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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, Treasurer

Analysts

David Goldberg - UBS

Michael Rehaut - JP Morgan

Alan Ratner - Zelman and Associates

Kenneth Zener - Merrill Lynch

Jim Wilson - JMP Securities

Timothy Jones - Wasserman & Associates

Joel Locker - FBN Securities

Nishu Sood - Deutsche Bank

Stephen Kim - Alpine Mutual Funds

Alex Barron - Agency Trading Group

KB Home (KBH) F1Q08 Earnings Call March 28, 2008 11:30 AM ET

Operator

Good day, everyone and welcome to KB Home's first quarter earnings conference call. As a reminder, today’s conference 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 April 6, 2008. You can access this recording by dialing 719-457-0820, or 888-203-1112 and entering the replay pass code of 7868747.

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 for future events but none are guarantees of future performance.

Due to a number of risks, assumptions, uncertainties and 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 would 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, Courtney. Good morning, everyone. Thank you for joining us today for an update on our first quarter results. With me this morning are Dom Cecere, our Executive Vice President and CFO; Bill Hollinger, our Senior Vice President and Chief Accounting Officer; and Kelly Masuda, our Senior Vice President of Investor Relations and Treasurer.

The first quarter of 2008 continued to be challenging. The most recent available national data indicates year-over-year declines in both sales activity and sales prices for new and existing homes. Inventory levels in both categories remain elevated at about a 10-month supply. Additionally, the ongoing turmoil in the financial markets and rising concerns about recession are negatively impacting consumer confidence.

Earlier this week, the conference board reported that the consumer confidence index fell 11.9 points to 64.5 in February, a level usually seen only during recessions. In addition, consumer expectations about the future fell to their lowest point since 1973 when a recession was followed by inflation.

Many potential buyers either cannot or will not make a purchase commitment today. Some are worried about losing their jobs, others believe prices have further to fall. Many are simply unable to qualify for financing, given the more restrictive lending environment.

Competition remains fierce for buyers who are prepared to close a sale, a reality which continues to pressure both home prices and margins.

While these factors impacted our first quarter financial results, the good news is that the apparent acceleration of these negative trends also gets us closer to the eventual recovery. For the quarter, we took $224 million of impairment and abandonment charges and a $100 million charge for a deferred tax asset valuation allowance. Largely as a result of these charges, we reported a net loss for the quarter of $268.2 million, or $3.47 per diluted share.

The impairment charges were triggered mainly by additional price reductions in several of our markets where rising inventory levels and tighter mortgage underwriting standards are creating intense competition for sales.

Record declines in home prices have continued into 2008, with home prices dropping approximately 11% year over year in January according to the S&P/Case Schiller home price index, primarily due to the higher supply of new and existing homes. These factors contributed to our need to make additional price reductions in many of our communities.

In addition, consistent with our focus on cash flow and a strengthened balance sheet, we booked $77 million in impairments for future land sales and targeted asset dispositions. About 16% of the impairment charges, roughly $36 million, were taken against our investment in unconsolidated joint ventures. Our total investment in unconsolidated joint ventures has dropped 32% to $281 million at February 29th of ’08 compared to $413 million a year ago.

As most of our projects have a three- to five-year life, you will continue to see our joint venture investment levels winding down over the next year or two and the associated debt being reduced.

Regarding the deferred tax asset valuation allowance, as you’ll recall we took a substantial charge in the fourth quarter of 2007 due to the accounting interpretations in this area. In the first quarter of 2008, we were required to book an additional charge to fully reserve the tax benefits generated from our pretax loss. We would expect to generate further reserves if we were to incur additional impairments and losses in the future.

As of February 29, 2008, our valuation allowance on deferred tax assets was over $600 million. Despite having this valuation allowance for book purposes, we expect to realize these tax benefits in future periods when we return to profitability.

We continue to execute on the action plans we put in place 24 months ago that have us well-positioned during the downturn. We remain focused at KB Home on strengthening our financial position, trimming our home building operations and overhead structure where appropriate for current demand levels, and making prudent strategic decisions to position us for the future.

Let me give you a progress report on our top three strategic initiatives. First, financial strength remains our top priority. At February 29, 2008, our cash balance was unchanged from year-end at roughly $1.3 billion. That reflects a concerted effort to preserve cash, given that we typically use cash in the first half of any year and then generate cash in the second half. We anticipate generating positive cash flows for the remainder of the year.

We further reduced our inventory levels to $2.9 billion and in the first quarter with approximately 59,500 lots owned or controlled. That is down 68% from a peak of 186,300 lots owned or controlled in the first quarter of 2006. Our quarter end inventory balance was down 48% from the $5.5 billion balance at February 28, 2007.

On the debt front, our leverage ratio net of cash was 35% at quarter end. This is well below our targeted range of 40% to 50% and also well below our 46% ratio a year earlier. We had more than $2.3 billion of liquidity at the end of the first quarter, with no borrowings outstanding under our $1.3 billion revolving credit facility.

Finally, we amended our credit facility in January with favorable terms that we believe reflect our solid financial status. We also believe this amendment provides us with the additional flexibility to operate our business as we navigate through today’s market conditions.

Second, we continue to take steps to consolidate our home-building operations and focus on our market strengths. We operated from 38% fewer communities during the first quarter, reflecting our strategy to downsize operations in certain markets as backlog is delivered and completely exit others.

As I have mentioned on previous calls, we see no reason to invest the cash required to open a new community if it will not achieve our financial targets. We will continue to operate with fewer communities until we see reasonable signs of a recovery and can justify additional investment in new properties.

