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KB Home (NYSE:KBH)

F4Q07 Earnings Call

January 8, 2008 12:00 pm ET

Executives

Jeffrey T. Mezger - President, Chief Executive Officer, Director

Domenico Cecere - Chief Financial Officer, Executive Vice President

William R. Hollinger - Senior Vice President, Chief Accounting Officer

Kelly Masuda - Senior Vice President Investor Relations, Treasurer

Analysts

Stephen Kim - Citigroup

Dennis McGill - Zelman and Associates

Carl Reichardt - Wachovia Securities

Michael Rehaut - JP Morgan

Daniel Oppenheim - Banc of America Securities

Kenneth Zener - Merrill Lynch

Jim Wilson - JMP Securities

David Goldberg - UBS

Timothy Jones - Wasserman & Associates

Joel Locker - FBN Securities

Andrew Brausa - Banc of America Securities

Alex Barron - Agency Trading Group

Stephen Percoco - Lark Research

Larry Taylor - Credit Suisse

Operator

Good day, everyone and welcome to KB Home's fourth quarter earnings conference call. As a reminder, today’s conference call is being recorded and webcast on KB Home's website at kbhome.com. The recording will also be available via telephone replay until midnight on January 16, 2008. You can access this recording by dialing area code 719-457-0820, or 888-203-1112 and entering the replay passcode of 9544624.

KB Home's discussion today may include certain predictions and other forward-looking statements. These statements may cover market or economic conditions, KB Home's business and prospects, its future financial and operational performance, and/or future actions and their expected results. They are based on management’s current expectations and projections about future events but are not guarantees of future performance.

Due to a number of risks, assumptions, uncertainties, and the events outside its control, KB Home’s actual results could differ materially from those expressed in or implied by the forward-looking statements.

Many of these risk factors are identified in the company’s periodic reports and other filings with the SEC, which the company urges you to read with care. For opening remarks and introductions, I’d now like to turn the call over to KB Home's President and Chief Executive Officer, Mr. Jeffrey Mezger. Please go ahead, sir.

Jeffrey T. Mezger

Thanks, Kevin. Good morning, everyone. Thank you for joining us today for an update on our business and financial results for our fourth quarter and fiscal year ended November 30, 2007.

With me this morning are Dom Cecere, our Executive Vice President and Chief Financial Officer; Bill Hollinger, our Senior Vice President and Chief Accounting Officer; and Kelly Masuda, Senior Vice President of Investor Relations and Treasurer.

We can debate the details but I think you will all agree that the last 18 months represent one of the most challenging periods the home building industry has confronted in recent history. By mid 2006, demand for single family homes had approached near-term saturation levels, prices peaked and began falling back from their historically high levels, and speculation distorted conditions in some of the country’s fastest growing markets.

Since that time, the industry has grappled with a series of problems that continue to feed off one another and intensify the challenges of an already weakened housing market. These include an over-supply of new and resell inventories, rising foreclosure activity, intense competition for sales, reduced affordability, declining consumer confidence, and most recently turmoil in mortgage lending and other credit markets.

Our fourth quarter and full year results clearly reflect the impact of these issues. In the fourth quarter, we booked an additional pretax non-cash charge related to inventory and joint venture impairments and the abandonment of land option contracts totaling $403 million. This charge was triggered by price declines and slower sales rates, both of which impacted inventory values.

We also were required for book purposes to establish a valuation allowance on our deferred tax assets that resulted in a non-cash, after-tax charge of $514 million. The allowance was determined in consultation with our independent registered public accounting firm. For tax purposes, the benefits associated with our deferred tax assets may be carried forward for up to 20 years.

Given KB Home's track record of results over its 50-year history, we believe we will generate sufficient profits over the next several years to convert these deferred tax assets into cash and reduce our effective tax rate.

The impact of these two accounting events, coupled with diminished results from our homebuilding operations, produced substantial net losses in both the fourth quarter and the year. Dom will walk you through these results in detail in a few minutes. These are not the financial results that any CEO wants to report to shareholders. As disappointed as I am, I can also tell you that we have made significant progress over the past 12 months improving our homebuilding operations, strengthening our financial position, and right-sizing our overhead structure for current conditions.

At the same time, we have continued to invest in the product and marketing innovation that has always made KB Home a leader in our industry. I’d like to spend my time this morning reviewing our progress with you.

Let’s start with current market conditions. As we enter 2008, we see no indication that markets are stabilizing. On the resell front, there were roughly 4.25 million existing homes for sale at the end of November. That represents more than a 10-month supply. With this continued overhang of excess inventory, prices for existing homes, which had held up fairly well for the first half of 2007, have begun to decline. Over the last five months, average sales prices have dropped almost 8% from a peak of $276,500 in June of ’07 to $256,800 in November.

As for new homes, inventories have come down somewhat since the beginning of 2007, driven largely by homebuilders reducing production. However, new home sales in November were off 34% from a year ago, representing a seasonally adjusted annual rate of just 647,000 units. At this sales pace, the inventory of new homes now stands at more than a nine-month supply.

