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Executives

Kelly Masuda – Sr. VP & Treasurer

Jeffrey Mezger – President & CEO

Domenico Cecere – Executive VP & CFO

William Hollinger – Sr. VP & CAO

Analysts

Dan Oppenheim – Credit Suisse

Dennis McGill – Zelman & Associates

Michael Rehaut - JP Morgan

Jim Wilson - JMP Securities

David Goldberg – UBS Securities

Timothy Jones - Wasserman & Associates

Joel Locker - FBN Securities

Larry Taylor – Credit Suisse

Alex Barron - Agency Trading Group

Jay McCanless – FTN Midwest Securities

KB Home (KBH) Q2 2008 Earnings Call June 27, 2008 11:30 AM ET

Operator

Good day everyone and welcome to the KB Home second quarter earnings conference call. (Operator Instructions) 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 or strategies and their expected results. They are based on management’s current expectations and projections about future events and business conditions but are not guarantees

of future performance.

Due to a number of risks, uncertainties, assumptions 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.

And now for opening remarks and introductions I would like to turn the call over to KB Home President and Chief Executive Officer, Mr. Jeffrey Mezger. Please go ahead Mr. Mezger.

Jeffrey Mezger

Good morning everyone; thank you for joining us today for a review of our second quarter results. With me this morning are Domenico Cecere, our Executive Vice President and Chief Financial Officer, William Hollinger, our Senior VP and Chief Accounting Officer and Kelly Masuda, our Senior VP of Investor Relations and Treasurer.

This morning I will cover the state of the housing market, our second quarter results and our outlook and strategies for the remainder of the year. Domenico will take you through our second quarter financial results and I will have some brief closing remarks before we open it up for your questions.

Let’s start with market conditions, the second quarter remained very challenging for home builders. Inventories of both new and existing homes hovered at a 10 to 11 month supply throughout the period with buyers remaining on the sidelines concerned with the weakening economy and tightening mortgage lending standards. Foreclosure activity continues to rise, compounding the inventory overhang and maintaining pressure on prices.

This is borne out by the SMP Case-Schiller composite 20 index which reported that prices in April had dropped 15.3% from a year earlier as well as the conference board’s recent release which indicated that the consumer confidence index fell to 50.4% in June, the lowest level since February, 1992. Taken as a whole, these operating conditions are some of the most difficult the home building industry has ever experienced. Our financial results for the second quarter reflect this persistently challenging environment and the decisive actions we have taken to address these conditions over the last two years.

The market price declines in the quarter and the uncertain timeframe for housing market recovery required additional reevaluation of our assets in the quarter. We took pre-tax non-cash charges of $177 million for inventory and joint venture impairments and abandonments and $25 million for goodwill impairment. We also recorded a $99 million deferred tax asset valuation allowance charge for the quarter.

Largely due to these charges we reported a net loss for the quarter of $256 million or $3.30 per diluted share. About 90% of our total impairments and abandonments in the second quarter were recorded against assets in California, Arizona, Nevada and Florida; the states hardest hit by foreclosures and falling prices. While we were disappointed with the substantial impairment charges in the quarter they are driven by the difficult market conditions that we and other home builders continue to confront.

Generally accepted accounting principals required that we book an additional charge in the second quarter to fully reserve the tax benefits generated from our pre-tax loss. As of May 31, 2008 our valuation allowance on our deferred tax assets exceeded $720 million. From my perspective this represents nearly $10.00 of potential additional book value per share which I believe is one of the highest among our peers and the real opportunity to unlock value in the future.

We believe that a meaningful improvement in market conditions will require a sustained decrease in inventory levels, price stabilization, reduced foreclosure rates, and the restoration of consumer confidence in making the home buying decision. While it is difficult to predict when these events will occur, what I can tell you with confidence is that we have responded quickly and judiciously to the dramatic reversal in the housing markets and I believe we will emerge from this down cycle a stronger, leaner and better company then ever before.

In the remainder of my opening remarks this morning I will give you a picture of where KB Home stands today and where we are headed.

Let’s begin with the here and now, for the past two years we have made financial strength and operating flexibility the centerpiece of our strategic response to rapidly declining markets. As a result, KB Home is among the financially strongest and best positioned national home builders operating today. Since early 2006, we have focused relentlessly on strengthening our balance sheet and repositioning our operations to align with market realities.

We’ve built up and preserved our cash position, reduced our inventory and community count and consolidated operations in some markets while selectively exiting others. This strategy has generated tangible results. At May 31, 2008 we had a cash balance of over $1.3 billion, more then triple the year-earlier amount. Typically our operations use cash in the first half of our fiscal year. But with a disciplined focus on curtailing expenditures we finished the second quarter with essentially the same cash level we reported at year-end and at the end of the first quarter.

Cash flow from operations was positive for each of the first two quarters of 2008, and we anticipate generating positive cash flows from our operations for the remainder of the year. We have reduced inventory levels by 50% from a year ago to $2.6 billion at May 31, 2008. We entered the second quarter with approximately 56,600 lots owned or controlled down 70% from a peak of 186,000 in the first quarter of 2006.