Last year, as you know, we chose to exit Indianapolis, Fort Myers, Treasure Coast, Gulf Coast, and [McCallen]. More recently, we have decided to wind down operations in Washington, D.C., Chicago, and New Mexico. That said, we are honoring all existing obligations in these markets and closing out communities in a measured, prudent manner while continuing to uphold our high standards of quality and customer satisfaction.

We will continue to evaluate and re-evaluate our existing markets based on current and projected financial performance. Our most important and largest geographic footprint remains in the Sun belt, the region of the country expected to deliver the strongest population and job growth going forward. We believe we are strategically positioned in the right markets to grow our business in the future as the home-building industry begins to stabilize.

Addressing affordability, we have reduced square footage and simplified our floor plans to meet buyer demands. We have also offset pricing pressures to some degree with a strategic focus on cost cutting, including value engineering of our home designs and renegotiating labor and supply contracts.

And we continue to focus on featuring design elements that blend low cost with high value, putting the custom home experience within reach of our home buyers. As a result, the vast majority of our communities now offer homes priced within current FHA, VA, and conforming loan limits, even before the recent loan increases were authorized. In fact, after the FHA increases are applied, 95% of our communities are priced within FHA range.

We have also launched a series of Why Rent? events across the country, in which countrywide KB Home loan counselors help customers determine their buying power. With pent-up demand as a result of population and job growth, we continue to target renters who do not need to sell a home in order to purchase a new home. Affordable monthly payments really resonate with today’s buyers, especially renters, who may not realize that home ownership is within their reach.

Third, we remain committed to the operating disciplines and product innovations that have made us an industry leader. No matter what changes we make to the size of our operations, our KB Next operating business model defines how we operate. It puts the total focus on our customer and employs a fact-based and process driven approach to what and where we build. It helps us deliver even flow production, outstanding customer service, and is a build-to-order system that gives buyers both choice and value. We believe it provides a road map to success in both strong and more challenging housing markets.

I will be the first to acknowledge that we are not pleased with our sales results for the quarter. Entering the new year, we had strengthened our balance sheet significantly, lowered our community count, and achieved our cash balance objectives. With those accomplishments in place, we were in a position to be more patient with our actions and to wait for a better day. We elected to hold pricing and focus more on restoring profitability.

During the quarter, the markets continued to move away from us, leaving us at a competitive disadvantage. As a result, our gross sales dropped while our cancellations as a percent of backlog held steady and our unsold inventory increased somewhat compared to our year-end total.

We have taken additional steps to reposition our communities in order to clear out this inventory in the second quarter. We remain primarily a pre-sold builder, a strategy that provides maximum choice to our customers and predictable delivery results for us. Our build-to-order approach offers buyers the lowest possible base price for their new home, with personalized design options from our KB Home studios that fit their needs and their budget.

While our lower community count will result in fewer sales year over year for the second quarter, we intend to close the gap relative to our first quarter comparison.

In our marketing efforts, we are focused on unique, high impact promotions that increase traffic at the community level while increasing national brand awareness. Strategic partnerships with Martha Stewart and Disney provide us with an exclusive competitive advantage over other builders, as well as over the resale market.

In addition, we are overcoming consumers’ uncertainty about buying a home right now with two powerful programs -- price protection and rate lock. These programs give homebuyers the confidence to buy a new KB home without worrying about the price of their home falling or interest rates rising while their home is being built.

Our Countrywide KB Home loans joint venture continues to perform very well. During these turbulent times for the mortgage banking industry, it has been extremely beneficial for us to operate through our low risk joint venture. Our preliminary view regarding Bank of America’s announced intention to acquire Countrywide later this year is that it will be business as usual for our mortgage banking joint venture. The strategic alliance we have with Countrywide has been great, creating many synergies.

We also believe the merger of Bank of America and Countrywide is a positive one for the mortgage industry and has the potential for creating additional stability in the financial markets.

One recent measure of our success as an industry leader came from our peers. This month, Fortune Magazine published its 2008 list of America’s most admired companies, ranking KB Home number one among homebuilders. Their rankings, based on surveys among industry members, placed us at the top of every category, including quality of management, innovation, long-term investment value, financial soundness, social responsibility, and the use of corporate assets.

Being named number one in our category puts KB Home in the very privileged company of other category leaders, including Apple, GE, Walt Disney, BMW, Nike, and Southwest Airlines.

While we firmly believe the long-term fundamentals of our business remain strong, given current macroeconomic conditions we see no reason to believe that new and resale absorption rates in the next few months will improve dramatically enough to clear excess inventories. Prices need to adjust further for that to occur.

Until that happens, and until some measure of consumer confidence is restored, we believe pricing and margins will remain under pressure. That said, we do see indications that improvement is on the horizon.

To begin with, existing home prices are dropping in both nominal and inflation adjusted terms. Whether you look at the dramatic declines registered by the S&P/Case Schiller home price index or the more modest decline reflected in the office of federal housing enterprise oversight’s results, the trend is down.

Earlier this week, the National Association of Realtors reported that the median price of a resale home in February 2008 was down 8.2% from February 2007. This decline was the largest on record, and that is good news for us because our biggest competitor is the resale market and a drop in price of this magnitude could clear the overhang of inventory more quickly and lead to price stability earlier rather than later.

Today, in most of our markets, we believe our prices are at or below the resale median for that market and while existing home prices are likely to fall further in 2008, we have anticipated this and have taken steps to ensure that our prices remain competitive and compelling to consumers.

Another source of encouraging news is mortgage rates. Even with ongoing credit market turmoil, interest rates for a 30-year fixed rate loan are now below 6%. That is approaching the lows we saw in 2003 when rates hit their lowest levels in 27 years.

