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Hovnanian Enterprises, Inc. (NYSE:HOV)

F1Q07 Earnings Call

March 9, 2007 11:00 am ET

Executives

Ara Hovnanian - President and CEO

Larry Sorsby - EVP and CFO

Kevin Hake - SVP and Treasurer

Analysts

Dave Goldberg - UBS

Carl Reichardt - Wachovia Securities

Michael Rehaut - JP Morgan

Stephen Kim - Citigroup

Dan Oppenheim - Banc of America

Robert Manowitz - UBS

Alex Barron - JMP Securities

Dennis McGill - Credit Suisse

Susan Berliner - Bear Stearns

Steven Fockens - Lehman Brothers

Lee Brading - Wachovia Securities

Joel Locker - FTN Midwest Securities

Basu Mullick - Neuberger Berman

Presentation

Operator

Good morning, and thank you for joining us today for Hovnanian Enterprises Fiscal 2007 First Quarter Earnings Call.

By now, you should have all received a copy of the earnings press release. However, if anyone is missing a copy and would like one, please contact [Donald Roberts] at 732-383-2200. We will send you a copy of the release and assure that you are on the company's distribution list.

There will be a replay of today's call. This telephone replay will be available after the completion of the call and run for two weeks. The replay can be accessed by dialing 888-286-8010, pass code 52966380. Again, the replay number is 888-286-8010, pass code 52966380.

An archive of the webcast slides will be available for 12 months. This conference is being recorded for rebroadcast, and all participants are currently in a listen-only mode.

Management will make some opening remarks about the first quarter results, and then open up the line for questions. The company will also be webcasting a slide presentation along with the opening comments from management.

The slides are available on the Investor's page of the company's website at www.khov.com.

Those listeners, who would like to follow along, should log on to the website at this time.

Before we begin, I would like to remind everyone that the cautionary language about forward-looking statements contained in the press release, also applies to any comments made during this conference call and to the information in the slide presentation.

I would now like to turn the call over to Ara Hovnanian, President and Chief Executive Officer of Hovnanian Enterprises. Ara, please go ahead.

Ara Hovnanian

Thank you. Good morning, and thanks for participating in today's call to review the results of our first quarter ended January.

Joining me today from the company are Larry Sorsby, Executive Vice President and CFO; Paul Buchanan, Senior Vice President and Corporate Controller; Kevin Hake, Senior Vice President and Treasurer; Brad O'Connor Vice President and Associate Corporate Controller; and Jeff O'Keefe, Director of Investor Relations.

For those of you viewing our slides at www.khov.com, please turn to slide number one. Prior to the effect of charges related to our Fort Myers-Cape Coral operations, pre-tax earnings for the first quarter were $26.7 million, equivalent to $0.20 of net earnings per fully diluted common share. This is above our previous guidance of earnings between $0.05 and $0.10 per fully diluted share in the first quarter.

This is based on deliveries for the quarter, excluding unconsolidated joint venture deliveries of 3,266 homes. We also delivered 289 homes in our unconsolidated joint ventures in the quarter.

During the quarter, we incurred $93 million of pre-tax charges related to the company's Fort Myers operations due to a continued substantial decline in sales pace and general market conditions, as well as increasing cancellation rates during the quarter.

The charges consisted of $42 million in inventory impairments, and a complete write-off of the remaining balance of intangibles associated with the acquisition of Fort Myers, which occurred in August 2005.

After these charges, we reported a net loss of $57 million for the first quarter of fiscal '07, or $0.91 per fully diluted common share, compared to earnings of $81.4 million or $1.25 per fully diluted common share in last year's first quarter.

In addition to the charges related to the Fort Myers operation, we incurred $4.6 million of impairment charges on land owned and $3 million in charges related to write-offs of predevelopment costs on option land during the first quarter.

When we announced our results for the fourth quarter of '06, we said that if market conditions remained stable and did not decline further in terms of sales pace or pricing in our communities, then we didn't expect to incur any significant additional land-related charges in '07.

However, we also stated that if market conditions continued to deteriorate further in any markets or locations, then we did remain exposed to potentially walking away from other options or additional land impairments. Well, market conditions continued to deteriorate significantly in the Fort Myers market during the first quarter.

As you can see on slide number 3, the level of resale listings, the top-line, has not continued on its torrid upward trend, but is still creeping up, unlike most other markets that have already begun to decline. The lower line on this graph, which shows sales pace, is very concerning in this market today. It has continued to fall during October through January.

The graph highlights the timing of our acquisitions, by the way, of Fort Myers and as you could see, it was at the peak of the market right before the listings started to take off. And in fact, we've joked about it, that it looks like it was within about two hours of the technical market peak.

Slide 4, shows the trend in cancellations for this market. Each month, the cancellations continued to get worse, and in fact for the quarter, we reported negative contracts for our Fort Myers operations. This led us to take further impairments. As I said, we took $42 million of impairments on inventory in Fort Myers.

As of January 31, we have about 2,600 lots owned and the remaining inventory balance on those lots after all impairment charges are $47 million or $18,000 per lot. In addition to the inventory impairments, we wrote off the remaining balance of the definite life intangibles that we carried on our balance sheet related to the acquisition. This balance was approximately $51 million.

If you turn to slide 5, we went through the process of the intangible impairment calculation at the end of fiscal '06, but at that time it did not trigger a charge.

Slide 6 shows the balance of our definite life intangibles that we have remaining on our balance sheet. As you can see, we are now down to $78 million, roughly where we were back in early '04. By fiscal year-end, we expect to be down to about $60 million of remaining definite life intangibles, with a normal amortization that's factored into our '07 projections.

We feel comfortable with the geographic diversity in the balance of our definite life intangibles. As you see on slide number 7, it's quite spread and quite small among several other remaining acquisitions.

To reflect the impairment charges that we took in the first quarter and our current expectations for the remainder of the year, we are adjusting our projections as in slide number 8 for '07.

We now expect total deliveries to be between 16,000 and 17,200 deliveries, including 1,000 to 1,400 deliveries from unconsolidated joint ventures. This should lead to total revenues of between $5.1 billion and $5.6 billion.

Prior to the effect of the charges related to Fort Myers in the first quarter, this would equate to an earnings per share of between $1.10 to $1.50 per fully diluted share. After the first quarter charges, we expect EPS to be between breakeven and $0.40 per fully diluted common share.

For the second quarter, we expect a net loss of between $0.05 and $0.20 per fully diluted common share. Thus the first two quarters could net out to breakeven before the effect of the Fort Myers charges and the $1.10 to $1.50 will be earned in the last two quarters with more than half in the final quarter. This is the result of greater volume of deliveries in the last two quarters, consistent with prior years, but the effect is amplified during periods of lower volume and profits.

When we add the 3,266 homes we delivered in the first quarter to those in backlog that are scheduled to be delivered in the remainder of '07, it accounts for approximately 68% of our forecasted deliveries for fiscal '07. In most of our markets, other than Fort Myers, contract pace and pricing held up fairly well during our first quarter, after factoring in seasonality compared to our fourth quarter ended October '06.

As shown on slide 9, excluding our Fort Myers operations, our net contracts for the first quarter were only down 2.3% and our cancellation rate dropped to 29% in the first quarter, compared to our cancellation rate of 34% in the fourth quarter. Including our Fort Myers operations, our consolidated contracts for the first quarter were down 23%.

For February, the first month in our second fiscal quarter, consolidated contracts were up 2.6% in units and 4.3% in dollars, including Fort Myers, compared with February '06.

Turn to slide 10. This is our first positive monthly comparison, since the market began to slow down. However, because we had a 13% increase in the communities, year-over-year, on a per community basis, our net contracts for February were down about 10%.

Our cancellation rate for the first quarter was 36% including our Fort Myers operations. If you turn to slide 11, you will see that this is up slightly from our fourth quarter rate of '06.

When calculated as a percentage of backlog, on slide 12, our cancellation rate decreased to 18% in the first quarter as compared to 20% during the fourth quarter of '06. Our contract backlog at January 31, excluding joint ventures, was 7,800 homes.

Slide 13, you'll see that our backlog decreased 33% in dollar value to $2.7 billion.

Now, I'll talk about what we are seeing in the rest of our markets today, outside of the Fort Myers market. Selling conditions continue to be challenging in many of our markets, but we have seen stabilizing trends in several measurable areas that give us a level of cautious optimism. The true test will be if these signs of stabilization continue through the remainder of the second quarter, which is the bulk of our spring selling season.

