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Executives

Jeffrey Mezger - Chief Executive Officer, President and Director

Jeff Kaminski - Chief Financial Officer and Executive Vice President

Analysts

Daniel Oppenheim - Crédit Suisse AG

Stephen East - Ticonderoga Securities LLC

Rob Hansen - Deutsche Bank Securities

Michael Rehaut - JP Morgan Chase & Co

Robert Wetenhall - RBC Capital Markets, LLC

Michael Widner - Stifel, Nicolaus & Co., Inc.

Buck Horne - Raymond James & Associates, Inc.

James McCanless - Guggenheim Securities, LLC

Adam Rudiger - Wells Fargo Securities, LLC

Susan Berliner - Bear Stearns

Joshua Pollard - Goldman Sachs Group Inc.

KB Home (KBH) Q1 2011 Earnings Call April 5, 2011 11:30 AM ET

Operator

Good day, everyone. Welcome to KB Home's 2011 First Quarter 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 April 12, 2011, by calling (719) 457-0820 or (888) 203-1112, and using the replay pass code of 6020115. 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 expectations or forecasts 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 be materially different from those expressed in or implied by the forward-looking statements. Many of these risk factors are identified in KB Home's filings with the SEC, which the company urges you to read with care.

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 as 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 releases link on the right-hand side of the page.

I'll now turn the conference call over to Mr. Jeff Mezger. Please go ahead, sir.

Jeffrey Mezger

Thank you, James. I'd like to thank everyone for joining us today for a review of our results for the first quarter of 2011. 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. I will begin this morning with some comments on our results for the first quarter, which were obviously a disappointment for us. I'll also provide some color on market trends, while Jeff Kaminski will discuss the details of our financial results. After a few closing comments, we will then open it up for your questions.

As we observed during our year end call in early January, our favorable financial results for the fourth quarter of 2010 reflected a number of factors that worked in our favor. We reported relatively high deliveries in revenue, our highest gross margins of the year, reduced SG&A expenses and solid leverage on both gross margin and SG&A that resulted in a pretax profit.

In contrast, our results for the first quarter of 2011 reflect the combined impact of factors that worked against us. Entering the year, we guided that our low level of backlog would result in lower revenues and a loss for the first quarter. While we did have an above average conversion rate of backlog to deliveries in the quarter, the drop in our revenue dramatically impacted both margin and our SG&A ratio, even though our SG&A expenses were down during the quarter.

At the same time, we recognized substantial charges related to the South Edge joint venture prompted by the court decision that we reported in February. Taken together, these negative factors blur much of the underlying progress we have made over the past few years in repositioning our company.

As the year unfolds, we plan to grow our revenue in part as a result of opening more communities and believe that this volume leverage will cause our financial metrics to settle back into balance by the second half of the year.

Due to the financial impact of the events in the quarter, we do not anticipate a net profit for 2011. However, we maintain that our operating strategy has us positioned to achieve profitability at some point later in 2011.

From a macroeconomic perspective, the economy is continuing to improve. We are pleased by the encouraging trends in many sectors. Even so, this recovery has yet to include significant job growth and has not spilled over into housing. The recently reported Case-Shiller Home Price Index and consumer confidence data further underscore the headwinds that housing markets continue to face. These headwinds will not go away, and a sustained broad-based housing recovery will not occur until we start to experience material job creation and higher consumer confidence levels.

Having said that, we are seeing evidence of stability in many of the more desirable submarkets, those located close to employment centers that feature supply and demand that is in balance and offer affordability levels that are extremely compelling relative to historical norms.

While the recently reported new home and resale data reinforces that a difficult housing environment continues nationally, the positive submarket trends we're seeing reinforce that housing is a very local business. We've been capitalizing on these trends by focusing our investment and community development in these high preference submarkets. As the stabilization process gains traction over time, we expect to see the housing recovery gradually spread to adjacent submarkets within each metro area, and our investment and revenue growth strategy will broaden as the recovery evolves. In the meantime, we will remain selective in our investments, continue to open new communities, work to increase sales and grow our backlog and take additional steps to align our overhead levels with projected revenue.

Turning now to our results. We reported an operating loss for the quarter of $48 million versus $36 million for the first quarter of last year. Excluding the South Edge loan guarantee loss in 2011 and inventory related charges in both years, we were essentially flat year-over-year despite a 28% reduction in deliveries.

Our pretax results for the first quarter included a large financial impact from charges we booked related to the South Edge joint venture. While we were surprised and disappointed with the court's ruling in February, we are endeavoring the work together with the banks and other builders in the South Edge joint venture in an effort to resolve the current situation and to gain ownership of the rest of this well-located master planned community.

The overall Las Vegas housing market continues to have its challenges. However, our Las Vegas division is actually performing quite well, with some of the highest sales rate per community in the company. Over time, the land-constrained Las Vegas market will recover and thrive once again, and we believe that our Inspirada community, including the land that we expect to get out of the South Edge bankruptcy has tremendous value to our business. Jeff Kaminski will provide further detail regarding the South Edge financial impact.

On the sales front, we normally limit our comments to activity within the quarter. However, given the unusual tax credit influence of last year and investor interest in realtime data relative to the current selling season, we have elected to also share our sales and traffic activity for the month of March. Today's consumers remain very cautious, whether they have concerns about home prices falling further, their job status, their ability to qualify for a loan or general confidence in the economy. The timeline to make the purchase decision has extended significantly, with a typical buyer visiting a community numerous times before signing a purchase contract.

As we reported, net orders in the quarter were down 32% year-over-year to 1,302. While we are not pleased with this result, there were encouraging trends that developed as the quarter played out. In all three months of our first quarter, traffic levels per community continued to be higher than the prior year, similar to our experiences in the fourth quarter.

