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DR Horton Inc. (NYSE:DHI)

Q2 2010 Earnings Call Transcript

August 03, 2010 10:00 am

Executives

Don Tomnitz - President and CEO

Bill Wheat - EVP and Chief Financial Officer

Stacey Dwyer - EVP and Treasurer

Analysts

Michael Rehaut - JPMorgan Chase & Co.

Josh Levin - Citigroup

Alex Barron - Housing Research Central

Dave Goldberg - UBS

Carl Reichardt - Wells Fargo Securities

Joshua Pollard - Goldman Sachs

Stephen East - Ticonderoga Securities

Timothy Jones - Maloney Securities

Nishu Sood - Deutsche Bank

Jonathan Ellis - Bank of America Merrill Lynch

Megan McGrath - Barclays Capital

Dan Oppenheim - Credit Suisse

Jade Rahmani - KBW

Joel Locker - FBN Securities

Jay McCanless - Guggenheim Partners

Michael Smith - JMP Securities

Operator

Greetings and welcome to the DR Horton American Builder, the largest builder in the United States third quarter 2010 earnings release conference call. (Operator Instructions) As a reminder this conference is being recorded. It is now my pleasure to introduce your host, Mr. Don Tomnitz, President and CEO for DR Horton. Thank you. Mr. Tomnitz, you may now begin.

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. As usual 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 DR Horton believes any such statements are based on reasonable assumptions, there’s no assurance that actual outcomes will not be materially different. All forward-looking statements are based upon information available to DR Horton on the date of this conference call, and DR 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 DR Horton’s current report on Form 8-K dated February 8, 2010, which updated our annual report on Form 10-K and our most recent quarterly report on Form 10-Q, all of which are filed with the Securities and Exchange Commission. Don?

Don Tomnitz

Thank you Stacey. We want to thank all of our DHI team members for generating an operating profit for the third consecutive quarter. Congratulations to each of you. We successfully competing in a difficult housing market. We are three quarters of the way to our goal of profitability in each any every quarter but we still have a very challenging quarter in front of us.

So far this year has unfolded as we expected. We saw strong sales through April and we just had our strongest third quarter homes closed in three years. We entered the year expecting the second half of the calendar year to be more challenging because of the flow forward effect of the federal tax credit combined with normal seasonality and a continued week economy.

Consequently, we began slowing our construction starts at the end of March quarter in anticipation of a drop off in demand. We will continue to be realistic on our expectations and we will adjust our business to compete now and in the future. Stacey?

Stacey Dwyer

Our net income for the quarter was $50.5 million or $0.16 per diluted shares compared to a net loss of $143.8 million or $0.45 per diluted shares in the prior year quarter. Pretax income was $37.4 million which included $30.3 million of inventory impairments and lot option charges and an $8.3 million loss on early retirement of debt. Financial service pretax income was $8.9 million which included $3.1 million of recourse expense. Bill?

Bill Wheat

Our third quarter home sales revenues increased 54% to $1.4 billion on 6,805 homes closed from $896.6 million on 4,240 homes closed in the year ago quarter. Our average closing price for the quarter was down 4% to $202,500. The timing of our revenues and earnings so far this year have been driven by the timing of tax credits instead of normal seasonality and we believe our operating strategy of having specs available to close by June 30 let us capture more of the available tax credit demand.

While the September quarter would typically be our strongest for closing volume and profitability our June quarter will be our strongest quarter in fiscal year 2010. Don?

Don Tomnitz

As we expected sales have slowed significantly after the April 30 deadline for signing the home purchase contract to qualify for the federal tax credits. As a result net sales orders for the third quarter were down slightly 3% from the prior year at 4,921 homes. Our sales in April were extremely strong followed by a sharp decline in May, a 20% sequential increase in June and then an approximate 10% increase in July. As we look at our sales comps for the next three quarters it will be difficult to achieve year-over-year increases, since each of the quarters saw strong sales volume driven by the various tax credits in effect.

While we remain focused on gaining market share for us to significant sustainable sales growth we need to see improvement in the overall economy, the jobs landscape and the consumer confidence. In the June quarter our average sales price or net sales orders in the quarter was essentially flat at $280,400. Our cancellation rate was 28%. Our active selling TMTs were up 7% sequentially. 39% of our net sales came from communities opened in fiscal year 2009 or later. Our sales backlog decreased to 18% from the prior year to 4430 homes or $954.4 million. Stacey?

Stacey Dwyer

Our gross profit margin on home sales revenues in the third quarter were 17.2%, up 590 basis points from our home sales margin in the year ago period and down 80 basis points sequentially from our March quarter. Our gross margins have been in the 17% to 18% range in each of the first three quarters this year with some volatility within the range. Our core margins increased 50 basis points from Q2 to Q3 as the average cost of our homes declined by more than our average selling prices. This was more than offset by the sequential gross margin impact from typical changes in estimates for development and construction completion costs and warranty and litigation accruals which were magnified when quarterly revenues fluctuated significantly, as they have this year.

A contributing factor to our core margin improvement was that 35% of third quarter closings were from new deals that were put under contract in fiscal 2009 or later. Margins on closings in our new projects were approximately 200 to 300 basis points higher than all the remainder of our closings. Our goal is to maintain our gross margins in the 17% to 18% range, or higher. However if current market conditions persist, we could see margins pressure in future quarters. Bill?

Bill Wheat

In our third quarter impairment analysis, we reviewed all projects in the company and determined that projects with a pre-impairment carrying value of $86.8 million were impaired, which resulted in $29.1 million of impairment charges, the majority of which were in the Chicago land area. We referred to our projects which have indicators of potential impairment, but we’re not impaired this quarter as our watch list, which represents those projects deemed to be at the highest risk for future impairments. Our watch list is currently approximately $350 million, down from $525 million at March 31, with the largest concentrations in California, Illinois and Florida.

$350 million is the lowest watch list balance we have reported during the downturn, and about half of the sequential reduction resulted from the removal of projects that no longer needed to be on the watch list. Our inventory impairment process in future quarters will incorporate any changes in market conditions and any adjustments we make in our business. However, we continue to expect fewer impairments than we incurred in 2009 and previous years. Don?

