KB Home CEO Discusses Q4 2010 Results – Earnings Call Transcript

Jan. 7.11 | About: KB Home (KBH)

KB Home (NYSE:KBH)

Q4 2010 Earnings Call Transcript

January 7, 2011 11:30 am ET

Executives

Jeff Mezger – President and CEO

Jeff Kaminski – EVP and CFO

Analysts

Jonathan Ellis – Bank of America Merrill Lynch

Ivy Zelman – Zelman & Associates

Michael Smith – JMP Securities

Michael Rehaut – JP Morgan

Buck Horne – Raymond James

Joshua Pollard – Goldman Sachs

David Goldberg – UBS Securities

Daniel Oppenheim – Credit Suisse

Carl Reichardt – Wells Fargo Securities

Megan McGrath – Barclays Capital

Nishu Sood – Deutsche Bank

Operator

Good day everyone and welcome to the KB Home 2010 fourth quarter and yearend earnings conference call. Today's conference call is being recorded and webcast on KB Home's website at kbhome.com. The recording will be available via telephone replay until midnight on January 16 by calling 719-457-0820 or 888-203-1112 and using the replay pass code of 4152590. A replay will also be available through KB Home's website for 30 days.

KB Home's discussion today may include certain predictions and other forward-looking statements that reflect management's current expectation 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 of its control, KB Home's actual results could materially differ from those expressed 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.

The discussion today may also include references to 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 website under Recent Releases and through the Financial Information News Release link on the right hand side of the page.

Now, I would like to turn the conference over to your host Mr. Jeff Mezger. Please go ahead, Mr. Mezger.

Jeff Mezger

Thanks, Kelsey. Happy New Year, everyone. Thank you for joining us today for a discussion of our fourth quarter and full year 2010 results. With me this morning are Jeff Kaminski, our Executive Vice President and Chief Financial Officer; and Bill Hollinger, our Senior Vice President and Chief Accounting Officer.

This morning, I’ll provide some color on our operational and financial results, and also discuss how our disciplined approach to executing on our strategic goals continues to generate steady improvement on many fronts despite the historic market conditions in which we are operating. Next, Jeff Kaminski will offer details on our financials and then I’ll conclude our prepared remarks by summarizing our outlook for KB Home as we begin the New Year. As always, we’ll then open the call to your questions.

One of our key message points today is our fourth quarter results reinforce the fact that our strategy to return our company to profitability is working. The primary components of this strategy, which we’ve consistently shared with you over the last couple of years, have remained the same.

These actions include; continuing to execute on our disciplined KBnxt Built to Order business model improving and refining our successful Open Series product offerings, right-sizing our overhead for current market conditions while retaining our growth platforms, maintaining a liquid balance sheet that allows us to be nimble and opportunistic and reinvesting in highly desirable sub-markets at attractive lot costs.

As we continue to follow this successful roadmap, we are very pleased with how we’ve transformed and repositioned our company as we head into 2011. We are also very pleased to report a profit for the fourth quarter of 2010 based on our solid financial performance in a number of areas of our business. We generated net income for the quarter of $17.4 million or $0.23 per diluted share, with these earnings driven by improvement in our core homebuilding operations. These favorable results demonstrate that we now have the capability to generate earnings on lower revenue levels based in large part on our tremendous progress in improving our gross margin and lowering our SG&A expenses.

Our reinvestment in top performing sub-markets in 2010 will create immediate opportunities for us in 2011. For the long-term, we continue to operate in 28 of the best positioned growth markets in the U.S. where we’ve experience delivering significantly higher volumes than our current levels. In essence, we’ve reset our cost to operate and breakeven volume needs and have a great opportunity to leverage our business platform as housing markets recover.

As we shared with you early in 2010 our goal was to achieve profitability at some point in the latter part of the year. In fact, on a cumulative basis, we actually achieved positive net income for the entire second half of the year, in spite of the volatility created by the homebuyer tax credits and the stronger than expected economic headwinds we experienced. While recent data suggest that the economy has started to recover, this improvement has not yet resulted in sustained job growth or higher consumer confidence, the two necessary components of any housing recovery.

We recognize that without these two drivers the combination of soft demand and excess supply will continue to be a challenge, and the overall housing recovery will be a slow one.

Having said that, there are some encouraging signs. In many markets, the most desirable sub-markets that are close to employment centers are stabilizing. These areas are demonstrating price stability, fewer foreclosures and supply and demand that are in balance. This dynamic is a result of incredible levels of affordability that are attracting buyers to these areas where they want to live but previously could not afford to. This trend will in the course of a typical recovery continue to gradually expand over time to locations that are a little further out.

At KB Home, we’ve been investing in these more desirable sub-markets that will be the first to significantly benefit once the eventual recovery and housing takes hold.

Turning back to our results, we were pleased with our overall financial performance in the fourth quarter, especially in light of the fact that we missed on our delivery projections. We delivered 1,918 homes in the fourth quarter as our backlog conversion averaged the highly efficient rate of nearly 90%.

However, deliveries were impacted by an unexpected increase in our cancellation rate, particularly during the month of November, primarily due to a more cautious mortgage underwriting environment.

In many cases, buyers who receive loan approval at the start of construction were subsequently declined as their homes neared completion. Underscoring this issue is the fact that the average FICO score of our buyers in the fourth quarter was 723. The highest level it has been in at least five years, reflecting the more stringent lending standards.

Net orders during the quarter totaled 1,085, a 25% decrease from the fourth quarter of 2009, in part due to the increased cancellation rates and new stricter underwriting guidelines I just referred to. In contrast, our gross orders were down just 17%. While our orders were disappointing, we did continue our sequential year-over-year improvement that has been occurring since the tax credit expired. We are hopeful this trend continues as we entered 2011.

During the quarter, we remained disciplined in our pricing strategy as we emphasized profit over volume. We’ll continue to evaluate the trade-off of sales pace versus margins depending on demand as we enter the selling season. On a positive note, for the first time in nearly five years, we saw an increase in year-over-year traffic levels in the fourth quarter of 2010.

While encouraging, it is also our experience that today's consumer is both patient and diligent, and is not buying a home on their first, second or even their third visit. Because of this lengthened buying process, driving increased traffic to our communities is an absolute priority.

We are constantly developing new ways to bring potential buyers in, from our offering free holiday family portraits at our communities in December to re-launching our How to Buy a Home events this month, which were such a great success last year.

In particular, we’ve an expanded emphasis on the advantages of our Build to Order approach. Our company has a history of creative marketing efforts and we’ve a lot plans for 2011.

When you coupled higher traffic levels with increased marketing outrage, the spring selling season and our plans to grand open 70 new communities in the first half of the year, it is our expectation that order rates will improve.

We’ve also been prudently planning for the future growth of our business by investing approximately $560 million in land and land development in 2010. Our strong and liquid balance sheet has allowed us to opportunistically reinvest in highly desirable sub markets at lower prices.

The kind of investments that can not only perform in today's market but have the potential for even greater margins or higher absorption rates as the market improves over time.

Our focus remains on finish lots or fully entitled land that can quickly go from land closing to housing revenue as we continue to transition KB Home into a more land alike homebuilding company.