On the sales side, our net orders improved sequentially each month from 276 homes in December to 400 in January and 626 in February. It was in February of last year that the tax credits started to gain traction with the consumer and as a result, we had a 36% shortfall for the month versus the prior year, even with the sequential increase over January.

For March, a month in which we also experienced a positive impact from the tax credit last year, we closed the gap in year-over-year net orders significantly, falling short by less than 6%, with 763 reported net sales for the month.

We generated sequential gains in net sales each week during March, and we anticipate sustaining solid sales results as we open up additional communities throughout the second quarter. We will have a negative year-over-year comp in April, which was the strongest sales month of 2010 and was also the last month of the tax credit. As you may recall, we reported that May sales results last year post-tax credit were extremely weak, and that our third and fourth quarter results did not materially improve from there. As a result, post-April this year, we expect to sustain positive year-over-year monthly sales comps for the balance of the year, which should be strong enough to lead to a favorable year-over-year comparison in 2011. This should also set us up with a larger backlog and momentum as we enter 2012.

Part of the improvement in March is tied to the performance of our new community openings in the first quarter and highlights that there are pockets of opportunity in every market. Our new communities that have opened are, for the most part, exceeding our pro forma projections. In the select submarkets where these grand openings are occurring, we are experiencing a solid sales pace that relies on traditional demand, driven by high affordability, desirable locations and the right product offerings.

Our focus remains on competing profitably with resales, our largest and fiercest competitor. While we cannot always compete with resales on price, we can absolutely compete through offering floor plans that meet the needs of today's homebuyer, a broad choice of features and options in our studios with our Built to Order approach, quality locations and most importantly, we can compete favorably against resales' total cost of home ownership.

A great example of our product's lower total cost of home ownership as demonstrated in the marketplace is our new KB Home Energy Performance Guide or EPG. As our sustainability initiatives have evolved, we now have the capability via third-party consultants to calculate and communicate to the consumer a projection of what their approximate utility costs should be in every community company-wide. The EPG marks the first time we have been able to truly quantify and project the financial benefit of the energy efficiency of a KB Home to the consumer and the advantage versus resales is significant.

The EPG was strategically launched in mid-February, just in time for the spring selling season, with a two-day major media tour that generated almost 200 million media impressions. As a result of this incredible media buzz, the EPG program is not only bringing more traffic to our communities, homebuyers are now choosing KB Home specifically because of the EPG projected savings and peace of mind that it brings as they plan their monthly home ownership costs. It is not uncommon to hear reports from our customers that the savings versus resale exceeds $100 per month. In today's economy, where every dollar is important, these savings are meaningful to our buyer.

On our last earnings call, we told you about the KB Home GreenHouse, an idea home created with Martha Stewart, our first net zero energy concept home in Orlando that also featured state-of-the-art water and energy-saving technologies. The home is registered with the Department of Energy, having the capability of actually selling power back to the grid. More than 2,000 people toured the home during the event, which also helped us to promote our nearby communities. We received such a positive response that we are now planning to build a net zero energy concept home within a model park in every division in 2011. Not only is it a terrific traffic generator for our communities, it's a great way to showcase KB Home's energy programs and available energy options for the consumer.

A third innovative energy program is our recent announcement that, for the first time, KB Home will be offering solar power systems as standard in 10 new home communities across Southern California. We are leveraging our strategic partnerships and supply chain in order to provide this valuable feature on our homes, while keeping them priced affordably and also presenting the consumer the opportunity for a potential federal tax credit. This is just another example of how we are setting KB Home apart in a competitive marketplace. If this program is positively received by the consumers, we have the capability to quickly expand it to other markets outside of Southern California.

Before I turn the call over to Jeff, I want to provide an update on our KBA Mortgage joint venture. During the quarter, we were informally advised by Bank of America that they want to strategically move away from operating under joint venture structures in their business. Recognizing that we still have over nine years remaining on our joint venture contract, we are working with them to see if we can restructure our relationship in a manner that is beneficial to both parties. As we explore new options, our business will continue to operate as usual. We are working toward a seamless transition for our business and our customers, both today and as we move to a new relationship.

Now I will turn the call over to Jeff Kaminski. Jeff?

Jeff Kaminski

Thank you. Jeff mentioned in his remarks that there are many factors that came together during the quarter to adversely impact our financial results. However, beneath the surface, there is underlying improvement and momentum in our business, and many of our financial metrics reflect this dynamic as well.

Our pretax loss in the first quarter of 2011 was $114.1 million compared to $54.5 million in the prior year. The current year quarter included $77 million of charges relating to the South Edge joint venture and $1.8 million of inventory-related charges. Our pretax loss in the first quarter of 2010 included $13 million of inventory-related charges.

Excluding the South Edge impact, as well as the inventory-related charges from both periods, we actually narrowed our pretax loss to $35.8 million, a 13% improvement versus 2010. We delivered 949 homes in the first quarter, representing a backlog conversion rate of 71%. Those homes had an average selling price of approximately $206,000, generating $195.2 million in housing revenues. This compared to 1,326 deliveries in the year ago quarter and an average selling price of approximately $198,000.

Housing gross margin excluding impairments was 13.4% in the first quarter of 2011 versus 18.8% in the prior year and 19.7% in the fourth quarter of 2010. Our lower overall volume of deliveries in the quarter had a significant impact on this number, accounting for 410 basis points of the sequential decrease from the fourth quarter to the first quarter. As compared to Q4 2010, we delivered roughly 1/2 the number of homes in the first quarter and at the same time, maintained field infrastructure necessary to support new community openings and revenue expansion later in the year. This obviously had a large negative impact on margins in the current quarter.

Other factors included the closeout of certain top-performing communities in Q4, some pricing pressure in select markets and to a lesser extent, a shift in regional and product mix.