The phrase that best sums up the current environment is that, it is not getting worse and it is slow, but steady.

The free fall in pricing, which occurred throughout most of '06, in the form of increases in incentives and concessions appears to have run its course. In most markets, the stabilization in pricing began in the early part of the first quarter and continued through February. However, our cancellation rates are still at higher than normal levels.

And we lowered prices in some of our communities in the beginning of the first quarter through additional incentives and concessions in order to maintain the pace of sales that we are targeting for those locations.

The result is that our sales pace has shown signs of stabilization. Our contract pace in the first quarter held steady in most of our markets, with a pace that we achieved in the fourth quarter of last year adjusted for normal seasonal factors. While it's difficult to get a good read on contract pace in the seasonally slow period between Thanksgiving and Super Bowl, we are encouraged that the market conditions held up in the first quarter and this trend has continued through February.

Pricing has generally stabilized since the reductions early in the quarter. However, those reductions led to lower margins in our backlog and our projected deliveries later in '07. So, we are lowering our margin projections further in '07. And, Larry will chat about that a bit more in a moment.

Most of our markets have begun to show signs of stabilization, but we are not yet confident that we have found the bottom of the housing slowdown. We are seeing instances of reducing our concessions, and thus actually improving prices in some locations, only to be offset by other communities where we continue to increase incentives or lower prices.

These situations are largely offsetting each other at this stage, and the number of communities where prices are falling has been declining. Thus, we feel as if pricing is stabilizing overall. In most of our locations, we are holding prices fairly steady and achieving a steady pace of absorption in line with our budgets.

To use a weather analogy, it's no longer a monsoon, but it has been downgraded to scattered thunder showers. As we would expect in the beginning of the spring selling season, traffic began to improve. For the first four weeks through March '07, traffic averaged 16 per community per week, compared to traffic in our fourth quarter, which averaged 14 per community per week.

While we've not seen a huge spike in traffic as we begin this spring selling season, we have begun to experience and see its normal seasonal pickup.

We are optimistic that the housing market will continue to stabilize and then remain in a steady pattern of absorption and pricing. We don’t anticipate any quick improvements or upticks in pricing or sales.

As shown on slide 14, we saw a steady decrease in the MLS listings through November, which then leveled off in January in markets like the DC market, in markets like Sacramento or Chicago, as the sampling of markets that shows on this particular graph.

Each of the three markets reported decreased MLS listings for about four months. The trends are cautiously optimistic and give us a little better sense for recovery. Levels are still high, but the trends are getting better.

Consumer sentiment plummeted in '06 to a level indicating that many potential buyers were waiting on the sideline. This indicator continues to improve as well, as you can see on slide number 15 that shows the University of Michigan's index on overall home buying conditions. This index dipped just a bit in the most recent months, but it is up significantly from September.

Pricing, traffic, MLS listings, and consumer confidence are very important data points. And the sense we get from the field is that conditions feel a little better today than in the summer or in the fall of '06, when it seemed like we had to increase price incentives or lower our prices on a weekly basis. Again, the market seems to be slow, but steady.

Turn to slide 16. Consequently, we are optimistic that the market may be near a bottom or could achieve a bottom sometime soon, perhaps near the sales pace and prices that we are experiencing. When we do find the bottom of this market downturn, we are not anticipating a V-shaped or even a U-shaped recovery. Rather, we believe that the recovery is more likely to first exhibit a prolonged period of stabilization and fairly flat performance before turning up.

I visualize this projected pattern of market improvement as being similar to the shape of a boat-hull, moving from the stern to bow, with the stern representing a recent sudden fall-off in the market and the bow representing the ultimate recovery with a more gradual smoother shape, after a flat period in between. What we don't know is whether the boat is an 18-foot whaler or a longer seagoing yacht.

Regardless, the period of stabilization that we are currently feeling is much preferred to the period of falling home prices and slowing the absorption pace that we experienced in most markets in '06.

Once it is clear that the market is not recovering rapidly, we are optimistic that land sellers will more fully adjust prices and we expect to be in a position to tie-up new parcels of land.

Typically, land sellers' behavior lags the market index by about six months to a year. Today, land sellers have lowered their asking price, but not significantly enough to fully reflect the decline in conditions for selling homes. Thus, very few deals meet our return targets.

As a result, our controlled land position, if you turn to slide 17, has shrunk for the third quarter in a row. We ended the January quarter with 91,158 total lots controlled and optioned. Approximately 63% of those are controlled through options.

The total amount of lots controlled represents a 24% decline from the end of the first quarter of '06. However, as you can see on the chart, the number of lots that we own has not been coming down as rapidly as the number of communities open for sale has been increasing.

Although, our total lots controlled declined 3.7% in the first quarter, the number of lots owned remained virtually unchanged. Together with a normal seasonal construction of homes in backlog, this led to an increase of about 2% in the total book value of inventories during the three month period.

Slide 18 shows our aggregated option position. For all of our lot options in the aggregate, the amount of deposits represents 9.5% of the average of the total lot purchases as of the end of January.

During this period of stabilization, we would anticipate the use of concessions and incentives to begin abating and cancellation rates to gradually improve. With prices stabilizing, consumers will begin to lose their fear of the housing market sliding and will abandon the mindset that a lower price on a given home will be available in a couple of weeks or months.

This should be evident in the continued improvement in consumer confidence, particularly with respect to whether now is a good time to buy a home, and should lead to improved traffic at our communities, ultimately yielding positive net contract results.

However, in each market we need to see that the higher levels of resale listings start to clear in a meaningful way to alleviate the current excess supply of homes available in the market.

Although, we are encouraged by current positive trends other than the normal seasonal pattern, we are not projecting any improvement in either our sales prices or pace in any of our communities.

I'll now turn it over to Larry to discuss the financial performance for the first quarter and our guidance in greater detail.

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Larry Sorsby

Thank you, Ara. I'll walk through some specifics from the first quarter, as well as provide you with more detail on our current projections for fiscal 2007. Our first quarter results are summarized on slide 19.

One unusual aspect that I need to clarify is our effective tax rate for the quarter. Because of certain nuances of the charges and impairments related to Fort Myers, which were not fully deductible for tax purposes, our effective tax rate during the first quarter was only 18%. Obviously, if our tax rate had been higher, we would have reported a smaller loss.

For the balance of fiscal 2007, we expect our effective tax rate to be approximately 38%. Gross margins, incentives and concessions that we have offered have driven our margins to below normal levels as shown on slide 20, which displays our homebuilding gross margins on a quarterly basis for the past several years.

Homebuilding gross margins were 18% for the first quarter excluding interest, down 240 basis points sequentially from last year's fourth quarter and down 760 basis points for the first quarter of 2006.

Based on the homes that we plan to deliver through the remainder of 2007, we are projecting that our homebuilding gross margins, excluding interest for the full year in 2007, will be in the range of 17% to 17.5%, a further decline from the gross margin of 18% that we achieved in the first quarter.

While our sales prices generally stabilized during the first quarter in most of our markets, we are lowering our projections for gross margins for the year, about 100 basis points from our prior guidance. This is partially due to the decline in our projected price and the margins in Fort Myers going forward.

The decline in our projected gross margins is also attributable to additional incentives and discounts we've implemented in many of our community locations in order to achieve the stabilized pace of sales that we are now experiencing in those locations. Such pricing was generally in place early in our first quarter, but was not fully reflected in our prior projections, which were based on community level budgets pulled together prior to the end of our fiscal '06 year.

As shown on slide 21, our projected gross margin for 2007 represents a decline of 560 to 610 basis points from our 2006 full year gross margin.

For the past several years through the end of 2005, our gross margin has been higher than normalized margins, which we estimate to be somewhere between 20% to 22%.

The above normal margins were the result of significant price increases that we experienced in many of our markets over that period. We continue to renegotiate with our subcontractors on their cost, and we are seeing varying degrees of success across all our markets.

We expect to see between 5% to 8% of saving adjustments to our labor cost, the majority of which have already been negotiated and are included in our projections. These cost savings help to partially offset some of the margin pressure we're seeing in 2007.

SG&A; as we opened more communities throughout the quarter, we experienced an uptick in total SG&A as a percentage of total revenue, which was 13.3% for the first quarter versus 12.8% in last year's first quarter.

In addition to expected relief from subcontractors, we have made headcount reductions of about 20% over the past three quarters. This percentage varies significantly by market, depending on how much our sales pace has slowed.

As market conditions dictate, we will continue to take appropriate steps to right-size our organization. We expect to see our total SG&A ratio increase again in 2007 in the range of 11.6% to 12.2%, due primarily to challenges related to reducing overheads as rapidly as revenues will fall in '07.