While our average community count into 2010 was down year-over-year, we do expect for the first time in many years that we’ll increase our average community count in 2011, with sales per community that continue to be among the best in the industry, we are confident that our growing community count will bode for our business going forward.

Now, I'll turn it over to Jeff Kaminski who will provide a review of our financials.

Jeff Kaminski

Thank you, Jeff. As previously mentioned, we substantially improved our operating performance for the 11th consecutive quarter. After reporting positive homebuilding operating income for the first time in nearly four years last quarter, we repeated that encouraging result again in the fourth quarter of 2010 generating homebuilding operating income of $29.1 million compared to a loss of $81.5 million in the prior year's quarter.

On a pre-tax basis, we reported income of $15.4 million compared to the prior year's fourth quarter pre-tax loss of $91 million, and it was especially satisfying to report net income of $17.4 million or $0.23 per share in the quarter. These results included non-cash charges of just $3.2 million for inventory impairments and abandonments in the fourth quarter of 2010 versus $77.2 million of charges in the fourth quarter of 2009 relating to inventory and joint venture impairments and the abandonment of land option contracts.

On a full year basis, impairments and abandonments totaled $19.9 million in fiscal 2010 with the majority of those occurring in the first quarter compared to $206.7 million incurred in fiscal 2009.

Despite the fact that we had anticipated some pricing pressures and product mix impact reflecting in part the sale of more spec homes, our margins actually improved in the fourth quarter. Our housing gross margin, excluding impairments increased to 19.7% in the quarter versus 19% in the prior year and was also up 150 basis points sequentially over the third quarter of 2010.

Factors contributing to this performance included continued pricing discipline, as we emphasized profits over volume and increased proportion of deliveries coming out of higher priced communities in California, improved operating efficiencies and product mix.

In addition, the trend of increased deliveries coming from new communities continued during the quarter. 37% of our deliveries in the fourth quarter related to previously impaired communities compared to 79% during the same period of 2009 and 47% in the third quarter 2010.

We delivered 1,918 homes in Q4 at an average selling price of $232,500 generating $446 million in housing revenues. This higher average selling price was primarily due to regional and product mix rather than pure price appreciation. Our backlog at November 30, 2010 stood at 1,336 homes representing potential future housing revenues of approximately $263.8 million. This lower year-over-year number reflects our high backlog conversion rate, increased cancellations and softer sales in the fourth quarter.

Our SG&A expense ratio narrowed steadily throughout 2010, representing 12.5% of housing revenues in the fourth quarter. Our continued actions to reduce overheads reduced our third consecutive quarter of improvement and a notable change from where we started out in the first quarter of 2010 at 27.5%. This figure also compared favorably to the 13.8% reported in the fourth quarter 2009.

On a full year basis, we’ve achieved an SG&A expense ratio of 18.4% in 2010 in line with our guidance since the beginning of the year. We ended our fiscal year with over $1 billion in total cash, maintaining our strong and flexible balance sheet even as we may considerable investments in land and land developments totaling approximately $560 million in fiscal 2010.

Now, I'll turn the call back over to Jeff Mezger for closing remarks.

Jeff Mezger

Thanks, Jeff. As we shared today, we are making strong progress on our financial results while maintaining a sharp focus on the disciplines of our KBnxt Built to Order business model and diligently expanding our growth platform.

We are also constantly looking for ways to differentiate KB Home in the marketplace recognizing that resales remain our biggest competitors. One of the most impactful ways we are standing out against other new homes and in particular resale homes, is through our sustainability initiatives.

KB Home is receiving a lot of media and other third-party recognition for our sustainability programs and consumers are responding favorably as well. We’ve developed ways to include features that provide significant benefit to our customers without materially affecting the price of their home. In fact, our EPA ENERGY STAR qualified homes dramatically reduced our buyers' ongoing cost of home ownership.

In an industry that does not have many game changers, this is definitely one of them and KB Home has clearly established itself as the front runner in this area. We are recently named the number one green homebuilder based on a study conducted by Calvert Investments, a leading voice on corporate sustainability performance across all industries. Our overall score was almost double that of the next best performing home builder and over 10 times the average score of the remaining eight builders in the study.

These results firmly establish KB Home as the leader of the industry when it comes to sustainability. Our spirit of leadership and innovation in the area of earth-friendly homebuilding will in many ways be embodied in our GreenHouse Idea Home, created with Martha Stewart, which will be unveiled at the International Builders Show in Orlando next week.

This beautiful and highly functional home is our first net-zero energy home, which means it produces more energy than it consumes over the course of a year, a maximized energy-efficient home according to the Department of Energy that results in an annual energy credit rather than a cost for the homeowner. This is an actual KB Home floor plan that we’ll offer in Orlando that has been inspired by Martha Stewart and equipped with state-of-the-art features we believe could one day be standard in all new production homes.

The KB Home GreenHouse has served as a laboratory for us to explore technologies that are new to KB Home and we look forward to showcasing how a volume homebuilder can apply these technologies that are good for the environment and a real benefit for our customers. We’ll also leverage the showcase event to promote a new Martha Stewart community nearby that will feature this floor plan and open for sales in the spring. Our sustainability initiatives are not only ingrained in our culture, these accomplishments are cementing the KB Home brand as a number one environmental choice for homebuyers.

In addition to sustainability, we’ve also differentiated a KB Home through our brand and marketing efforts, our Open Series product innovation, and the many benefits of our Built to Order business model. From the value and choice consumers appreciate, as they go through the studio process to the risk-averse attributes of our presold delivery cycle, land like positioning, and mortgage venture with Bank of America. We also believe our business is concentrated in the right markets for when housing recovers.

In closing, let me summarize our 2010 accomplishments. We continuously improved our operating performance including reducing costs and growing margins culminated in a fourth quarter and second half profits. We refined our popular Open Series product lines lowered our cost to build and accelerated our earth-friendly homebuilding initiatives to meet the demands of today's home buyers.

We achieved record high customer satisfaction levels based on both the recent J.D. Power and Associate surveys and our own internal customer satisfaction scores and we invested in well positioned sub-markets that set us up for future growth, while maintaining over $1 billion in cash.

As gratifying as it is for our company to reach profitability in the fourth quarter and second half of 2010 we recognize that there are many challenges still facing the housing market that will likely persist until the improving economy translates into job growth and higher consumer confidence.

It was the transformation of our company over the past few years with a constant focus on operating efficiencies that allowed us to report our fourth quarter profits and set up the capability to achieve profitability at lower revenue levels. At the same time, we’ve retained the strategic leverage of our growth platform which will provide significant opportunities as the markets recover.

As we look forward to 2011, the essential elements of our strategy as a company include, adhering to the pure execution of our KBnxt Built to Order business model working diligently to expand our top line by growing our community count and increasing traffic and sales conversion levels, continuing to opportunistically invest in targeted desirable sub-markets, seeking out additional efficiencies and driving down our costs, maintaining our strong balance sheet, remaining nimble and proactive in response to the market conditions and achieving world class customer satisfaction levels.