We currently have an attractive geographically diverse land portfolio that represents about a three year supply to us. We believe that our short land position is prudent given the current environment. As the market stabilizes we expect to reload our pipeline with lower cost lots at a competitive advantage that should expedite our return to profitability.

Our leverage ratio net of cash was 40.2% at quarter-end. This is at the low end of our targeted range of 40% to 50%. Net debt was $856 million at quarter-end, down from $2.4 billion at the 2007 quarter-end, a reduction of 65%. We had approximately $2.4 billion of liquidity at the end of the second quarter with an undrawn revolver and $1.3 billion of cash. This will enable us to be opportunistic with land acquisitions from distressed builders, developers and banks as they arise.

With our lower inventory levels and strong liquid balance sheet we recently decided to reduce debt further. In July we will redeem all 300 million of our outstanding 7 ¾% senior subordinated notes. The economic case for the redemption is compelling. Based on our current cash yields, this should generate almost $16 million of annual savings and a 4.5 month breakeven on the 1.9% redemption premium. This is another example of a measured action that we are taking to position ourselves to return to profitability.

All of these targeted measures have given us ample dry powder for the future so let’s look forward. Our central priority now is to restore the profitability of our home building operations. For the immediate future this means selling at the right price, with the right product and the right marketing strategy for each individual market in which we operate. Single-minded pursuit of market share or higher volume has no economic traction in today’s environment. And given the strength of our financial position we believe that generate a profit is more critical to our shareholders then generating additional cash.

It also means continuing our focus on cost reduction and operating more efficiently. Our KB Next principals of lean, build-to-order production have never been more important. Finally it means looking to the future and preparing for the recovery. We have the financial strength to capitalize on land and lot purchase opportunities as they arise and we are ready to do so to create an inventory base that can generate future profitable growth.

Here’s a brief look at our current key strategies. First we will operate in individual markets at a size that optimizes economic returns and avoid markets where profitability currently appears improbable at any size. As you know, over the past several quarters we have aligned the size of our business with lower levels of demand. Our community count is down 37% from a year ago as a result of our downsizing operations in certain markets as backlog is delivered and completely exiting others.

We are comfortable with our current position in markets across the country and believe they will provide a solid platform for growth in the future. We will continue to assess and reassess our geographic footprint seeking optimal volume levels at which to operate and we will adjust our community counts to maximize financial performance. We are confident that our current platform positions us well for solid growth as each market stabilizes.

Next we will use our financial strength to acquire land and lots in good, long-term markets at distressed prices. Opportunities will inevitably arise to reload our pipeline and we will not hesitate to do so when the price and timing are compelling. Even now we are in the market actively analyzing potential land acquisitions. Deal flow is increasing and we are seeing both portfolio and single-asset transactions. However we are being careful and patient in order to seize the right opportunities. Our land acquisition and development will remain limited in the near-term as we continue to rescale our business with reduced sales rates.

We are developing smaller phases and restructuring our land development expenditures at each community to match with demand. Currently for 2008 we are budgeting total land acquisition expenditures of approximately $300 million and total development expenditures of approximately $400 million. We will remain conservative in our assumptions and thoroughly evaluate the specifics of each deal. We will also be highly strategic in our choice of submarkets and product types.

Next we will develop product types and marketing strategies on an individual region, market and even community level. Our entire team is dedicated to improving our pre-tax results. This may mean implementing a specific set of marketing decisions for individual market conditions. We will continue to balance sales rates and pricing and evaluate the best use for our assets including whether we should modify entitlements or redesign product if the profit potential is greater.

With little pricing power in today’s markets we will be particularly vigilant in maintaining a competitive value proposition. In most of our markets we believe our prices are already 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 selling prices remain competitive and our value proposition continues to be compelling to consumers.

We will also remain focused on lowering our direct costs. We have already made substantial in reducing square footage and simplifying our floor plans to meet buyer demand. We have also offset pricing pressures to some degree with strategic cost reductions including value engineering our home designs and renegotiating labor and supply contracts. 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.

We will continue to pursue further cost reductions and improve efficiency by streamlining our core business processes with the goal of improving gross margins. We will also remain relentless in removing unnecessary overhead costs. Our selling, general and administrative expenses decreased by $75 million or 38% in the second quarter of 2008 from the year earlier quarter. While a portion of these expenses are variable, the sizable overhead reductions we have achieved have been outpaced by the rapid and dramatic decrease in our revenues. As margins are likely to remain compressed due to pricing pressure, we will continue to bring overhead in line with our reduced revenues.

We expect to see further improvements on this front over the next several quarters due to our ongoing initiatives. One analyst report recently pointed out that we have the highest revenues per employee among our peers, a testament to our disciplines and business model. Based on the latest available data for 2007 our revenue per employee was $2.2 million while the next highest of our peers was $1.8 million and the average was $1.3 million. If we maintain our financial discipline and concentrate on the markets and product types we know best and we will, I am confident that KB Home will continue to successfully manage through this downturn.