Our selling, general and administrative expenses in the first quarter were $49.6 million versus $72.2 million in the same quarter the prior year and $55.7 million in the fourth quarter of 2010. Reduced revenue levels obviously had a major impact on our SG&A percentage, and while this is typical of our first quarter, it did show an improvement versus the prior year as implemented cost-reduction initiatives benefited this year and the first quarter of 2010 included significant legal expenses, which did not repeat.

On a sequential basis, significant drivers of the variance from the prior quarter included the reduced volumes in the higher variable selling expenses in the first quarter of 2011 and the favorable legal recoveries realized in the fourth quarter of last year. We basically maintained our favorable annualized run rate of the underlying fixed SG&A expenses in the first quarter of 2011.

Early in the quarter, we completed the bid process and sold our Anavia condominium rental community in Southern California at terms we believe are favorable to KB Home. Although this was a valuable asset, it was not core to our business strategy. Cash proceeds from the sale were used to pay off the related secured debt.

As Jeff mentioned, our first quarter results included significant charges related to the South Edge joint venture. As a result of the February 3, 2011, court decision confirming the involuntary bankruptcy of the joint venture, we have determined that our investment in the JV is no longer recoverable, and we recognized a charge of $54 million to write off the remaining amount on our balance sheet.

In addition, we recorded an obligation to cover our estimate of a probable amount that we will pay to the lenders if we cannot offset or defend against the enforcement of the Springing Guaranty. Our obligation relating to the Springing Guaranty is partially offset by an amount equal to the current estimated fair value for the South Edge land.

In connection with recording a probable obligation, we took a charge of approximately $23 million in the quarter. Excluding our estimate of KB Home's share of the probable amount due for a related arbitration award, which is separately reserved, this leaves a liability on the balance sheet of $137 million relating to the South Edge joint venture at February 28, 2011. Essentially, the charges taken in the first quarter are due to our reassessment as a result of the court decision in early February of probable amounts that will be paid to the lenders and the underlying legal status of the JV entity. As of year end and up through the time of filing the 10-K, we did not consider probable that the court would enter the order for release. We were obviously surprised and disappointed by the court's ruling and had to recalibrate our liability estimates based on that event.

However, South Edge continues its legal defense in relation to this matter and it has appealed the court's decision. I want to emphasize that this is a complex situation with a range of potential outcomes that may take many months to finalize. As Jeff said, we are looking at a variety of ways to resolve the issue. We remain committed to eventually taking ownership of our share of the South Edge assets and in the land-constrained Las Vegas market, we believe this will provide great value to KB in the future. Please refer to our Form 10-Q, which will be filed on Monday for additional disclosures and details relating to this issue.

I would also add that the remainder of our company's joint venture exposure is quite low as we have been actively working to reduce this over many years. We actually just favorably resolved our Kyle Canyon JV during the quarter, and we have no debt associated with any of our remaining eight joint ventures.

Moving on, our backlog at the end of the first quarter decreased 38% on a year-over-year basis to 1,689 from 2,713, while the projected future revenues in backlog declined 32% to approximately $354 million at the end of February 2011, from approximately $524 million at the same time last year. We began the year in a trough in terms of backlog and deliveries, and our backlog at the end of the first quarter remains low but our momentum is growing. As sales activity picks up during the year, and as we continue to introduce more new home communities, we expect volume and margins to expand in the second half.

Until more of our planned new communities are aligned, and we see the sales pace that is established during the spring selling season, it is difficult to make predictions. However, our view is that our backlog should be higher year-over-year by the end of Q3.

Our cash position at quarter end was approximately $857 million, reflecting the normal seasonal cash burn of a low delivery quarter, our first quarter land acquisition and development spending and a heavier bond interest payment schedule. As we plan our cash management for the rest of the year and evaluate our capital structure, we remain mindful of our potential South Edge obligations and continue to evaluate our financing strategy going forward.

Now I will turn the call back over to Jeff Mezger.

Jeffrey Mezger

Thanks, Jeff. As I have shared, the stabilization process is commencing, with select submarkets in many of our cities and based on our previous land investment and new community opening strategy, we are well positioned to benefit.

As we continue to navigate these times, we remain nimble, prudent and strategically opportunistic in our land and lot acquisitions. We spent $140 million on land acquisition and development in the first quarter, a figure which could, depending on market conditions on the ground, increase in future quarters just as our investments increased in the latter half of 2010. If markets strengthen, we have the flexibility to spend more. But if markets weaken further, we will hold back on future investment until we feel the timing is right.

We grand opened or reopened with new product 33 new communities in the first quarter of 2011, most of which occurred in the month of February, while at the same time closing out 18 communities in the quarter. We have plans to open about 40 more communities in the second quarter for a total of around 70 in the first half of the year, setting up a nice growth trajectory for the latter half of 2011.

As we open more new home communities, we remain committed to our Built to Order model, which historically provides for stronger margins and better visibility in our business, as well as higher customer satisfaction. The sales momentum we have experienced since March was based primarily on Built to Order sales. Our Built to Order homes represent the utmost in quality, value and choice to the consumer, and our products and company continue to be acknowledged. KB Home's leadership in building energy-efficient homes was recently recognized by the U.S. Environmental Protection Agency with their highest honor, the ENERGY STAR Sustained Excellence Award based on our many years of successful collaboration. KB Home was the only builder to receive this prestigious award in 2011.

KB Home was also, once again, named the number one homebuilder in FORTUNE Magazine's 2011 list of the World's Most Admired Companies. This is the third time in the past four years that KB Home has achieved the top ranking, and our company also received the highest score in the subcategories of innovation, people management and social responsibility among homebuilders. This kind of independent recognition from analysts and our peers as to how we are running our business is gratifying for us as a company and confirms for us that we are doing the right things to stand out and succeed in our industry going forward. I'd like to thank our talented and hard-working employees for their efforts in making all of these accomplishments possible.