Although many of our overhead costs are variable, some amount of advertising and selling, general and administrative costs are fixed. And we must continue to effectively staff the increased number of communities that we now have opened for sale, despite the lower volume of activity per community.

2007 projections; the gross margin and SG&A projections are shown on slide 22, which also provides additional details that were factored into the revised breakeven to $0.40 EPS range that we are giving as our projection for fiscal '07.

The details of our summary projection for fiscal '07 are also available on the financial information page of the Investor Relations section of our website at khov.com.

We anticipate that the average sales price per home, excluding unconsolidated joint ventures, will be between $331,000 and $346,000 in fiscal '07, compared to $348,000 in the first quarter of fiscal '07 and $329,000 for all of fiscal '06.

The year-over-year expected increase in average sales price in our markets is primarily the result of geographic and product mix of our deliveries rather than inability to increase home prices.

This price range also takes into effect incentives offered on contracts in backlog, and currently being offered for the homes we anticipate selling and delivering in 2007.

For fiscal 2007, we are also projecting total pre-tax land sale profits to be approximately $5 million compared to the $45 million of pre-tax profits from land sales in fiscal '06.

I'll now provide some additional clarification of our land-related charges in the first quarter. Ara already commented on the $42 million land impairments that we took in Fort Myers operations and the $7.6 million of total land-related charges in our other markets.

These charges were offset by approximately $8 million of reversals of prior land charges. This reversal was the result of two deposits on land contracts that we walked away from in the fourth quarter.

Portions of these two deposits were returned to us in the first quarter. As a result, the total amount of the line item on our income statement for inventory impairment loss and land option write-offs is equal to $41 million for the quarter, roughly matching the total impairments from Fort Myers.

As long as market conditions remain relatively stable and do not decline further in terms of sales pace and price in our communities, then we do not expect to incur material amounts of additional land related charges during fiscal '07.

Thus, we have not included any amount of such charges in our projections for the balance of fiscal '07. However, if market conditions deteriorate further in certain markets and locations, then we may need to potentially walk away from other land options to incur additional land impairment charges.

And even with current conditions holding up, I would not be surprised to see a small amount of impairment walk-away charges related to the nuances of specific community situations over the remainder of the year.

Joint ventures; for the first quarter, we reported pre-tax income of $2 million from unconsolidated joint ventures, a decrease of 74% from the first quarter of fiscal '06, primarily as a result of the wind-down of a couple of our joint ventures on individual communities along with the continued wind-down, and thus fall-off in deliveries and profits in our Hovstone joint venture with Blackstone.

Our investments in unconsolidated joint ventures increased modestly year-over-year to $206.2 million as of January 31, '07 from $196.3 million at the end of last year’s first quarter.

We report significant details on the balance sheet, profits, debt structure, and leverage levels of our joint ventures each quarter in our 10-Qs and 10-K.

We are currently projecting total pre-tax income from unconsolidated joint ventures to be greater than $25 million in fiscal '07 versus $15 million that we reported in fiscal '06. While our joint venture with Blackstone continues to wind down, we have one mid-rise development in our joint venture, where there are significant deliveries projected for our fourth quarter, when the building is anticipated to be completed. Any slippage of the delivery of the mid-rise building in to the first quarter of '08 will negatively impact our '07 earnings from joint ventures.

Now, I will update you on financial services operations, which continue to add to our overall earnings. If you will turn to slide number 23, our pre-tax earnings from financial services increased 48% to $8.5 million for the first quarter of '07, compared to pre-tax earnings in the prior year's first quarter of $5.7 million. For fiscal '07, we expect pre-tax earnings from financial services to be greater than $25 million.

Turning to slide 24, our recent data indicates that our customers' credit quality remains very healthy. We experienced higher FICO scores in the first quarter of '07 compared with last year, and we continued to see a declining use of adjusted rate mortgages at 27% of our originations in the first quarter versus 32% for the full year in fiscal 2006.

The sub-prime mortgage market has been in the news quite a bit lately. Due to the numerous questions, we have been receiving recently on this topic, I'll comment on how many of our customers chose to use these types of loans in the past.

Turning to slide 25; during fiscal 2006, our wholly-owned mortgage subsidiary originated and closed 8% of their volume in sub-prime loans. In addition, our mortgage company brokered another 10% of their volume in sub-prime loans to third-party mortgage lenders during '06.

Year-to-date fiscal '07, our use of sub-prime products have declined to 6% originated and closed in an additional 8% brokered. During prior down cycles in our industry, it was not uncommon to see mortgage underwriting criteria type. We're seeing that pattern repeat itself in this cycle. While we do not know the precise impact of tighter mortgage underwriting criteria, it is safe to say that the overall pool of qualified customers has shrunk.

I'll now turn back to our balance sheet and credit statistics. For the first quarter, we generated adjusted EBITDA of $70 million. On a trailing 12-month basis, our adjusted EBITDA was $652 million, which covered interest 3.6 times.

Due to the slowing velocity of deliveries in each of our open communities, our inventory turnover and thus interest coverage is declining in '07. However, as we begin to bring our level of inventory investment into alignment with our lower revenues and profits, we expect coverage to stabilize and start to tick upward again.

For the full year, we're expecting EBITDA coverage to remain above two times and the ratio of total debt to EBITDA is expected to remain below six times as of the end of fiscal '07.

Adjusted EBITDA represents earnings before interest expense, income taxes, depreciation, amortization, and land charges. A reconciliation of our company's consolidated adjusted EBITDA to net income can be found as an attachment to our quarterly earnings release.

We ended the quarter with $225.7 million outstanding on our $1.5 billion unsecured revolving credit facility. The ratio of net recourse debt to capitalization as of January 31, '07 was 54.8%.

As we expected, our inventories grew 2% in the first quarter. We also expect inventories to grow modestly in the second quarter as we invest in new communities and associated land development and home construction.

While we expect to be cash flow positive in our fourth quarter, we may not be cash flow positive for the full year due to our community cap growth in fiscal '07. We anticipate that our average ratio of net recourse debt-to-capitalization for the full year of '07 will be slightly in excess of our target of 50%.

For the second quarter in a row, we've brought down the number of spec homes per community slightly, as you can see on slide 26. This number of spec homes represents about a 2.2 month supply of started and completed unsold homes based on our February sales pace. This is a manageable level of spec inventories and is substantially lower than the industry average of 5.7 months supply of started and completed unsold homes.

At January 31, '07 common stockholders' equity was $1.7 billion or $28.22 per share. During the first quarter of '07, we repurchased 200,000 shares. We anticipate continuing to repurchase shares but only at a measured pace, which more or less offsets the shares that are issued either through options or stock plans that many of our senior executives participate in.

Although we believe our stock remains undervalued, we intend to maintain only the current pace of share repurchases at this time.

I'll now turn it back to Ara, for some closing comments.

Ara Hovnanian

Thanks Larry. I want to reiterate that we are not being overly optimistic in calling for a recovery. What we are talking about here is finding a bottom. The initial data that we have regarding the first four weeks of our spring selling season, combined with the market data are showing some positive trends that we may be getting close to a bottom.

Again, we also don't expect a quick recovery. We expect to remain in a range near the bottom for a bit.

Before I turn it over to questions, let me walk through a quick list of some of the markets that are relatively stronger or weaker than others. In terms of bad markets for us, the Fort Myers market is definitely our worst market today. It is followed closing by our operations on the East Coast of Florida and in the greater West Palm Beach market.

Our Southern California markets are still struggling with some locations better than others and most locations seeming to have at least found some price stabilization. Houston and Dallas continue to hold up better than other markets.

And until recently we would have put North Carolina in that category, but they've generally gotten a little softer over the past couple of months. While the North Carolina markets are still doing relatively well, they continue to be highly competitive at all times.

We are seeing increasing strength in the DC market on both sides, but particularly in Virginia, as well as certain locations in New Jersey. In these markets, we're actually performing reasonably well and we are happy with the direction of the sales pace and pricing right now.

What we are looking for is stability in both pricing and absorptions. We've just started the selling season. But I can say that the stabilizing trends experienced during our first quarter have remained fairly steady through the month of February.

With the dollar value of net contracts up 4.3% in February, things are feeling a little better today than they did in mid-to-late '06.

I am hoping we might be there right now, but we'll see over the next couple of months, how this plays out. Obviously, every market is a little different. We are maintaining a conservative strategy in today's market given the uncertainties, but there are a couple of macroeconomic conditions that give me a little more comfort and confidence.