But the larger picture is even more compelling because looking a little further down the road, I believe the prospects for our industry and our company are excellent. The fundamentals of our business remain strong especially for builders like KB Home that focus on first time home buyers. I believe no one understands this market segment better then we do. No one anticipates buyer trends more accurately; no one innovates more effectively in product design and marketing strategies.

Recently Fortune Magazine featured KB Home in its pages making essentially the same point. After the magazine named us the number one home building on its list of most admired companies of 2008 its editor-at-large Shawn Tully took an in depth look at our company in its June 9th issue. The story highlighted our renewed focus on the needs of first time home buyers and our diligent efforts to ensure we are offering the right homes at the right price for today’s market. He referred to our obsession with making homes affordable while still offering features that sharply distinguish KB Home from the competition. In answering his own question why will housing come back? Tully concludes that it will be, and I quote, “for a reason as solid as floor joists, the entry level buyer for the first time in years is finding that owing a new house is suddenly just as cheap as renting.” And I totally agree.

Home prices have come down in many areas of the country for nearly two years while rents have increased closing the affordability gap of renting and owning a home. A KB Home we are effectively demonstrating this increased affordability to our first time buyers by featuring potential low monthly payments in our marketing and advertising outreach. These monthly payments allow renters to make a direct comparison to what they are paying in rent today often discovering that home ownership is within their reach.

So we are encouraged that the precursors of a housing market recovery are in place and we believe that KB Home is uniquely positioned to respond. The great uncertainty of course, is when that recovery will begin. Whatever the future brings we remain focused on running our business prudently at whatever volume market conditions support. We will pursue our goal of restoring profitability while maintaining our strong financial position. By adhering to our proven KB Next operating business model and leveraging our strengths we are poised to emerge from the downturn as one of the strongest national players in home the home building industry.

Now I’ll turn the call over to Domenico for his financial review.

Domenico Cecere

Thanks Jeffrey. Net orders of 4,200 new homes in the second quarter were down 42% on a year-over-year basis due primarily to a 37% decrease in our community accounts and a softening demand in a number of our served markets. We had 215 active selling communities in the second quarter of 2008 compared to 342 in the second quarter of 2007. Community count was lower in each of our four regions with decreases ranging from 24% to 45%.

We anticipate operating with lower year-over-year community counts for the remainder of the year consistent with our renewed focus on restoring profitability. Second quarter net orders were nearly triple the 1,449 we posted in the first quarter of 2008 partly due to our improved cancellation rate. The order cancellation rate in the second quarter of 2008 improved to 27% of gross orders from 53% in the first quarter of 2008, 58% in the fourth quarter of 2007 and 34% in the year-earlier quarter.

Cancellation rates have been volatile over the past couple of years but have recently returned to more normal levels. This metric may indicate some stability in returning to the market. We entered the second quarter with 4,843 sold homes in backlog and converted 2,810 or 58% of beginning backlog to revenue in the quarter. This compares to a conversion ratio of 43% in the second quarter of 2007. The higher conversion rate and lower cancellation rate suggests the quality of our backlog is improving. Our backlog does remain geographically diverse with the largest portion on a value basis in our West Coast and Southeast regions.

We incurred a net loss of $256 million or $3.30 per diluted share in the second quarter largely due to pre-tax non-cash charges of $177 million in inventory and joint venture impairment and abandonments and $25 million for goodwill impairment. We also recorded a $99 million charge for deferred tax asset valuation allowance. In the second quarter of 2007 our net loss totaled $149 million or $1.93 per diluted share including a pre-tax non-cash charge of $308 million for impairment and abandonment charges partially offset by an after-tax income of $25 million or $0.33 per diluted share from our French discontinued operations.

Excluding the impairment and abandonment charges and the valuation allowance we would have reported a net loss of $32 million or $0.41 per diluted share in the second quarter of 2008 and net income of $37 million or $0.47 per diluted share for the second quarter of 2007. We delivered 2,810 homes in the second quarter of 2008, down 41% from the earlier quarter mainly due to our reduced community counts. Each of our regions delivered fewer homes compared to the earlier quarter with decreases ranging from 30% to 50%. With our emphasis on improving margins and gaining profitability we will continue to review and adjust our community counts as necessary to maximize our performance in each region.

Consistent with the rate of broader market price declines our average selling price for the second quarter decreased 17% to $226,600 from $271,600 in the second quarter of 2007. The lower average sales price was the exact result of the efforts we have taken over the last several quarters to address affordability. Floor plans were simplified, the average square footage was lowered by 10% and pricing was adjusted to remain competitive in the market.