We believe pricing and margin pressures affecting our industry will continue until these inventory levels are in better balance with demand, and that will not occur, in our view, until prices have stabilized and consumer confidence is restored.

With these current market dynamics, we don’t believe sales rates are improving enough to clear excess inventories in the short term. Against this market backdrop, we continue to execute on a number of strategies that we adopted in the spring of 2006 to reposition our businesses for today’s realities. We’ve discussed these initiatives in prior calls. I’d like to review our progress now.

First and foremost, we have moved quickly to solidify our financial position, strengthening our balance sheet and generating cash. We delivered 8,132 homes in the fourth quarter, converting into revenue more than two-thirds of our backlog at the beginning of the quarter. This is a clear illustration of the benefits of our build-to-order business model and the reductions we have achieved in our average cycle time from sale to close.

We generated just under $700 million in cash in the fourth quarter, ending the year with $1.3 billion in cash and no amounts outstanding under our $1.5 billion bank revolver. We have reduced our net debt from a peak of $3.3 billion in the third quarter of ’06 to $837 million today, surpassing the goals we established earlier in the year.

Entering 2008, our capital structure is in excellent shape and we are well-positioned to capture potential opportunities as they arise, to reload our lot pipeline for higher margin deliveries.

Our leverage ratio, as measured by the ratio of net debt to total capital, has improved to 31% at fiscal year-end ’07 from 43% a year ago, and we’ve accomplished that despite the negative impact on book equity of inventory impairments, abandonments, and the fourth quarter’s deferred tax asset valuation allowance.

We have reduced owned and controlled lot counts by 65%, from 186,000 at their peak in the first quarter of ’06 to 66,000 today. Of these, just 45,000 lots are owned and 21,000 are controlled via land option contracts.

And we have aggressively converted other operating assets into cash where it made strategic sense. Most significantly, the sale of our 49% stake in our French operations on highly attractive terms at a price close to a recent market peak in France.

Second, we have intensified our focus on our unique core competencies and operating disciplines. Our most important market segment remains the first-time homebuyer, and we have been relentless in our pursuit of design and production strategies that produce a more affordable product that is highly desirable for this buyer and also competitively priced against the resale market.

We have reinvigorated our commitment to adhere to all aspects of our KB next operating principles. We are a build-to-order homebuilder with even flow production based on an order backlog of sold homes with limited spec inventory.

We have capitalized on our unique strategic partnership with Countrywide to provide attractive mortgage programs for our buyers while minimizing our exposure to defaults. In the fourth quarter, 79% of our closings were processed through our joint venture. Of these JV closings, 90% were conforming or government loans, compared to 33% one year ago, and 81% of the borrowers chose a fixed rate mortgage.

We carefully reviewed our market positions, community counts, and overhead requirements, reducing exposure where it made strategic and financial sense. Our net orders were off 32% in the fourth quarter, in large part due to the reduction in active selling communities. For 2008, we are now estimating that our community count will be down 25% to 30% versus 2007.

As we have shared in the past, it does not make sense to invest the cash required to open a community if we cannot achieve our financial targets.

On a regional basis, net orders for the West Coast were down 12%; Southwest net orders were down 16%. In Central, net orders fell 43% while in the Southeast, they were down 40%. For both the Central and Southeast, we are experiencing a more dramatic drop in community count and sales comps due to exiting the Indianapolis, Gulf Coast, Texas Valley, Fort Myers, and Treasure Coast markets.

Third, we have continued to build a highly visible brand pursuing strategies that differentiate KB Home from other builders in the marketplace. Over the last 12 months, we’ve introduced newly designed, more affordable homes in our active selling communities at lower price points.

Our KB Home studios remain at the core of our unique build-to-order approach, allowing homebuyers to customize their homes with thousands of design choices at an affordable price. This remains a huge advantage as option revenue from our design studios in 2007 averaged $31,500 per home, or 13.3% of the base price. That compares to $32,300 or 12.4% of the base price per home in 2006.

And these comparable results were generated during an environment of significant pricing and affordability pressure, underscoring the importance the consumer places on choice and value.

We’ve launched highly successful co-branding initiatives with two of the world’s leading brands, Martha Stewart and Disney. We now have Martha Stewart communities in six states across the country, offering buyers the opportunity to create a home that features Martha’s distinctive design.

Under our collaboration with Disney, our homebuyers in all communities will be able to choose from Disney’s imaginative line of home products designed exclusively for KB Home buyers.

We are making great progress in our My Earth environmental initiatives, with the goal of positioning KB Home as the most environmentally friendly national builder. For example, we announced in December that we will exclusively offer only Energy Star certified appliances in our homes. Having one business model company wide allows us to leverage volume with our national accounts and provide this enhanced product in every community with minimal additional cost. This is but one of several opportunities we have identified for our My Earth program. It builds our brand, helps the environment, is appealing to the consumer, and does not add to the cost of the home.

In summary, we’ve moved aggressively over the past 12 months to strengthen our financial position and align our operating structure to reflect current market realities, while continuing to enhance key strategic programs for our future.