To the point, we are at a very unusual time for a housing slowdown, because we have a positive economy and low interest rates. By historical standards, these factors should work in our favor.

This concludes our formal comments. And I’ll be pleased to open up the floor for questions.

Question-and-Answer Session

Operator

And, thank you for the presentation. The company will now answer questions so that everyone has an opportunity to ask questions. (Operator Instructions). And your first question comes from the line of Margaret Whelan with UBS. Please proceed.

Dave Goldberg - UBS

It’s actually Dave Goldberg on for Margaret, how are you doing?

Ara Hovnanian

Very good, thanks.

Dave Goldberg - UBS

I was wondering if you could give us some more details on the communities that are going to open by the end of the year and where they are going to be and maybe the average tenure of how long you've controlled the land that's making up these communities?

Ara Hovnanian

We really don't have the new communities broken down by market at our fingertips. But, I can tell you and obviously the question regarding the tenure is trying to figure out what the margins or prices would look like. We've tried to incorporate our best guess and analysis as to what the margin and sales pace of those communities might be. And they are already baked into our projections.

Basically, as we reviewed all of our options, we made what we refer to as go/no-go decisions. Based on the financial returns on those properties on a go-forward basis, we treated the existing costs as some cost and said, okay, does the property make economic sense and satisfactory returns on a go-forward basis? Those that did not, we walked from and most of that occurred in the fourth quarter. And those that did, we are going forward with them.

However, while it may make sense on a go-forward basis, if you go back and do include the sub-costs, the margins are obviously not what we would like. And hence, that's part of the reason we are projecting a little more margin decline for this year.

Dave Goldberg - UBS

Were you able to change the product offering in those communities at all, maybe smaller homes?

Ara Hovnanian

In many of them, we did. And typically, we either reduced the specifications in our homes, reduced what we did at standard flooring, or cabinets or appliances. Or in other cases, we actually introduced new lower-priced, smaller or more cost-efficient homes.

In some cases, that was practical. In other cases, we are too far long. And by the time you built models and went through the additional expenses, it might not have made sense.

Dave Goldberg - UBS

Thanks. And then as a follow-up, wondering if you can give more details on the reversal on the prior deposits you had expensed on the option deposits? I guess, do you have any other deposits that you think there might be reversals on in the future? What were the circumstances behind that?

Larry Sorsby

No, we really don't. Those were really a couple of very unusual situations to where there was a dispute on whether or not the deposit was refundable or not. We took it to arbitration and we ended up winning partial refunds in arbitration.

Dave Goldberg - UBS

But there is not really any other case like that outstanding?

Larry Sorsby

Not that we know of.

Ara Hovnanian

We don't anticipate it.

Dave Goldberg - UBS

Okay. Thank you.

Operator

And your next question comes from the line of Carl Reichardt with Wachovia Securities. Please proceed.

Carl Reichardt - Wachovia Securities

Good morning guys. How are you?

Larry Sorsby

Good morning, Carl.

Ara Hovnanian

Very good.

Carl Reichardt - Wachovia Securities

I am not sure, if I saw this in the release or not. What was your penetration rate for the mortgage company in Q1 and if you have it for last year?

Larry Sorsby

Both last year and this quarter were roughly 70%, Carl.

Carl Reichardt - Wachovia Securities

Okay. So the 18% total originated and brokered is on the 70, so there is still 30 out there that could be also prime, but probably aren't. Okay. And then the next technical question is, just on the tax rate, is it a function of the write-off of the intangibles that creates the tax rate issue? Can you just give me a little more detail on that? And does that mean that assuming that you've finished that, obviously in Fort Myers, you don't have any more of your tax rate in Q2 even the loss should be more normal?

Larry Sorsby

That is correct. The intangible that we ended up putting on our books from the acquisitions had to do with the fact that the seller had booked the lot sales for tax purposes already and he paid the taxes on those. But for GAAP purposes those profits should not have been recognized. As a result of putting that on their books, it was totally a GAAP adjustment.

Therefore, as that intangible amortized from that GAAP entry, it was not deductible. Amortizing it over 8 to 10 years, it had a minimal effect on our effective tax rate as a permanent difference. Writing it off all at once had a substantial effect on our effective tax rate because the vast majority of the intangible write-off was a permanent difference for tax purposes.

Carl Reichardt - Wachovia Securities

Okay. That makes sense. All right, great, I appreciate that. Thanks so much, guys.

Larry Sorsby

Thank you, Carl.

Operator

And your next question comes from the line of Michael Rehaut representing JP Morgan. Please proceed.

Michael Rehaut - JP Morgan

Hi, Thanks.

Larry Sorsby

Hi, Michael.

Michael Rehaut - JP Morgan

Good morning. On the sub-prime also, I guess just following up with Carl, first just to understand the originated at 6% and the brokered at 8%. You kind of blend that together and get a feel for the mortgage that falls under your own capture rate. How do you think about the 30% that’s not in that capture rate? Is that safe to assume that’s a higher portion of sub-prime?

Larry Sorsby

The real answer is we don't know for sure, but it wouldn’t surprise us if that 30% was more highly weighted towards sub-prime than our 70% that was but it's just a guess. We just don’t keep that data.

And the overall market's use of sub-prime, I have seen statistics around 20%. So my belief is that our use of sub-prime is not unlike the overall market. That’s my expectation for what most people used to tell me. If you would have asked me two weeks ago, frankly we hadn’t really focused on this a great deal and we would have been working under the premise that we were 5%, 6%, 7% use of sub-prime. But once we actually did the analysis and got the data put together, we're telling you what our mortgage company originated. We just don't know for sure what happened on that 30%. But I think it's a safe bet that it is slightly higher.

Michael Rehaut - JP Morgan

I appreciate that. And then just obviously this has been unfolding very quickly over the last 3 to 4 months and continuing in terms of the turning off the spigot of credit in particular. Have you seen in some of your markets that have, maybe two parts to this and then I'll get back in the queue. But, which of your markets that you’ve seen higher levels of sub-prime and in those markets over the last two, three months, have you seen any particular changes in demand in those markets as the sub-prime financing has shrunk?

Larry Sorsby

I think California has always been a user of the most exotic mortgages that you can find including the sub-prime. So of our 14% year-to-date, probably a disproportionate percentage of that is in California, because of the affordability factor. As we've increased incentives, lowered prices, affordability is coming into line a little bit better, but it is going to shrink the number of qualified customers in all of our markets, including in California. There is going to be some impact. I just don’t know how to quantify it.

Ara Hovnanian

It is important to note that number one, I think about 72% of our buyers are using plain vanilla fixed-rate mortgages much more so than before. Even just normal adjustables are much lower in usage given the rates. But the other thing that’s important to note is that the sub-prime mortgage market has not gone away. They've just tightened the criteria. That clearly does shrink the pool of potential qualifying buyers, but that market has not going away. Other questions?

Operator

And from the line of Citigroup, with the next question we have Stephen Kim. Please proceed.

Stephen Kim - Citigroup

Thanks. I was wondering if I can get a little clarity on the specific dollar amount that was written off in terms of the definite life intangibles this quarter and may be if there was any in previous quarters?

Larry Sorsby

I mean the definite life intangible was $51 million this quarter.

Stephen Kim - Citigroup

Can we get a couple of decimals on that?

Larry Sorsby

Excuse me.

Stephen Kim - Citigroup

Can we get any more decimals on that?

Ara Hovnanian

You mean more precision than $51 million

Stephen Kim - Citigroup

Yes.

Ara Hovnanian

Give us a few minutes, we'll find it out.

Stephen Kim - Citigroup

Okay. If you can just come back to that, that will great. Second question I had, in your guidance for the margins over the course of this year, wanted to try to get a sense for what's embedded in that. First of all, I thought you had made some sort of an offhand remark about not being surprised if you are needed to take additional write-offs and so forth. Let us say you did take some additional write-offs, would that be embedded in -- is any portion of that embedded in your 17 to 70 math?

Ara Hovnanian

No, our assumption is that the market is stable and we won't take any more write-offs. What I said was in spite of that, there may be a community here or a community there, nothing on a material basis. But, it just wouldn’t surprise us if they were some. We just (inaudible) in any of our projection.

Stephen Kim - Citigroup

Okay. Great. Thanks.