We expect increasing supply and weakening demand to exert additional downward pressure on the housing market through the remainder of this year. We are calibrating our pricing and sales rate to strike an appropriate balance that would lead to improved financial performance. However our [bias] is to hold pricing as much as possible to maximize future results. We will be reducing production costs, be reevaluating spec levels, refining and value engineering our home designs and renegotiating supplier contracts to achieve better terms.

Our housing gross margin in the second quarter of 2008 fell to a negative 17.5% from a negative 3.9% in the second quarter of 2007. Excluding inventory impairment and abandonment charges the housing gross margin was 8.7% in the second quarter compared to 9.0% in the first quarter, 10.1% in the fourth quarter of 2007 and 14.9% in the second quarter of 2007. We anticipate that our margins will remain compressed in the second half of the year. Having said that our goal is to mitigate pressure on margins with cost savings.

Selling, general and administrative expenses in the second quarter decreased $75 million or 38% from a year ago. This is a significant reduction in gross SG&A dollars but our revenues have fallen even faster. SG&A as a percent of housing revenues was 18.7% up from 14.9% in the earlier quarter. We expect this percentage to remain above 2007 levels for the remainder of the year. It will take some time for overhead to fully align with our lower revenue levels. This area will be a constant focus for us as we work hard to close the gap.

Our home building pre-tax loss of $258 million for the second quarter of 2008 included $156 million of inventory and joint venture impairment charges, $21 million of option abandonment charges related to about 800 lots under option contract we have chosen not to pursue, and a $25 million goodwill impairment charge. During the quarter we impaired approximately 40 projects. Around 90% of the second quarter impairments and abandonments incurred in California, Arizona, Nevada and Florida. The impairments were mainly driven by price reductions in markets as housing inventory increased in the face of rising foreclosures and softening demand.

Overall our inventory in joint venture related charges of $177 million in the current quarter were 43% lower then the $308 million of similar charges in the earlier quarter. The lower charge may indicate that fewer impairments will be needed in future periods unless market prices drop dramatically. The financial services business contributed pre-tax income of $3 million in the second quarter of 2008. Our Countrywide KB Home Loans mortgage joint venture continues to perform well. Within the joint venture retention rate for the second quarter of 2008 was 80% compared to 70% a year ago. The average FICO score of the joint venture mortgage customers in the quarter was 696, slightly lower then 706 a year ago. Buyers also continued to use more fixed rate product; just 4% of the quarter chose an adjustable rate mortgage.

Government and conforming loans were used in 97% of our second quarter deliveries. Over two-thirds of our backlog of sold homes were qualified with an FHA loan. There has also been some recent press on down payment assistant programs. It is not a meaningful portion of our business representing only 74 deliveries in our most recent quarter. Our total pre-tax loss was $256 million in the second quarter of 2008 compared to $149 million in the second quarter of 2007. Our income tax provision of $0.6 million in the period reflects a $99 million deferred tax asset valuation allowance charge that we were required to book under accounting rules. Normally if we generate a loss we recognize a tax benefit. However this required allowance essentially eliminated any tax benefit for the quarter.

While the deferred tax asset valuation allowance is a non-cash item, it did impact our balance sheet and our book value. Including the valuation allowances we reported in the fourth quarter of 2007 and the first half of 2008 we had over $720 million of deferred tax assets fully reserved as of May 31, 2008. As we generate taxable income in the future to utilize these tax benefits we expect to be able to reverse the valuation allowance and our effective tax rate on future income would decrease. However to the extent we generate future operating losses we would continue to add to the valuation allowance and income tax provision would be adversely impacted.

As a result of the strategic actions Jeffrey noted in his remarks we have streamlined our land position significantly, reducing inventory and community accounts while consolidating or exiting under performing markets. At May 31, 2008 we had $2.6 billion in inventories compared to $3.3 billion at November 30, 2007 and $5.2 billion at May 31, 2007. At the end of the quarter we owned or controlled approximately 56,600 lots, down 70% from the peak of 186,300 lots in the first quarter of 2006 and 41% from the 96,700 lots in the second quarter of 2007.

Our land position also decreased from the 65,700 lots at November 30, 2007. Our current inventory represents about a three year supply based on trailing 12 months deliveries. Of the 56,600 total we own less then 39,800 lots and have approximately 16,800 controlled via land option contracts. Our view is that it is better to be short rather then long in lots during these uncertain times. There will be opportunities to reload our lot pipeline at attractive terms with finished lots as the markets begin to stabilize.

Homes in production are down almost 73% from the peak in the end of the second quarter of 2006 and 57% from the second quarter of 2007. This is a clear illustration of our adherence to a build-to-order business model. We currently have approximately 4,700 homes in production with 17% or 800 homes unsold that is down from about approximately 1,400 homes unsold in the first quarter of 2008 and is one of the lowest spec production levels in industry. We had approximately 500 finished unsold homes in inventory at quarter-end.