It is also good news that HUD this month finalized new FHA loan limits for the majority of the markets in which we operate. While there still are many unanswered questions, in March Countrywide KB Home loans began accepting loan applications at the higher FHA, VA, and conforming loan limits. This combination of low interest rates, increases in loan limits, and the upcoming tax refund could provide some welcome stimulus to home-buying, especially as apartment rental rates are increasing in many markets and renters reconsider the math of purchasing their first home.

There is no silver bullet to restore consumer confidence but hopefully these are precursors to market recovery. But whatever the future brings, we remain focused at KB Home on running our business prudently at whatever volume market circumstances support, with a primary goal of restoring profitability. We continue to pursue cost reductions and to seek out ways to improve our core business processes.

Taking these steps not only addresses today’s difficult market conditions but also sets an important foundation for future opportunities, and they will come. Every crystal ball is different as to time it will take but the market will eventually recover. When it does, we will be ready. I believe that with our proven KB Next operating business model, financial strength, market experience, and commitment to product innovation, KB Home will emerge from this downturn as one of the strongest national players.

Now I’ll turn the call over to Don for a financial review.

Domenico Cecere

Thanks, Jeff. Let us start with operating results. Reflecting the actions we have taken over the past few quarters to reduce inventory and community counts by consolidating or exiting underperforming communities, net orders of 1,449 new homes in the first quarter were down 75% on a year-over-year basis. Community counts in the first quarter of 2008 were down 38% from the prior year.

We had 224 active selling communities in the first quarter of 2008, compared to 364 in the first quarter of 2007. Our community count was lower in each of the four segments, with year-over-year decreases ranging from 19% to 56%.

The decline in net orders also reflects challenging conditions in most of our markets. Our conscious decision to wind down operations in certain markets, our efforts to hold the line on pricing and margins, our growing supply of new and existing homes, including increased foreclosures, and tighter consumer mortgage lending standards, as well as the decreased consumer confidence.

The cancellation rate in the first quarter of 2008 was 26% of beginning backlog. Over the last several quarters, the ratio of cancellations to beginning backlog has ranged between 26% and 33%. Weak overall demand for housing has negatively impacted the cancellation rate when compared to gross orders and this comparison, the cancellation rate in the first quarter was 53%, an improvement from 58% in the fourth quarter of 2007 but up from 34% in the year earlier quarter, which was closer to our normal historical rate.

We entered the first quarter with 6,322 sold homes in backlog and converted 2,928, or 46% of our backlog to revenue. This compares to a conversion ratio of 49% in the first quarter of 2007. Our backlog remains geographically diverse with the largest portion of our backlog value in the West Coast region.

In the first quarter of 2008, we incurred a net loss of $268 million, or $3.47 per diluted share, compared to a net income of $27.5 million, or $0.34 per diluted share in the first quarter of 2007, which included $16.8 million, or $0.21 per diluted share from our French discontinued operations.

The loss resulted primarily from a 43% decrease in revenues, $224 million pretax non-cash charge from impairments and abandonments, and a $100 million charge for deferred tax asset valuation allowance.

Excluding the impairment and abandonment charges, and evaluation allowance, we would have reported a net loss of $27.6 million, or $0.36 per diluted share. We delivered 2,928 homes in the first quarter of 2008, down 43% from the year earlier quarter, largely due to our efforts to resize our operations and reduce community counts. Each region delivered homes, fewer homes compared to the year earlier quarter.

We anticipate operating from significantly less communities for the remainder of 2008 as compared to the prior year. The average sales price of the homes we delivered in the first quarter of 2008 decreased 7% to $248,200 from $267,400 in the first quarter of 2007.

Year over year, sales prices were down 17% in the West Coast, 14% in the Southwest, and 4% in the Southeast. Sales prices were up 4% in our central region.

We believe our average selling price will continue to decrease in the short-term as we continue to address affordability challenges and tougher lending requirements and continue to operate in an environment against a backdrop of significant decline in the resale prices.

We have and continue to work diligently to offset these pricing pressures by reducing costs with a series of strategic measures that include re-evaluating spec levels, fine-tuning and value-engineering our home designs, and renegotiating supplier contracts for improved terms.

Our housing gross margin in the first quarter of 2008 fell to negative 6.2% from negative 4.3% in the fourth quarter of 2007, and a positive 15.5% in the first quarter of 2007. Excluding impairments and abandonment charges, our housing gross margin in the first quarter of 2008 was 9.0% compared to 10.1% in the fourth quarter of 2007, and 15.9% in the first quarter of 2007, reflecting lower sales prices and an increased use of incentives and discounts to sell homes.

We anticipate our margins for the balance of 2008 will remain compressed due to continued price pressures and heightened competition for sales.

Selling, general, and administrative expenses in the first quarter decreased $78 million, or 38% from a year ago. As a percentage of housing revenues, however, these expenses rose to 17.6% from 14.9% in the year earlier quarter, mainly due to the substantial decrease in housing revenues reflecting our community count reductions.

We expect our SG&A expenses as a percentage of housing revenues to remain above the 2007 levels for the duration of the year as it will take some time for overhead to align with the lower revenue levels. Nevertheless, this area will remain a constant focus for us for the rest of the year.

Our homebuilding pretax loss of $276 million for the first quarter of 2008 included $217 million of inventory and joint venture impairment charges and $7 million of option abandonment charges related to about 700 lots under option contract. Approximately $36 million of the impairment charges were against our investment in the unconsolidated joint ventures.

During the quarter, we impaired approximately 88 projects, some of which were active and some of which were not. The impairments were mainly driven by price reductions we made in certain markets due to increasing levels of housing inventory in the marketplace and tighter consumer mortgage underwriting standards and are monetizing properties in certain markets where we decided not to make additional investments.