Donald Tomnitz

Our consistent focus on controlling SG&A has been a key to our return to profitability. We have leveraged our SG&A structure to focus on profitable opportunities in our existing markets with our current division operations. Homebuilding SG&A expense for the quarter, which includes all corporate overhead was $143.2 million or 10.4% of homebuilding compared to 14.7% in the year ago quarter. SG&A increased only $8.9 million or 7% on a 60% increase homes closed. We will continue to actively manage our SG&A levels relative to our expected number of home closings. Bill?

Bill Wheat

We recorded $19.6 million in homebuilding interest expense during the quarter, which was approximately 47% of the $41.3 million of interest we incurred. We are required to directly expense a portion of interest incurred, while our homebuilding debt level exceeds our active inventory. We recognize the loss of $8.3 million on the early retirement of $345 million with principal amount of our senior notes during the quarter. Discharge primarily related to the premium paid for the debt and also includes the write-off of unadvertised discounts and issuance costs. Stacey?

Stacey Dwyer

Financial services pre-tax income for the quarter was $8.9 million compared to $2.8 million in the year ago quarter. 93% of our mortgage companies business was captive during the quarter. Our company wide capture rate was approximately 61%, our average FICO score was 705, and our average combined loan-to-value was 92%. Our product mix in the quarter was essentially 100% agency eligible, with government loans accounting for 66% of our volume. Bill?

Bill Wheat

Our total inventory decreased by approximately $169 million, excluding non-cash impairment charges during the quarter. We reduced our homes and inventory about $220 million and increased our investment in residential land and lots and land held for development by $51 million. Our homes and inventory at the end of June totaled 10,800 homes, down 22% from March, of which 1,200 were models, 6,100 homes were speculative and 3,100 of these specs were completed.

We continue to make to manage our total homes and inventory relative to our expectations of our sales demand, and we all prospect homes, primarily to accommodate our first-time homebuyers who represented 60% of the third quarter closings captured by our mortgage company. As we enter the second half of the calendar year, which is a slower selling season we expect that our homes and inventory will decrease further in our September quarter. Don?

Donald Tomnitz

Our land and lot acquisition investments remain controlled, and we continue to evaluate our land development plans based on current sales trends. We have been actively contracting for finished lots to increase our actively selling communities and increase our gross margins. In our third fiscal quarter, we invested approximately $228 million, primarily in finished lots. Our spending on finished lots will remain largely dependent on our sales pace while our spending on land and development costs will continue to be at low levels.

Our supply of home, land and lots at June 30, 2010 was approximately 89,200 lots, of which approximately 22,200 are finished. We control an additional 27,300 lots through option contracts, up 24% from March 31, and our net earnest money deposit balance for these lots is only $10.6 million. We are focused on managing our supply of owned finished lots in line with our sales demand in a low-risk capital-efficient manner. Stacey?

Stacey Dwyer

Cash flow from operations for the June quarter totaled $159.3 million, primarily from earnings and the decrease of homes and inventory. This cash generation was offset by our spending on finished lots and development, and an increase in our mortgage loans held for sale. Our fiscal year to-date cash flow from operations totaled $587.1 million. We ended the quarter with approximately $1.7 billion of homebuilding cash and marketable securities, even after repurchasing $345 million of our outstanding notes in the open markets to reverse inquiries during the quarter. The balance of our public notes outstanding at June 30 was $2.2 billion. Our remaining note maturities now total only $63 million in fiscal 2010 and $205 million in fiscal 2011.

After June 30, we repurchased an additional $53.3 million of our outstanding notes, subsequent to those repurchases our board has approved a $500 million debt repurchase authorization effective through July 31, 2011. As we mentioned in our press release with these repurchases and the scheduled maturities in September our retirement of debt for the fiscal year will total at least $1 billion. Bill?

Bill Wheat

At June 30, our homebuilding leverage ratio, net of cash and marketable securities grew 17.5%, a 13.2 percentage point improvement from a year ago. Gross homebuilding leverage at June 30 was 45.6, an 8.6 percentage point improvement from a year ago. This improvement in leverage is due primarily to our cash generation and reductions of outstanding debts. Don?

Donald Tomnitz

In summary, our financial performance this quarter demonstrates the progress of our company has made toward achieving profitability, balance sheet strength and market share gains in this challenging and uncertain housing market. Our most important accomplishments this quarter include, pre-tax income totaling $46.3 million, home sales gross margins increased 590 basis points over the prior year same quarter as we continue to improve the cost and design of our products, and continue to open new communities on recently acquired lots at higher margins.

Fully loaded SG&A, which again includes all corporate overhead as the percentage of revenues was 10.4% up only $9 million on a 60% increase in homes closed. $883.6 million in homes, building, debt, repurchases and redemptions this fiscal year-to-date and total principal payments in fiscal year of 2010 will total more than $1 billion. There are still challenges in the homebuilding industry, rising foreclosures, significant existing home inventory, high unemployment, tight mortgage lending standards, the expiration of certain government support for the housing and mortgage markets and weak consumer confidence.

However, new home inventory remains low, interest rates are favorable and housing affordability is near record highs. We will continue to focus on providing affordable homes for the first time buyer, controlling our cost, contracting for new communities with attractive priced finished lots and maintaining our strong balance sheet. Consistent profitability at DHI is the ultimate goal.

DR and I celebrate our 28th anniversary in 12 days. In the 28 years we have been together, DHI is currently in the strongest position ever as evidenced by the strongest balance sheet in our history, a large national footprint, the significant in increasing penetrations in the majority of our markets and the best people in the industry. DHI has is in a preeminent position to capitalized on the future of the homebuilding industry, whatever it maybe.

Again, we thank all of our DHI team members who continued to outsell and outperform the industry. Our third quarter is over, now we need to focus intently on marching toward profitability in Q4. Keep up the great work. This concludes our prepared remarks, we will host any questions.

Question-and-Answer Session

Operator

[Operator Instructions]. Thank you our first question is coming from Joshua Pollard with Goldman Sachs. Please proceed with your question.

Joshua Pollard - Goldman Sachs

My first question is on your comments on June and July, the 20% and 10% sequential increases there, I am wondering if you feel like that is the performance you’re seeing across your markets in these two months, and if not where do you think you are taking share? Do you think it’s from other smaller private builders or do you think it’s coming from the short sales side and the existing home side?