The decrease in our inventory contributed about $218 million in operating cash flows in the first half of 2008. At May 31, 2008 we had $1.3 billion of cash. Through the first half we held our cash balances essentially flat with a balance at November 30, 2007 which demonstrates our ability to manage spending. Historically we experience negative cash flows in the first half of our fiscal year. We generated positive cash flows from operations in each of the past four quarters and expect our operations to continue producing positive cash flows in the second half of 2008.

We had total debt of $2.2 billion at May 31, 2008 which was $651 million lower then the balance at May 31, 2007. As at the end of the second quarter our debt net of cash totaled approximately $856 million compared to $2.4 billion a year ago. Our net debt to total capital ratio was approximately 40.2% at the end of the second quarter compared to 31.1% at the end of 2007 and 46.6% at May 31, 2007. The increase on net debt to total capital ratio from year-end was due to the impairment and abandonment charges and the deferred tax allowances recorded in the first half of the year which reduced our retained earnings.

With $1.3 billion of cash at quarter-end and about $1.1 billion net of letters of credit available under our bank revolving credit agreement, which matures in November, 2010, we believe we have substantial liquidity to navigate the current environment and to capitalize on opportunities as they arise. We recently decided to call $300 million of a 7 ¾% senior subordinated notes on July 14, at a redemption price of 101.938%. We believe this makes economic sense due to the generation of nearly $16 million of annual savings in a four and a half month breakeven on redemption premium. Following the redemption we still expect to have a substantial cash position. We do not anticipate having any outstanding borrowings under the bank revolving credit agreement for the remainder of the year.

As of May 31, 2008 we had $295 million invested in 34 consolidated joint ventures. Of these 22 had more then $10 million in assets and only 11 had more then $50 million of total assets. Now five consolidated joint ventures represent almost 80% of the $295 million investment, the majority with public builders and financially sound developers in good submarkets. Twenty of our unconsolidated joint ventures have bank debt with varying levels of obligations under debt. As we discussed in our last quarter we continue to tightly manage the challenges some of our joint ventures face in light of the difficulties of the current housing environment.

Although we cannot disclose any details, we continue to work with select partners and banks to find the best solutions for us and our stockholders. We expect our joint venture investments to continue to decrease as we move ahead. Joint ventures have a place in our business but in the short-term we are limiting our participation and reviewing each investment to ensure it fits into our overall marketing plans and business objectives.

Now let me turn it back to Jeffrey.

Jeffrey Mezger

Thanks Domenico. Let me add a few comments before we take your questions. Although currently experiencing a prolonged downturn the housing market will return. People have and will continue to buy homes and the American dream will continue to exist for the substantial number of new US households that are country will experience in the next several decades. From the 2008 report of Harvard University’s joint center for housing studies issued this past week, we learned that changes in the number and age distribution of the adult population should lift household growth from 12.6 million in the decade of 1995-2005 to 14.4 million in the decade of 2010-2020.

KB Home will be there and we’ll be ready to meet the demand generated from these expected demographic trends. In past calls we have discussed some of the distinct competitive advantages that differentiate KB Home from other home builders. I think they bear repeating. Our KB Next business model defines how we operate no matter what conditions exist. The KB Next discipline maintains our 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 and outstanding customer service and its built-to-order system gives buyers both choice and value. There is no better model for both strong and challenging housing conditions. We are committed to our long-term strategy of providing high quality homes for the first time, first move-up and active adult buyer. No matter what market conditions exist, we firmly believe the desire for home ownership is a constant for Americans and fuels the first time buyer market. Serving first time buyers is an especially attractive position since they do not have the additional obstacle of selling an existing home.

We remain fundamentally a pre-sold builder, a business model that provides maximum choice to our customers and predicable delivery results for us. Our built-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 budget. In fact our studio revenues per unit have remained relatively constant through the downturn and in our second quarter were 14% of our base price revenues; the highest level ever underscoring the value proposition of choice.

Our largest and most important geographic footprint remains in the Sunbelt, the region likely to experience the strongest population and job growth going forward. Today we operate in 32 of the top MSAs in nine states across the country. Once market conditions stabilize these attractive markets could support two to three times the delivery volumes we are currently generating. We are strategically positioned in the right markets to fuel our future growth.

We are focused on unique, high impact marketing strategies that increase traffic at the community level while building national brand awareness. Our present marketing campaigns are designed to address the concerns of first time buyers. Our strategic partnerships with Martha Stewart and Disney also give us an exclusive competitive advantage over other builders as well as an advantage over the resale market. Our Countrywide soon-to-be Banc of America, KB Home Loans joint venture provides a reliable source of funding and makes available to our buyers all programs currently offered in the marketplace.

In the second quarter of 2008 80% of our home buyers who financed their home purchase used Countrywide KB Home Loans. Operating through this joint venture structure is beneficial because it lowers our financial risk and allows us to focus on our core competency of home building.

Recently we have been working hard to foster another advantage, one that benefits our environment as well as our buyers. This year KB Home became the first national builder to sell new homes exclusively with ENERGY STAR qualified appliances. We now offer a wide variety of environmentally friendly options to home buyers at our KB Home studios as part of our My Home, My Earth environment initiative. And these options are becoming extremely popular.