The financial services business for KB Home contributed pretax income of $7.9 million in the first quarter of 2008. Our Countrywide KB Home loans mortgage joint venture continues to perform well. Within the joint venture, the retention rate for the first quarter of 2008 was 79% compared to 63% a year ago. The FICO score for the joint venture mortgage customers for the first quarter of 2008 was 701, slightly higher than a year ago.

Buyers also continued to use fixed rate product, with only 14% using adjustable rate mortgages in the first quarter of 2008. Government and conforming loans represented more than 90% of our first quarter deliveries, with a similar percentage in our backlog.

Our total pretax loss of $267.9 million in the first quarter of 2008 compared to pretax income of $50.3 million in the first quarter of 2007. Our income tax provision of $0.3 million as a percentage of the pretax loss was not at the statutory rate because we recorded a $100 million charge for deferred tax asset valuation allowance, as required under the accounting rules. The allowance essentially eliminated any tax benefit for the quarter under generally accepted accounting principles.

For tax purposes, the majority of tax benefits associated with our deferred tax assets can be carried forward for 20 years and we expect to realize the benefits as we generate profits in the future.

Including the valuation allowance we recorded in the fourth quarter of 2007, we have more than $600 million of deferred tax assets that are fully reserved as of February 29, 2008. To the extent we generate taxable income in the future to utilize these tax benefits, we expect our effective tax rate on future income to decrease as the valuation allowance is reversed.

Now I will move to the balance sheet. As a result of the actions over the past several quarters, we have streamlined our land positions significantly, reducing inventory and community counts while consolidating or exiting underperforming markets. At February 29, 2008, we had $2.9 billion in inventories compared to $3.3 billion at November 30, 2007, and $5.5 billion at February 28, 2007.

At the end of the first quarter, we owned or controlled approximately 59,500 lots, down 68% from a peak of 186,300 lots owned or controlled in the first quarter of 2006 and 43% from the 104,100 lots in the first quarter of 2007. Of the 59,500 total, we own less than 42,000 lots, which is approximately a three-year supply of land and we have approximately 17,500 lots controlled via land option contracts.

Homes in production are down almost 72% from the peak in the second quarter of 2006 and down 48% from the first quarter of 2007. This is a clear illustration of our rigorous adherence to out built-to-order business model. We currently have approximately 4,600 homes in production with 30% or 1,400 homes unsold. This is up from approximately 1,000 unsold homes in the fourth quarter of 2007, but still one of the lowest levels of spec production in our industry.

We had approximately 900 finished unsold homes in inventory at year-end, spread across 224 active selling communities. We had total debt of $2.2 billion at February 29, 2008, which was essentially unchanged from year-end and $714 million lower than the balance at February 28, 2007.

As of February 29, 2008, our debt net of cash totaled approximately $845 million, compared to approximately $837 million at year-end, and $2.5 billion at February 28, 2007. Our net debt to total capital ratio was approximately 35% at the end of the first quarter of 2008, compared to 31% at year-end 2007 and 46% at February 28, 2007. The net debt to total capital ratio at February 29, 2008 was adversely impacted by the impairment and [inaudible] charges and by the deferred tax allowance recorded during the quarter.

Now I would like to spend a few minutes talking about unconsolidated joint ventures. We have participated in unconsolidated joint ventures for a number of years. Through these joint ventures, we reduce the capital we had to invest in order to ensure access to potential future home sites. In some instances, participation in joint ventures allows us to obtain land that we could not otherwise have access to and they also provide an opportunity for more favorable terms. The risk that corresponds to these benefits is that we could be adversely impacted by our joint venture partner’s failure to fulfill their own obligations.

As of February 29, 2008, we had $281 million invested in unconsolidated joint ventures. Of our joint ventures, 28 had more than $1 million in assets and only 10 of these had more than $50 million in total assets. Five of the unconsolidated joint ventures represent about 75% of the $281 million investment, the majority with public builders and financially sound developers in good sub-markets.

Of our consolidated joint ventures, 21 have bank debt with varying levels of obligations on the debt. The majority of our unconsolidated] joint venture partners are large, well capitalized builders with financing structured as acquisition and development loans.

We strategically manage our unconsolidated joint ventures assets like any other asset in terms of bulk sales, building through, or facing development -- phasing development. The majority of our joint ventures continue to perform despite market conditions. We are working with a subset of our joint ventures to resolve either partnership or financing issues.

Due to confidentiality constraints, we cannot disclose the details of our ongoing discussions but we continue to diligently work with our joint venture partners and banks to find the best solution for our shareholders. Any additional information will be disclosed in our SEC filings.

During 2007, we began to reduce the number of joint ventures in which we participate and the related indebtedness of such joint ventures. Our unconsolidated joint venture investments are down 32% from $413 million at February 28, 2007. As we continue to make further strides, our investments should continue to decrease in the foreseeable future.

Turning to an update on the status of our credit facility, we would like to thank Bank of America and the rest of our bank partners for working in an expedited manner to address the impact of the deferred tax valuation allowance charge on our revolver credit facility financial covenants.

As previously mentioned, we completed an amendment to our revolving credit facility on January 25th. In the amendment, we reduced our minimum consolidated tangible net worth from $2 billion to $1 billion and reduced our overall facility size from $1.5 billion to $1.3 billion. The November 2010 maturity date for our revolving credit facility was not impacted by the amendment.

With $1.3 billion of cash at quarter end and an undrawn revolver, we have substantial liquidity to navigate the downturn and to be opportunistic when the land prospects arise. Now I will turn it back to Jeff for closing comments.