Donald Tomnitz

Frankly I believe that we are taking market share from both the small medium size builders who are under-financed, under-capitalized, but also we continue to sell the largest percentage of new homes each quarter of all the public homebuilders. And I think that’s reflective clearly of our strategy of making spec homes available, essentially to the first time home buyers and also the realtor community who sells a large percentage of our homes. So clearly, we are taking market share from the whole industry, currently. And in terms of across our company we are seeing increases from May to June to July in each of our internal regions.

Joshua Pollard - Goldman Sachs

And then a quick follow-up to that is what percent of your sales are coming from realtors this quarter and maybe if you can compare it to a year ago? And then my bigger follow-up is if you look at the backlog burn rate its just been traveling right around that 100% range, is that something that you guys feel like you can keep up for a long time, or is that a bit more phenomena of what’s been going on with different tax credits? Thank you.

Stacey Dwyer

I think the backlog turn will moderate back in to more historical ranges. And we may be able to achieve something better than what we achieved before we went into the downturn simply because we are running with a little bit higher spec percentage, because our first time home buyer percentage is higher. But the 100% plus convergence rates that you’ve seen in the last two quarters are not something that we would expect the same.

Donald Tomnitz

On a historical basis we have focused largely on the realtor community because as you know advertising is a very small percent of our overall revenues, which is much lower than all the other builders. And frankly we appreciate the realtors very much because they bring us a qualified buyer in most instances, and we can actually assign a success rate to that a lot easier than we can in advertising. Just a rough number I would say that our realtor sales consistently average above 60%, and it depends upon clearly what kind of promotions we have going in various markets at various times. But again, the realtor community has been a big aid to Horton over its existence as 1978.

Operator

Thank you. Our next question is coming from Michael Rehaut with JPMorgan. Please proceed with your question.

Michael Rehaut - JP Morgan

First question, I was hoping if you could describe on the gross margin side if specs, obviously it’s been a key part of your strategy going forward, but if you were with ending the quarter down sequentially in terms of your homes under construction and I believe your specs as well, did that play a role in some of the sequential fall off from 2Q to 3Q and are you comfortable right now in terms of your specs in terms of what you have in inventory, I know you mentioned that you planned for further lower homes under construction in general but would you say that the sequential fall off was more due to more aggressive inventory work down during the quarter?

Bill Wheat

No we really wouldn’t like as Stacey mentioned during the call our core margins in the quarter which really represent the margins on the homes that closed actually increased by 50 bps from Q2 to Q3. We do continue to see our historic difference of 200 to 300 basis points in margins between spec and build jobs, but that certainly did not weaken during the quarter.

Michael Rehaut - JPMorgan Chase & Co.

Well I’m sorry Bill but when you say core margins, I mean your had pre-impairments went from 18.0 to 17.2 right?

Bill Wheat

The reported homes margin had decreased 80 bps sequentially. Our core margins increased about 50 bps and as Stacey referenced that was offset by routine adjustments in estimates and accruals for development and construction completion costs and warning litigation accruals. The impact on gross margin from Q2 to Q3 has offset that. I can give you an example to describe what the type of adjustment like that would be. But really it’s driven by the fluctuation in revenues. We’ve seen significant volatility in our revenues from quarter to quarter and so the same adjustment on an accrual in a low volume quarter will have a much greater impact on margins than it will in a higher volume course.

Don Tomnitz

And if there’s confusion on it, I’d certainly wish you would follow up on it as one of the things that we’re very sensitive about but also very proud of is that our core margins on our homes close did increase by 50 bps.

Michael Rehaut - JPMorgan Chase & Co.

Okay, no, I appreciate that. Thanks for the clarification. The second question just in terms of the strength in orders or the rebound that you have seen a little bit sequentially, I was wondering and I know you don’t break this out as much, but it’s an important part of the story. I believe last quarter you had said that community count was up sequentially and year-over-year by it was either lower mid single digits, if I recall. I was wondering if you can give an update as to where you are there in terms of year-over-year and sequentially for 3Q and how you’re thinking about 2011 as well.

Bill Wheat

Yeah, our active selling communities were up about 7% sequentially from Q2 to Q3, on a year-over-year basis. They are up about 20% and our goal for fiscal year ‘11 is to continue to increase our community count as we help investors as well as developers as well as banks work through there own lot positions.

Michael Rehaut - JPMorgan Chase & Co.

Would you say for 2011 you’re also looking for a double-digit gain?

Don Tomnitz

We are focusing on the gain. I don’t want to get focused on a single or double digit increase but we are certainly continuing to enter into new contracts on a daily basis in each one of our regions.

Stacey Dwyer

And a lot of whether it’s a double digit increase or single digit increase will be dependent on the level of sales that we see in the market.

Operator

Thank you our next question is coming from Josh Levin with Citigroup. Please proceed with your question.

Josh Levin – Citigroup

You said that we could see some gross margin pressure if sales I guess don’t pick up. So how do we think about that? I mean if sales continue to trend along these levels do you start lowering prices or increasing incentives, or would you wait for sales to drop from here? What’s the evolution of the pricing strategy over the next few months?

Bill Wheat

Well, clearly each one of our divisions and each one of regions have stated specific sales goals and they adjust their incentives relative to the number of units we want them to sell in close. As we have said before it doesn’t make any sense to hold out for unrealistic gross margins if the market is not willing to pay those margins.

So, as Stacey said in her conference call our margins have really ranged between 17% and 18%. Our goal is to keep that between 17% and 18%. And I would say it to you that we are going to make small adjustments as necessary to continue to hit the sales volumes and the closing volumes that we want to hit as a company.

Josh Levin – Citigroup

Okay. You talked about sequential increases in orders in July and July. Was that driven primarily by increased incentives or prices or is it more just a rebound after the tax credit drop.

Bill Wheat

I think the focus on two things really a slight rebound but secondly we have focused on sales programs and sales contest in each of our regions and we just completed one in our south region as of this weekend and had a very good sales over the weekend. So as a result one that Horton has not done a lot in the past in our history is that national and regional sales, contest and sales incentives and we are focusing on that to drive our sales and our volume and our closings in those regions where we want to drive it further.

Operator

Thank you. Our next question is coming from Alex Barron with Housing Research Central. Please proceed with your question.

Alex Barron - Housing Research Central

I wanted to ask or get a little bit more insight into your impairments. I noticed you mentioned your watch list has been dropping significantly especially quarter-over-quarter and I guess given the slowdown in the sales in the last few months, I am trying to understand what are the drivers of the watch list coming down so significantly?