All these initiatives are serving us well in today’s market conditions, but just as importantly they set a foundation for future opportunities. As the market recovers, I believe we will be better positioned than most. Favorable demographics and continuing population growth in the markets we serve provide an expanding pool of renter households that will drive first-time homebuyer demand for the foreseeable future.

With our unique product appeal, our effective Countrywide partnership, our dedicated sales counselors, and our built-to-order approach, KB Home is the clear choice for the consumer.

I would like to close my remarks by thanking all our KB Home employees for their extraordinary accomplishments in 2007. I am proud of their performance. They’ve moved quickly and effectively to reposition our company for today’s market conditions and done a great job in preparing us for the market opportunities to come. In our 50-year history, KB Home has successfully managed through many tough economic cycles, each time emerging a stronger company. With this track record and the steps we have taken to properly position ourselves, our future is bright.

Now, let me turn the call over to Dom for a financial review.

Domenico Cecere

Thanks, Jeff. Let’s start with operating results -- net orders of 2,574 new homes in the fourth quarter were down 32% on a year-over-year basis. Community counts entering 2008 are down over 30% from the prior year. We had 380 active selling communities in 2007 and expect community counts in 2008 will be down 25% to 30% from this level.

We entered the fourth quarter with 11,880 sold homes in backlog and converted 8,132, or 68% of our backlog to revenue. That compares to a conversion ratio of 42% in the third quarter and 60% in the fourth quarter of 2006.

Cancellations in the fourth quarter were 30% to beginning backlog and over the last six quarters, this ratio of cancellations to beginning backlog has ranged between 29% and 33%.

The average sales price of the homes we delivered in the fourth quarter decreased 12% to $247,800 from $280,000 in the fourth quarter of 2006. That average sales price was just slightly below the $256,800 average sales price for a resale home in November.

Year over year, sales prices were down 19% on the West Coast, 14% in the Southwest, and 7% in the Southeast. Sales prices were up 4% in the Central region, solely due to mix.

Our housing gross margin in the fourth quarter, excluding impairments and abandonments, was 10.1%. That’s down from 13.9% in the third quarter and 14.9% in the second quarter of 2006. The average sales price has dropped 9% in the last two quarters, while resale pricing was down nearly 8%.

SG&A expenses in the fourth quarter decreased 31% from a year ago and at 11.3% of housing revenue was slightly better than 11.4% in the fourth quarter of 2006. This improvement primarily resulted from a more than 50% reduction in G&A in the fourth quarter compared to the year earlier quarter.

Homebuilding’s pretax loss from continuing operations for the fourth quarter included $320 million of inventory land option contract and joint venture impairment charges, and $82 million in option abandonment charges related to 5,800 lots under option contract. Approximately $100 million of these charges were against unconsolidated joint ventures.

Excluding these charges, our continuing operations remain slightly profitable in the fourth quarter.

At the end of the fourth quarter, we owned or controlled approximately 66,000 lots, down 65% from a peak of 186,000 lots owned and controlled in the first quarter of 2006. Of the 66,000 lots total, we own less than 45,000 lots today -- approximately a two-year supply of land and have approximately 21,000 lots controlled via land option contracts.

We have approximately 6,000 homes in production at the end of the fourth quarter, with just 16%, or 945 homes unsold. That’s up slightly from 14% in the third quarter of 2007, one of the lowest levels of spec production in the homebuilding industry. Homes in production are down almost 70% from their peak in the second quarter of 2006, a clear illustration of our adherence to our built-to-order business model. We had approximately 484 finished unsold homes in inventory at year-end, spread across 418 active selling communities -- just over one per active selling community.

Now let’s move to the balance sheet. As of November 30, 2007, our debt net of cash totaled approximately $837 million. That represents a 62% reduction from over $2.2 billion of net debt just one year ago. We reduced debt net of cash by approximately $1.4 billion, improving our net debt to total capital ratio to approximately 31% at the end of 2007, from 43% at year-end 2006.

Our tangible net worth declined by approximately 37% over the last 12 months from $2.9 billion at the end of the fourth quarter of 2006 to $1.9 billion at the end of the fourth quarter of 2007. This was largely a result of approximately $900 million in after-tax impairment and abandonment charges and approximately $514 million related to the deferred tax asset valuation allowance. As we generate future profits, the valuation allowance will reverse and book equity will be restored.

As noted in our press release, we have begun discussions with our bank group regarding the balance sheet impact of the non-cash FAS-109 valuation allowance on certain net worth covenants. We have already received a waiver from our bank group covering this issue for the fourth quarter 2007 and we expect to complete an amendment to our financial covenants in the first quarter of 2008.

We have a longstanding relationship with many of our banks and remain confident, especially in light of our strong cash position and low leverage, that we will successfully negotiate the necessary modifications on our bank agreement by the end of this quarter.

Now let me turn it back to Jeff for closing comments.