Jeffrey T. Mezger

Thanks, Dom. I’ve just a couple of closing comments before we begin to take questions. A few weeks ago, the NEHB research center announced that KB Home was the first builder in the U.S. to achieve national certification under the national housing quality program. This means that we are the first and only national builder to have completed a rigorous quality audit in all of our divisions, ensuring that our top notch quality assurance systems and those of our trade partners are aligned to improve both quality, performance, and customer satisfaction.

It is an achievement that we feel sets the bar for quality in our industry and is something we are celebrating and promoting in all of our sales offices across the country. In these market conditions, product quality and customer satisfaction will be a true differentiator.

While today’s market is difficult for homebuilders, people have and will continue to buy homes. The challenge is capturing a larger share of the more limited pool of consumers in a buyer’s market. We have implemented a number of strategies that position us not just for when the market recovers but for selling homes today. We are firmly committed to our long-term strategy of providing a high quality, built-to-order home for the first time, first move-up, and active adult buyer. No matter what the market is doing, the desire for home ownership remains constant, especially for the first-time buyer.

I am confident that once we turn the corner on today’s challenging economic conditions, the future will once again look bright. Favorable demographics and ongoing population growth in the markets we serve will provide and expanding pool of renter households to drive first-time homebuyer demand for years to come. We will be there to make sure their dream of home ownership becomes a reality.

Our decisive actions taken in 2007 to bolster our cash position, reduce inventory and community count, and consolidate or exit underperforming markets puts us on the path to ensure that we are building a bright future for our company, our homeowners, and our shareholders.

For more than 50 years, KB Home has driven innovation and progress in the homebuilding industry. This KB Home team has skillfully navigated many difficult market cycles, each time emerging as an even stronger company and we will once again. But we are not waiting for the future to come to us. I am privileged to work with a seasoned and talented leadership team with deep expertise in this industry who have and will continue to see out the opportunities that the market presents today.

As we move ahead, we will continue to realign our business to the shifting market while also strategically capitalizing on emerging opportunities in order to drive results that we are proud of.

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

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from David Goldberg with UBS.

David Goldberg - UBS

The first question is really about the gross margin and the gross margin trend. Domenico, you commented that gross margins are going to be compressed for the rest of ’08. I guess the question is as you look forward to the land position and the cost basis on the land position, when do you see those pressures abating a little bit and where do you think, assuming prices were to stay stable, where do you think margins can get to as we look out a little bit further?

Domenico Cecere

Well, David, the big question is what’s going to happen to resale prices over the next several quarters and that’s the factor that is very difficult to predict. I mean, there was a significant decline in the last couple of months and the [inventory has yet to crack], so if I had a crystal ball that could be able to forecast what happens to resale prices, I could have a better understanding of what would happen to our margins.

David Goldberg - UBS

Maybe the better way to ask the question is how much lower is the cost basis, maybe percentage wise, on land out in the future versus land that you are delivering on now?

Domenico Cecere

Well, I mean I think as we reload, you know, and since we have a lean land position, as we reload new lots, we’re reloading those lots with margins closer to our normal levels, which would be closer to 20%. But with the existing lots that we have today, there’s still not a lot of margin in those lots.

David Goldberg - UBS

And if I could just get a follow-up; Jeff, you were talking about price protection and rate locks, and I was just wondering how extensive the use of those were, if we had like an idea how you are thinking about it, especially if we think there’s going to be some price declines moving forward, how you are thinking about what the potential liability that creates for you guys.

Jeffrey T. Mezger

Well, the liability is only to that home under construction for that period of time, Dave. We rolled the program out in January. It’s been well-received by the consumer. Frankly, if you have a home in backlog with an approved loan and a buyer is ready to close and markets erode around you, you have to react to that anyways. And all we commit to is if we were to lower the prices of our homes in that community while their home is under construction, we’ll give them the lower price. It has nothing to do with what a competitor does across the street or a resale down the street.

David Goldberg - UBS

And with the rates, you just lock it up for the construction period then?

Jeffrey T. Mezger

Correct, and there’s no risk to that for us. It’s one of the synergies we have with our partnership with Countrywide.

David Goldberg - UBS

Okay, great. Thank you.

Operator

Thank you. We’ll hear next from Michael Rehaut with JP Morgan.

Michael Rehaut - JP Morgan

The first question relates to comments you made earlier about order trends and I think you kind of indicated that aside from the difficult market conditions, that you had tried to hold price to some degree and the market kind of got away from you a little bit. I was wondering if you could give some color in terms of perhaps over the next quarter or two what the degree of incremental price cutting you might have to do and in particular, on a percentage basis from where you are today, which regions in particular do you feel that -- that you felt this more, you know, relative to others -- more acutely relative to other regions.

Jeffrey T. Mezger

Obviously, Mike, it’s a market specific and community specific answer because there’s different price trends and pressures depending on the inventory in that sub-market. The impairments that were taken in February were a reflection of the steps we took to adjust to market conditions coming out of the quarter and on a price range in a region, it could be 2% to 5%.

Michael Rehaut - JP Morgan

Two to 5%, and so which regions do you feel that you -- you know, that you took the more full brunt of that? Was it inland California? Was it Vegas? Was it other areas that kind of stand out?

Jeffrey T. Mezger

I don’t have the data in front of me, Mike, but it will be in the Q and I can tell you that it was in the markets that ran up the hottest in the good times, continued to slide the most in the down time, so the coastal markets.

Michael Rehaut - JP Morgan

Okay. Just one other question -- you know, you had -- Dom had kind of reviewed some information on the JVs and I understand that you might not be able to talk about specifics, but you know, JV, individual JVs, but I was wondering if you could give us an idea of the amount of debt that’s associated with the JVs in its entirety. How much of that is currently not -- the interest is not being paid on the debt, where the liabilities in terms of future impairments or re-margining or where you might be more susceptible? If you can just give us an idea of the overall debt levels and percent of debt that is not properly functioning.

