KB Home F3Q08 (Qtr End 08/31/08) Earnings Call Transcript

Sep.26.08 | About: KB Home (KBH)

KB Home (NYSE:KBH)

Q3 2008 Earnings Call

September 26, 2008 11:30 am ET

Executives

Kelly Masuda – Sr. VP & Treasurer

Jeffrey Mezger – President & CEO

Domenic Cecere – Executive VP & CFO

William Hollinger – Sr. VP & CAO

Analysts

Dan Oppenheim – Credit Suisse

Ivy Zelman – Zelman & Associates

Michael Rehaut - JP Morgan

David Goldberg – UBS Securities

Stephen East – Pali Research

Kenneth Zener – Macquarie Research

Chris Hussey – Goldman Sachs

Timothy Jones - Wasserman & Associates

Josh Levin – Citi Investment Research

Joel Locker - FBN Securities

Nishu Sood – Deutsche Bank

Megan Talbott McGrath – Barclay’s Capital

Alex Barron - Agency Trading Group

Operator

Good day everyone and welcome to the KB Home third 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, 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.

And now for opening remarks and introductions it is my pleasure to turn the conference over to KB Home’s President and Chief Executive Officer, Mr. Jeffrey Mezger; please go ahead sir.

Jeffrey Mezger

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

By now you have probably had the opportunity to read our earnings release. In a few moments I will turn the call over to Domenic who will go through the numbers in greater detail. Then of course we will open it up for your questions. But first, I would like to offer my own perspective on the state of the industry, our quarterly results, and how KB Home’s strategic decisions are enabling us to manage successfully through these very difficult market conditions and to emerge from the downturn a more nimble company well positioned to seize attractive growth opportunities as they arise.

The past few weeks have been truly historic and certainly represent the most drastic change in the capital markets that I have seen in my lifetime. While it will be some time before the impact of any comprehensive government intervention will be fully understood, we welcome any steps that help to stabilize the mortgage markets and increase consumer confidence.

However, it should be noted that the current proposal provides no direct relief for housing despite the fact that policy makers recognize that once again housing will be a cornerstone for the broader economic recovery.

For the time being, difficult market conditions persist. Lending standards are tightening further. In the mortgage market and consumer confidence which remained low prior to the recent news, may decrease even further.

At 6.1% unemployment stands at the highest level in five years and inventory of both new and existing homes remains bloated. While resell inventory driven in large part by the spike in foreclosures now stands at [$] 4.26 million, we are encouraged by the uptick in activity in some markets.

This increased sales activity however driven by extraordinarily low pricing levels as local markets seek to reach an equilibrium between supply and demand. Markets will eventually stabilize and when they do new normals will be set for pricing, demand and credit terms against which future housing market performance will be judged.

We should not expect a snap-back to the pricing and credit dynamics we saw a few years ago even after the current downturn comes to an end.

We believe success in today’s environment calls for an integrated and disciplined approach to balance sheet and profit management centering on three strategic imperatives. First, maintaining a strong cash position and balance sheet, second, restoring operational profitability and third position ourselves to capitalize on a housing market recovery when it occurs.

When we first embarked on these imperatives in 2006 our initial objective was to generate cash and reduce inventory levels. At that time, we were among the first builders to recognize the importance of having a strong balance sheet with plenty of cash on hand during a downturn.

The benefits of this choice can still be felt today as we entered the third quarter with reduced debt levels and a sizable cash balance of $942 million. We expect to be cash flow positive for both the balance of and full year 2008 with over $1 billion in cash and no cash borrowings outstanding on our unsecured credit facility at year end.

This positions us well to weather the continued downturn and capitalize on investment opportunities when they arise. Although, until the market stabilizes we will remain conservative with our spending and investment decisions.

Having accomplished our primary objective of a strengthened balance sheet we are now focusing our efforts on maintaining this position while restoring profitability and we are making progress towards this goal.

Our net orders in the third quarter declined 66% to 1,329 homes driven in large part by three factors. First, we enforced price discipline in the face of some very powerful downward pressures. Because of our cash position we do not have to sell and build homes at a loss just to generate cash.

Second, our community count was down by 38% year-over-year and over 50% from the 2006 peak. We will continue operating with fewer communities until we believe investments in new communities will deliver financial results with acceptable returns.