Don Tomnitz

Alex, the biggest driver this year has been the improvement in our gross margin. As referenced this quarter our margins were up 590 bps in Q3 versus a year ago so as we are achieving better margins across the board that has caused a significant reduction in our watch list. This quarter specifically as we got past the tax credit and we are able to get a glimpse as to post tax credit demand we were able to more closely evaluate some individual projects and those projects that were performing better than we had assumed when we put them on the watch list we were able to remove some of those, from the watch-list.

So it’s a continual evaluation quarter-to-quarter, project-by-project and when it no longer makes sense to be on the watch-list, we take it off.

Alex Barron - Housing Research Central

Okay, got it and my other question has to do I guess with the kind of the absolute sales level or sales pace we have seen in the last few months. Now, as the tax credit has gone, do you guys feel that that’s just borrowing sales from the future or do you think it’s something more structural where certain first time buyers maybe just don’t have the means to buy a home, and what are your general thoughts about the tax credit? Do you want it to come back, or do you want it to stay off, or have you heard anything about along those lines?

Don Tomnitz

Well I think that clearly the two tax credits are for demand and now we work that as we see in July we are getting back to a more normalized demand. We had a couple of months there where we were going through the pain and the process of giving up the tax credit as the withdrawal from the federal tax credits.

Frankly, I don’t want the tax credits to be reenacted or be recreated or extended. We want to get back to a normalized market. It’s a lot easier to run a business based upon designing your business with the current demand I suppose than having any kind of stimulus or incentives to create abnormal demand. I do believe that a lot of the first time home buyers are back in the market slowly but surely as they adapt to the changing guidelines for down payments and mortgage underwriting and one of our preeminent parts of our company as our home buyers club, who continually graduate people as I educate them on how to clean up their credit and become aware of the credit systems.

Stacey Dwyer

And the expiration of the tax credit really doesn’t change the mortgage qualification or approval process. Those funds could not be used toward closing and at the time of closing toward closing costs and they could not be considered in terms of the debt to income levels or peoples qualification process.

Operator

Thank you. Our next question is coming from Timothy Jones with Maloney Securities. Please proceed with your question.

Timothy Jones - Maloney Securities

First of all what were your finished and total specs in homes under construction in March?

Stacey Dwyer

We had 13,900 homes under construction at March 31, and of that 7,300 were spec, 2,900 completed.

Timothy Jones - Maloney Securities

And how many models?

Stacey Dwyer

1,200.

Timothy Jones - Maloney Securities

Now look, when you basically brought your spec inventory down, the total spec price 1,200 units, you said at that time that you expected it to dramatically reduce your specs, and I think you did a very good job in April. But I still think that probably, having only 200 left finished units and still has in over 6,000 separate accounts with over half of your units under construction its still too high given the market we’re in right now. Would you like to comment on that?

Donald Tomnitz

Yes, certainly. We’re bringing that down as we speak and we’ve been brining that down. And at September 30, we will tell you that it will be much lower than what it is today, because we’ll get our total inventory in line with pretty much what we expect to close. Times two over the course of the next 12 months and one of our specs running somewhere around 50% of our total inventory, which is where historically we run.

Stacey Dwyer

And one of things we’re doing with our spec inventory in particular, is we’re trying to match that and keep the platforms out there for the first time home buyer. First time home buyers were up in the last quarter were 60%, and so we’re doing a good job of keeping those two numbers pretty close together.

Donald Tomnitz

So we’re en route to accomplishing your goal.

Timothy Jones - Maloney Securities

Okay. And then is there a little more about this core margin beneath the three things that have been speculative, that have affected your gross margins by 80 basis points. It’s actually more, 130 to be precise. So you think it is a (inaudible) and so forth especially the land development, how things are flowing in?

Donald Tomnitz

Absolutely, let me give you an example. Our core margins will increase by 50 basis points during the quarter, these other factors of which the largest portion of this quarter related to changes and estimates on development and construction completion costs. All these other things offset that by 130 basis points.

Timothy Jones - Maloney Securities

Is that a nice way of saying cost overruns?

Donald Tomnitz

Actually, no. It’s actually the opposite, that’s why I want to give you an example. What we see a lot of times when we wrap up a development project, is we close up the project and we have credits that maybe available to us, maybe part of reimbursements of certain of our development costs from municipalities or other entities that we may see. And so those are actually positive, have a positive impact on margin. So in this quarter, or last quarter Q2, we saw $7 million of those sorts of development credits come through as positive impact on margin. Last quarter on the low revenue that we saw in Q2 that was a 75 basis points improvement to margin, positive impact on margin.

Timothy Jones - Maloney Securities

That was the second quarter right?

Donald Tomnitz

That was the second quarter right. And of course these credits have nothing to do with our quarterly closings volume, they just occur when we wrap up the projects. This quarter, development reimbursements post closing credits from developments were around $3 million. Of course our homebuilding revenue was much higher this quarter. So that $3 million positive impact on this quarter’s homebuilding revenue was about a 25 basis point positive impact on margin. So the sequential difference between those two, 75 basis point positive in Q2 25 basis point positive in Q3 that actually causes a sequential decline, a negative impact sequentially of 50 bps.

Timothy Jones - Maloney Securities

Was that a timing issue?

Donald Tomnitz

Its timing the revenue and those items have nothing to do with the actual closings volume, and we’ve seen a lot more volatility in quarterly closings volume from quarter to quarter.

Timothy Jones - Maloney Securities

That’s very good. And the warranties, anything out of the normal go there?

Donald Tomnitz

You see some of the same sort of things in terms of sequential changes based on the revenue volume, but the warranty litigation had a 20 bps negative sequential impact. The other biggest piece was also changes on estimates on our vertical construction and the sequential change there was 40 bps.

Timothy Jones - Maloney Securities

How did that happen, why did you change your BP?

Donald Tomnitz

Well it’s the same sort of things when we close out our homes and we have estimates of what is remaining to spend, we will leave those accruals out there, we will pay our bills and then at some point there’s a day of reckoning in terms of do we need this remaining accrual. So typical there is some relief of that accrual several months after our homes closed, and so that’s typically a positive impact on margin. Last quarter in Q2, that was a 70 basis points benefit to margin, this quarter it was a 30 basis point benefit to margins. So sequentially we lost 40 bps.