Domenico Cecere

The information on the amount of debt will be in the Q, so you will have to wait for that. But I want to go back to something we had said, which is that we only have 28 joint ventures and only 10 have more than $50 million in assets. So we are really settled down. There’s five JVs that represent 80% of our investment and that’s where most of our debt is, and that is where the majority of large public builders and financially sound developers, so we think we have a good handle around it.

Michael Rehaut - JP Morgan

And re-margin payments? I mean, is there an expectation there over the next quarter or two to keep some of them more solvent?

Domenico Cecere

There will always be some margin repayments but I can’t tell you exactly how much there will be today. Again, I would say our portfolio of joint ventures is not onerous.

Operator

Thank you. We’ll next hear from Alan Ratner with Zelman and Associates.

Alan Ratner - Zelman and Associates

Dom, I was hoping to follow-up a little bit on a comment you made I think to David on his question about the idea of prices stabilizing, and you mentioned it will depend on what happens in the existing home market. Several builders have kind of commented in recent quarters that one advantage in the new home market right now from an affordability standpoint is that prices are actually below existing homes in many markets and that kind of is opposite of what it has historically been. And they’ve kind of argued that kind of has a buffer built in towards some of the existing home price declines that may happen.

Do you think that if existing home prices start to come down, whether it’s a function of foreclosures or other things in the market, that the new homebuilders will respond in step to keep pricing below the existing market? Or do you think that that gap eventually closes and kind of returns back to what it’s been historically?

Jeffrey T. Mezger

I think over time it will stabilize because the consumer does put a premium on new home versus used. In our case, we are certainly we feel below the medians in every one of the markets we operate in. We are below the resale median but it depends on how deep the resale adjustment is to clear inventory will impact what the new home pricing does. And that’s what is still to be told. You mentioned foreclosures. That’s really a gray area. We can’t get our arms around what the foreclosure activity is, how many are actually going on, how many are selling, what it’s doing to pricing. But it’s -- there’s a lack of clarity for us on where the resale pricing will get to, other than we know it has to come down further to clear inventory. And if it comes down too much, then we’ll have to adjust our prices more.

Alan Ratner - Zelman and Associates

And Jeff, you had mentioned kind of that you have taken steps in 2Q to reduce inventory and gotten a little bit more aggressive on pricing than you may have been in the first quarter, and that contributed to a lot of your impairments in the quarter. What was the exact timing in terms of your aggressiveness on the pricing? Did it happen in February or has it been kind of subsequent to the quarter? And have you seen any kind of improvement in absorptions as a result of that aggressiveness?

Jeffrey T. Mezger

We don’t talk intra-quarter about trends in that quarter, Alan, but the steps we took were the latter part of February.

Alan Ratner - Zelman and Associates

The latter part, okay, so that would -- it would completely be captured in your impairments, there wouldn’t be any kind of risk based on the pricing that you’ve taken for --

Jeffrey T. Mezger

No. We do our impairment process every quarter at the end of the quarter and this quarter’s scrub included any steps we took to generate sales.

Alan Ratner - Zelman and Associates

Okay, perfect.

Operator

Thank you. We’ll move next to Kenneth Zener with Merrill Lynch.

Kenneth Zener - Merrill Lynch

I just want to discuss you guys paring down the business, or your exit strategy. Because in my mind, I think there’s a big difference Chicago, D.C., which are very large markets for the public builders, and smaller places like Albuquerque and Indianapolis. So can you talk about how you think about Chicago, D.C., these markets longer term given your prior interest and what your motivation is for trimming those markets? Is it really just to get the G&A out? Because I know you are still building out those 15 odd communities. So it seems like you will be revisiting these markets given their appeal over the long-term, so I’m surprised you guys are pulling out, given that land prices are collapsing and given your very strong liquidity.

Jeffrey T. Mezger

Ken, you are absolutely right; we could revisit it some day but it won’t be in the -- we don’t feel in the short run. The filters that we use as we evaluate the markets are where we see the trends in the marketplace relative to pricing and lot prices and supply and demand, and our view of the profit projections going forward over the next two to three years, offset by whether we have a franchise in place and a real brand in that marketplace.

And in the case of D.C. and Chicago, we entered the markets later in the cycle. We never really got to scale. They are both markets that you could get back into if you wanted to and rather than continue to carry the overhead to support a small entry where you are not going to reinvest because we feel that lot prices are still declining and land prices are out of whack, we decided to leave.

If you go to Albuquerque, it’s a little different look, in that Albuquerque’s a market that we call a secondary market -- much smaller. It was a distorted market over the last few years in that it was larger in activity levels than the underlying economic demand would support. It was fueled a lot by investor activity from other areas. As that market has receded, it’s back down to a scale that we don’t think supports our business model. Where we look at a market and want to have a large business, there’s a certain activity level that you need to sustain in order to support the cost of a studio and get your returns. And we didn’t feel that Albuquerque strategically fit that need.

While I say that, what we also mention in the release, the markets we are in have significant upside in market share and we’d rather focus on the markets where we’ve been a long time, we have a brand, there’s a lot of upside to our business there where we could grow our business significantly without entering any markets for a while, and at a point in time where we’ve achieved that and we are getting the critical mass again in many of our markets, we would revisit -- okay, what’s the next growth platform? But we don’t see the need to look for that growth platform for years.

Kenneth Zener - Merrill Lynch

All right, well, given that price is really the prominent dictator, when you guys made the go/no-go decision to exit let’s say D.C., what were your numbers telling you that land was still overpriced?

Jeffrey T. Mezger

It’s not that necessarily our land is overpriced because we deal with it every quarter, as we said on our --

Kenneth Zener - Merrill Lynch

Right, the buyers, or the seller’s price.