Larry Sorsby

The combination of intangible write-off and intangible amortization for Fort Myers for the first quarter, so this is the amortization we had taken for November, December, January, and then the write-off as of January 31, was $54,439,000. This is the first time we've ever written-off an intangible associated with an acquisition, definite life intangible associated with an acquisition that we made of any material amount anyway. We write it off. Is that number okay?

Stephen Kim - Citigroup

Yes. That’s great. Thanks.

Ara Hovnanian

And the 54, Steve, obviously differs from the 51 in that we had one quarter of normal amortization we are doing anyway.

Stephen Kim - Citigroup

Yes, I know. I figured.

Operator

As a reminder ladies and gentlemen, please limit yourself to one question and one follow-up.

Ara Hovnanian

Steve, we didn't tell her to say that.

Operator

From the line of Banc of America, with the question, you have Dan Oppenheim. Please proceed.

Dan Oppenheim - Banc of America

Thanks very much. I was wondering if you can talk about the order trends in February. Looking at your early slide on Fort Myers market, you showed a lot of cancellations there in December and January. How much of that then ends up being orders coming in February where you are discounting those homes to sell those? And what do you think the order trends would have been in February without that, if that did impacted?

Larry Sorsby

I would say that net contract in February was an immaterial amount in Fort Myers. I mean we were positive, but single-digit or maybe double digit in terms of absolute numbers. So, there are very, very few net contracts in Fort Myers in February.

Ara Hovnanian

It happened to be a month where we cleaned out a lot of deposits in Fort Myers. So, not a meaningful comparison, Dan.

Dan Oppenheim - Banc of America

Okay. Thanks. And then just one other question. I was wondering about your outlook for some of the markets where you’re seeing signs of stabilization. As you see inventory coming down a bit, clearly some of that is seasonal, how do you look at that where we are seeing sales continue to fall with inventory falling? Is that a sign that sellers of homes are just not optimistic about selling it right now, and you have concerns that will have more inventory coming to market once people do get a sense that there is stabilization out there?

Ara Hovnanian

Well, that is clearly a big question that no one knows the answer to. It is important to note that while we are saying the level of listings are coming down, they are still way above the normal levels. So, there is still a lot of oversupply in the markets. As it comes down and prices stabilize, will other buyers say, okay, I am going to list now? That certainly could happen. So, it's definitely not yet time to break open the champagne bottles.

Dan Oppenheim - Banc of America

Okay. Thanks very much.

Operator

And with UBS, you have a question from the line of Robert Manowitz. Please proceed.

Robert Manowitz - UBS

Hi, good morning. I was wondering if you could talk a little bit more specifically about the book value of your inventory through the remainder of '07, the peak level and how you envision yearend?

Larry Sorsby

In terms of the inventories?

Robert Manowitz - UBS

Yes.

Larry Sorsby

I think inventories at year-end are going to be not materially changed versus the end of last year. So, it's going to peak up. On a normal seasonal basis, our inventories typically probably peak in July and then fall off quite a bit in the fourth quarter.

Robert Manowitz - UBS

Okay. And then as a follow-up to that and I'll play around after the call with the math on those comments. But could you help me understand the magnitude of that cash flow deficit for '07?

Larry Sorsby

I don’t think it’s going to be huge. We were hoping that it would be positive and it might still be a little bit positive. I am just not as confident that it will be.

Ara Hovnanian

Yeah, the fourth quarter itself will be very cash flow positive. But as Larry mentioned, we are growing our community count. I will emphasize, this is not something we are doing now that the market is slow to try to counter that. We put a lot of those decisions into motion back in '05. And if it continues to make economic sense on a go-forward basis as I said, we are proceeding with those investments.

In retrospect, obviously, I wish we weren't quite as aggressive in '05 for organic growth. But we are where we are, and the investments do make economic sense on a go-forward basis. And that's part of reason our inventories are not shrinking and we are not generating the surplus cash.

Obviously, if the markets really deteriorated, we certainly have the ability to not go forward with option exercises and then we would be generating more cash. At this point those investments are warranted.

Robert Manowitz - UBS

Great. If it is alright, I would like to speak one last question?

Larry Sorsby

Sure. Go ahead.

Robert Manowitz - UBS

Thank you. And that is that, historically you guys have been a fairly large user of third-party capital and controlling land. And I was wondering if you can speak, somewhat generically to your understanding of the financial position of some of those partners, and how they are faring. And most importantly, how do you envision the cost of that type of capital evolving over the next two to three years?

Larry Sorsby

It's just to clarify your question. You are talking about on our existing joint ventures?

Robert Manowitz - UBS

Yeah, joint ventures. And I imagine some of the off balance sheet capital is directly with land bankers.

Ara Hovnanian

Okay. Yeah, well, we use options in general as a strategy. As you know, we have about 63% of our total lot controlled though options. Really, I think we have about maybe a dozen and a half properties out of 400 some odd, that we could not get the seller to option them. And therefore we went out to find a financial institution to option that for us. We have gone back in several cases and walked away from some of those options. And more often in those cases, we have renegotiated with them.

At this point, we don't see any financial health issues with those [optioners]. They are usually representing significant institutions and have a pretty decent capital base.

Larry Sorsby

And with respect to using them on a go-forward basis, it was beyond our expectation, that as land sellers adjust to today's economic realities of a lower sales price and a lower sales pace; that we've already seen them losing up the terms, rather than winning all cash, because there are bidding frenzies for every property. They are just not losing up the terms and lower the prices enough to make it attractive now.

But my full expectations would be that there would be even less of a need going forward to use, what you'd call, traditional land bankers, as we find new deals. Just because I think the land sellers will just be giving us takedown 20% of it upon approval, and then six months later takedown another 20%. So that it just takes less capital and no longer be demanding all cash upon approval. So I just think there is going to be less pressure on builders overall to try to go to land bankers.

Robert Manowitz - UBS

Great. And on the cost of that capital through the land bankers, is that yet hitting higher or is it too early to tell?

Larry Sorsby

We've really not been renegotiating or trying to get new deals with them.

Robert Manowitz - UBS

Yeah.

Larry Sorsby

Kevin, I don't know if you have any feel for that.

Kevin Hake

I don’t think we've had a sense that they're going to adjust pricing. I think it's a question of availability and we also haven't heard that they’re completely out of the market. Although, they're clearly, dealing with their current portfolio is now more than they are doing the business.

Robert Manowitz - UBS

Great, I really appreciate it. Good luck.

Larry Sorsby

Thanks.

Kevin Hake

Thanks

Operator

And your next question comes from the line of Alex Barron representing JMP Securities. Please proceed.

Alex Barron - JMP Securities

Good morning guys.

Larry Sorsby

Good morning

Alex Barron - JMP Securities

Just to ask about how many communities you guys impaired this quarter, as well as how many lot options you walked away from?

Ara Hovnanian

We impaired three communities. And the expenses regarding the options walk-aways, really were the predevelopment expenses. I think the option deposits were refundable at that stage, but we had dollars expended in analyzing and researching the properties. And that's what was expensed.

Alex Barron - JMP Securities

And those three are all Fort Myers?

Ara Hovnanian

No, outside of Fort Myers.

Alex Barron - JMP Securities

Okay. And how many were in Fort Myers.

Larry Sorsby

Fort Myers, we owned it. So we impaired it. But it is really in the communities, because there are scattered lots. But the impairment we took in Fort Myers was on owned lots, they just weren't divided in the communities. So I can't answer the question with an answer of a community.

Alex Barron - JMP Securities

Right, sorry about that. And these three were in what markets?

Ara Hovnanian

I think they were primarily in Minnesota, and New Jersey.

Alex Barron - JMP Securities

Okay. Got it. My second question here has to do with, again financing a little bit. What is your CLTV, for the quarter and then what percentage of the loans in order of 80/20's option ARMs, no-dock, low-dock those kind of stuff?

Larry Sorsby

We don’t have all that data at our fingertips. We gave you, 77% loan-to-value that wasn't a combined loan-to-value. The combined loan-to-value is probably in the mid 80s. So that's where the combined is and we don't break out the statistics and certainly don't have it anywhere in this room, Alex, to give you how much we do of each one of the different kinds of loans. So as more and more interest is there, we might begin to try to accumulate that data as well.

Alex Barron - JMP Securities

Got it, Larry. And as far as your guidance for next quarter, can you give me some break down like units, I guess, margins, are you implying any write-downs? I am just trying to get to the $0.05 to $0.20 loss, where you guys are getting that from?

Larry Sorsby

I have given you as much guidance as we can give you. Our website has the full year. We have told you that we're not going to make money. You can back into the numbers if you want to back into.

Alex Barron - JMP Securities

Okay. Great. Thanks.