Operator

[Operator Instructions] Our next question is coming from Stephen East with Ticonderoga Securities. Please proceed with your question.

Stephen East - Ticonderoga Securities

If you look at the gross margin in your backlog, your core gross margin in your backlog, given how have you all been talking about specs and pricing in driving volumes, is there any deterioration in the backlog?

Bill Wheat

You know its overall it’s hanging in pretty good Stephen. We’ve been looking at new projects and our old projects. Our new projects are hanging in above our thresholds, we’ve actually been seeing continual improvement. In our old projects as we continue to work down the cost of our homes, and adjust our product to the lower price affordable product. So we’ve seen improvement there, our in store is spread between specs and both jobs are staying about the same. And overall improving, versus what we were seeing a year ago. So overall, I think we’re continuing to make progress on our margins. Obviously we don’t know what the environment will be going forward, and we do expect this to going to continue to be a challenging environment. So we could see some pressure, but so far we’ve been able to maintain margins pretty well here last few quarters and I would say to you that and (inaudible) our south regional President and we had a screaming home sale in Texas this past weekend and we sold a number of homes and the good thing that I heard from him yesterday late was that he thinks our margins in his region stayed pretty much in the same range in all of his divisions as they were prior to the sale. So very good news to me.

Stephen East - Ticonderoga Securities

Okay, that’s exactly what I was looking for. And then you all have done a great job in buying back your debt and I wish other builders would do the same. But as you look at it when do you have a debt level target that you are trying to get to over the next year to and then if you look at qualifying inventory how close are you to your debt levels and will we see interest expense?

Don Tomnitz

Before Stacey answers that question I will tell what our desire is. We have little ways to go to get the (inaudible)

Stacey Dwyer

Yeah I would not say that we have a specific goal Stephen. We are going to opportunistically continue to reduce our debt as long as that seems to be one of our best investment alternatives. If we see a short recovery in the home building industry that may change our plans in terms of future debt reduction we still have unscheduled maturities of just over $400 million coming due in the next three years. So we are cognizant of that fact as well.

Stephen East - Ticonderoga Securities

And the qualifying inventory on it?

Stacey Dwyer

The qualifying inventory right now this quarter we expect 47% of our interest incurred. There are two factors, our debt is coming down but depending on our sales level our active inventory could come down as well. At a minimum we would expect our interest that we directly expense to continue to come down. It may not come down as a percentage of our incurred.

Operator

Thank you. Our next question is coming from Dave Goldberg with UBS. Please proceed with your question.

Dave Goldberg - UBS

I wanted to follow up on the question on the watch list a little bit and I understand that projects come off as the margins prove to be better than what you expected but what I’m trying to understand a little bit better is how you think about pricing as you kind of consider the watch list on a go forward basis. Clearly even though things improved in June and July and maybe things weren’t as good as the last time you ran the analysis but I’m just trying to get an idea of, get some more detail on maybe how you think about sales pace and price when you think about in terms of the watch list?

Bill Wheat

We try to be as realistic as we can with what we know at the time. Clearly when we were evaluating our projects during the tax credit time, we realized that the tax credit was driving some of our sales, driving some of the volume we received. So we recognized and expected that there will be some decline in absorptions post the tax credit. So this certainly has not been a surprise really in any area of our business, but our assumptions when we are looking at projects have typically assumed volumes either at or below current absorptions and typically pricing at or below current pricing. So we try to be realistic, try to be conservative in our assumptions but it is a project by project analysis and we’ll revisit again next quarter.

Don Tomnitz

And Frank, we appreciate the questions about our watch list because I’m sure all of you appreciate that we do have a watch list and share with you as opposed to our competitors.

Dave Goldberg - UBS

It’s great to give a detail but just to make sure I understand is it fair to say that conditions kind of stayed where they were at the end of July and I realize maybe the depressed pace is not necessarily reflecting exactly whether that be some hangover, would the watch list grow from where we are now or we are just going to stay where we were?

Bill Wheat

No, not necessarily, again it’s project by project but I would not expect it to change materially if things stay basically the same. As time moves on those projects that perform a little better than we assume to make come off the watch list. Those that perform a little worse and make come on the watch list. So there will be movement in and out but overall things stabilize from here. I wouldn’t expect significant changes. And one of the things helping our watch list quite frankly is our purchasing managers in the field who are doing a better and better job of buying our jobs and we frankly as we I think explained on the last conference call seeing noticeable improvements on our cost, our direct cost. That’s the primary driver behind our margin improvement this year as our cost decreases.

Dave Goldberg - UBS

And then just a quick follow up I know you guys talked about the realtors and realtors helping their sales. I am just wondering kind of commission wise what you end up paying realtors versus internal sales people and how it goes, is that on a go forward basis of existing home sales, slowing maybe that’s a good avenue for realtors to kind of look at?

Stacey Dwyer

Okay our typical commission to an outside realtor would be around 3%. There are times when we will pay more, for running a specific commission we may pay 4% or 5%. There are certain divisions that have a bonus structure. So if realtor was going to specify time periods, and sell three homes, then they would get a bonus of $500 per additional home that they close on top of the 3%. In terms of what you are seeing right into our cost of sales it’s really close to 3%. Internal sales commissions are structured a little bit differently. They are probably going to be closer to 1.25% to 1.5% in those who pay consistently on a 100% of our home that we close.

Operator

Thank you. Our next question is coming from Carl Reichardt with Wells Fargo Securities. Please proceed with your question

Carl Reichardt - Wells Fargo Securities

Kind of getting granular on this issue, I just want to make sure Bill you can’t take the development credits that you anticipate and advertise them over the life of the community on a per house basis, it’s got to be timed at the end, is that right?

Bill Wheat

No in an ongoing project if there is a change in estimate on an ongoing active project then that would be spread over the entire project. What we were discussing earlier were primarily credits that we received after the project is complete. We do our best to try to estimate what those might be, what those reimbursements might be but there’s a lot of factors that go into what the ultimate reimbursements may or credit may be and so once the project is done we close all the home we own no more lots. Any adjustments post closeout due immediately comes through the P&L.