Jeffrey T. Mezger

Thanks, Dom. In closing, I would like to reiterate a few key messages -- as we’ve now demonstrated, we moved quickly to strengthen our financial position and generate cash. In fact, we exceeded our goals in that regard for 2007. Our strong balance sheet and ample liquidity provide us the opportunity to selectively reload our land pipeline with higher margin communities in 2008.

We’ve intensified the execution on our unique core competencies and proven KB next operating disciplines, and we continue to build a highly visible brand, pursuing strategies that successfully differentiate KB Home from other builders in the marketplace.

We have a proud 50-year history in which we’ve navigated through difficult times like this before, every time coming out a stronger company. Our past experience managing through downturns helped us in identifying the appropriate steps to take and these actions now have KB Home well positioned to capitalize on opportunities as they arise.

It is unclear when the markets will stabilize and therefore difficult to provide a forecast for 2008. I can assure you that we will remain diligent in prudently running the business at whatever volume market circumstances support, with the primary goal of restoring profitability.

With that, let me open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) First up on our roster is Stephen Kim at Citigroup.

Stephen Kim - Citigroup

Thanks for all the information on your call. I had a quick question regarding your deferred tax asset balance. I just want to make sure that I’m clear on what your residual balance that exists today implies for your ability to harvest deferred tax assets over the next four quarters. My understanding of the ENY interpretation is that they are essentially requiring you to write-off whatever deferred tax assets are unlikely to be harvested through delivering homes or selling land in the next four quarters.

But I was curious as to whether or not that interpretation applied both to the deferred tax asset created by the impairment charges as well as the deferred tax assets that have been built up or accrued related to other corporate activities, like deferred comp and other things like that. So I just want to make sure I understand what exactly we can expect in terms of cash flow implications from the $222 million you have in deferred tax asset on the balance sheet right now.

Domenico Cecere

I’m going to ask Bill Hollinger to respond to you on the 200.

William R. Hollinger

I’ll try to do the best. It might need some multiple follow-ups, but first of all I’ll kind of answer the last part of that question -- the $222 million, we would realize that probably in ’08 and ’09, so that really represents a long-term receivable that we would collect here in ’08, ’09, the years, so we fully expect to get that and there’s really no issue on realizability of that.

The issue of -- you said as far as the auditor’s interpretation, there is really I don’t think any difference or view in terms of the impairment, or in terms of the valuation allowance to either the impaired deferred tax assets or the unimpaired deferred tax assets, so that issue is more or less one and the same.

Stephen Kim - Citigroup

I see. Okay, that’s great. No, that helps greatly. The second thing I wanted to ask relates to what you are seeing in terms of buyer activity in your communities. Can you give us a sense for -- if you have seen any change in the kinds of buyers who are actually stepping forth and actually on whom you are actually closing transactions with? Are you finding that there is an increased number that are currently renting? Are you finding that there is a shift in the age of your buyers? And I’m talking really in the last three months or so, three to four month, or any other salient difference that you have noticed in terms of your actual closed customers in the last quarter or so.

Jeffrey T. Mezger

I can talk to the period through November. We don’t make comments intra-quarter, but I don’t know that things have changed much since November in terms of buyer profile. We’re definitely seeing a buyer that views owning a home as their lifestyle and something they intend to live in for a while. The days of buying it to flip it six months from now as an easy make or as an investment really are gone, so this is a true, normal housing climate, traditional buyer.

A lot of the move-up buyers are having difficulty disposing of their existing home, in many cases, upside down on their equity so those buyers for the most part in our business have left the market because they can’t dispose of their current residence and that’s why we’re focusing very diligently on lower price points and reaching out to the first-time buyer who has the ability to close on a transaction.

Operator

Moving on to our next question, this is Ivy Zelman at Zelman and Associates.

Dennis McGill - Zelman and Associates

It’s actually Dennis McGill. The first question just had to do with the dividend -- is there any covenants that you guys would have to revisit in response to the dividend over the next year, or do you feel that that’s fairly safe?

Jeffrey T. Mezger

Dennis, I’ll have Kelly Masuda answer that one.

Kelly Masuda

From a covenant compliance perspective, Dennis, we have cushion both under our revolver and our senior subordinated debt.

Dennis McGill - Zelman and Associates

Implying that you would not have to make any adjustments currently?

Kelly Masuda

Correct.

Dennis McGill - Zelman and Associates

Okay, and then just a second question would be kind of a big picture view -- realizing where you guys are today, you’re in a great liquidity situation, you’ve got a lot of cash on the books, you’ve got $17 of cash per share, which is basically where your stock is trading today. The market is making a pretty dire case for what the fair value of your assets, [looking at] what your debt’s currently at. I’m just wondering what your interpretation of that view is right now. It seems overly bearish in our mind, looking at where your balance sheet situation is and looking out over the next five to seven years, but maybe you guys could answer what you think is going on in the view of the market, just thinking about what you know about your assets right now.

Domenico Cecere

I think the market now at least understands that we have a -- you know, [inaudible] cash and as you all pointed out, at $17 a share. We also have $700 million of deferred tax assets -- that’s another $9 per share of future cash. So we look at it as a $26 value and the market has our stock down under $18, so we believe that the stock is under-valued compared to the liquidity of the assets that we have in place.