Eight KB Home divisions have just received the 2008 ENERGY STAR Leadership in Housing Award from the EPA for building new homes that are energy efficient and help protect the environment. These divisions are in Austin, Dallas Fort Worth, Houston, Las Vegas, Phoenix, Sacramento, San Antonio and Southern California. Last month KB Home was named the number one Green National Home Builder by the prestigious investment firm Calvert Asset Management and the Boston College Institute for Responsible Investment. It is certainly gratifying to be recognized although it is clear that we along with the entire home building industry have more to do in this area.

Our goal is to be a leading environmentally friendly national builder. Environment sustainability is yet another distinction that sets our homes apart from other choices in the marketplace particularly resale homes.

In closing I would like to recognize our employees at KB Home for their dedicated work and outstanding achievements and for continuing to make our buyers their highest priority. I am confident that together we will continue to meet the challenges ahead and build a bright future for KB Home.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Dan Oppenheim – Credit Suisse

Dan Oppenheim – Credit Suisse

Can you talk about some of the markets where you saw better order trends and kind of what did you have to do on pricing in those markets to get there?

Jeffrey Mezger

I don’t know that we have that kind of detail because the story will vary by community and by submarket within a city. I think we do have the sales by region. It’s in the press release. What I can tell you is that our entry level products and our more affordably priced products are selling better then the move-up products where the buyer has a home to sell.

Dan Oppenheim – Credit Suisse

Could you give us an idea of how orders trended throughout the quarter?

Jeffrey Mezger

We don’t normally disclose that data. You can’t respond too much to what happens in one month. It’s a quarterly look for us.

Operator

Your next question comes from the line of Dennis McGill – Zelman & Associates

Dennis McGill – Zelman & Associates

On the carry back opportunity for what you get in 2009, what’s the amount that you paid a couple of years ago?

Kelly Masuda

I think we’ve used it all up.

Dennis McGill – Zelman & Associates

Did you say the $21 million of option abandonments related to 800 option lots or 8,000?

Domenico Cecere

It was 800.

Operator

Your next question comes from the line of Michael Rehaut - JP Morgan

Michael Rehaut - JP Morgan

Your comments about the low exposure to the down payment assistance program really surprised me, a few years ago we had it that you had about 13% of your consumers using down payment assistance, the FHA as an overall entity about 35% of their loans have down payment assistance, and yesterday [Lenar] said about a third of their loans use down payment assistance, so its just kind of surprising to hear you say only 74 closings, I was wondering if you could describe how you get to that conclusion, how you track your mortgages?

Jeffrey Mezger

Within our venture we have the ability to track loan specific, what loan type it was. I can tell you that a few years ago we moved away from DPA, stopped offering it altogether. There is a lot of pressure as you’ve seen in the news from congress to eliminate the program and we’re sensitive to that so we don’t want to create a business that relies on something that could possibly go away in the future.

Michael Rehaut - JP Morgan

So you’re pretty comfortable that, with the accuracy of that statistic then?

Kelly Masuda

Yes we are.

Operator

Your next question comes from the line of Jim Wilson - JMP Securities

Jim Wilson - JMP Securities

I was just wondering if you could talk a little bit about as you’re targeting deploying capital, how you feel about your inventory position in certain markets. You’ve reduced it significantly, are there places now you really feel you’re short and you might be targeting or is it just purely any market price driven?

Jeffrey Mezger

I believe strongly that a land light position right now is very prudent and the right position to be in. We do have markets that by the end of 2009 will be tight on lots. However I think that’s a healthy tension right now because there are opportunities coming across the transom every week in just about every market now to acquire lots. We’re remaining very patient because I think the opportunities will get better. The only deals we’re doing right now are those that are in A submarkets at a price point that we feel is strategic for that market. So preferably at the low end of the price scale in that market and we’re also being very cautious in our underwriting to ensure we have some cushion in case the market were to erode further where ever that asset is.

Domenico Cecere

And we like much better being in a position to pick up finished lots where our cash inflow to first delivery is probably a year quicker then it would be if we had to develop those lots.

Jim Wilson - JMP Securities

What are the terms on those look like, are you able, say cash are you actually going to buy lots, can you option them, do the terms look seemingly different then they did in prior years?

Jeffrey Mezger

Every story is different as you know. The terms loosened up a year ago so terms have been out there and it’s the trade-off. If you do an option you’re probably going to pay a little higher price. If you pay cash you’ll get a little lower price. Most of the deals we’re doing right now are on easy rollers. We’re not doing a lot of cash bulk; I don’t think we’re doing any cash bulk deals right now. It’s all small option takes.

Operator

Your next question comes from the line of David Goldberg – UBS Securities

David Goldberg – UBS Securities

Could you give us a little bit more color on the cost side of the business and really, the direct cost and material cost and what kind of savings do you think you’re seeing there, and then also some of the efforts you have put forward on the logistic side of the business, supply chain and where that stands?