Carl Reichardt - Wells Fargo Securities

And then Don I’m curious about what you are seeing in the finished lot market. Some of your peers have talked about continued competition for finished lots and is that a follow which you own now where you have a 2,000 or so finish. In your sense especially if you think sales are going to slow and the contribution from new projects will be 200 and 300 basis points up on the gross that you may be much less aggressive looking at finished lots over the next two or three quarters which will be of course beneficial to your cash flow and your debt buy back.

Bill Wheat

With the right price and the right terms we are going to be very aggressive as we continue to replace them of our core performing option contracts. So I believe as we move forward we will continue to be in the premium position simply because of the fact that our inventory strategy of building specs and making them available for those first time home buyers places us in the strong position where we are dealing with sellers whether they banks, investors or developers or whomever.

So I anticipate continuing to add new deals into 2011 as we mentioned earlier.

Don Tomnitz

And the way we are approaching the new deals, the investment level is limited in each project we don’t own a lot at any point in time. So we are turning our cash pretty quickly on these deal so right now it is not been a significant drain on our overall cash position simply because of the terms that we’re trying to strike on our new deals.

Operator

Thank you. Our next question is coming from Nishu Sood with Deutsche Bank. Please proceed with your question.

Nishu Sood - Deutsche Bank

I wanted to follow-up with my first question on what Carl was just asking about your land strategy. So, sticking to as you were talking about with Carl, mainly land spend on finished lots for a quick turn around. I wanted to ask specifically about challenges to that, that might cause you to begin to look more upstream to land position that require more development. First thing was obviously, some of the other builders have been talking about rising lot costs that are flung through their income statement just because of how much more aggressive a lot of your competitors have become, obviously you were earlier than folks. And the other thing was just the scarcity of those finished lots, most of the markets that we look at it sounds like there’s not that many opportunities left like that. So, are either of those challenges creeping up? So do you expect to begin to look at lesser developed deals?

Bill Wheat

Currently given what we see as the demand going forward, and we believe that the next 12-24 months will be challenging in the homebuilding industry. We have one focus right now, and that is if we invest a dollar in a piece of land or a lot, we want that dollar returned to us within 12 months. And that’s our underwriting criteria today. Are we missing some deals out there? Yes, we are missing some deals out there, by our calculations the competitors were losing those deals, two are working for 15% gross margins and a lot of the deals that they’re closing their inventory and their banking, and we don’t understand that, and we don’t want to try to understand that. But we are focused on continuing to produce a margin on our houses between 17% and 18%, and getting back every dollar we put up out to divisions within 12 months of its on own piece of raw land or whether its on a finished lot. But our main focus is continuing to do low earnest money, rolling option contracts, restructured take downs and limiting our spec inventory in those communities.

Nishu Sood - Deutsche Bank

And the second question, at the beginning of this fiscal year you told us that you had a goal of achieving profitability for this fiscal year, and it looks like you are going to come through on that, which is certainly a nice achievement given how tough things are out there. But to borrow one of my favorite phrases of yours, no good deed shall go unpunished, so I have to ask you about 2011, what are your initial thoughts on that anything you are willing to give us on that?

Donald Tomnitz

I think 2011, as I said before and 2012 both are going to be tough years in the homebuilding industry. As we mentioned on our conference call I just don’t see any sustainability of growth or profitability until we get some jobs created in this country, until consumer confidence improves. And I don’t see either one of those factors benefiting us in ‘11 and ‘12. What I will say is that we will structure this corporation’s SG&A and meet the demand that’s out there. As far as our fourth quarter is concerned, we are sitting today with about 4,400 homes in backlog; we think that places us in a decent position, to have a decent shot at being profitable in Q4, but its going to be a real challenge.

Our goal is to continue to take market share. As I was in our purchasing managers’ meeting out in Las Vegas last week, addressing over 90 vendors who came to Las Vegas, one of the things I told them was that we are focusing on market share, and at the end of the second quarter we don’t have the statistics yet, but we will have. D. R. Horton sold 25% of all the new homes at end of our second quarter sold by all the public homebuilders. So clearly, we are increasing our market share across the country, and we plan on continuing to do that at the expense of the small medium size and large builders.

Operator

Thank you. Our next question is coming from Jonathan Ellis with Bank of America Merrill Lynch. Please proceed with your question.

Jonathan Ellis - Bank of America Merrill Lynch

The first question I had was just on your cancellation rate. I noticed that it did pick up sequentially, and I am just wondering was that a function of orders that at least initially before the tax curves extended with expectation that the homes wouldn’t be completed by the end of June, or anything else we should be sensitive to in terms of the sequential change in cancellations?

Bill Wheat

No, as a matter of factor what it was directly a function of was that we wrote every deal that we could write by April 30. And we knew our cancellation rate was going to increase, and I was surprised it only increased to 28%, but nevertheless we wanted to give every buyer the opportunity to buy and close on home. And so if they had a pulse and they were warned we wrote them, and so as a result we did have some cancellations because people couldn’t qualify.

Jonathan Ellis - Bank of America Merrill Lynch

And then the second question is, just can you talk a little bit about some of the promotions in place, and I think initially the Eastern region perhaps have been a little bit more proactive, and other regions have filed subsequently in terms of offering promotions. I guess the question is, if I look into the trends in the quarter pricing on orders were down in the East on a year-over-year basis, for orders more or so than any other region and most them were actually up. Is that just because the East was more aggressive, or was it because the promotions were just more effective meaning that the customer base is more receptive to the promotions in the East than in other parts of the country?

Bill Wheat

You sort of had a pet peeve when I was in Stacey’s office this morning sort of discussing with her why we get hit with the fact that if our ASPs average sales price goes down that is a function of our incentives. When really in the East specifically, is a function of our pricing and product offerings, and two of the things the company has done is, one we have downsized our product significantly over the course of the past two years. Secondly, we have taken a lot of the amenities and upgrades out of the house, which also leads to a lower sales price. So, if you look at those two factors in particular, that’s one of the things that’s driving our ASPs lower as we continue to try to capture as big a percentage of the first-time home buyers as we possibly can.

Jonathan Ellis - Bank of America Merrill Lynch

So the mix was more a factor in the East than in the other regions, is that fair to say?

Bill Wheat

It was a function of the East building smaller and lower priced homes. And a part of that is also that they had a greater number of new communities that have factored in which are focused on the affordable products. So yes, their mix of affordable product has increased more in other regions.