Dennis McGill - Zelman and Associates

I guess that’s it for us now. Thanks.

Operator

Moving on to our next question, this is Carl Reichardt at Wachovia Securities.

Carl Reichardt - Wachovia Securities

Good morning. Jeff, last year some of your peers talked about attempting to hold margin headed into the spring selling season tactically. I’m curious if you’ve had sort of a broad overview of what your base marketing strategy is headed into this spring, if it’s much different than what you’ve been running the last couple of quarters. I’d just like your thoughts on that.

Jeffrey T. Mezger

I think you will see a shift, Carl, as I said in my final closing comments, we’re focused on the primary goal of restoring profitability and we have this war chest of cash now and it’s patient money for us. We’re not going to jump and do anything with it. We’re going to stay opportunistic and we’re focused on increasing margins.

So we don’t need -- you can always use more cash. We don’t need it right now to run the business. What we need is more profit and that’s where the focus will be in ’08.

Carl Reichardt - Wachovia Securities

Is that a function of the -- well, I mean, this is a -- is that a function of the mix of your stores likely changing in 2008 and into 2009 because you are able to reinvest into some deals that make more sense, or is that a function of in existing communities where absorptions are slow saying we’re willing to take those slower absorptions?

Jeffrey T. Mezger

I think it’s both, Carl but clearly we think we’re well-positioned to acquire new lots that are aligned with our strategy at lower price points and higher margins and that’s where our focus will be.

Carl Reichardt - Wachovia Securities

Okay, great. I’ll get back in queue. Thanks, Jeff.

Operator

Next up we have Michael Rehaut of JP Morgan.

Michael Rehaut - JP Morgan

Thanks. Good morning. First question, just on the orders and the order ASP numbers, were you surprised given the sharp drop-off in orders relative to the fact that your order ASPs came down another 20% from the third quarter? And if you could give us a little bit of color on in terms of the order ASP number, which we have at 174 on average, I know region by region it’s very different but particularly like the West Coast, how much of that change was mix versus pure price declines?

Jeffrey T. Mezger

Mike, we can work with you offline on the numbers because you are trying to track back from backlog to backlog at the end of each quarter. Our prices are not down anywhere near the kind of numbers that you just quoted.

In terms of our price drops, however, it’s a combination of things. In part, the markets have softened a bit, so prices came down in the normal course but we’ve strategically moved to reposition to lower price points and smaller product that’s more affordable. In many of the land constrained, high-price areas, frankly our product got too big for the normal consumer.

So we’re moving our prices down strategically with these smaller products. However, at the same time, our community count is way down so sales -- in part, the negative sales comp is that we’ve intentionally reduced community count because we don’t want to fuel a bunch of cash in the communities where we can’t get our returns.

So in terms of sales rates, the last thing I was going to say is in terms of sales rates, our lower priced products are actually selling well. It’s the move-up communities that continue to struggle.

Michael Rehaut - JP Morgan

So your community count on average for 4Q was 418, did I hear that right?

Domenico Cecere

Yeah, but those were a lot of close-out communities. Entering 2008, our community counts were down over 30% and that’s what affected the order trends. And the reason the prices were down is because resale prices, we’ve been pricing against resale. Resale prices dropped 8% and we dropped 8% with them. So our pricing is tracking against resale, which is, you know, we’re at about $250,000 right now.

Michael Rehaut - JP Morgan

Okay, so just --

Domenico Cecere

But it’s really a question of whether you invest in opening more communities in a market where there’s no demand. We’ve decided that we’d rather generate cash than open new communities and be prepared to grow the business when the market starts to recover.

Michael Rehaut - JP Morgan

Okay, so what was the average community count for 4Q and the 4Q end community count?

Domenico Cecere

Well, the average for 4Q I believe was 418, but that -- you know, that’s the peak always in the air, and then going into ’08, it’s going to be -- we averaged 380 and we’re going to be down to just under 300, I believe.

Michael Rehaut - JP Morgan

Okay, last question, if you have it -- in the quarter, can you give us what the gross margin benefit was from impairments in prior quarters?

Domenico Cecere

I don’t really think it means anything, so probably the answer is no.

Michael Rehaut - JP Morgan

Okay. Other builders have been able to provide that, but --

Domenico Cecere

Some do and some don’t, I think, Mike.

Michael Rehaut - JP Morgan

Sorry?

Domenico Cecere

Some do and some don’t.

Michael Rehaut - JP Morgan

Okay. All right, well, thanks a lot.

Operator

Moving on now to Daniel Oppenheim, Banc of America Securities.

Daniel Oppenheim - Banc of America Securities

Thanks very much. I was wondering if you could talk about the -- a little bit more in terms of move-up and price points. If you look at your cancellations, if you were to think about that, how much of that was coming from move-up buyers who weren’t able to sell versus low-end buyers where there’s a financing issue, or just getting cautious in the environment?