As we look ahead to the remainder of 2011, we like our position from a strategic, geographic and financial point of view. The encouraging sales trend we are beginning to see develop should play out in the second half in the form of improved financial results. The transformation we have undergone over the past few years is also starting to gain traction in our business. We have dramatically reduced our overall costs to operate the business. We have a product that is attuned to today's buyer in design, features and price point. We are operating in 30 of the best long-term growth markets, with new communities concentrated in the best submarkets within each of those locations.

Our community count growth is underway. We are enhancing our brand awareness through our marketing and PR outreach, and we are achieving record levels of customer satisfaction. Lastly, our current sales pace and trajectory should allow us to generate favorable monthly sales comparisons starting in May, positioning us for a positive year-over-year sales comp and strengthening our backlog as we head into 2012.

While the economy is improving, it is unclear whether the broader housing market is bouncing along the bottom, stabilizing or improving. Nonetheless, tangible momentum is building in our business, and we look forward to leveraging the talents of our entire team to seize opportunities.

And with that, we will open it up to you for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Stephen East with Ticonderoga Securities.

Stephen East - Ticonderoga Securities LLC

If we could focus a little bit on, go back to Inspirada. And could you sort of give us a rundown of, okay, if you reserve for everything, this $180 million, $200 million, is that fully reserved with the liability of $137 million? I guess, I'm just not clear as to where we are on that. And then for the focus group, the arbitration that was won earlier, is that already reserved for as well? And just sort of what's involved with bringing the land onto the books and did you bring any on this quarter?

Jeffrey Mezger

Yes, Steve, we could cover that. First of all, as you know, the situation remains very complex. There's the bankruptcy that's out there, there's various constituents involved, so it is a complex situation. Our reserve at year end was over $100 million relating to the issue. And we increased the reserves during the first quarter because of the trigger, the February 3 court order. After the court order, we considered it probable that our obligation would grow, and we made reserve adjustments as a result. Just to answer more specifically some of your questions, the reserve at the end of the quarter includes about $212 million relating to principal, interest and fees due to the lenders. It's offset, as we talked about in the script, by the fair value of the land that we estimated. We have a reserve on the books as a result at the end of the quarter of $137 million. In respect of the focus arbitration, we do have a separate reserve set up for that, that did not change during the quarter. So that reserved for focus is not included in the $137 million, and it was separately set up and preserved during the quarter. As we said earlier, it is complex. It's described, this whole issue is described in much more detail in the 10-Q that will be filed on Monday and I ask you to please refer to that for additional disclosure and information.

Stephen East - Ticonderoga Securities LLC

Okay. And then so from your standpoint, it looks like you don't believe there's anything else out there that would get your book value? And what would be involved in bringing the land back on the book that, Jeff, you had alluded to and did you do any at the first quarter?

Jeffrey Mezger

No, we did not record any land on the books this quarter. It was more used as an offset to the estimated liability. The involvement there, we have to work through the bankruptcy process to actually gain ownership of the land. We will work through that either through an agreed reorganization plan or through a repayment under the Springing Guaranty and then dealing with the bankruptcy as a follow-up.

Operator

Next, we'll hear from Michael Rehaut with JPMorgan.

Michael Rehaut - JP Morgan Chase & Co

First question, I was hoping to get -- drill down a little bit more on the gross margins. The detail on the 410 bps from lower volume was hopeful. As you look at -- so but on that number and the other numbers, the 410 bps, did that also include kind of incremental, let's say, fixed or overhead you're seeing in addition to the lower volume because of the new communities? And then if you could also kind of rank the other impacts that you mentioned for the balance of the, I assume, the 410 was a year-over-year decline, so if you can give us a sense of how the others, order of magnitude or how that kind of -- if there's a way to quantify that impact as well?

Jeff Kaminski

Yes, okay, let's start with the leverage impact. The leverage impact was more a maintenance of our expenses as opposed to increased expenses during the quarter. As our volumes were down significantly from the fourth quarter to maintain the same percentage although we would have had to cut several different types of expenses on a pro rata basis, which we elected to not do that and instead keep those resources in place for upcoming launches. And those expenses included things like our land operations in the field, our construction operations, purchasing, customer service, those type functions that don't really fluctuate that tremendously by volume on a quarter-to-quarter basis. We saw less of an impact on the leverage when you look to year-over-year because we had taken some reductions on those expense types as we moved through 2010 but the difference between the fourth quarter and the first quarter were not there, so we maintained at that level.

Michael Rehaut - JP Morgan Chase & Co

So the 410 was a sequential number?

Jeff Kaminski

That was the sequential number from the fourth quarter, that's correct.

Michael Rehaut - JP Morgan Chase & Co

Okay. And then the other items, if you can kind of give us a degree of magnitude and how they impacted the closeout of the higher communities' negative pricing and mix?

Jeff Kaminski

Yes, the closeout of the higher communities was in the neighborhood of 150 basis point impact. The pricing was about 50 basis points and the rest, the mix impact kind of fills in the balance.

Michael Rehaut - JP Morgan Chase & Co

Okay. Second question on just looking at the order decline for the actual quarter, I think, Jeff mentioned that the communities that you opened were mostly in February. And if I understand it right, you ended the quarter around 140. Well, can you give me what the average community was for the quarter. But my question, I guess, is really for the fourth quarter, you had a decline, average communities down year-over-year of about 24%. Is it fair to say that the majority of the declines during the quarter were driven by the community count decline versus the absorption? Or how do you think about year-over-year absorption pace?