Jeffrey T. Mezger

Within the marketplace, we didn’t see opportunities to acquire assets that would hit our financial thresholds, IRR or margin.

Operator

(Operator Instructions) We’ll take our next question from Jim Wilson with JMP Securities.

Jim Wilson - JMP Securities

I was wondering on the cancellation rate front, and I know it would seem that you are -- obviously you are almost entirely focused on the entry level and the lower end, so it’s going to be higher. But do you see things evolving in just the underwriting process, the pre-screening process in and of itself, particularly as things have changed over the last couple of months that might start to lead to better cancellation rate experience?

Jeffrey T. Mezger

Jim, there was a nuance to the data that we share in the script, that Dom shared. Our can rate as a percent of backlog was 26%, which is actually the lowest its been in several quarters. Our backlog is firmed up relative to what we saw through ’07. The can rate as a percent of orders was distorted because frankly we didn’t have a high enough gross level. We converted our deliveries to our historical percentage of backlog, so we did fine delivering the backlog but we didn’t sell enough houses. And my expectation is we get our sales pace back on the growth side, you’ll see our can rate settle right back down to more historical levels.

Jim Wilson - JMP Securities

Okay, that makes sense. And then just one other thing, and I know you -- it’s great you’ve given the detail on the JV, those five largest at 75%. Is it safe to say or can you say the two, your investment of the two in Las Vegas, is that kind of even half of the total for those five, or something in that neighborhood?

Domenico Cecere

We don’t give out the detail by [project] but obviously Las Vegas is a large investment for us.

Jim Wilson - JMP Securities

Okay. All right, thanks.

Operator

Thank you. We’ll move on next to Timothy Jones with Wasserman & Associates.

Timothy Jones - Wasserman & Associates

I’m still confused on these three large markets that you said you were either getting out of or slowing down. I applaud getting rid of all the [inaudible] ones you got out of the five, but on Washington, D.C., Chicago, and New Mexico, are you saying you are not buying more land? Are you saying you are decreasing your exposure by X percent or are you saying you are getting out of these markets?

Jeffrey T. Mezger

What we stated in our release is it is a withdrawal from the market. We’ve made the decision not to invest additional dollars there, so we have assets in every one of these markets we have to manage to. But our view today is that we wouldn’t invest additional dollars, Tim.

But if you put it in perspective, in Chicago in ’07, I think we delivered 150 homes, or something like that. It’s not a large business. D.C. it was the first year of deliveries, a very young start-up without a lot of deliveries, so --

Timothy Jones - Wasserman & Associates

How many there?

Jeffrey T. Mezger

Less than 100, I think. I don’t know.

Timothy Jones - Wasserman & Associates

And how about New Mexico? Are you talking about Las Vegas or what?

Jeffrey T. Mezger

No, no -- Albuquerque -- 300 miles from --

Timothy Jones - Wasserman & Associates

That’s what had me confused. I can’t believe you’d be leaving New Mexico.

Jeffrey T. Mezger

No, Las Vegas is in Nevada.

Timothy Jones - Wasserman & Associates

I’m having a blonde moment. That’s okay.

Jeffrey T. Mezger

I don’t think you can say that.

Timothy Jones - Wasserman & Associates

Can I ask my second question? Can I just get some housekeeping -- you gave us the -- which is an excellent number, I might add -- your homes under construction, your inventory unsold under construction and finished inventory for this year. Could you give me the comparable numbers for last year with the 4,600, the 14, and the 900?

Domenico Cecere

I could get it to you. If you call, Kelly will give it to you right after the phone call.

Operator

Thank you. We’ll move next to Joel Locker with FBN Securities.

Joel Locker - FBN Securities

I just wanted to talk to you about your SG&A a little bit. Just -- you know, saw the 38% improvement year over year but with the revenue starting to slip a lot further than that, just wondering when you think the actual SG&A as a percentage of revenues would start to stabilize and head down to the low double-digits or so?

Domenico Cecere

Well, in the first quarter our -- and remember, that’s always our most difficult quarter because that’s our least amount of deliveries, but it was -- sales were down 43%, SG&A was down 38%. We did significantly cut SG&A. It was down close to $80 million year over year. And we also announced that we were, you know, as Jeff just talked about, getting out of some markets. As those unwind, that saves us G&A, so it will come back into balance when you start to see some demand pick up a bit.

Joel Locker - FBN Securities

And just going forward, I guess, with the backlog down almost 60% or so on a dollar basis, I mean, I guess you would really have to start cutting SG&A. And could you, even exiting those markets, could you cut SG&A by 60%, which looks like what your revenues will start to be down, at least in the next couple of quarters? Or will it -- you know, will it linger around these higher levels for at least until --

Domenico Cecere

It will be around the higher levels at least for the next several quarters.

Jeffrey T. Mezger

Higher than ’07.

Domenico Cecere

But you know, a lot of our SG&A isn’t fixed. I mean, you’ve got a lot of selling expenses and fees and everything else, the commissions that follow revenue, so it’s not like it’s a fixed cost totally that doesn’t adjust when volume adjusts.

Joel Locker - FBN Securities

Right, just one last one, in the first quarter, do you have a breakdown of the SG&A between headcount and actually the selling expenses?

Domenico Cecere

No, I don’t have it off the top of my head.

Jeffrey T. Mezger

Joel, what I can tell you is we’ve demonstrated over the years that we’ve been aggressive and persistent in lowering our overhead and we took a lot of steps in ’07 and made significant progress, and we’ll continue to do so in ’08, but it’s a tougher challenge now with -- as you mentioned, our scale is going to be down, unclear what. We’ll be able to tell you after our selling season concludes. But you are chasing revenue.