Jeffrey T. Mezger

Dan, that’s a moving number by market so I really -- we don’t have the data that would detail entry level buyer versus a move-up buyer at hand.

I’ve seen a lot of media coverage or analyst coverage talking about the first-time buyers’ inability to get a mortgage. It’s absolutely not true. FHA, VA Financing, or in the price points that are slightly above that conventional conforming, there’s ample liquidity out there. They just have to have a 3%, 4% down payment on FHA loans and they go.

So as we shared in our statistics, we’ve quickly moved to a different mortgage product that is qualifying the buyer.

Domenico Cecere

And by the way, in our backlog now, one out of every three buyers are government loan.

Daniel Oppenheim - Banc of America Securities

Okay, and then in terms of the inventory, you were talking about how it takes some time to work through that, what are you thinking about your community count plans for 2008?

Domenico Cecere

Well, we said they’d be down 25% to 30% in ’08 from ’07.

Daniel Oppenheim - Banc of America Securities

Sorry, I missed that. Thank you.

Operator

Next from Merrill Lynch, this is Kenneth Zener.

Kenneth Zener - Merrill Lynch

I wonder, how many of your owned lots, the 45,000, are in active communities?

Domenico Cecere

The vast majority.

Kenneth Zener - Merrill Lynch

Okay, so when you talk about not investing, upwards of 80%, 90% of your lots are in those active communities?

Domenico Cecere

I would say yes -- maybe probably closer to 80 than 90.

Kenneth Zener - Merrill Lynch

Okay, and then can you talk about what you expect to spend on land development and land acquisitions in ’08 versus ’07?

Domenico Cecere

It’s probably down another 30% -- [inaudible] is spending about $3 billion a year, half purchased land and half development and that’s been cut by two-thirds. But it’s going to be dependent on what demand is going to be throughout the year. But it’s definitely less than $1 billion.

Kenneth Zener - Merrill Lynch

Okay, and I guess of the -- going back to the FAS-109, the 514, is it -- you’re under this opinion that you have to actually report taxable income in each period to recognize it or do you just have to reverse the trend where you now start having positive taxable income?

William R. Hollinger

I think it was kind of both but I’m not sure I understood the question. Can you repeat it again?

Kenneth Zener - Merrill Lynch

Once you start reporting positive taxable income, can you recognize or reverse the whole piece that was turned around based upon your current negative taxable income?

William R. Hollinger

I mean, again there’s a lot of judgment and facts and circumstances that surround this issue but you are first going to have to get yourself out of the -- in all likelihood, the three-year cumulative loss issue before you can start recognizing it. So you might turn profitable but you may not be able to recognize it until you get yourself out of again this cumulative loss situation.

Kenneth Zener - Merrill Lynch

Okay, good, and just one last question; Jeff, on the last quarter, I asked you about this large Inspirada joint venture in Vegas. Was that part of the joint venture impairment this quarter?

Jeffrey T. Mezger

We did take an impairment in Inspirada this quarter.

Kenneth Zener - Merrill Lynch

And what was the change in assumptions? Because last quarter, it was kind of described as something bought really well below the market. Was it volume or pricing?

Jeffrey T. Mezger

Prices have continued to come down a bit in Vegas; in particular, resales and we still view Inspirada as a great asset. It’s in the top sub-market. It’s entry level product but it got squeezed a little bit in price like the rest of the market.

Kenneth Zener - Merrill Lynch

Thank you.

Operator

A question now from Jim Wilson, JMP Securities.

Jim Wilson - JMP Securities

Thanks. Good morning, guys. I was wondering if you could give a little color regionally on two things, that’d be my two questions; one on impairments during the quarter, where you took them, and I’m not sure I missed it; and the second on margins pre-impairments. I know your overall number but I was wondering what it -- could you give any color in general what it looks like by region?

Domenico Cecere

Let me look for the -- in the fourth quarter, over 30% of the impairments were in California, 46% were in the Southwest, 17% were in the Southeast. Those are the major three areas for the impairments. And that was in 57 communities, which includes 11 JVs.

On margins by region, I’m not sure I could give you that. I wouldn’t have that. I just don’t have it in front of me.

Jim Wilson - JMP Securities

Okay. I was just wondering, any sense of where is higher, where is lower, things of that nature? I can get back to you on it.

Domenico Cecere

Yeah. There’s not as big a swings as they used to be.

Jim Wilson - JMP Securities

Okay. All right, fair enough. That’s good. Thanks.

Operator

Now from UBS, this is David Goldberg.

David Goldberg - UBS

I was wondering if you could give us some more color -- you were talking about the percent of the average selling price that was coming from options in the design studio. I was wondering if you give us a little bit of color if there’s been a change in what kind of options people are choosing and maybe the profitability of the options that they are choosing?

Jeffrey T. Mezger

One of the shifts we saw through ’07 was less money on the sizzle type options and more focus on the core things, like cabinets, flooring -- less of the luxury lifestyle and more of those things that are fundamental in need for the consumer.

But we really don’t right now expect that our studio sales will change much going into ’08. I think they will continue to spend the same dollars, just move it around to more core items.