Jeffrey Mezger

Michael, let me make a couple of comments because what we're trying to figure out how to reposition our communication to the investor world on community count. Because we traditionally counted it based on deliveries of the minimum of 5.25. We've done it that way for 20 years, and it's been an ongoing debate both for us and our industry to try to get something that's clear and objective and makes sense. When your deliveries drop the way ours did, it understates your communities because we didn't have as many deliveries of five or more in a community as we would have in previous quarters. And having said that, I shared what's opening for sale because our community-opening strategy remains totally on track. Our delivery results blur what's actually going on in the specific community count. So Jeff, I don't know if you want to share what kind of numbers we want to set up for the year.

Jeff Kaminski

Yes, sure. I think as Jeff said, the delivery decrease predominantly was due to absorption as opposed to community count change. We did open 33 new communities in the first quarter, we had 18 closeouts. As Jeff mentioned, we're still on pace with our opening plans as we discussed during previous calls. We still have 40 additional openings scheduled for Q2. The historical method of calculating it based on deliveries really doesn't make a lot of sense. It's giving us a number that really distorts our view of our store footprint, and we pulled back really from going public with that number at this point and really rethinking the way we're counting communities on that basis. The reason we started providing more detail into this last quarter was really in relation to the current year strategy, where we're opening new planned communities. As we reopen these communities and start delivering homes, it will take several months and, in many cases, a two-quarter lag before you see those in the way we've historically measured community count. But despite that, by the third and fourth quarter, our community count should be reflecting the 25% increases as we previously discussed. So I think the message, the underlying message is the quarter volume was mainly absorption-related as opposed to community count change. We are on track with our community count openings, and we're optimistic on the success of those openings as we move through the year. We've seen that success with most of the openings. In fact, even early on, at this point in the year and we're hitting our pro forma numbers that we underwrote too. So that's sort of the high level on that one.

Operator

We'll hear from Michael Smith [ph] with GMP Securities.

Unidentified Analyst

If we could just dig into the margin question a little bit more. Jeff, could you talk about just seasonally how the margin changed a little bit and specifically, if there's some stuff that you guys generally load into Q1 that isn't there in the other quarters that might make the margins a little bit lower seasonally in Q1?

Jeff Kaminski

No, there's nothing to the accounting or through any kind of loading of expenses or loading of accruals or anything else in Q1 that would make it significantly different than Q4. Like I said, the main driver is really the volume and the leverage on the volume in the first quarter as compared to the prior quarter.

Unidentified Analyst

Okay. And can you guys comment on what your margins are on your backlog right now, your gross margins?

Jeffrey Mezger

We really haven't guided on gross margins, Michael. As we've shared in our strategy, we have a nice trajectory of new communities opening that are in better locations and positioned for better margin, and we know that the higher revenue that comes with the increased openings will leverage our margins and our SG&A later in the year. But until we get deeper into the selling season, see how things totally evolve in the next couple of months, we're really not giving guidance on go-forward margins.

Unidentified Analyst

That's fair. Can you guys -- can you comment on what kind of spread you're seeing in sort of new versus old land on the gross margin front?

Jeffrey Mezger

Michael, I don't know that we've really done that. As we've shared, our basis, our lot basis in these new communities is better positioned for higher margins, but we want to see how the sales evolve. At a high level, you'd expect the new communities are going to have better margins than your legacy book of business, I'll call it. But we haven't guided on that because we want to see what happens. April, May and June are critical selling months for us and then we'll have that answer.

Jeff Kaminski

One of the things we have been talking about the last couple of quarters is the mix in deliveries coming from impaired versus unimpaired communities. And we saw sequential improvements in that. In other words, more towards new in both the third quarter and the fourth quarter. The difference between the fourth quarter and the first quarter of this year has been more consistent. We remain at about 1/3 of our deliveries coming from impaired, which is about the same number that we had in the fourth quarter. So that was an improving factor on margins in prior quarters and because of the flatness in that, it really had very little impact this quarter.

Operator

Next, we'll hear from Bob Wetenhall with RBC Capital Markets.

Robert Wetenhall - RBC Capital Markets, LLC

I wanted just to get some clarity on your backlog and to confirm, did you say that the number of backlog in the third quarter was likely to be higher year-over-year on an absolute basis?

Jeffrey Mezger

Yes, we did, Bob. We're going to go through what we call an inflection point, where we're confident in our sales comps because they were so weak after April of last year. We're confident that we'll have positive sales comps, and we're projecting that we'll cross over and have a higher unit backlog by the end of the third quarter.

Robert Wetenhall - RBC Capital Markets, LLC

If that's the case, then are you expecting your conversion rate to -- what kind of conversion levels are you looking for in the next two to three quarters?

Jeffrey Mezger

That's a great question because part of what we're working through here is a transition back to a fully-loaded Built to Order model. And in normal times, our conversion rate will be 50% to 60% because a lot of the backlog is yet to be started. And then in turn with those dirt sales, you convert to even-flow production, you get the synergy and benefits of the even-flow. So my guess would be as our backlog grows, you'll see our conversion rate go down a little bit. We've been running at higher with -- covering some of the inventory that was a carryover from last year that we're not going to have by the third quarter or fourth quarter of this year. Having said that, I said in normal times at 50% or 60%, we have positioned the company for a much quicker turn from contract to close. So maybe 60% in a fully-loaded backlog, which we're not at yet. We still have some inventory to cover, and you saw what we did in the first quarter. But once the backlog is fully spread out, it will drop down probably around 60%.

Robert Wetenhall - RBC Capital Markets, LLC

Fair enough and that's very helpful. If you can just enlighten me a little bit, I'm trying to bridge through and understand your commentary about new orders. It sounds like you're excited and can achieve pretty strong favorable comparisons in 3H, in the second half of the year. But can you give us some guidance on the May quarter? Like you expect positive comps in May. It sounds like you don't know yet in April, and it was still a tough March. Is that a fair summary of it?

