities.

Michael Smith – JMP Securities

Hey, guys, good morning. Just a couple of quick things. One is what you are talking about with the color, with the specs and the disadvantage you guys are at? I am wondering if you can quantify that, can you give us what percentage approximately, I mean you can give me a quarter, a half or whatever came from specs in March and April and how that actually compared with say, February and January?

Jeff Mezger

You are talking about our sales?

Michael Smith – JMP Securities

Not your sales, your orders.

Jeff Mezger

As I shared in the comments, it was a limited number. It was in some communities, as I said, where we had price stability and it’s a first time buyer product, we may have thrown one month’s worth of sales in the ground earlier in a year, so you are talking four, five, six, eight homes no more in that location and it wasn’t company-wide. So it definitely helped our sales for the quarter, because we may not have otherwise received the sale, but it wasn’t the lion’s share of our sales, by any means. I don’t know that we have the number broken out that way.

Michael Smith – JMP Securities

That’s helpful. Does that mean then, is it safe to assume that, I mean are you hearing about good traffic coming through in March and April and then people leaving for subdivision down the street, because maybe they have more specs or leaving to buy an existing home. I mean, is that what we’re talking about, where people are actually coming and where interested and then being turned away because you guys (inaudible) on the ground?

Jeff Mezger

If you think about it, Mike, and again, we are competing more with the five million resells that are out there. If on April 15th, the realtor takes a buyer to our community and they like the home, but down the street, there is a recently completed resale, where they automatically have an $800,000 free benefit. So we were definitely at a disadvantage in that period of time. That’s now gone.


We’ll now move to David Goldberg with UBS.

David Goldberg – UBS

Thanks. Good morning, guys. Question here is on cancellation rates and if you guys had expected to see the cancellation rate maybe drop off a little bit more? And talk about maybe where people were canceling in the process, in other words, is that creating any kind of inventory areas fairly early on?

Jeff Mezger

David, to me our can rates were right in the normal range that we typically run. And as you know, in our business model, the preponderance of our cans occur before we start the home, where you’ve got the filtering process, you take the contract and if they’re unable to get their loan approved or they change their mind, it happens pre-start to construction. Our can rate post-start remains very low. As I look back, I don’t know that there was any extra influence on the can rate up or down, because it was fairly typical quarter for us.

David Goldberg – UBS

Got it. The follow-up question is actually on the land market. It’s good to see you guys being pretty aggressive on the land market and finding opportunities. But I’m just wondering if you can kind of talk about where the opportunity is coming from, we’ve been hearing increasingly that land prices are getting better for certain, especially for quality lots and there’s kind of a constrain on A quality or B quality lots in the market right now, being able to repurchase at affordable prices. So I’m trying to get an idea kind of where you’re getting access to lots? Clearly, you think they’re pretty high quality and what that means as you kind of look forward?

Jeff Mezger

It’s absolutely a mixed bag, David. We are not players really in the large bank portfolios that are being shopped around and that’s what a lot of the media coverage is regarding, where prices are getting pushed up. You’re only as good in each city as your land team and it’s tied to relationships you have on the ground. So, our lots are coming from other builders, land developers, land owners, in some cases, banks that are offloading a single community of lots and you have to be on the ground working the relationships there. So before the tax credit dynamic, we were actually seeing and continue to see an increase in opportunities out there and a little less frenzy push in price up.


Our next question will come from Nishu Sood with Deutsche Bank.

Rob Hansen – Deutsche Bank

Hi, this is Rob Hansen on for Nishu. With the kind of recent slowdown in May and June, have you seen any signs that the builders having second thoughts in terms of the land deals that are currently in the pipeline?

Jeff Mezger

No. I mean it’s too early, Rob.

Rob Hansen – Deutsche Bank

Okay. And then, foreclosing this quarter, what percent were pre-sold versus specs?

Jeff Mezger

I don’t know that we track it that way, Rob, but my hunch is preponderance would be pre-sold.

Rob Hansen – Deutsche Bank

All right. Thanks very much.


Our next question will come from Buck Home with Raymond James.

Buck Home – Raymond James

Hi, thanks. Just briefly on the SEC, I know you are limited here, but is there any way you can give us an indication if the SEC is looking at your potential impairments or the impairments you either didn’t take enough in those communities or were a little bit too aggressive, any indication in which direction they were looking?

Jeff Mezger

We’ve shared the comments that we can relative to the SEC. I wanted to touch on it because many people have enquired, but it’s ongoing and we just don’t want to speculate.

Buck Home – Raymond James

Fair enough. Also, do you have the ending spec home count that you finished the quarter with and also, if you have it, the number of finished model homes you might have?

Bill Hollinger

Buck, we had 3,176 homes in production, of which 534 homes were not sold and of that 534 homes, there were 152 finished unsold homes.


And we’ll now move on to Mike Widner with Stifel Nicolaus.

Mike Widner – Stifel Nicolaus

Hey, good morning, guys. Just wanted to follow-up on a couple of things. First, did I hear you right the guidance you gave for deliveries this year was 8,000 units to 8,500 units?

Jeff Mezger


Mike Widner – Stifel Nicolaus

Okay. So that’s a substantial increase in the second half. About 60% up from first half run rate. I do realize you got a June spike coming. But how should we think about that in terms of your assumptions on orders per community? It seems to imply that you expect a big boost in orders for community going forward even with the tax credit gone?

Jeff Mezger

I’m not sure that that would be the case, Mike. Our orders per community in Q2 were 18 per community. You can do the math with the units we’ve closed, where our backlog is and how many homes we still have to sell.

Mike Widner – Stifel Nicolaus

I was just doing the math and I come out to, you need to deliver 100% of your backlog next quarter, and then have a pretty strong orders volume next quarter. I mean if that’s the math that you are suggesting and I guess that’s the math you are suggesting, I was just trying to –

Bill Hollinger

It’s really not because if you look at our community count, what we said is it’s going to be slightly down in Q3 and slightly down for the year, which implies it’s going to be slightly up in Q4. Our community counts were down more in Q1 and Q2. We expect a very strong level of backlog conversion in Q3 just given the June deliveries from the tax credit expiration.


Ladies and gentlemen, that is all the time we have today for questions. Mr. Mezger, I’ll turn the conference back to you for closing or additional remarks.

Jeff Mezger

Thanks, Kelsey. Thank you, again for joining us this morning. We remain confident in our strategy and enthusiastic about our long-term outlook for housing and for our Company. Thank you, again and everyone have a great day.


Thank you, Mr. Mezger. Again, ladies and gentlemen, that does conclude our conference for today. On behalf of KB Home, we thank you all for your participation.

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