Operator

From the line of Credit Suisse with the next question, we have Denis McGill. Please proceed.

Dennis McGill - Credit Suisse

Hi guys, just a question on the cash flow. Larry, can give us a sense of in '06 and then your expectation for '07, how much you spent and expecting to spend on the acquisition of land versus the development?

Larry Sorsby

Yeah, we just don't have that break down.

Dennis McGill - Credit Suisse

Do you have this?

Larry Sorsby

That’s not something we normally track.

Dennis McGill - Credit Suisse

Do you have the total spend?

Ara Hovnanian

Nobody sits around this table just saying yes. We really track change in inventories frankly and project change in inventories. We don't break it down further than that.

Dennis McGill - Credit Suisse

To do that, wouldn't you have to have the piece of how much you're acquiring?

Ara Hovnanian

No, we don't break down land acquisition. What we do, every single community does a projection for what its inventory will be by quarter. Sometimes, the inventory growth is by land development. Sometimes, it's because we've got a big slew of homes under production. Sometimes, it's a payment in fees. Sometimes, it's taking down more land. We do not analyze what part of that is in each of those components. What we do is, we track every single community for the total capital that's laid out and we look at it that way. I will mention that our incentive programs are based on return on investment for our divisions. So they were wary and try to focus on not spending more than they have to, either on land or land development or fees et cetera. And they try and monitor it tightly.

Dennis McGill - Credit Suisse

Okay. I look at it in a different way then. I would guess work in progress is coming down particularly with spec coming down and with inventories up year-over-year, I guess that you would expect to be spending more on acquisition and development than you are selling through --?

Larry Sorsby

I think the real answer is, because we are increasing our community count, therefore it's partially on land for those communities, models for those communities, and work in process for those incremental new communities.

Ara Hovnanian

And putting land development in place.

Larry Sorsby

Yeah, land development. So, that's what's driving it.

Dennis McGill - Credit Suisse

Okay and second question. The average delivery price in the west seemed a little high relative to prior quarters versus the order rate. Is there something unique about the first quarter or is that the run rate that we should expect for the rest of the year?

Ara Hovnanian

I think the coastal area in Southern California might have had a higher proportion and they tend to have a higher average price.

Larry Sorsby

I don't think, I'd imply that for the full year.

Dennis McGill - Credit Suisse

Okay. Thanks, guys.

Larry Sorsby

Okay.

Operator

And representing Bear Stearns, the next question comes from the line of Susan Berliner. Please proceed.

Susan Berliner - Bear Stearns

Thanks, good morning. Can you give some details, I guess, on your incentives? Was that a lot of focus in the financial services business?

Larry Sorsby

I am not sure, I understand.

Ara Hovnanian

What do you mean by it?

Susan Berliner - Bear Stearns

Well, I guess, in terms of providing incentives or giving someone instead of a reduction in price, any sort of benefit in the financial services business?

Ara Hovnanian

Not primarily. Often times, we'll include any closing costs. Often times, we'll tie an incentive to the mortgage company. But generally speaking, the incentives have been more in upgrades and options that we provide at a better value, or just an outright reduction of the purchase price.

Susan Berliner - Bear Stearns

Okay, that’s helpful. And I am sorry to repeat this. Again on the sub-prime, I guess, if the overall market is about 13% sub-prime based on originations, if things are going to be pulling back at least for the short term, what kind of impact overall, is that a few percentage, could it be higher? Any sort of additional outlook would be great.

Larry Sorsby

We don’t know how to quantify it. Clearly, as Ara mentioned, the sub-prime market is not going away. So, the sub-prime market is going to get tighter by 5%, 25%. Use whatever number you like and multiply that times our percentages. And, that’s the impact. Now, some of those people, we can still qualify on some basis, but it shrinks the pool by something.

Susan Berliner - Bear Stearns

Okay. And then, my last question just following up on that. On sub-prime, it seems with the added detail you guys are giving that your sub-prime exposure is higher. But with your product diversification and some of your peers, it may seem rather unlikely. So, is it apples-to-grapefruit comparisons, or what's going on?

Ara Hovnanian

We don’t necessarily think ours is higher than anybody else.

Susan Berliner - Bear Stearns

Right.

Ara Hovnanian

Frankly, it’s nothing that we ever tracked before. It was never a big issue. And as Larry mentioned, if you asked us a couple of weeks ago, we would have guessed it within a few percent. But, we read the papers as well as everyone else and it’s something that we are now focused on. And as we dove deeper, we got more of the data points that we shared with everyone today.

Larry Sorsby

I mean, it's possible that someone else is defining sub-prime differently than we define it. There is not a definition that is precise with respect to what a sub-prime loan is. But, we went back and used credit scores between X and Y at different loan amounts, and did the research that way. I am not sure everybody else can track it in the same fashion that we do or did. But I just don't believe in my heart that we are a disproportionate higher user of sub-prime. Now, I would say that geographically, someone that didn't have a California operation, their sub-prime is going to be lower than ours, because California is a higher user of the sub-prime market. So, there are specific geographies that are disproportionate users of sub-prime. And I don't think that we are weighted dramatically towards that, vis-à-vis our peers either, but who knows.

Susan Berliner - Bear Stearns

All right, and I appreciate it very much.

Larry Sorsby

Okay.

Operator

And representing Lehman Brothers, you have a question from Steven Fockens. Please proceed.

Steven Fockens - Lehman Brothers

Hi, guys. Just one question, recognizing may be that your timing wasn't as greater as you would like on the Fort Myers acquisition. Have you gone --

Ara Hovnanian

That is an understatement.

Steven Fockens - Lehman Brothers

I appreciate your honestly on that. Have you gone back and looked at that deal and found any factors, either in the marketplace or in the company itself, that with hindsight would have prevented you from doing the deal and any plan to use that factor or look at that factor when you consider future deals?

Ara Hovnanian

Yes, one of the things we do know is as we look back, there was a period of almost a year where resale listings equaled monthly sales. What that should have told us is; hey, you have a market which is out of balance and overheated, and we should not have done our analysis based on that condition. But we had been eyeing that market and frankly talking to this company for many, many months and it continued, and continued, and continued, and finally we negotiated transaction and of course as it turns out in hindsight, it was just as it was about to end. But I'd say that's probably one thing we would really focus on a little bit more that we never use to track.

Larry Sorsby

Yes. And frankly, even if we are not making company acquisitions, we think that MLS data is something that on our organic operations to track meticulously every month as well. That gives you a hint as to whether the market is getting better or getting worse. It might be a leading indicator. It's kind of a thesis that we have at this point. But clearly, if supply-demand gets out of balance on used homes, it has a repercussion on the homes.

Steven Fockens - Lehman Brothers

So you had planned to use that kind of analysis more so, than in the past?

Ara Hovnanian

Well we haven't used at all in the past.

Steven Fockens - Lehman Brothers

Fair enough, great. Thanks very much.

Ara Hovnanian

Okay.

Operator

With Wachovia Securities, the next question comes from Lee Brading. Please proceed.

Lee Brading - Wachovia Securities

Hi guys.

Larry Sorsby

Hey Lee.

Lee Brading - Wachovia Securities

Hi. Thanks for the detail, and going by the markets, I was wondering if I could drill down a little bit more in the mid-Atlantic. From that order trends data that we saw this past quarter, it was up 22%, average sales price down 16%. I was wondering, what drove the growth? Was it incentive side, or community count growth or if you are seen positive comps in that market?

Ara Hovnanian

Well, in general we're seeing a little more strength in that market. Virginia was one of the first markets to slowdown. So it seems to be one of the first markets that hit the bottom and I don’t want to get overly optimistic and use the recovery word. But that market is showing a little sign in recovery. We are being aggressive in terms of the incentives that we need to do keep product moving there. But on the whole, we've been much more pleased. It's one of our better performing areas today.

Larry Sorsby

Absorptions in the DC market really has exceeded our own internal total budgets in recent months. They certainly don’t have pricing power to increase prices, but at the level that they are pricing now, we've got a little more pace than we expect.

Ara Hovnanian

I would like to say, it's just us, we are so brilliant. But I think that market in general is getting a little stronger.

Lee Brading - Wachovia Securities

All right, that’s helpful. Also I want to follow-up on the free cash-flow comment. Another way to look at it, should we be expecting debt levels by the end of the year to approach debt levels where you ended your fiscal '06 year?