Jeffrey Mezger

Let me go the other way, Bob. We actually shared March and we were pleased that it's "only a negative 6% comp" because last year, March became the feeding frenzy tied to the tax credit deadline. I also shared in the comments that April, we will have a negative comp because April last year was the pinnacle of frenzy, and then our sales fell off the map for the rest of the year. So we know we'll have a negative comp in April. We also feel very confident we'll have a positive comp in May. And as April and May unfold, we'll see how we end up the year. But the trajectory of our sales is very favorable, and we think after April and May, we'll be repositioned with a better community count and a weak comp from last year. You got all these things that will be working in our favor once we get past April.

Operator

Next, we'll hear from Joshua Pollard with Goldman Sachs.

Joshua Pollard - Goldman Sachs Group Inc.

My first question is on gross margins. If you look back over the last two years, both '09 and '10, you've seen a range of somewhere around 200 to 250 basis points from high to low on your gross margin. Is there anything about this year between what you've seen from the first quarter margin, what you guys see from your backlog and how your sales experiences has gone that would suggest that, that range should be wider in 2011?

Jeffrey Mezger

Yes, Josh. I think it will be wider in 2011 as we were talking about. When our volume levels and our deliveries come back in the second half, we will basically have eliminated much of that negative leverage impact that we saw in the first quarter, so there's 410 basis points coming from that. And keep in mind too, when we're talking of these swings right now, off small top line numbers, that's $8 million. So we had an $8 million expense penalty, I'll call it, in the first quarter for maintaining those expenses. At a $400 million top line, we have basically eliminated a lot of that, that negative leverage. So I think you will see wider swings this quarter particularly between the first half and the second half.

Joshua Pollard - Goldman Sachs Group Inc.

So, I mean, is it unreasonable when we think about modeling going forward to have you guys getting back towards your second half 2010 levels as you get into the second half of 2011?

Jeffrey Mezger

I don't think that's unreasonable.

Joshua Pollard - Goldman Sachs Group Inc.

Okay, that's helpful. I guess the other question that I have for you guys was centered around your cash balance and ultimately, your balance sheet. You're now sitting at 60% to 60%-plus net debt to cap. I recognize that the deferred tax asset is off the balance sheet. But A, was the target there? B, could you talked about what, if any, cash impact you guys would expect from the South Edge ruling as you look at where your cash balance would be and how much cash outflow would need to happen? And then could you talk about any other large expected use of the capital for this year?

Jeff Kaminski

Okay. sorry you asked a lot of questions into one. I guess starting with the South Edge like we talked about, there's $212 million that we have accrued as an obligation and I think that's probably a fair start point for the cash impact from that issue. You've had to add some estimate on the arbitration, depending on when that's settled. And also consider that there are other strategies other than an outright cash outflow from the company that we could employ to reduce the cash impact from that, partnering, financial partners, et cetera, are other things that we're exploring and looking at. So the timing is a little uncertain. The ultimate resolution is uncertain but there are some range of options there. The largest impact on cash is land spend, that's somewhat discretionary as we move through the year. Jeff mentioned, we are watching that very carefully. Our underwriting standards have remained very high and consistent, and we will meter that up or down depending on our outlook on strength of the market, strength of deliveries and on the opportunities that we see as we move through it. Now those are the two primary sides. As far as targeting goes, you're correct in pointing out, the DTA [deferred tax asset] is not on the balance sheet. Over $800 million of valuation allowance right now that would significantly move our leverage ratio, so it remains our company's focus and one of our highest priorities to remain and continue down the path of sustained profitability, so that we're able to recapture that DTA and fix a lot of issues right now with our leverage ratio as a result. So we're watching it closely. We are mindful of the obligations that we have, and we'll continue to maintain and watch the capital structure.

Operator

Our next question comes from David Goldberg with UBS.

Susan Berliner - Bear Stearns

Hello, it's actually Susan on for David. I just wanted to go and ask a little bit about the discussion that you're having with BofA around your mortgage JV. I know that you mentioned that you're exploring some different or new options. Would this kind of include different JVs or could you potentially bring this back into sort of more of an in-house model?

Jeffrey Mezger

Susan, we could. We haven't contemplated that at this time. As you look back over the years, we had the JV with Countrywide and then in turn, BofA, it was a very nice partnership and that it frees us up to focus on what we do well, which is building homes and taking care of our customer and leaves the mortgages to the mortgage experts. And it worked well on both sides, so we like that. At this time, we continue to talk with BofA, where we're in the first few innings of the discussions on where to take it but there's numerous avenues that we could follow. We just haven't picked one yet because we're continuing to work with BofA.

Susan Berliner - Bear Stearns

Okay. And so can you give us any sense on timing of this? I mean, is it something that you expect to sort of resolve within this fiscal year or any sense of how long it could take?

Jeffrey Mezger

I'd say by the third quarter.

Susan Berliner - Bear Stearns

Okay.

Jeffrey Mezger

We'll have some clarity where we're going.

Susan Berliner - Bear Stearns

Okay, and the...

Jeffrey Mezger

In the meantime, we're continuing to operate delivering homes and working within the JV structure today.

Operator

Dan Oppenheim with Crédit Suisse has our next question.

Daniel Oppenheim - Crédit Suisse AG

I was wondering if you could talk a bit more about cancellations. I didn't hear so much about that in terms of your remarks but clearly the high percentage of the backlog, in the last conference call, you talked about how there's a spike in the month of November. Clearly, it continued for the quarter. What would you say is causing -- what were you doing now to try to work on that here?

Jeffrey Mezger

Good question, Dan. Actually, it's a nice story. We did have some carryover issues in December tied to those things that we referenced on our last call, with the tapering of loans in the current environment. But the trajectory here on the can side is very similar to the experience on the sales floor. So, Jeff, why don't you give him the actual numbers.