Operator

Thank you. Our next question is coming from Megan McGrath with Barclays Capital. Please proceed with your question.

Megan McGrath - Barclays Capital

Just wanted to ask a little bit of a follow-up to that, and could you give us any regional color, specifically on Texas reports of mixing around the Texas market recently, but primarily focusing if that market is weakening a little bit or not growing as fast as other markets? So any commentary on Texas?

Bill Wheat

Well there are sure a lot of whiners out there among some of our competitors about Texas; I would have to say we are kicking a lot of tail in Texas. And we have some great operators in Texas, and I would say to you in Houston, we have increased our market share dramatically down there, because we have got a great division present and a great team down there because we’ve got a great diversion President and a great team down there. We continue to increase our market share in San Antonio. We continue to increase our market share in Austin and Glean and we also continue to increase our market share in the Dallas Fort Worth area which there is a report that came out recently which reflected that DR Horton had started 3200 homes and the number two builder with their five business names and operating entities in Texas markets started less than a 1000 homes so that’s an incredible position for Horton to be and to have well over two-thirds of the market in the Dallas Fort Worth area and we are continuing to penetrate our existing markets in Texas deeper and deeper and taking market share away from our competitors. Bottom line.

Megan McGrath - Barclays Capital

That’s helpful thank you and then just a follow up to the conversation about the land market, I just want to ask in general do you feel as if the land market and the market for finished lots or lots in general has adjusted yet to the slowdown in pace that we have seen in the market or are they lagging a little bit and getting sort of maybe prices more in line to get, you guys wanted them (inaudible).

Don Tomnitz

Land owners are always unrealistic whether it be an up market and a down market and I would tell you that a lot of the land and even finished loft pricing that we are seeing today is a function of the benefit of the tax credits over the last nine months and clearly the demand associated with the tax credits is far higher than the demand is going to be wouldn’t the tax credits. So I think the land sellers and that’s a major adjustment downward in the finished loft prices be able to sell the lofts where we can market a home at a current market price.

Megan McGrath - Barclays Capital

Thanks and just a quick do you have you deferred tax asset as of the end of the quarter?

Don Tomnitz

Yes let me get that for you. Its $879.2 million which is fully reserved by valuation allowance.

Operator

Thank you. Our next question comes from Dan Oppenheim with Credit Suisse. Please proceed with your question.

Dan Oppenheim - Credit Suisse

Thanks very much. I was wondering if you can talk a little bit about this trend in terms of the orders and such. You touched on the increase there in June-July. With July, where is the absorption relative to what you would like it to be in terms of your goal and is that a satisfactory levels for sales per community or do you think you need to still do more in terms of promotions and marketing in terms of trends in August-September.

Don Tomnitz

I will clearly say that our July sales are not where our goal is. And so as a result, we’re gong to continue to be aggressively marketing homes in all of our regions and all of our divisions and our sales are slower than we want them to be. They are not slower than we anticipated. We anticipated that post the tax credit, that our sales would drop off further dramatically and unfortunately they did but we’re focused on a specific level of sales in closings and we’ll focus on that and achieve that.

Dan Oppenheim - Credit Suisse

Thanks and then in the south you talked about the ability to have the promotions and generate strong sales without hurting margins there. Certainly, great to have customers respond to that, having to get anything away that way but wondering how aggressive you would end up being in terms of trying to go after the absorption.

Don Tomnitz

Clearly, our goal as Stacey mentioned, is to keep our gross margins at the 17% to 18% range. As I mentioned earlier, our phenomenal sales this past weekend in the south region in specifically the State of Texas. We held our margins very nicely during that sale and we would anticipate as we move forward is to keep our margins between 17% and 18% unless there’s a dramatic slowing of demand, more than we’re seeing today.

Operator

Our next question is coming from George Bose with KBW. Please proceed with your question.

Jade Rahmani - KBW

Yes, hi this is Jade Rahmani for Bose George from KBW. I was just wondering on your gross margin can quantify the direct impact to margins of say 1% price decline, other possible offsets in raw materials of construction cost that you are currently seeing.

Don Tomnitz

We are continuing to see significant ongoing reductions in our constructing costs, as you can see on a year-over-year basis our average selling prices are still down. But our margins are up significantly. So we have been successful in offsetting those thus far. That’s not guarantee going forward, its something we will continue to work on.

But if we see on an apples to apples house a reduction in price of 1%. We are going to the best to offset as much of it as we can but I don’t have a clear answer for you just in a theoretical case of exactly what we will be able to accomplish.

Bill Wheat

But rest assured that our vendors and our subcontractors are working very closely with us simply based on our volume. They clearly are interested in doing the business for Horton and growing their business as we continue to grow our business. So, we have ultimate cooperation from our vendors which is tremendous based upon the trade show that we had in Las Vegas last week.

Jade Rahmani - KBW

Great thanks. And then on the first time home buyer and tax credit related sales, were those on average at lower prices and can you give the percentage of May through July sales that are coming from first time home buyers.

Bill Wheat

For the quarter we had first time home buyers represent 60% of the closings that our mortgage company handled for the company. On average, since we do have probably a greater percentage of those being first time home buyers the average selling prices would be lower on those homes. It doesn’t mean the margins are lower but on average the average selling prices were a bit lower when we have a higher home buyer, first time home buyer percentage.

Jade Rahmani - KBW

Okay and so then the May through July sales were around 60% level.

Stacey Dwyer

May through July we actually get our best indication when homes close from our mortgage company. So I don’t really have good color to give you on May through July.

Don Tomnitz

And we have closings through June, that’s the (inaudible).

Operator

Thank you. Our next question is coming Joel Locker with FBN Securities. Please proceed with your question

Joel Locker - FBN Securities

Hi guys just on the, do you have a percentage of land costs as a percentage of home sales for the third quarter and if you have it for year-over-year period too.

Bill Wheat

We’ve been running right around the low 20% range on our lot costs pretty consistently for a long lot in terms of the lot cost percentage of revenue.

Joel Locker - FBN Securities

Right, so that hasn’t changed at all or just anomaly if anything.

Bill Wheat

Yeah just anomaly if anything, not much, not quite changed.

Joel Locker - FBN Securities

And your sales and obviously there was a 20% from May to June and then another 10% from July but did you give out a nominal figure for May on net orders.