As I have said many times, we cannot control the market but we can control how we operate within it and these strategic actions are all within our controls. We do believe the economy is starting to improve, however it will be some time before housing markets fully recover. In the mean time, KB Home will continue to execute our integrated strategy that allows us to successfully compete in today's environment as we remain committed to the goal of running a profitable business at whatever scale the market will sustain.

I'd like to recognize and congratulate the KB Home employees for their continued efforts and accomplishments. I know our company would not be this well positioned without the commitment, pride and enthusiasm that the KB Home team brings to work each day.

As we begin the New Year, we are confident that our business strategy and results have positioned us to be profitable. If the market gains strength, we're poised to generate upside. If the market does not strengthen, then we’ll react accordingly and make adjustments. We are both optimistic and cautious, but above all we are prepared for whatever the future holds.

With that Jeff, Bill and I’ll now take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question come from the line of Jonathan Ellis with Bank of America Merrill Lynch. Please go ahead.

Jonathan Ellis – Bank of America Merrill Lynch

First, I want to talk about just the cost structure. Gross margins and SG&A; on gross margins, given the strength in orders in your California market, would you expect gross margins through the first half of 2011 to remain around current levels or perhaps because of product mix shifts, there may be some gross margin compression? Then on SG&A, any reason to think that the current level of SG&A and obviously putting aside how sales commissions may affect that number, but just the G&A portion, any reason to think that that would deviate from where we are right now going into 2011?

Jeff Mezger

Jonathan, let me make a couple of comments, and then I'll refer it to Jeff K to differentiate us today to give you the specific numbers. Relative to gross margin and mix, based on where we've invested in 2010, we do expect over the year for California and Texas to become a larger parts of our mix. California, in particular, being the driver and it's difficult to peg in, say, margins will be higher and that even within California, there is a big difference in margin between a home that we deliver in Redwood Shores and a home we deliver in Sacramento within the same division. So, in any given month with our revenue levels, you can influence margin a lot by a handful of communities within the mix and again, I'll let Jeff speak to the specifics. As to SG&A, I can share that the improvements in SG&A have not necessarily been tied to the variable sales cost. I believe that our selling cost whether its commissions or closing cost has remained fairly static and the improvement is more in the other cost within that bucket. Any color there?

Jeff Kaminski

Yes, I'll add a little bit of color on the SG&A side, especially, the volume impact we are running at about 6% variable, that stayed pretty much consistent quarter-over-quarter as Jeff said and as well as in last year same quarter that brought us about $10 million of savings in the third quarter due to the top line volume levels. We had some pretty significant savings in categories such as salaries, rent, incentive compensation and insurance of about $12 million. We did had some legal recoveries during the quarter, which is good news for us as everyone is aware.

We had some unusually high legal expenses in the first part of the year and we're going through some tremendous efforts right now to gain recoveries whether it'd be through insurance or through any others means possible as we go forward. So we had about $3 million of recoveries in the quarter and plan to continue to push for that as we go into 2011. Then professional fees and outside services were also down about $3 million in dollar terms.

So, the way I characterize it is actually both on the margin side and on the SG&A side, as we’ve as always the number of the things going both ways but the predominance of the activity this quarter and during the closing process were on the positive side. So we had just about everything going the right way for us. It was a very satisfying quarter both from an expense control point of view as well as from a margin point of view and we are pleased with that result.

Jonathan Ellis – Bank of America Merrill Lynch

My second question is just looking into a community, because I appreciate the guidance in terms of 70, 80 new community openings. I think you had previously given a target of 25% growth in 2011. Maybe if you can just help us out with where community count ended this year, so we’ve a sense of what the starting point is. And then to the extent, do you still feel that your community count will grow for the full year around 25%?

Jeff Kaminski

Yes, we ended the year at about 132 communities which gave us an average for the year of 130, under our calculation methodology. As we had mentioned, we are planning to open about 70 communities in the first six months. I think, importantly, the regions where we're planning to open those communities are heavily weighted towards California in our central region, with about 50 communities opening in those two markets overall, and we are still expecting a 25% increase in that average. So, it's pretty much as planned as we've been talking about for the past couple of quarters.

Jeff Mezger

It's actually a very nice mix as we've shared where – we're positioned now where we're incurring the cost – we're starting to incur the cost of these openings as they come online in the next five months, at the same time having lowered our overhead structure. So you have a nice revenue opportunity at a lower cost levels.

Operator

The next question come from the line of Ivy Zelman with Zelman & Associates.

Ivy Zelman – Zelman & Associates

With respect to your impressive profitability, I think everyone is kind of looking at the sustainability of that, and you said that you were challenged with underwriting, that's more stringent which resulted in a pretty nice increase in cancellation. So, I guess, whether we ask it slightly different than the prior question. Your sustainability going into 2011, even on your backlog being as low as it is, do you feel pretty comfortable with that and that the revenues although likely to be down because of backlog and continue to struggle for the challenges the market should not be mitigating the profitability and enabling you to remain profitable in the first and second quarter?

Jeff Mezger

Ivy, I'll talk to the backlog in the market situation, and then Jeff can go to any guidance on where we're headed. As we mentioned in our prepared comments, we were surprised by the cancellations we incurred which were primarily on homes under construction in that dirt. As you know our business model normally your can rates higher on homes you haven't started as you sell through before you start the home. We're trying to get our arms around whether it's changes in documentation, the cautious approach that lenders are taking. I'd say that industry, not just our venture partner has required us to kind of reset expectations on what you have to provide the lenders in the process and upfront, so we don't have any surprises at the 11 hour.

I don't think that that's a sustained can rate, I think it's a short-term spike, as we'll reset and we'll figure it out and we'll go right back to work. Relative to backlog, obviously, we'd like more backlog at any time because it is crystal ball for us since we're going to stay disciplined as a Built to Order company. We shortened our cycle times, where we can take backlog and converted into deliveries and revenue much faster than in the past and heading into the year we’ve some work to do. Our backlog is down – while you can (inaudible) the percentage I want to say it's 400 or 500 in unit something like that.

So, it's not a big number to catch up and pass, and we'll wait and see what happens as we open these communities and as we see how the spring selling season evolves. We elected not to chase sales in early November at that time in the year by getting very aggressive on pricing because there is not that many buyers that are going to show up and close in three weeks there in the thanksgiving season or certainly into December, so we elected let's turn the corner in 2011 and see what type of market we're facing.

Jeff Kaminski

On the guidance side, Ivy, given the current uncertainty around the markets and the lower orders rates that we've recently experienced, we're really not planning to give detailed guidance during this call as far as how 2011 will shape up. It's that we'd like to make a few more directional comments. I guess, first of all, starting with the first quarter, given the backlog levels and what we expect volume and top line to be, it's not likely to be a profitable quarter for us. While we certainly like to push for that, it's probably not in the cards for us in the first quarter. Despite that, however, subject to the selling season again and the strength in the top line, we do believe we are well positioned to have a profitable 2011 in total as we go through the year. So that's pretty much where we're at right now as far as specifics as far as percentages. We're basically going to stay away from that during the call.