Jeff Kaminski

Yes, we'll give you some detail on the numbers to give you a better feel for it. We are looking and more focused on the percentage of the gross sales because of the low backlog numbers and you've seen a lot of distortion in the can rate percentage just moving up or down based on end of quarter backlog. So as an alternative, we are looking more to monthly, and we've always looked at it internally this way, the monthly percentage of gross sales, and there has been a nice progression, as Jeff mentioned. In the fourth quarter, we talked a fair amount about the spike in November, and our cans reached almost 43% in the month of November again as a percentage of the gross. That was starting at 29%, September; 38% in October; 43% in November. As we started dealing with the issues and started really digging in and putting a focus on it as a company, we've seen a progression downward in the first quarter. December started or more or less continued the trend from November with a slight improvement down to 37%. January came in at about 29% and the February can rate was down around 24%. So we're continuing to work that issue down and seeing some positive result as a result of the actions we've taken.

Daniel Oppenheim - Crédit Suisse AG

I guess, and maybe I'm confused here but I guess everyone else in the industry and given the seasonality of orders, most everyone else has looked at the percentage of backlog rather than the orders especially as you get into the seasonal stronger period, those numbers are clearly going to look more favorable. But, I guess, is that trend still the same as a percent of backlog?

Jeffrey Mezger

Say that again, you're asking for the percentage...

Daniel Oppenheim - Crédit Suisse AG

I mean, I'm just surprised you've looked at it as percentage of orders that way.

Jeffrey Mezger

Well, in the Built to Order model, I think it's more consistent. We're seeing a lot of cans before we're starting our homes, so although they're ending up in backlog at a point in time, the can rate before start is an issue and is the main issue from our point of view. We see more secured backlog, I think, than a lot of the peers as a result of that, as a result of the process and we have less issue from that point forward.

Jeff Kaminski

Dan, when it's an inflection point on backlog, our backlog at the beginning of this quarter was the lowest it's been in years, and we've shared we're going to be growing it through the year. So I don't -- the reason we're back to growth is you can take the lowest point in the year and say that's a typical can rate. And conversely, while the growth is lower, it's a better reflection of your contract activity and that number's continued to decline.

Operator

Adam Rudiger with Wells Fargo Securities has our next question.

Adam Rudiger - Wells Fargo Securities, LLC

The last quarter, we heard from a couple of builders talk about tightening in the mortgage underwriting standards. I was wondering how that changed sequentially for you, if at all?

Jeffrey Mezger

It really didn't change too much. I'm sure you heard of the FHA [Federal Housing Administration] news and what they did on their mortgage insurance premium, which on our average loan within our bid was probably $30 worth of payment. So I guess you'd say that's an underwriting impact because you have to be able to cover $30 more in payment. The trends we shared in the fourth quarter were more tied to documentation and the paper required for loan approval. FICO scores haven't changed and ratios haven't changed. So I would say that underwriting remains challenging because it has been for quite some time. But I don't think it necessarily got any more difficult in the quarter.

Adam Rudiger - Wells Fargo Securities, LLC

Okay, great. And then secondly, just a housekeeping, can you give us your owned and option lot count?

Jeffrey Mezger

Yes, owned and option at the end of the quarter was 37,000.

Adam Rudiger - Wells Fargo Securities, LLC

The breakout?

Jeffrey Mezger

We had 7,000 option and the remainder was owned.

Operator

Next, we'll hear from Nishu Sood with Deutsche Bank.

Rob Hansen - Deutsche Bank Securities

This is Rob Hansen on for Nishu. So you got a 22% month-over-month increase in sales in March, and you opened most of your communities in February. So that implies the absorption pace was pretty good as well. So how does this compare to kind of a typical pace from a March over February perspective, historical perspective?

Jeff Kaminski

The 22% you referenced was from February to March?

Rob Hansen - Deutsche Bank Securities

Yes, from March over, yes, March, February.

Jeff Kaminski

My gut reaction would be it's a little higher than normal.

Rob Hansen - Deutsche Bank Securities

Okay. I mean, did you have to offer more incentive to get buyers off the fence? Or was this -- I think, you kind of mentioned that was kind of a natural progression but...

Jeff Kaminski

In March, you typically sell more than you do in February. I think ours was helped by the new community opening impact. So it wouldn't be that we have more incentives on our sales, is that we have more communities opened that are in more desirable submarkets and are working okay.

Rob Hansen - Deutsche Bank Securities

All right. And then if you exclude the JV charges this quarter, would you still -- would you expect to be profitable for the full year?

Jeffrey Mezger

Excluding the JV charges for the quarter, we also had other events in the quarter but I don't think we'll comment on that one. I think -- it depends on the sales event in the spring.

Jeff Kaminski

Coming back to your other question on the March versus February. I think it's very important, the comments that Jeff made during the scripted portion of this, we had a 36% year-over-year shortfall in the month of February this year versus last year. We closed that gap significantly in March. It's less than 6% in the month of March. So If you look at it, in the last year, it wasn't the usual progression either with the tax credit but there's a pretty large gap closure in one month.

Operator

We'll move on to Jay McCanless with Guggenheim Partners.

James McCanless - Guggenheim Securities, LLC

Two questions. First one's a housekeeping. What was your finished and unfinished spec count at the end of the quarter?

Jeff Kaminski

Okay. Finished and unfinished was about 400, exclusive of the condos.

James McCanless - Guggenheim Securities, LLC

And then my other question, just wanted to find out. Historically, I don't believe you have given out much on incentive levels but if you could comment on what they were in the first quarter of '11 relative to, say, the fourth quarter and then maybe first quarter of last year, what you're all having to give for incentives?