David Goldberg - UBS

Great, and then I guess my follow-up question was just about Countrywide, if you’re thinking at all about changing the JV -- any concerns about liquidity and availability or capital or anything like that, maybe bringing in a [inaudible] or someone like that moving forward?

Jeffrey T. Mezger

Well, we don’t have that concern right now. Countrywide’s been a great business partner. They’ve stepped up in every way along the way and we had a great fourth quarter in our closings, in large part because of their performance.

We have our own line in the JV and it operates independent, so to us it’s a great partnership and we’ll just keep running it with them.

David Goldberg - UBS

Thanks.

Operator

Next up is Timothy Jones, Wasserman & Associates.

Timothy Jones - Wasserman & Associates

Congratulations on the $2.4 billion reduction in inventories. Nice to see for once -- not for you, for the industry.

First, a question -- I’m really surprised on this 46% impairments in the Southwest. But you include more -- that’s not just Texas, so that -- was that in the other markets you have in the Southwest?

Domenico Cecere

No, that was actually Las Vegas and Arizona.

Timothy Jones - Wasserman & Associates

Okay, because I don’t think you’d have any in Texas. Okay --

Domenico Cecere

And a little bit in Albuquerque.

Timothy Jones - Wasserman & Associates

Okay. I’m intrigued and I’m pleased with your 30% reduction in communities. You have the strength, financial strength to rather than have to sell these marginal communities to mothball them. Do you have any kind of a number there that you’ll just put it aside, either partially completed or communities and just mothball them and just carry them?

Domenico Cecere

We don’t have that many. Remember, we’re down to 45,000 lots owned so we really have just gotten ourselves into a very lean land position overall.

Timothy Jones - Wasserman & Associates

I see. That’s a nice position to be in. And lastly, can you tell me what’s going on in the Central region, why the sales are down so sharply there?

Jeffrey T. Mezger

As I mentioned in my comments, Tim, while Indianapolis wasn’t a large business for us, it was 600, 700 units a year in ’06, so that’s gone now. We pulled out of Texas Valley, which was 300 or 400 units in sales in ’06 and also now from the Gulf Coast. So we’ve knocked down our community count and that, on an annual basis, is probably -- from the markets we withdrew in that region, it’s probably 1,000 sales a year. But even in the markets that we’re in, like Houston, Dallas, San Antonio, our community count is down year over year and that’s driving a lot of the negative sales comp. The Texas market is actually holding up okay relative to the coast.

Timothy Jones - Wasserman & Associates

That’s what I thought. Thank you very much.

Operator

Next up we have Joel Locker, FBN Securities.

Joel Locker - FBN Securities

Just wondering if you had a breakdown of the other 90%, with a 10% gross margin, just the 90% expenses between land, labor, and materials?

Domenico Cecere

I don’t know if I can -- I don’t think I quite understand the question. You mean the 90%, what is the -- how much is land and how much is the construction of a house?

Joel Locker - FBN Securities

Land, labor, and materials, if you have.

Domenico Cecere

Well, off the top of my head, I would say it’s 55% is the construction of the house, 25% is land, and then another 10% is expenses. I don’t know if I hit that right but 55 and 35 would be 85 --

Joel Locker - FBN Securities

Right, another 10 -- 10% expenses --

Domenico Cecere

It’s 55% -- 54% direct construction and -- that’s got the impairment in it, Kelly, so it’s hard for me to get. Yeah, 55, 25, and 10, roughly.

Joel Locker - FBN Securities

And the other question, you had $290.3 million of just impairments between land and option walk-aways. What part was the actual option and pre-acquisition cost charges?

Domenico Cecere

$72 million is abandonment.

Joel Locker - FBN Securities

All right. Thanks a lot. I’ll jump back in the queue.

Operator

And we’ll move on to Andrew [Brausa] at Banc of America Securities.

Andrew Brausa - Banc of America Securities

I wanted to know if you could comment on the absorption trends you saw throughout the quarter and whether you saw month to month any sort of major changes.

Jeffrey T. Mezger

We don’t typically get into too much of the month-to-month trends, Andrew. I can tell you, and this is a ways back -- keep in mind the quarter ended in November, but September clearly got rattled because that was on the heels of the credit market tightening up and a lot of the mortgage product having been eliminated in June, July, and August, but I don’t recall in reflection that it was materially different from month to month.

Andrew Brausa - Banc of America Securities

Okay, and I guess obviously you don’t have anything maturing until late 2008 and obviously plenty of cash on hand, as you guys alluded to. When you look out into 2008, you see community count down 25% to 30%. Is there any sort of order of magnitude of cash flow you guys might be expecting to get into the company?

Jeffrey T. Mezger

We do expect in ’08 to be cash flow positive, if things hold and, you know, we run the --

Domenico Cecere

We’ll know later in the year. The big swing factor is how many homes do we get delivered in ’08 and once that’s solidified and we see the selling season, then we’ll know how much cash we generate. But our goal is to be definitely cash flow positive, just like we’ve been in the past -- just not the same level.