Ara Hovnanian

We don't anticipate a lot of change in debt levels during the year, just some minor fluctuations, up and down. We do think our leverage should go down by the end of the year by the fact that we will make some equity in the following quarters and it will bring the ratio down in that way. And again as we mentioned, the big burst in earnings is really going to go at the very tail end of the year in the fourth quarter.

Lee Brading - Wachovia Securities

Okay, thank very much.

Operator

(Operator Instructions). And your next question comes from the line of Joel Locker representing FTN Securities. Please proceed.

Joel Locker - FTN Midwest Securities

Hi, guys. Just wanted to get your take on the interest percentage of the homebuilding revenues, I see it’s 3.1% as projection of total interest. But do you expect it to stay around 2.4% range that was reported in the first quarter?

Larry Sorsby

Yes.

Joel Locker - FTN Midwest Securities

Right on that. And also, how much total deposit dollars do you have from your customers on the --?

Larry Sorsby

The customer deposits?

Joel Locker - FTN Midwest Securities

Yes.

Larry Sorsby

Hold on, we'll look that up right on the balance sheet.

Ara Hovnanian

I was going to say about a $140 million.

Larry Sorsby

142, 143, something like that.

Ara Hovnanian

Hold on, we will get the exact number.

Larry Sorsby

143.

Joel Locker - FTN Midwest Securities

143 million. And just on the trajectory of your debt-to-capital ratio. If you are modeling that, how would you expect it to play out like at the end of the second, third, and fourth quarters?

Larry Sorsby

We gave you pretty good hints that we are going to be little above our target of 50%. We are above that right now. So, it's not going to be above roughly where it was in the end of January. And then, it should come down a little bit by yearend.

Joel Locker - FTN Midwest Securities

All right. Thanks a lot.

Ara Hovnanian

Okay.

Operator

And with Citigroup, you have a follow-up question from the line of Stephen Kim. Please proceed?

Stephen Kim - Citigroup

Thanks. Early on your presentation, Ara, I think you made a few comments. So, I just wanted to follow up on. One, actually maybe this one was from Larry, but you talked about deliveries. And, I think you had given numbers to try to help us triangulating on what you thought deliveries might be for the second quarter. But, I think I may have misheard you, so I was just wondering if you could sort of give us an idea of what we should look for in terms of closings for 2Q?

Larry Sorsby

We didn't really give any guidance on that.

Stephen Kim - Citigroup

I thought you said like first half or something like that, like a certain percentage of your closings.

Larry Sorsby

You know what’s that, Steve, is that the earnings were going to be negative in the second quarter. And therefore, all the earnings were going to happen in the second half of the year. And more than half of the earnings in the second half of the year will be in the fourth quarter. So, we said weighted towards the fourth quarter.

Stephen Kim - Citigroup

Okay. So you were talking about earnings in other words you are saying not the --. No, there was some comment you made I thought about closings. You said that a certain number, your percentage of deliveries like 28%, 38% something like that in the first half. I thought that you had said something like that, no?

Larry Sorsby

I don’t think so.

Stephen Kim - Citigroup

Okay. Well, then, you didn't and maybe I just completely misheard. That's fine. That way it is certainly possible.

Ara Hovnanian

Also, replay the webcast later.

Stephen Kim - Citigroup

Well, that's okay. That's fine. The second question I had related to Ara, a comment you made about the longer-term gross margin. I believe you made a comment about something from 22% is what you sort of felt was the long term sort of normal --

Ara Hovnanian

No, no. What I said, that's a more a normalized gross margin. Obviously, we were above that for good many years 24, 25. And we are well below that right now.

Stephen Kim - Citigroup

Right.

Ara Hovnanian

But I'd say that's a more normalized. I will caution although by saying, we are IRR focused.

Stephen Kim - Citigroup

Right.

Ara Hovnanian

And sometimes, we get that with a lower margin and high turnover like buying developed lots on an option basis. Sometimes, we get it through high margin, low turnover like when we have to develop our own parcels and larger parcels. So this is a mix. We don't focus specifically on gross margins.

Stephen Kim - Citigroup

And that's obviously a welcome change from 10 to 15 years ago, as we covered at our conference. I guess, I just wanted to sort of revisit though. Given what does matter, what do you think the normalized return on equity or the return on capital is?

Ara Hovnanian

I would say, somewhere in the mid 20s on an after tax return on equity. With our debt targets of 50% debt to cap or slightly less, it should work backwards to at least with that kind of level. We underwrite specific communities to a 30% unlevered IRR.

Stephen Kim - Citigroup

Right.

Ara Hovnanian

The only thing that it doesn't include is an allocation for corporate overhead. But all the other overheads, and frankly, there are far more overhead in the divisions than there is at the corporate level. But if you took all those 30% IRRs and we hit them, we would be slightly above the mid 20% for an after-tax ROE.

Stephen Kim - Citigroup

Okay. And so you are basically basing that long-term sort of conversation about where normalized margins are. With an assumption that eventually you will have the majority of your projects hit the intended IRR at the time of feasibility basis?

Ara Hovnanian

Yes, yes. We have been in excess of our IRR targets for the last few years. And obviously if we reversed it, we are well under right now. But we would expect it on normal basis to be able achieve our pro forma IRRs.

Stephen Kim - Citigroup

Right. And the move to adopt this IRR focus, as you said, the genesis of that was somewhere around 96-97, correct?

Larry Sorsby

Correct.

Stephen Kim - Citigroup

Got it. Thanks a lot guys.

Ara Hovnanian

Okay.

Operator

And your next question comes as a follow-up from the line of Alex Barron representing JMP Securities. Please proceed.

Alex Barron - JMP Securities

Yeah, thanks guys. I wanted to ask about SG&A. I guess in dollars, it was kind of flat this quarter. So, I wanted to understand, how much in the way of headcount have you guys already done reduction and I guess, how should I think about SG&A going forward?

Larry Sorsby

I don't know whether you may be missed part of the presentation, but in my part, Alex I said that we have already reduced headcounts in the past three quarters by 20%.

Alex Barron - JMP Securities

Okay. Sorry, Larry

Larry Sorsby

What we are going to do going forward, is as particular markets experienced lower sales, we'll obviously right-size the organizations, market-by-market and if they have great sales, we won’t have to make adjustments. So it's a market-by-market kind of decision.

Alex Barron - JMP Securities

Got it. And in terms of your covenants, interest coverage, leverage, what are those ratios?

Larry Sorsby

Well, our revolving credit agreement does include a debt service coverage test. However it only applies, if our leverage ratio is substantially higher than where it is today. We don't anticipate allowing that leverage ratio to reach that level. However, we recognized that we need to increase cash flow, decrease debt levels during this period of our slower housing market to just provide an even bigger cushion. But right now, with respect to our revolving credit facility, we are in fine shape.

Alex Barron - JMP Securities

But what is that ratio?

Larry Sorsby

You are not going to be able to calculate, because it’s adjusted debt levels and adjusted tangible net worth divided by adjusted debt. But just trust me it's substantially higher than where it is today.

Alex Barron - JMP Securities

Okay. If things don't pick up in term of sales pace, are you anticipating you are going to have to cut prices in some regions or how are you thinking about what is -

Ara Hovnanian

Again, we don't need prices, I mean sales pace to pick up. We just want them to stay stable. And based on the last few weeks, it seems like they are stable. If sales pace drops then absolutely, we would likely adjust our thinking by reducing prices further or adding concession and then we reevaluate land options again, the remaining land options. All of our discussions are really assuming that the most recent market environment continues. It doesn’t get better and it doesn’t get worse. And all of our projections assume flatness in the price and flatness in the pace.

Larry Sorsby

And frankly, Alex since early in our first quarter, which began in November, at the very beginning of the quarter, we did offer some additional incentives and concessions but since that time we've really not had to, other than a community here and there. We've not had to increase incentives and concession. We've already kind of been feeling some stability for a number of months now in the aggregate across the country. I mean obviously there is some exceptions to that here and there but that's how it feels on average.

Alex Barron - JMP Securities

Great, but assuming the sales pace is stable, is that an acceptable sales pace to you guys or would you rather do something for you to pace higher?

Ara Hovnanian

[I'd like to double the] current sales pace.

Larry Sorsby

I'd like to triple that.

Ara Hovnanian

But I don't know what the word acceptable means. But it's what we have incorporated into our forecast. Obviously, we’d love to do more. We want to raise prices and increase sales pace, but we have to balance everything with the market realities.

Alex Barron - JMP Securities

Okay. All right, thanks.

Ara Hovnanian

Okay.

Operator

And your next question comes as a follow-up from the line of Stephen Kim representing Citigroup. Please proceed.