Ivy Zelman – Zelman & Associates

My second question with the media having recently discussed the joint venture you're involved in with the largest I guess, seller [ph] at 48% of Inspirada. Can you give us as much information to, I guess, mitigate uncertainty around the potential risk associated with this joint venture with JPMorgan trying to push you guys and turn it all into bankruptcy and the risk associated with the debt and taking down lots priced at $500,000 as the original value in '04?

Jeff Mezger

I am glad you asked that question Ivy, because I know that that issue has gotten some media coverage recently. Before Jeff gives you the financial details, I'd like to make a few comments about the actual Inspirada community itself, which is the development that's underlying the South Edge joint venture. To-date, we’ve delivered 534 homes at Inspirada since it opened in 2010, and it continues to be one of our best selling communities in Las Vegas due to its highly desirable location in one of the top performing submarkets of Vegas today.

We're currently opened for sale within the development and we'll actually be introducing an additional product line this spring. During the fourth quarter, we delivered 40 homes in the various Inspirada communities, where there is amenities in place including pools, there is clubhouses, there is parks, there is amphitheater. It's really a nice community where we are selling the homes today, and I'd say that because we’ve a real stake in the success of this community where we’ve our employees and also our customers that matter greatly to us.

Now, I'll talk briefly about the recent news regarding Inspirada and then Jeff can give you the financial detail. All of which is intended to address the questions that the people on the call may have. As you've seen and heard, on December 9, JPMorgan and two of the other lenders filed an involuntary Chapter 11 bankruptcy petition against the South Edge joint venture. It's another step in what's been a several year litigation process, yesterday the South Edge JV filed papers asking the bankruptcy court to dismiss the involuntary bankruptcy petition. We agree with the South Edge filing. The bankruptcy judge is scheduled to decide by early February whether the case would proceed or whether it will be dismissed. Jeff, recognizing some litigation, can you provide the details that we can share?

Jeff Kaminski

Yes, I'd be happy to, Jeff. Much of this we’ve shared in past public filings, but I think it will be helpful to go over a few things again. First of all, we’ve accounted for this entity as an unconsolidated joint venture. Subsidiary of KB Home Nevada Inc. owns 48.5% of entity and at year end, of course, we had $49 million of investment balance and the unconsolidated joint venture had bank debt of approximately $328 million in outstanding principle. The original capacity of the bank facility was about $585 million.

As you can read in our third quarter 10-Q, the company has also provided to the lenders a limited several guarantee of certain other JV's obligations which maybe triggered by an involuntary bankruptcy of venture that is not dismissed within in 60 days. At November 30, 2010, if the guarantee was not enforced, the company's maximum potential responsibility under the guarantee could have been about $180 million in principle. In addition, there may be claims by the bank for fees and for crude and unpaid interest. Our share of which could run into the tens of millions of dollars with the bank are successful.

However, none of these figures take into account any offsets or defenses that could be available to us. Also, disclosed in our third quarter 10-Q on July 6, 2010, a decision was issued in an arbitration proceeding regarding the South Edge joint venture in order to address one member's claims for specific performance of lot takedown contracts and in the alternative damages. In its decision, the arbitration panel denies the specific performance claims that would have forced the purchase of the land, and instead the panel awarded damages to one of the venture members in the amount of $36.8 million, which we thought was erroneously high and which we are seeking to reduce on appeal. KB Home Nevada Inc. will be responsible for share of the final awards.

Now let me take a minute to return to the involuntary bankruptcy filing that we discussed earlier. You may have read that the lenders are seeking the appointment of a trustee for the venture, who would then, according to the press report, attempt to force the donors, including our subsidiary, KB Home Nevada Inc. to buy land from South Edge. For a number of reasons, we do not believe that this should occur. As Jeff said, we believe that the involuntary bankruptcy petition should be dismissed. If that happens, litigation between the builders and the lenders will continue in the Federal Court. The lenders have asserted claims under other guarantees as well as other claims, all of which are disputed.

In connection with our period-end closing procedures, and in accordance with U.S. GAAP, we assess the carrying value of our joint venture investments, and we assess our potential liabilities resulting from pending litigation. In prior periods, we recorded and at year-end, we carried significant provisions on our balance sheet for potential contingencies relating to this issue. There's a wide range of possible outcomes in the South Edge litigation from good to bad, as in any complex litigation and the ultimate result could be materially different than our assessment. As Jeff said, we are proud of the Inspirada community, and we want us to continue to succeed.

We remain hopeful that we can reach a mutually satisfactory resolution with the lenders. Through the outstanding litigation, we really can't comment much beyond the above. Please also reference our 2010 Form 10-K that will be filed prior to the end of January for disclosure relating to our unconsolidated joint ventures including this one. So, like I said, that's pretty much what we're prepared to say today on the JV, and hopefully that provides some additional level of details to the folks on the phone and helps clarify some of the uncertainty around the issue.

Operator

The next question come from the line of Michael Smith with JMP Securities.

Michael Smith – JMP Securities

Just a couple of quick questions. One is, could you just give some color on what's happening out there on the land market, I know we heard early in 2009 it really got heated and then it slowed down quite a bit. I'm wondering in anticipation maybe a little bit better 2011, especially in the spring if you've seen it start to heat up again and what affect that's having on pricing in the places where you guys are looking?

Jeff Mezger

You're absolutely correct that back in the spring of '10 there was some frenzy out there as people start to feeling better about things whether it was builders or some of the speculators that are out there playing in the land market, and their frenzy quickly went away by late summer and into early fall. The public builders, in particular, continue to be very disciplined. We're not seeing a lot of pressure right now on land prices moving up, I think it has calm down again. We remain very disciplined on underwriting to our hurdles and very selective in where we're going to invest.

So if the things that hit the media like the portfolio launching with 50 bidders in the high class road show, we're not even participating in those kind of things. Most of our acquisitions continue to be created through our network, our long-term relationships with developers and land sellers. And frankly in many cases the parcel doesn't even go to market when we've tied it up. So, I think if the market improves you'll see more pressure on land pricing but we're not seeing it at this point in time.

Michael Smith – JMP Securities

Another question just to kind of follow up. You were speaking earlier Jeff, about not lowering your prices in November as a way of kind of bringing our buyers because you understood you didn't have much time – or they wouldn't have much time to close. I'm wondering if that's a way of saying that you might be more open to some price cuts or some added incentives in spring, if the demand doesn't materialize. Are you guys still kind of the opinion that's pretty inelastic at this point as, sort of, the buyers are going to come in, the buyers are going to come in, there is not a whole lot of pricing options that you have there?

Jeff Mezger

I can make a few comments, Michael. It's kind of a numbers game, and the more traffic and the more demand and the more buyers, the less you have to do to sell homes pretty fundamental theory. In November, your traffic levels are lower than they are in February or March, so you'll have more people and more interest naturally and we just elected not to even test if we lowered prices by X percent, how many more could we sell in November because I just don't think it would have had that much of an impact. As we enter the year and we've always shown flexibility to do what it takes to run our business, we’ll continue to manage each asset.