Andrew Brausa - Banc of America Securities

Okay, thanks, guys.

Operator

We have a question now from Alex Barron at Agency Trading Group.

Alex Barron - Agency Trading Group

I was hoping you could break out the impairments between what you did for option write-offs versus the community write-downs, land write-downs?

Domenico Cecere

Well, we said options was -- go ahead.

Kelly Masuda

$72 million and $218 million.

Domenico Cecere

And $218 million community impairments.

Alex Barron - Agency Trading Group

Okay, thanks. I was also wondering, as far as your joint ventures, were there any sales of any of the joint ventures or did you walk away from any that maybe some other partners have gone, or vice versa? Any joint ventures that you had to consolidate where somebody else walked away?

Jeffrey T. Mezger

We did dispose of three in the quarter through a sale, Alex. We manage all our JVs just like every other community and it is our intent to lessen our investment in JVs through ’08.

Alex Barron - Agency Trading Group

Okay. Can you comment at all on the purchase price or location?

Jeffrey T. Mezger

Of the three that we disposed of?

Alex Barron - Agency Trading Group

Right.

Jeffrey T. Mezger

One in Texas, one in Sacramento, and one in Tucson.

Alex Barron - Agency Trading Group

Okay, great. Also, I didn’t catch here if you mentioned your finished specs for the quarter.

Domenico Cecere

I think it was about 484 I believe is what I said -- just a little over one per community in the quarter.

Alex Barron - Agency Trading Group

Okay, got it. Last question, as far as your community count, it seemed to have gone up slightly from last quarter. I was just wondering how to interpret that.

Domenico Cecere

You really can’t. I mean, it’s a -- the fourth quarter is when we are closing out of a lot of communities and we are opening new communities to enter 2008, so it’s an anomaly. It comes right back down in Q1. It’s best [inaudible] just to look at the year-to-year and not quarter-to-quarter.

Operator

We’ll go to Lark Research and Stephen Percoco.

Stephen Percoco - Lark Research

Thanks. Could you give us some additional information on the impairments? For example, what was the fair value after impairment of those properties that you took charges on?

Domenico Cecere

I wouldn’t have that, to be honest with you, in front of me.

Stephen Percoco - Lark Research

Okay. Can you give us any idea of the assumptions that you have used to determine the threshold for impairment going forward?

Domenico Cecere

We’re using the same assumptions every quarter on impairments. I mean, the good news is we’re down to 45,000 lots owned and only 20,000 options and land which was at peak $7.2 billion is down to $3.3 billion, so we are working our way through it but we’ve really got a pretty lean lot position and inventories have been shrunk significantly since the beginning of the -- well, since six quarters ago.

Operator

Next up we have Larry Taylor at Credit Suisse.

Larry Taylor - Credit Suisse

Thanks very much. I wonder if you could talk about the potential uses for free cash flow in 2008. Do you have a priority and if market conditions don’t change, do you intend to continue to stockpile cash? Would you reduce other debt on the balance sheet?

Domenico Cecere

Well, we did say that we would generate free cash flow next year so we are going to continue to generate cash. There’s no debt that would be reduced until December 2008 when $200 million of the senior subordinated debt becomes due.

Larry Taylor - Credit Suisse

Okay, and can you envision -- so I think that answers the question that you would basically be stockpiling cash? In other words, continuing to build liquidity?

Domenico Cecere

Unless we see a change in the market.

Jeffrey T. Mezger

We intent to keep ample liquidity until there are signs that the markets are stabilized and we’ll reinvest as opportunities come up.

Larry Taylor - Credit Suisse

And that may already answer my second question, but let me ask it anyway to be clear; are there any markets today that you would invest in or opportunities going into the first quarter here, given your liquidity and financial wherewithal where you could see yourselves putting money into those markets in --

Jeffrey T. Mezger

Are you referring to our existing markets or new markets?

Larry Taylor - Credit Suisse

Either existing or new markets, but basically where you would be increasing your investment, essentially building a larger block of available lots, for example.

Jeffrey T. Mezger

Well, I was asking in that we do not see the need to enter additional markets right now. There’s so much upside in market share gains where we are at. In any given market, we’re absolutely interested in investing in the right opportunity at the right price point. There’s demand in every market that we’re in. You just have to figure out how to make margin at an affordable price point and that’s where we’re headed in ’08.

Larry Taylor - Credit Suisse

But you would say we’re not there yet, or --

Jeffrey T. Mezger

We think there will be better opportunities in the future.

Larry Taylor - Credit Suisse

Thanks very much.

Operator

With that, ladies and gentlemen, we’ll wrap up the question-and-answer session and I’ll turn things back over to our speakers for any additional or closing remarks.

Jeffrey T. Mezger

Thank you for joining us today. We hope to speak again with all of you in the near future. Have a great day.

Operator

Again, that concludes today’s conference call. Thank you again for joining us, ladies and gentlemen. Have a good day.

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Source: KB Home F4Q07 (Qtr End 11/30/07) Earnings Call Transcript
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