Stephen Kim - Citigroup

Okay, thanks. I guess I wanted to follow-up on your guidance on the margins with respect to your $17 or $17.5 I think is what you gave for the next three quarters. I was curious as to what you felt might be some potential drivers that could move that number, that could happen in time to able to move let’s say your fourth or third quarter number up. We all know what could move it down, that’s obviously been covered very well. But you had made some mention about efforts on your part to get your cost down with your suppliers. I was wondering how much if any was embedded in your let’s say third and fourth quarter gross margin outlook from that particular area?

Ara Hovnanian

We have incorporated a much of it, of the savings we are getting, but not all of it yet. And keep in mind, as for example, new prices that we've negotiated in the last month or two, if it’s a concrete [person], well, homes we are delivering in the fourth quarter, we've already paid for that concrete because that’s in the ground already.

Stephen Kim - Citigroup

Right.

Ara Hovnanian

So it does get phased in. But in general, we feel like we've built in a lot of the cost savings we are getting, frankly margins might have been worse if it wasn’t for that fact. Might there be a little more upside on the cost in terms of benefit for us with further cost reductions, a little bit but we think we've captured a lot of it and built it in. At this point we have as we mentioned 68% either delivered or in backlog. So we really only have price opportunities on, up or down I guess in the remaining 32%. However, I will caution that I guess we've learned something that we have never really had to worry about before, that old backlog does not necessarily close at the price they are contacted for in some markets and luckily is quite isolated. But in some markets, we had to offer concessions at the closing table. Particularly, if we've lowered prices in the community and at lower net prices or new houses that are backlog. So, we've tried to build all of that into our best guess for today.

Stephen Kim - Citigroup

Okay. So, that was where I was going to go at this. In other words, that phenomenon which we know has been obviously impacting yours as well as many other people's margins in terms of your margin not being as good at the closing tables as you thought it was when it was in backlog. You've already factored something for that over your remaining two or three quarters?

Ara Hovnanian

Yes.

Stephen Kim - Citigroup

Okay, continuation --.

Ara Hovnanian

Obviously, you don't really know until you get to the closing table.

Stephen Kim - Citigroup

Sure.

Ara Hovnanian

But we've taken our best guess of the market and tried to build that in.

Stephen Kim - Citigroup

So, I guess where I am going with this. And again, I am not trying to put words in your mouth or trying to make it seem like everything is starry-eyed and rosy. We all know the downside. I am trying to understand the upside. If your pricing environment stabilizes or even slightly improves, and the impetus for buyers in your backlog or the strength they have to come to you at the closing table and demand such concessions -- well, my guess would be, it would probably not likely happen to the degree anywhere close to what you had seen over the last six months. So, what you are saying is that, since you've factored something of that in your guidance that could actually affect your gross margin realized even in the next two to three quarters, is that correct?

Ara Hovnanian

I think, I understand your question. And I guess that's correct, yes.

Stephen Kim - Citigroup

Because ordinarily, people wouldn’t think so. Someone would say, well you are going to sell it, maybe you don’t have to give as much concessions on it in let’s say three to six months. But that's not going to close until next fiscal year. And I am saying that that dynamic of having pricing stabilizing or strengthening in your communities might actually affect your backlog's margin being closer to what you think it is currently today. And if you factored in some allowance that it might be lower than that when you get to the closing tables. And that portion of it could represent upside. That's what I am getting at.

Ara Hovnanian

Yes, it could. In this environment, I just would be very cautious.

Stephen Kim - Citigroup

Sure, you shouldn't be embedding anything differently in your guidance. I am just trying to understand it. Okay and I think that was it. Thanks very much.

Ara Hovnanian

Okay.

Operator

And representing Neuberger Berman, your next question comes from Basu Mullick. Please proceed.

Basu Mullick - Neuberger Berman

Hi, I have a quick question. Can you tell me what the $51 million of intangibles write-down, how would it flow through the income statement? And the other question is, as I look at your backlog, which shifts significantly from 6,000 in south east down, and I look at the new contracts written as only very small percentage of the contracts, which is obvious for your Fort Myers write-off. How does that change the gross margin in net contracts that you are writing now?

Larry Sorsby

The first question on intangibles, I didn't hear all of it.

Basu Mullick - Neuberger Berman

My question is, using intangibles, how do they impact the going forward gross margin of the company, or is it is G&A that's flows through?

Larry Sorsby

It is in the intangible amortization line on the income statement.

Basu Mullick - Neuberger Berman

Okay. So, $51 million would impact how much in pro forma '07?

Larry Sorsby

About $12 million a year.

Basu Mullick - Neuberger Berman

Okay. And my next question is, if you look at the mix change as south east becomes much smaller on the net contracts in '07 first quarter; how does that change your gross margin?

Larry Sorsby

You mean, as we have --

Basu Mullick - Neuberger Berman

As you write the contracts, yes.

Larry Sorsby

Contracts for next quarter. As you write new contracts? Well, Fort Myers is just not a market that you could say much about right now. So the margins are --

Basu Mullick - Neuberger Berman

Zero.

Larry Sorsby

Yes, non-existent.

Basu Mullick - Neuberger Berman

So, if I took 5,800, which was in your backlog, right.

Larry Sorsby

Yes.

Basu Mullick - Neuberger Berman

And now its 2,100, right?

Larry Sorsby

3,100, yes.

Basu Mullick - Neuberger Berman

Right, so that’s --

Larry Sorsby

But not all of that is Fort Myers, but large portion is.

Basu Mullick - Neuberger Berman

That’s 2,700, right?

Larry Sorsby

Yes. I think your point Basu, and you are right; is we are getting a very sub-par margin on any Fort Myers deliveries which were affecting our average margins.

Basu Mullick - Neuberger Berman

So, between the two, what kind of gross margin are you writing at; in the net contracts that you are writing, assuming that the south-eastern mostly was zero, and that’s coming down to nothing. In your 2600 net you wrote this quarter.

Larry Sorsby

I am not sure, I understood the question Basu.

Basu Mullick - Neuberger Berman

Once again, its 2600 homes you wrote this quarter, right?

Larry Sorsby

Yes.

Larry Sorsby

Out of that only 144 is south-east?

Larry Sorsby

That’s correct, yes.

Basu Mullick - Neuberger Berman

Down from a year ago, 1,015.

Larry Sorsby

Yes, that’s correct.

Basu Mullick - Neuberger Berman

Out of 3,600.

Larry Sorsby

Right.

Ara Hovnanian

Right.

Basu Mullick - Neuberger Berman

So, net-net, what happens to the gross margin now? I took a 1,000 out of the 3,624 to 2,613.

Kevin Hake

Yes, well we don’t look at gross margin as [median or a] contract. We tend to look at any backlog. We now have 8,600 total homes in backlog, as you said with only 3,000 of those from the south-east versus a higher percentage last year 14,000 homes in backlog. We know that, we are giving you guidance as we deliver that backlog and so another 30% of the homes as we need to sell still for this year; we expect to have gross margins that for this year will average 17% to 17.5%.

Ara Hovnanian

And the Fort Myers is definitely substantially lower than that and the other market which is dragging it down. So the other markets are obviously higher than that, but we don't give specific details by market in terms of Fort Myers.

Larry Sorsby

But I think it is safe to say because of the Fort Myers impact that what we are selling on average, because we are not selling anything in Fort Myers. The new contracts we’re selling on average of higher margins perhaps than what we are going to be delivering in margins this year.

Basu Mullick - Neuberger Berman

Which stands in sharp contrast to what you just reported in gross margin, your guidance for rest of the year?

Larry Sorsby

Well, except that it has impacted, because there is still stuff in backlog from -

Basu Mullick - Neuberger Berman

Which is flying, which is flowing through there?

Larry Sorsby

Which is flowing through there, right?

Basu Mullick - Neuberger Berman

Okay. Got it. Thank you.

Larry Sorsby

Okay. Thanks Basu.

Operator

Ladies and gentlemen, this now concludes the question-and-answer session. At this time I will turn the call over to Mr. Ara Hovnanian for closing remark.

Ara Hovnanian

Thank you very much. It's obviously not as pleasant reporting in the last couple of quarters that it has been for the last 5 or 10 years. But we've been through these ups and downs for many years, many times in our 50-year history. And we are sure that in the not too distant future, we will be reporting some more positive results. Thank you very much and we look forward to giving you an update in the next quarter.

Operator

This concludes our conference call for today. Thank you all for participating and have a nice day. All parties may now disconnect.

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