It's not a company strategy, it's a community strategy where we'll try to balance the sales pace to the price to the margin to the cash flow, what's the return, what's the best way to manage in that sub-division. If in a sub-market in that sub-division we're not getting close to the sales we need, we'll do something to make that a more attractive value proposition to the consumer. Having said that, we don't fall in the trap of throwing more incentives out there; our business model is based on value to the customer, so you won't see us playing let's make a deal, we'll offer the best value and if we're out of the market and it's not selling and we got to get out of the asset it would probably come in adjustments to price. We're hopeful here between the mix of community openings, the traffic uptick that we saw which tells us there is momentum building in consumer demand that we can fall into a, what I'll call a muted typical spring selling season and if we get that, I think we'll be fine. If it doesn't show up, we'll take whatever steps we need to, to keep selling at a level that covers our overhead.

Operator

The next question come from the line of Michael Rehaut with JP Morgan.

Michael Rehaut – JP Morgan

First question if I could just circle back to the order trends during the quarter and I was wondering if just to peel back the onion a little bit more. You had mentioned that the can rate difficulties were centered, popped up in November. Did they come back down in December and I was wondering if you could also just walk us through how the can rate trended throughout the quarter and also order trends, in general, if you saw a softer sales pace or absorption rate as you got through the quarter as well?

Jeff Mezger

Well, Michael, I had mentioned the can rate spiked in particular in November. It was higher in October than it had been. September was fairly typical and the can rate normally is the sign of how a stable or instable the market is and for a five-quarter period, our can rate had been pretty consistent. When I say can rate, we look at it both as a percent of backlog or a percent of gross and as a percent of backlog, even it had been pretty consistent for five quarters. All of a sudden it's spiked here in October and November. I don't think it was a spike because of a big shift in consumer sentiment or people that don't want to buy a home.

Normally, when people have made the decision to buy with us, been through the Studio process, have been advised that their loans are either approved or very approvable. They are now relieved and they wait for us to get their home completed and what happened here in the fall and again, particularly in November, as homes were getting completed, new conditions came up, more requirements came up and people that were once approved now can't be qualified for the home. So it was not dynamic that we're trying to get our arms around.

As we said in our prepared comments, the traffic trends in November are very, very encouraging because they were up not just November the whole quarter, but November our traffic held very well, so we can say it's a softer holiday season but traffic levels were high. Traffic was up about 11% and in December, we can share. We don't like to do a lot within the current quarter and you'll certainly don't like to gauge December as a reflection of what the overall market is going to do because of the influence of all the activities in the holidays. Even in December, our traffic levels continued to be up year-over-year, so it's very encouraging as we had ended up 2011 and we'll see what it means.

Michael Rehaut – JP Morgan

Just the second question. First off, just following up on the first question if there is any way just to comment on if can rates receded as you said you expect it to be. It's a spike you expected to come back down. I was just curious if you could comment on December but aside from that, my follow-up, my second question is on the comments from last quarter regarding spec that you saw you might increase spec as a percent of your product offering, historically, I think with the KBnxt Built to Order, it's in the single-digit perhaps of closings. I was under the impression that you are thinking may be pushing it up to 20-ish percent type of range, which is still below I think a lot of other builders but higher for you guys. With the volatility in the can rates, does that give you pause to, maybe, go back to historically how you approach spec in the lower single digits or are you going to stick with maybe a higher level of spec for you guys as we go into the spring?

Jeff Mezger

Michael, you just exceeded two questions by the way, but we'll answer it since you successfully landed it together and tied it to the same thing. We don't have with us right now what the can rate is in December; and again, we're early in the quarter. My hunch is it will settle down, and whatever it is we'll manage to that issue. Relative to the spec strategy and our Built to Order model and where we're going ahead of time or not ahead of time but into '11, it's been my experience over the years that it's not unusual to resell a spec two or three times. It's not a predictable business model.

So the last thing I would want to do is throw more specs in the ground, the lower a can rate, or to have more of a predictable revenue stream. Jeff can talk to the spec and the backlog ratios in a minute. We, as a company, have always had the goal of a 90-10 ratio, 90% sold under construction, 10% unsold. It's been elevated a little bit over the last few years, depending on what level of stability there is in the marketplace. So it's probably been 80-20, 85-15. It broke my heart to decide to go into that spec strategy going into the second half of '10. When you take a look back at the 10 years or 12 years, I personally pleaded and blessed in order to get us through this business model you risk giving it away as you are dealing with today's business environment, nevertheless we did. I think along the way it creates some confusion for our sales team or our brand or our customer.

We’ve a intense focus on getting back to our core business model, are not starting much if any inventory today maybe that odd lot that is left on a colder stack and will appear on our business model from a selling effort point of view. The spec strategy was successful relative to helping us cover revenue and achieve the deliveries that we did in the fourth quarter. But it's not something we're sustaining going forward. The flag is in the ground, we're committed to be in our Built to Order company.

Jeff Kaminski

I'll give you a little more detail on the numbers more specifically. As you know when we ended the third quarter we had a higher amount of unsold inventories as usual for KB and we had about 400 units to finish and about 600 under construction or little over a 1,000 units total. The spec sales during the fourth quarter helped to cover a part of our unexpected spike in backlog that we experienced – can spike. So, we're happy with that. The strategy work well. We sold through a fair amount of the inventory during the quarter and we ended Q4 reducing the total unsold inventory by about 300 units. So, we're down about 30% from 1,000 units down to about 700 units at the end of the fourth quarter.

Of this 700 and I think it is important to note that of this 700 about 175 of those units relates to the two Southern California condo projects that we've discussed in the past and that's pretty significant numbers. So, if you pull those out, you had about 500 specs at the end of the quarter both finished and under construction and a much more reasonable number for the business. So, in summary a few things, during the quarter, again, we did think the strategy worked well. It helped cover some of the cans that we had. As Jeff said, most of the additional specs, if any, that started during the quarter were actually as a result of cancellations, so we're really back to the business model as we've operated in the past and as we'll continue to operate it.

We'll continue to work through those unsold units through the systems, and we expect to work through those in the first half of 2011 as we get to much more normalized level for the business and for the strategy. So, we really don't see it as a problem or an issue and we're really not totally out of the line as running 2011. We do believe it will be an issue that we'll address and we'll continue to stay on our strategy of Built to Order.

Jeff Mezger

The other thing that I could add is in our experience in the fourth quarter deliveries, the margins on the inventory we did sell was lower than our Built to Order deliveries, while it got us the top line and help us cover the overhead it does mute your gross margin because your margins don't run as high. So, I like being predictable with higher margins and that sort of goal.

Operator

The next question come from the line of Buck Horne with Raymond James.

Buck Horne – Raymond James

I guess, just talking a little bit about buyer preferences right now for those that are qualifying for the mortgages and don't have any cancelled. Have you noticed any shifts in buyer preferences or the economy has started to improve here or buyers feel very value focused, are they starting to look at larger floor plans or more upgrades in options. Is there any change in the consumer, are they loosening up the purse strings any?

Jeff Mezger

One of the things I would like to add to your question, when we talk about some signs that maybe things are normalizing certainly in the more highly desirable submarkets, but prior to the frenzy, in the middle of the decade, about 50% of our buyers would go to the Studio, identify what options and features they wanted in their home and then go buy the house. That had been in place for seven or eight years prior to that and that would have suggested at the time that a buyer intended to live in the home longer and wanted exactly their features and benefits in the home. In the frenzy when people started buying to flip, or buying as an investment, or not expecting to live there very long that process really was muted and most of the people bought the home and then went to the Studio.