Bill Wheat

No we did not. We are talking about the trend after the tax credit, after the first month post the tax grade we talked about the sequential improvement 20% of June and an additional 10% in July.

Joel Locker - FBN Securities

I mean because I guess being significantly it could be 20% down or 80% down I am just trying to get a base line to see.

Bill Wheat

Also to get that base line you would need to know how great sales may have been in April and so to really give the four picture you’d have to perhaps go back to start of the year and get..

Joel Locker - FBN Securities

Could you (inaudible) the work back from just the normal number mail, just trying to get some kind of how the quarter with one of those, and that could be 3,800 backup to sales, somewhere along those lines. So you guys, I guess are obviously not going to disclose that?

Bill Wheat

No, we prefer not to, and we did see a significant decline in May. We did see very good sales in April. I have always said a month is not a trend, so basically we’ve refused to do that over the years just simply because the quarter is really what we are focused on. April wasn’t a trend, neither was May.

Joel Locker - FBN Securities

Right and just a last question on customer deposits, just I guess backlog at quarter end, if you have that figure?

Donald Tomnitz

I’d say deposits continue to be minimum, that’s not the real reason that someone is going to close or not close a home.

Stacey Dwyer

They are running a little bit over 1% of the sales product.

Joel Locker - FBN Securities

Over 1%, alright thanks a lot guys.

Operator

Thank you. Our next question is coming from Jay McCanless with Guggenheim Partners. Please proceed with your question.

Jay McCanless - Guggenheim Partners

Could you repeat what the lots and their option were at the end of the quarter?

Bill Wheat

Lots and their option at the quarter were 29,000…

Stacey Dwyer

27,300.

Jay McCanless - Guggenheim Partners

And then my other question on August 17, you are supposed to have this thing called the future of housing finance conference. Didn’t know if you have any thoughts on that, and what if anything you would like to see come out of that conference that might help DR Horton?

Donald Tomnitz

I don’t have any expectations of any of those people right now. We are just focusing on reacting to the market and continue to grow our business back. Hopefully, we will deal with a stable market relative to what the government is doing to housing.

Stacey Dwyer

Jay our goal is to continue to deal with the market conditions that come our way that includes anything that would change on the mortgage financing front. The changes have been numerous over the three to four years of the downturn. So, we’ll continue to adapt and adjust, and as Don said that we don’t have any specific expectations or goals for that conference.

Donald Tomnitz

And frankly we as a company don’t participate with the other builders in a lot of those initiatives they have up there. We just focus on dealing with our company and meeting the challenges we have, as the challenges change from time to time.

Operator

Our last question is coming from Michael Smith with JMP Securities. Please proceed with your question.

Michael Smith - JMP Securities

I have two questions, one can you talk a little bit just about order patterns in June and July, and what I mean by that is where are you seeing strength, where is still relatively weak compared to April, if you want to geographically, or sub-markets, or mix issues or anything like that, just trying to get some color on what’s outperforming what out there?

Donald Tomnitz

You are making Stacey nervous right now, but I think we have one of our competitors who does a great job of grading the market. So I would ask you to please wait until he has his conference call, because he does a much better job than we. We’re just approaching each individual market, trying to penetrate each market more profitably as we move forward. And the color on those markets changes so dramatically from month-to-month and quarter-to-quarter that we just stop giving color on the markets.

Stacey Dwyer

In terms of those trends I would say June and July have been stronger than May, almost across the board. And June and July continue to be weaker than April, almost across the board.

Michael Smith - JMP Securities

And then second question, as far as the off balance sheet DTA that you guys have that you take evaluation allowance, now that you have been profitable a few quarters in a row and maybe going forward, do you have any visibility on when you will be able to start bringing those back on your book? And what that process might eventually look like?

Donald Tomnitz

Before Bill, answer that question, I will tell you that we will be later than most of the other builders bringing those back on just simply because of Bill.

Bill Wheat

That’s a great way to end the call.

Michael Smith - JMP Securities

I am not trying to sell any of the sense in here guys

Don Tomnitz

Well, there’s no sense and we just laugh about it, there’s nothing you can do about it.

Bill Wheat

However, if we continue to generate profits on a quarter-to-quarter basis and other builders do not, we will recognize it before them. Now, going forward it will all depend on the level of profits that we generate and how consistent we are able to and our visibility into how well we can operate profitably in the post tax credit environment. So this is our last quarter in which we will be getting some profits from the tax credit.

Next quarter, as Don has already said, its going to be challenging to be profitable but we believe it is achievable and then if to the extent that we are successful in adjusting our business to the environment for 2011 and we can continue profitability then we can start having some serious discussions around when is the appropriate time to bring that back on to the balance sheet as far as trying to he nail a specific time right now, I am not going to do that. We don’t know what next quarter and next year are going to bring but rest assured as we get closer to that time as we have better visibility, we will share that, we will disclose that in our 10-Q, we’ll let you know what we’re looking at and then you’ll start having better feel for the timing but its not going to be next quarter or two.

Michael Smith - JMP Securities

Is it safe to assume that they will comeback on in chunks as opposed to all at once?

Bill Wheat

It would typically be in larger chunks if not all as the guidance that we hear, that’s ongoing discussion as well. There’s actually not a lot of precedent out there for companies who have taken full valuation allowances and then recover and actually get back to a point where they can bring it back on our balance sheet. So, it’s an emerging item and an issue for the accounting for us to deal with as well.

Operator

Thank you. There are no further questions at this time. I would now turn the floor back over to Mr. Tomnitz for closing comment

Don Tomnitz

Thank you. We are very proud of the fact that our closings increased dramatically this last quarter. Our sales orders were only down slightly and most importantly our core margins continued to improve. I believe that proves beyond the doubt that DR Horton strategy was correct and our business model superior.

I want to thank two people, our two groups of people, one, all of the DR Horton team members who continued to outperform everyone else in the industry and most importantly our realtors who have been with us for many, many years and I think enable us to outsell everyone else in the industry. The realtors have been a great asset to DR Horton and we appreciate all the buyers you bring us.

Bottom line is that we have finished the third quarter and as I told all of our people earlier in the conference call we had, the third quarter is over and now we need to march toward profitability in the fourth quarter. So thank you very much and we appreciate everything you do for us

Operator

This concludes today teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: DR Horton Inc. Q2 2010 Earnings Call Transcript
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