Jeffrey Mezger

There’s a lot that goes into cost, as we’ve shared now strategically for the last 18 months to two years, we’ve been working diligently to retool our product lines to go to smaller footages then we had back in 2005 and 2006. As Domenico mentioned on the call our average sized home was down about 10% in the last 12 months. So it lowers your cost an equivalent amount to whatever our average price per foot is you can take that right off as a cost savings. For the year right now we’re tracking, we’re approaching a 10% reduction in directs. I am concerned with the unknowns out there about what the price of fuel does to directs going forward. So we’ll continue to fight that fight.

On our direct buy third party logistics program that you referred to we’ve rolled it out in Southern California. It’s working very well. We are seeing some synergies due to the direct buy and distribution. We’re about to put it on the test pilot in Texas where we’re expecting to see similar synergies. But it’s still in its infancy. These things take time to rollout and we’ll have a better story for you by the end of the year.

Domenico Cecere

One way you can look at it is that our prices dropped sequentially 7% in the fourth quarter and they dropped another 8% and 9% this quarter yet our margins on the business have remained relatively flat, they’re down slightly but we have reduced price and part of that is because we reduced square footage and taken some the amenities out of the house but also its been cost reduction that has helped us to kind of hold the margin while making a home much more affordable.

David Goldberg – UBS Securities

You were talking about the ENERGY STAR program and the energy efficiency and I’m just wondering how much more it costs you to put in the ENERGY STAR appliances relative, doing some of the more environmentally friendly stuff and if consumers are starting to pay a premium for homes that are energy efficient and environmentally friendly.

Jeffrey Mezger

As we shared in the past the cost increase to go to ENERGY STAR was very, very minimal in part because we have one business model we could roll it across the whole system and work with Whirlpool on a volume scale for ENERGY STAR and get better pricing. So there wasn’t a margin adjustment for us as a result of the ENERGY STAR appliances. We continue to endeavor to find additional low-hanging fruit that we can offer to the consumer that don’t increase our costs a lot. The mainstream consumer right now is focused on affordability, can I really buy this home or not, they’ll purchase options where there’s an economic trade-off. Where they know over a period of time they can recoup their investment and that’s the beauty of our studios. For the buyer that’s really into the environmental side they have the choice to go buy whatever they want and then the mainstream consumer that’s into the environment but maybe not to the same degree, we’re offering what we can that doesn’t increase our costs. So we’re hitting it both ways.

Operator

Your next question comes from the line of Timothy Jones - Wasserman & Associates

Timothy Jones - Wasserman & Associates

Your margins continue to be at high single-digit right now and you’re operating margin before impairments was about a 10% loss, one of your competitors had a similar thing last quarter saying basically there were getting rid of a lot of spec units, and [inaudible] competitor earned about 0.5% and another one lost maybe 2%. Why are your losses so much greater given the fact that you really are holding down your spec units?

Domenico Cecere

I don’t think it’s directly related to spec units.

Timothy Jones - Wasserman & Associates

Is it related to California?

Domenico Cecere

No, where we are now is if there’s a loss it’s because our SG&A has moved up a little bit and that for us has been really essentially the fact that revenue is down 50% and we were able to take our costs down almost 40%.

Timothy Jones - Wasserman & Associates

I know the SG&A but the gross margin of 8.7 that was bothering me.

Jeffrey Mezger

And there are a few things that impact that, it bothers us also and it’s where we’re spending a lot of our time right now. We know that we’re not going to see a lot of price increase obviously in the short-run so the only way to improve your margin is cost or being a little more strategic on pricing one plan to another if they’re not tracking. But as we continue to whittle away at our community count and our investment some of the cost, there’s a tail to, I always call it the tail to the comet, where your overhead doesn’t move down as fast as your revenue because you have a lag on the cost side. So as we closed out a lot of communities, there’s another quarter where the costs continue to flow through the system while the revenue is gone. And our challenge right now is how do we keep lowering our overhead, how do we keep lowering our cost to produce the houses and at the right time reload with a lower lot that’s going to really lift our margins.

Domenico Cecere

And we said in the overall Q&A or discussion that we had focused for a long time on generating a lot of cash. We will continue to be cash flow positive this first half of the year. Some others were not and we said that we’ll be positive cash flow in the second half of the year. And then said strategically we’re going to go back and try to work the margins back up because we’ve done all the heavy lifting on becoming, generating cash and holding our inventories. We’ve done a good job on the balance sheet and now we’re going back to focus on profitability.

Timothy Jones - Wasserman & Associates

One of the questions is one competitor went up to 230 basis points saying they benefited from that 9% decline in raw materials, 7%, 8% decline and two, obviously they’ve written down land of a year ago, coming into cheaper prices. Why aren’t you benefiting from that kind of thing?