Over the last 90 to 120 days, we’ve seen the trend reemerge where a lot of the buyers, I don't know that it has but it's a big number, are once again visiting the Studios before they buy their home. So, it tells me we are back to a buyer that's value conscious and wants to put in the home what they want for features and benefits because they intend to live there. Having said that, I don't know that we’ve seen any material shifts over the last six to nine months relative to the selections that they are putting in their home. For most of last year, the buyer was very much value conscious. My quotes always would be the Jacuzzis and granite are gone and they would rather have an extra bedroom or a second bathroom or functions in the home or a little bit larger cabinet combination in the kitchen, things like that. So, very value conscious and a buyer that intends to live there.

Buck Horne – Raymond James

My follow-up is kind of shift here, but just wanted to drill down real on the Florida markets and just wondering what's your current thoughts are on the State of Florida in terms of the housing situation right now and would you plan to possibly shrink your presence here until we start to work through some of these foreclosure and excess vacancy issues?

Jeff Mezger

Buck, I don't know if you saw any of the comments from Bernanke this morning, but he and I seem to be on the same page because he observed that while the economy is definitely headed in the right track, there hasn't been a lot of traction on jobs. You need the jobs to help housing and he went from there right to housing and that housing still has issues. I think those two combinations are most appropriate for Florida, where a lot of the markets were driven by second homebuyers or pure speculators instead of people who want to live in the home because they were occurring in markets that didn't have a lot of jobs in the first place.

I think it will be sometime before those peripheral areas get any kind of traction in housing, up around Punta Gorda and North Fort Myers or the stretch between Palm Beach and Daytona Beach. Having said that, we're very bullish in the long run on the core markets that we're in of Jacksonville, Orlando and Central Florida, and then Tampa and the West Coast. I smiled when you asked if we are reducing our presence and that we already have by default. We are a much smaller business than we once were. I do believe we are the largest builder in Orlando, the last number I saw were – and if not the largest, one of the top builders favor staying in Jacks and to a lesser extent, Tampa. So our intent is to manage our assets, keep our position, keep our network, keep our brand, be as lean as you can on overhead and when things show the stability that we're seeing in Texas or in California, we'll go right back in and have a spring coil. So, we like to stay. We just think it's going to be one of the slower recoveries.

Operator

The next question come from the line of Joshua Pollard with Goldman Sachs.

Joshua Pollard – Goldman Sachs

The first is, you talked about having higher traffic levels in the fourth quarter and I think even into December. I'm looking at the comp and the fact that the first version of the homebuyer tax credit expired right around this time last year. When you guys look out to the first half of 2011, would you anticipate that traffic levels would continue to be higher than they were versus the previous year comp?

Jeff Kaminski

Let me make an observation for you, Josh, and then I'll give you my thoughts. We stopped promoting that first tax credit in July and August because we are a Built to Order company and you had to sell it in order to build it and still qualify for the credit. So, our promotions tied to the credit actually ended midyear. In '10, about this time last year, we saw an uptick in traffic. We saw an uptick in interest. My sense is the tax credit didn't start to be a real driver till March and April when you approach the deadline, and there was this urgency created because of the deadline. It is normal this time of the year for traffic to pick up. I find it very interesting that in the November, December period, traffic picked up, when in theory it's everything else going on and people aren't out looking for houses. So, it's encouraging, and I would expect traffic levels overall will be up in the next few months because of the time of the year we're in, unclear whether it's going to be up greater than it was with the tax credit influence, but we'll see it. It's as an encouraging sign.

Joshua Pollard – Goldman Sachs

The other question I have, and I'll make it a two part question in Mike Rehaut's fashion, but I won't tie them together. The first is on your balance sheet, with your debt levels, I think you guys are net debt to cap roughly 55%. Are you guys comfortable there, or in the cautiousness of your outlook, do you guys think that it starts to make more sense to start paying down debt with your cash? I'd love to understand what you guys think is more than just a long-term capital structure, but where you think your capital structure should be over the next 12 to 18 months? The other question I had because I want to try and sneak it in is if you look at your spec as a percentage of your backlog, it was under 40% at the beginning of this fourth quarter. As you guys head into the first quarter, it's over 50%. That's just a quick calculation of what your spec count is relative to your backlog. I'm trying to understand how that supports stable to higher margins?

Jeff Mezger

I’ll speak high level, and then Jeff can share his thoughts on our balance sheet. First off, in normal times our range of a comfortable ratio as we've been for years is 45% to 55%. We are net debt 55% today, but you're excluding the value of the DTA and as we can restore profitability. If that DTA were to reverse, you've got a ratio significantly below that, I think it's even under 30%. Obviously, nobody knows when that will be reversed and what impact it would be, but I want to remind people that there is another element to this that's influencing our ratio relative to historical.

On the sec-level, again keep in mind of those numbers you just rattled off, 170 of them are tied to two condo project. One of which we just started reporting in the – not those numbers in the fourth quarter. So you have to look at each community on its own and these condo buildings, you don't open for sale till they are completed. So it's going to look like we’ve more inventory. If you back those two out, what is in our backlog and you've got this inventory, I think your ratio is much better and we demonstrated in the fourth quarter we got rid of some inventory. It did hurt margin, yet our overall margin was favorable. As I have shared on this call, we'll deal with each community on its own and keep the balance of sales pace and margin. Any thoughts on capital structure?

Jeff Kaminski

Yes, I'll talk about the balance sheet for a minute. First of all, Josh, yes, we are comfortable with our debt levels right now from the point of view of being able to obviously to service the debt and also to refinance the company as we’ve maturities. I think you are aware that we do have a $100 million maturing in August of this year, which we obviously tend to take down and at this point not replace, so we'll get some more leverage out of that. We also had some project debt that we're looking at taking down in, actually, certainly in the first quarter and with its combination of that two, we'll obviously have some leverage improvement. There are some opportunities beyond that. Those opportunity that we are exploring to reduce the negative carry, as you know with the $1 billion in cash and the debt levels we’ve and with the current interest rate environment, we are experiencing some negative carry, very obviously statement on the outlook are on the full power right now and we are exploring those opportunities to reduce debt.

Jeff Mezger

I can share also that we recognized the cash. It's an interesting observation when you say the cash is a dead asset and it's relative to us not generating any return or it could be used to lower your cost or debt restructuring. Having said that, it's also our opportunity for growth and our assurance that we can be able to manage through an extended downturn, and I continue to look at the economic environment. If things were to work again, I think the cash will come in handy. There isn't a day that goes by that Jeff and the team aren't talking about what to do with this or I mean they are talking about what to do with this. So it's definitely on our radar, and as Jeff said, we are exploring alternative but there is nothing we're ready to say we want to do right now.

Operator

The next question come from the line of David Goldberg with UBS Securities.

David Goldberg – UBS Securities

The first question I had, I was wondering if there was a way to tie the increase in traffic maybe not coming through in orders at this point, just something with the underwriting standards. In other words, do you think the people that are coming into the community can qualify under tighter underwriting standards, do you think that's an issue for people that are out there shopping now, but maybe not moving forward with the decision?