Jeffrey Mezger

I don't know how much you covered our business model, but we're really more priced to the consumer focus. So we're not a heavy incentive company. I don't know what the actual number is but it has to be tenths of a percent movement. It's not...

Jeff Kaminski

It's not significant.

Jeffrey Mezger

Yes, it wasn't a big number.

James McCanless - Guggenheim Securities, LLC

Okay. So that was not a significant factor in the year-over-year decline in the gross margin?

Jeffrey Mezger

Right.

Operator

Next, we'll hear from Buck Horne with Raymond James.

Buck Horne - Raymond James & Associates, Inc.

You kind of covered this a couple of times. I just wanted to see if you can help me quantify it a little bit better. So you're down 36% in February in terms of orders and then, you were down 6% in March. I was wondering, can you quantify for us to what the year-over-year percentage change and the community count was in March versus February, then what it was in March? Were you up 10% in February and then it went to up 20% in community count in March?

Jeff Kaminski

Yes, we're really more focused on what we're opening this year and where we're going. If you look at the progression during the last year, we started the year at a higher number, declined as we went through the year and picked it back up in the fourth quarter a little bit. Compared back to the first quarter of the last year, I'd tell you, we're relatively the same in actual communities out there. Again, trying to differentiate between a five delivery per community where it counts and what's actually physically on the ground, I think you're asking more what's physically on the ground because we've pretty much reloaded the pipeline to get us back about even with last year.

Jeffrey Mezger

But we've shared what we opened and closed in Q1.

Jeff Kaminski

Right.

Buck Horne - Raymond James & Associates, Inc.

I think it would help the communication certainly if you would reconsider the definition of what's the active community.

Jeff Kaminski

We're going through that, Buck, we talked about it a couple of times. We're going through that as a company. There's pros and cons from doing it. Having a very rigidly defined definition helps you with consistency. The company has been very consistent for a number of years. On the other side of it, the con of it is when you're having a quarter-to-quarter delivery volume impact that we've seen, it makes the number a little less meaningful, I think, to people.

Buck Horne - Raymond James & Associates, Inc.

Okay. Last one, can you just characterize the nature of the pricing pressure that you're starting to see and kind of which markets are you starting to -- where is that starting to show up the most right now?

Jeffrey Mezger

Buck, as I mentioned in my comments, it's an extremely local business, so even within any of the cities we're in, you'll have different pressures in one submarket than you would across town. If you go to a more broad-based point of view, the pressures would be in the places that you've heard about like the Phoenix or Orlando, parts of Central Florida. Houston, in Texas, we've seen more price pressure than we have in Austin and San Antonio. When we look at it and view resale as our biggest competitor, you can look at the resale pricing and tell where markets are moving around. The caution there is, you have to look at the submarket that the communities are in and what's happening to resales there. We mentioned price pressure because it is an element but it's not a broad-based, prices are going down across the system kind of a thing. It was a much less of an impact on our margin than the leverage side.

Operator

Our final question will come from Mike Widner with Stifel, Nicolaus.

Michael Widner - Stifel, Nicolaus & Co., Inc.

Most of my questions have been answered but just wondering if you could comment a little more on geographies and where you might see greater strength, especially in more recent trends both from a volume standpoint as well as competitive pressures on pricing standpoint?

Jeffrey Mezger

Clearly, the closer you are to the coast, in California, the better the markets are. And there's parts of coastal California, for instance, Santa Clara County up in the Bay Area or Orange in San Diego, down here in SoCal that are performing very well. In fact, prices are going up as the months go by, not huge but $1,000 this month and $2,000 next month. The further inland you get, the softer it is. And the more inventory there is, so we think there will be pricing pressure that's sustained out 40, 50 miles out compared to what you see on the coast. D.C. continues to perform well as job growth and prices are up for the second year in a row. Texas overall is holding, didn't boom, hasn't busted. There's parts of Texas that is seeing some pressure, more so in DFW [Dallas Forth Worth] and Houston than in Austin and San Antonio. Colorado is holding its own. I shared our Vegas results. We're doing well in Vegas because of the price points that we're offering product at, not that the market's healthy. And Carolina's about flat, maybe a little more pressure in Charlotte than in Raleigh. It's a mixed bag out there. That's why there is a submarket in every city that's firming up, but it's offset by many that is still difficult, the further you get from the job centers.

Michael Widner - Stifel, Nicolaus & Co., Inc.

And if I could just one follow-up on the South Edge, clearly there's still some unknowns out there. I'm just wondering if you could talk about kind of the exact state of where that discussion is with JPMorgan? And specifically what I mean, is it kind of in arbitration at this point? Is it still individual negotiation between you and JP representing the creditors? Or is it -- how is that all evolving? And when can we expect any sort of next step towards finality in that?

Jeffrey Mezger

Okay, yes. I think to start with, we are still in litigation on the various pieces of this, the South Edge entity has appealed the bankruptcy decision, so that's still in litigation. There is a number of other outstanding cases surrounding it, so our comments are somewhat limited on this. But like I said earlier, I mean, there's a couple of different paths this could go down. We have not been presented with the guarantee payment request at this point. There are discussions happening. To talk much beyond that's probably not terribly appropriate right now but it is and continues to remain to be a very complex situation.

Operator

That will conclude our question-and-answer session. I'll turn the conference over to Mr. Jeff Mezger for any additional or closing comments.

Jeffrey Mezger

Thank you. Before we sign off, I want to reiterate KB Home's solid position when it comes to our strategy, customer focus, product offering, well-balanced geographic footprint and tenured management team. We look forward to improving our results and are prepared to take KB Home to the next level of performance as the housing markets continue to improve. Thank you again, and have a great day.

Operator

This does conclude today's conference call. Thank you for your participation and have a nice day.

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