Domenico Cecere

I don’t think you can take one or two quarters and say we are or we’re not benefiting. You’ve got to look at it in the long-term and I think when we come out of this you’ll see the full benefit.

Jeffrey Mezger

You can also link it back, we are benefiting in that our price was down significantly because we’re repositioning for first time buyers, insolating ourselves from any additional resale market downturn yet our margins were flat.

Operator

Your next question comes from the line of Joel Locker - FBN Securities

Joel Locker - FBN Securities

Just on the order front, obviously they improved a lot from the first quarter and I’m wondering if you could give some kind of a figure on how much your price per order declined sequentially?

Domenico Cecere

I think it was probably pretty consistent, wouldn’t you? When we looked at our price in backlog I would say it’s pretty consistent with what you saw first quarter, second quarter deliveries where our prices I think sequentially were down 8% to 9%. I think the backlog would be similar.

Joel Locker - FBN Securities

Have you seen, there’s a lot of management teams from the private side that are out of work now and a lot of the capital on the private equity side, have you seen any new home builders actually in the stages of being formed where those are split to capital with the private equity, hire the management team and then go to the distressed land sellers and buy permanent property or lots to actually build on?

Jeffrey Mezger

Where the builder would go to a fund to buy the assets?

Joel Locker - FBN Securities

No not a builder, out of work say management team hooks up with a private equity who puts a billion dollars in there to buy land from distressed land sellers.

Domenico Cecere

The one theme that we’ve been hearing is they can generate some equity but they’re having a hard time finding the debt side of capital to go with the equity to do deals so I don’t think you’ve seen a whole lot being done.

Jeffrey Mezger

There are a lot of funds that have been created and a lot of home building executives that have gone to manage those funds but they aren’t doing a lot of transactions today. And at the right point in time we will align ourselves with the right fund, with the right managers and take advantage of that for future opportunities.

Operator

Your next question comes from the line of Larry Taylor – Credit Suisse

Larry Taylor – Credit Suisse

Net debt at 856 has been about flat for the last couple of quarters, you’re going to use cash to repay this debt that you’re going to take out in July, is that about the right number, somewhere in that range that you are sort of comfortable supporting as far as net debt is concerned given the current earnings power?

Domenico Cecere

Well it will probably improve because we said we’d be positive cash flow in the second half of the year so you’d probably the net net, it should actually go down.

Larry Taylor – Credit Suisse

When we think about the order of magnitude of the land purchases that you might do opportunistically in the second half of this year relative to the potential for cash flow how should we think about that in terms of a [plug] versus how much debt the business is supporting today?

Jeffrey Mezger

Our strategy right now is to hold our ratio between 40% and 50% and one of the keys to the reload is to continue to get terms to align yourself strategically so you’re not using all your cash but we do think that when the opportunities hit that we’re going to use some of our cash and the ratio is going to go up from whatever level it is at that time.

Domenico Cecere

And don’t forget that we have $720 million of deferred tax asset that when we [return] to property will be an influx of cash for us.

Operator

Your next question comes from the line of Alex Barron - Agency Trading Group

Alex Barron - Agency Trading Group

If you could give us of the communities that you currently have, how many have been impaired at least once and I’m trying to understand a little bit of your impairment methodology because my impression was that if impairments are taken that at some point the gross margins would start trending back up and so since we haven’t seen that, I’m just trying to understand what might be going on there.

Domenico Cecere

Actually when you take an impairment you’re not going to see a much higher gross margin then we have today. You’ve got some price back or your cost down to bring your margins up. Generally the impairments don’t yield a higher margin then, I don’t know, would you say at 10%, 11%, 12% max. Kelly do you know how many have impaired more then once of our communities?

Kelly Masuda

Of our current impairments for the quarter about half the projects were impaired more then once and in aggregate a little bit more then 100 of our communities have been impaired more then once.

Operator

Your next question comes from the line of Jay McCanless – FTN Midwest Securities

Jay McCanless – FTN Midwest Securities

Just wanted to talk very quickly about the deferred tax asset that’s rolling back onto the income statement, how many quarters of profitability do you think you’ll have to see in order to get those back?

Domenico Cecere

They haven’t come out with a clear rule on how fast that can be restored.

Jay McCanless – FTN Midwest Securities

I wanted to ask on the foreclosures, I would assume that the markets that ran up the most during the upturn are the ones where you’re seeing the most foreclosures, but are there any specific markets where you’re having undue burden from foreclosures?

Jeffrey Mezger

The markets that we referenced in our comments, the Nevada, Arizona, Florida, and California is where the foreclosure levels are the highest and based on the research we’ve seen, it’s expected to continue at high levels for a little while still.

Operator

That is all the time we have today for questions so Mr. Mezger, I’ll turn the conference back to you for closing or additional remarks.

Jeffrey Mezger

Thank you for joining us today for our second quarter 2008 conference call. Have a great day and we’ll look forward to speaking with you again soon.

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Source: KB Home F2Q08 (Qtr End 05/31/08) Earnings Call Transcript
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