Jeff Mezger

Obviously, tighter underwriting standards are going to reduce the number of potential buyers, but some of the anecdotes I was sharing, David, these buyers that we were managing through in Q4, it wasn't always income or credit, it was other issues, other conditions, other documents, other requirements that came into play that may not have been as big an issue in the past. Whether it's FHA & VA or conforming conventional, the money is still available. We've have been selling homes at the (inaudible) with the FICO scores and FHA for some time now. So, it absolutely reduces your pool but there is still a pool out there for us that is more than ample to service our business needs.

I think it gets down to people. May or may not feel good about the economy, may or may not feel good about their jobs, definitely see the traction to the affordability levels that are out there today and that the appeal of our proposition, the product that we’ve to offer. They are just taking their time. The days of the floor pop are gone, as I used to call it. I think because of that, our strategy is let's go invest and be more aggressive to generate more traffic. It's a numbers game, the more traffic you get the more sales you get and depending on your conversion of traffic to sales, you'll target a traffic goal that will eventually turn into a sales goal.

Jeff Kaminski

I wouldn't tie it to the qualifying. I just say people are cautious and concerned.

David Goldberg – UBS Securities

Jeff Kaminski, just to make sure I understand, with the change in the SG&A that you outlined in the comments, my understanding was about, if we look sequentially, and the number was about $23 million reduction in the SG&A and I think you said $10 million came from variable cost reduction and just lower volumes generally and the remainder was from fixed cost, if I understood you correctly. Within this fixed cost, it seems like it was $6 million delta from legal cost of which about half of that was recoveries and the other half was not incurring the additional legal cost that were out there. Is that correct how I heard that?

Jeff Kaminski

Well, yes, it's correct in some respect and maybe incorrect in others. First of all, the comps and the numbers, I went through, were year-over-year, so it wasn't third quarter to fourth, it was fourth to fourth. I thought that was a fair comparison and the way to depict it due to some seasonality that you always get in the fourth quarter. So, with the $173 million odd reduction in volume, that had about a 6% expense savings associated with it, because that's a part of variable cost ratio. So, that's where we started the other comp numbers were compared to that prior year. You are correct in your assessment on the legal side. We did have $3 million of recoveries, and we had $3 million of improvements of reduced basically professional and not just legal, but overall professional and other outside service cost during the quarter.

Operator

The next question come from the line of Daniel Oppenheim with Credit Suisse.

Daniel Oppenheim – Credit Suisse

I was wondering if you can talk a little bit more about the specs. I guess, what last quarter you talked about, 850 specs, now you're saying that the number is really 1,000, but either way it came down to 700, but you said the cancellation rate went up in October, November closer to the end of the quarter, and that you weren't pushing the volume. Was it that your spec levels came down significantly in September at the start of the quarter? Just trying to understand what has happened and if you have cancellations in the quarter, typically that means more specs, not fewer.

Jeff Kaminski

Dan, just to clarifying the numbers. At the end of last quarter, the 1,000 specs that was total, that was the gross. It was 850 or roughly 850 net of the condo units; just a quick clarification on that. We’ve been separating that as we talked about before because of the nature of condo buildings where you're putting up the building and you're building the units, and by definition, if you choose to open the building all at once, you have all those spec units either under construction or final. So, that's the situation with the numbers.

Jeff Mezger

The other thing I could add Dan, and you've tracked us for a long time. Typically, we've had the benefit of a backlog that's stable and delivers when the home is completed, and it got disrupted earlier a few years ago when things got a little more fragile, and it has settled down for five quarters in a row, but the can rate, we didn't break it out between inventory we sold in the quarter and presold homes that came to completion, and then the buyer couldn't qualify or didn't perform, but there was a lot of cans that occurred on homes that were sold and in construction at the start of the fourth quarter. So, if you look at it, we're covering some of the inventory and we've shared that that did help with the revenue. We’ve some cans on some of those that were started that we then would have covered, but overall, we dropped our – if you eliminate the noise of these condos that are not a large part of our business, we dropped our inventories I would project 300 units in the quarter.

Daniel Oppenheim – Credit Suisse

On gross margins, there's a significant sequential increase there in contrast of what we're seeing from most others in the industry. You're selling more specs in the quarter, which typically isn't good for gross margins. The ASP on closings was significantly higher than ASP on backlog. Seems that there are some things going on there, I guess. How do you describe what's underlying trends there and as you think about that into the start of 2011?

Jeff Mezger

We know the margins were lower on the inventory deliveries, the spec sales that delivered. We also shared that we're seeing more business come out of our new communities, as we open them. So, you have this lift going on of 'good bank', I put specs in the bad bank. You had offsets going both ways on margin that blended together, had a very nice outcome. At our revenue size, your margin can move around a lot depending on the mix, and if we deliver 50 homes out of San Jose or Redwood Shores at a $100,000 a copy in margin versus a suburban Houston home at 15,000 a copy in margin, it's a big difference. So we don't have the straight line we once had when we had a lot more scale, but I don't know if you want get more thoughts on it.

Jeff Kaminski

The drivers that we talked about during the first part were the main drivers on the margin. The pricing discipline, the specs were less of an impact than we had thought coming into it, our mix shifted a bit during the quarter versus what we had anticipated, and it is significant that we did decrease the level of deliveries coming from previously impaired communalities by another 10 percentage point during the quarter. So it was like I said earlier on the SG&A and the margin, virtually any of the factors, almost all the factors were positive this quarter, which is a little bit unusual. You usually get more assets going both ways and we had a very fortunate quarter and a very good quarter of management by the team here at KB Home to generate the result.

Operator

The next question come from the line of Carl Reichardt with Wells Fargo Securities

Carl Reichardt – Wells Fargo Securities

First do you have the owned and auction lot counts at the end of quarter, Bill?

Jeff Kaminski

We had 9,300 lots auctioned at the end of the quarter, we had 39,500 in total.

Carl Reichardt – Wells Fargo Securities

Can you talk a little bit about to the extent you have a projected land spend for 2011, and land in development spend, and also do you think there will be a point over '11 or into '12 a tipping point where your qualifying inventory balance will start to allow you to cutback your interest expense and capitalized more?

Jeff Mezger

Carl, I can make the few comments. We haven't pegged the number yet for '11 on land spend, whether for acquisition or development. Frankly, our sales experience over the next three to four months will drive that. We continue to be opportunistic in these preferred submarkets that I'm talking about and we continue to underwrite at today's price, which gives you an automatic governor on how much money you're going to spend and to our hurdle. So you have these governors in place where we're opportunistic, but it needs to make sense, it needs to be aligned with our strategy, and for the year in '10, as I recall, we ended up growing our lots owned and controlled by about 2,000 through the year.

Heading into '11, we've now demonstrated and you know we’ve $1 billion on the books, we can be as aggressive as we're comfortable with and we can be as prudent as we need to be depending on where the market take us. I don't think anybody has asked the question yet, but our investment heavily, heavily weighted to do highly desirable submarkets in California right now. I say that because in a lot of the other markets it's an easy term option and you can buy a lot when you sell a home, but those also are places where the market is not as robust. So we're spending the dollars in the right places. We're not really going to give a guidance. You know we’ve capacity and the ability, but we want to see how the year unfolds.