Domenico Cecere

And remember, a large portion of it centers around marketing, advertising, sales allowances, and sales commissions. Our sales headcount is all commission based, so -- I mean, when you adjust your community counts, these expenses automatically adjust with them.

Operator

We’ll go next to Nishu Sood with Deutsche Bank.

Nishu Sood - Deutsche Bank

I wanted to ask you about -- you mentioned that you have begun to offer loans under the higher FHA and conforming loan limits. I’m just wondering, what’s the rate differential on the loans under the higher limit versus the loans under the prior limits?

Jeffrey T. Mezger

That’s one of the things that’s still being resolved, Nishu. The loan limit between the old limit and the new increased limit we’re being told may have a slightly, an incrementally higher rate because it will be in a different bond when it’s sold.

Nishu Sood - Deutsche Bank

Got it, so do you have a sense of any kind of ballpark range? Is it going to be like 30 basis points, 100?

Jeffrey T. Mezger

Less than 100 and possibly less than 30. They are talking 25.

Nishu Sood - Deutsche Bank

Okay, great. And the second question, a lot of the builders have been talking about the concept of price inelasticity, the stage at which a community gets to the point where lowering prices isn’t really going to drive your absorptions anymore. I can imagine that that phenomenon is going to pick up as the pricing in the resale market continues to adjust.

What percentage of your communities would you estimate -- you know, just roughly ballpark, are in a state of price inelasticity already?

Jeffrey T. Mezger

Let me answer with a different response to your question. The price inelasticity is at the higher price points. If you have a $700,000 home, that’s a jumbo loan or above conforming and you drop the price $100,000, and the buyer has a home to sell, it’s still pretty inelastic.

When you are dealing with the lower price points and a first-time buyer, it’s all about affordability. So any time you move your price, you are expanding your buyer pool.

Operator

Thank you. Next we’ll move on to Stephen Kim with Alpine.

Stephen Kim - Alpine Mutual Funds

A couple of questions for you; first, can you give us a sense for what percent of your buyers currently have a house to sell and whether that ratio has changed at all over the last year or so?

Jeffrey T. Mezger

It’s very limited, Steve. We have some very strict requirements before we’ll even take a contingent sale -- larger deposits, we have a lot of filters. It’s one of the benefits of having a JV partner in Countrywide where we can flag a contingency at loan app because we don’t like them. We like to sell homes where we get paid for them when they can close and we don’t view a contingency sale as a sale today.

So I won’t say that we don’t have any because there’s some, but it’s a very limited amount. I couldn’t tell you what it was last year but I know it was higher than it is today. That’s why our backlog is a solid backlog. We need to sell more houses.

Stephen Kim - Alpine Mutual Funds

Okay, great. The second question I have relates to your option deposits and letters of credit. Do you know what that amount was if you include the letters of credit? And what purchase price, underlying purchase price they are related to?

Jeffrey T. Mezger

Kelly, at all? I don’t even know how to --

Kelly Masuda

Well, we had about $229 million of letters of credit and generally between 50% and 60% are related to communities, with the balance being deposits. But part of that is also earnest money deposits, Steve.

Stephen Kim - Alpine Mutual Funds

Okay, the 229 includes cash deposits, you’re saying?

Kelly Masuda

No, no, the $229 million includes letters of credit related to communities and letters of credit related to deposits on land purchases, of which part of that is earnest money deposits and part of that is hard deposits.

Stephen Kim - Alpine Mutual Funds

I see. Okay. Well, great. I’ll use that. Thanks.

Operator

Thank you. We’ll move next to Alex Barron with Agency Trading Group.

Alex Barron - Agency Trading Group

I wanted to -- I think you mentioned cash flow but I didn’t catch the amount, if you mentioned that this quarter, the operating cash flow.

Domenico Cecere

It was just slightly positive this quarter. You’ll see it in the Q, and what we had said in the comments on the cash flow is generally we use cash in the first half and generate cash in the second half, so we went through the first quarter with really not having used any cash. We really felt that was a positive.

Alex Barron - Agency Trading Group

Okay. Were there any amounts that you had to spend on joint ventures, like either buying up your share of joint venture lots or making the re-margin payments or anything like that?

Domenico Cecere

That will all be in the Q.

Alex Barron - Agency Trading Group

Okay, my other question is --

Domenico Cecere

I would say that the amount of money we spend on land purchases and land development is significantly lower than what’s it been the last several years.

Alex Barron - Agency Trading Group

Right. My other question has to do with your community count. You said that the community count has been coming down and I guess some of it, I am assuming it’s communities you sold out of and others it’s the ones that you shut down, so I was wondering if you had a breakdown of those two.

Domenico Cecere

No, we don’t track that. I mean, we said that our community counts were down about 38% in the first quarter. That trend will probably continue through the year.

Alex Barron - Agency Trading Group

Last question, if I could; what’s happening in Texas? I mean, I guess that seemed to be market that was holding up pretty well but it looked like your orders were down quite a bit. Is it just becoming more competitive or what would you say is happening in Texas?

Jeffrey T. Mezger

Texas held up better than the coasts in ’07, Alex, and we are seeing it soften some.

Operator

Thank you very much. That does conclude the question-and-answer session today. At this time, I would like to turn the conference back over to Mr. Mezger for any closing or additional remarks.

Jeffrey T. Mezger

Thank you for joining us today for our first quarter ’08 call. Have a great day and we look forward to speaking with all of you again soon. Thank you.

Operator

Again, that does conclude today’s program. We thank you for attending and have a great day.

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Source: KB Home F1Q08 (Qtr End 2/29/08) Earnings Call Transcript
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