Jeff Kaminski

I'll just add to that a little bit, as Jeff said, the underwriting process continues to be very disciplined at the company. We'll continue that as we go into 2011 and it won't waiver as we go forward. On the capitalized interest question, my view on that and maybe coming from outside the industry is a little bit different than you hear from others. Interest is interest to me. Whether you are going to put it up in inventory and defer the expensing of it in a future period or take it upfront, I'm less sensitive on it. I tend to look more at the cap side and the cash impact on the business. KB Home has a relatively conservative capitalization policy here within the company.

As a result, we probably cap less than you might see out of some of the peers, but I do know, at the bottom line, it really doesn't make a difference over time on that policy. It's just a deferral of expense. What if we hit an inflection point during 2011, as you said? To be seen, I guess, depending on the land spend. We like our land-like position. We definitely like the underwriting that we're going through in the new communities that we’ve coming online, and depending on the spend, pretty much I would say it's going to depend more on the spend in the second half of the year whether we actually hit that inflection point or not.

Jeff Mezger

I can also add the observation. Our inventory was up year-over-year for the first time in many years. To me that's a good thing because it's inventory coming in the door in desirable submarkets as we continue to clean out and whittle away some of our holdings that weren't performing so well. So, it's not tied to house inventory; it's investment in our future. You'd love to see our inventory grow more right now, but it would only be if the investments makes sense.

Operator

The next question come from the line of Megan McGrath with Barclays Capital.

Megan McGrath – Barclays Capital

Most of my questions have been answered, but just wanted to see if you could give us any more detail on the submarkets that you talked about, the two areas that you are really focusing on for the first half of '11 being California and Texas and why your decision to go very aggressively there? Is that where you found the best deals on land, so you are seeing a return, or are you seeing incrementally better traffic patterns in those two areas of the country or both?

Jeff Mezger

You'll never find the best deals where your strategy is targeted because everyone knows that's where the better opportunities are. It requires a lot of digging and had work to uncover and negotiate and tie up the assets that are in a more preferred market, because they are typically more land constrained and that's what creates a better supply and demand balance. When we walked through our investment dashboard in every city, we’ll balance how resell inventory is performing, what levels is it at, what's pricing doing, is it stable or not, and to us a market is imbalanced when prices are stable or up, and there is a six-month or less supply of resale, and through pretty much all of 2010, the more coastal oriented markets of California were demonstrating all the statistics that would suggest it's a good place to invest.

They are in particular has held very well, frankly, through this whole cycle and Southern Cal had a bump so prices dropped much more, but where they dropped was 60 to 100 miles from the coast not in Orange County or closer to the coast in L.A. County or around Chino and Corona, and those are more close-in submarkets near job. So we’ve a strategy in every city. Those metrics will drive it. If you over the Texas, Austin and San Antonio in particular, are seeing good job growth right now. They are easier places to play in the market and find opportunities that align with your strategy, but whether it's the military, that's stimulating things there or just the overall excess economy, they're performing better and compare that and contrast it with a Phoenix, where there is a lot of inventories still and prices are still under a lot of pressure, you wouldn't strategically say, let's go, grow our Phoenix business. We like every city we're in. We just will use your dashboard and our underwriting requirements to keep control of where we spend.

Megan McGrath – Barclays Capital

California, no concern there that you sort of had a doubly positive impact in 2010 because they had their own tax credit or have they really – they've maintained that same momentum throughout the year?

Jeff Kaminski

Yes, the first tax credit in California, Megan, absolutely was favorable. It was favorable because it was only on new homes, it was $10,000 and you could literally monetize it at closing. Between the federal and the state tax credit you therefore had $18,000 in tax credit, definitely a motivator that helped us in the spring and summer of '09. The tax credit for '10 did not have nearly that kind of impact. For starters the refund was spread over three years and you needed a calculus degree to understand what your refund would be. It was a very complex formula, had a specific tax situations for each customers. So, it didn't have the impact that the previous one did.

Operator

The next question come from the line of Nishu Sood with Deutsche Bank.

Nishu Sood – Deutsche Bank

The trend from your third quarter EPS to your fourth quarter EPS, if I look at the last few years, the last three years there has been a dramatic, dramatic upswing in your margin performance from the third to fourth quarter. Now, obviously there is seasonality for ever build related to the fourth quarter, but it's been a lot more dramatic for you folks both on the gross and the estate margin line. So, I was wondering if you could maybe help us to understand that maybe that's due to your fiscal year end, maybe the November versus the calendar quarters for the other builders, maybe it was just a function of the downturn since it was just the last three years and that should go away. I was just wondering if you cold may be help us wrap our heads around that?

Jeff Mezger

I would make a couple of comments again and then Jeff can give you his thoughts. It's very interesting in the years I had been in public home building, which are now too many for me to even share anymore, because I am starting to feel old. Every company, depending on when their fiscal year end is, has a great fourth quarter. We always say, it's a seasonal business, but whether it was a spring fiscal, a fall fiscal, or a December, you seem to have a great quarter and results typically in your fourth quarter. One of the interesting things for us that does influence the margins is that these communities that we're getting into are not several year investments. They are typically 60 lots or 100 lots or 140 lots. We work hard to get them open in January, February, March, and then a lot of them close out in your fourth quarter. So, many of the smaller more desirable area communities that we open will open and close in the same year. They typically have a delivery spike in Q4. So, that's one of the influence. I also know that volume can influence these ratios as well to a degree. If you look at this year our Q3 and Q4 we had a lot of higher delivery volume than the first half.

Nishu Sood – Deutsche Bank

In the first question – I am not sure, maybe I didn't ask you correctly, I was asking why the seasonality would have been more pronounced in the last couple of years as opposed to – normally I understand that the fourth quarter obviously is strongest, but I don't know if you have any particular thoughts on that. But my second question was just you'd mentioned the percentage of your closings that were from communities that are not impaired, should I take the inverse of that to be the percentage of closings that are in new communities. I was just wondering if you could give us a sense of what that number is now that's trended and what you are expected to be going forward?

Jeff Kaminski

Yes. I'd say generally you can look at the inverse of that as being newer communities. It's not a 100% across the board because we do obviously have some older communities 'that were not impaired.' Generally, you can look at that as meaning newer land, newer land purchases and newer acquisitions that we're working through.

Operator

Ladies and gentlemen, once again that was all the time we’ve for questions. Mr. Mezger, I'll turn it back to you for closing or additional remarks.

Jeff Mezger

Thanks again, Kelsey. When you combine the power of more efficiently run homebuilding company with an expanded community count and even more compelling value proposition for consumers plus the reduce competitive landscape, the incredible opportunity ahead of us really begins to come into view and we're excited as we enter 2011. I'd like to thank everyone for attending. Have a great day and we look forward to talking to you again soon.

Operator

Thank you, Mr. Mezger. Again, ladies and gentlemen, that does conclude our conference for today. We thank you all for your participation.

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