Finally, we accelerated a major product transition strategy which slowed the sales pace in a number of our communities in the short-term.

These three factors will exert downward pressure on our net orders in the fourth quarter as we position ourselves for restoring profitability going forward.

We also continued to realign our business to operate efficiently in this environment. In the third quarter we consolidated the operations of seven of our divisions. While taking steps like this to become as lean as possible we are also staying mindful of our strategic growth platform.

The markets where we operate today are the same markets where we delivered over 30,000 at the housing peak. We expect these markets to lead the housing recovery and we will be ready to mobilize when they do.

These division consolidations produced one-time charges that hit in the third quarter. As a result of these moves and other reductions in our workforce, our employee count is now 66% below the 2006 peak including an 18% reduction in the current quarter.

As much as we have already done, our SG&A is still at unacceptable levels and cost reductions in this area will continue to remain a top priority.

Perhaps our most significant move in the quarter was accelerating the transformation of our product line. As we sharpened our focus on the first-time buyer, we recognized that many of our product offerings were not aligned with their current needs and affordability levels.

Our houses were too big, included too many costly features and as a result were too expensive for our core customer. So we began downsizing and down-specing our homes. For example, last year in California’s Inland Empire region, we quickly moved from building 3,400 foot homes that sold for $450,000 to building 2,400 foot homes that sell for $300,000.

That worked for a time, but the market continued to move away from us. Now we have introduced a new line of homes that start at three bedrooms and 1,230 square feet for just over $200,000; a price that is very competitive with today’s resales including foreclosures.

The market has responded very favorably. Even in the Inland Empire arguably one of the most difficult housing markets in the country we are seeing more than two sales per week in the communities where we have introduced these new plans.

I share the detail behind this success story because it typifies our strategic direction company-wide. We are heavily focused on competing with resale price points in every market. As you know, KB Home does best when we focus on our core market of first-time homebuyers.

These buyers are especially important in these times because they are not burdened with the need to sell a home before making the buying decision. We continue to differentiate the customer experience by offering built-to-order homes that give buyers the power to choose exactly the features and upgrades they want in their home. And even with the pressure on pricing the sales and margins at our KB Home studios where our buyers can personalize their homes, have held up quite well.

Environmental leadership is also an increasingly important differentiator and we have a stated goal of becoming a leading environmentally friendly national company. During the quarter we released our first sustainability report; a comprehensive review of our current initiatives and commitments.

The report is part of our larger my-home-my-hearth initiative that among other things, helps drive costly waste out of our business. As I have noted on earlier calls the country’s long-term economic and demographic outlook remains very encouraging for the housing industry.

Even with the disruptions in the larger economy we do not see the fundamental desire for home ownership diminishing. Harvard University’s [Joint] Center for Housing studies has projected the annual increase of housing needed between now and 2020 at 1.4 million units as the US population continues growing and social trends create more single person households.

Our job now is to navigate our way carefully through today’s economic cross currents so we are well positioned to serve this market on the other side.

I will now turn the call over to Domenic to discuss our results in more detail and then I will have a quick final comment before we open it up to Q&A.

Domenic Cecere

Thanks Jeff. Net orders of 1,329 new homes in the third quarter were down 66%. The decline was largely due to our reduced community count, down 38% from a year ago, and our strategic decision to hold firm on pricing and reduce the use of sales incentives.

In addition we designed and are introducing new more affordable product at several of our communities that is better tailored to the needs of today’s first-time home buyer and is more cost effective to build.

As we make this transition we are shutting down some communities for a short time and consequently are experiencing a temporary lag in orders in other communities where our current product will be discontinued.

We expect to have our new more affordable product on line by the first quarter of 2009 which should have a positive impact on orders going forward.

We had 232 active selling communities in the third quarter of 2008, down 38% from 372 in the third quarter of 2007. Our community count was lower across all four of our regions with decreases ranging from 33% to 41%.

Clearly our highest operating priority remains increasing our margins and returning profitability. For now that means operating at reduced volume and corresponding SG&A levels.

As conditions change however, we will continue to review and adjust community counts as appropriate to maximize our performance in each region. Third quarter order cancellations as a percentage of gross orders were essentially flat at 51% in the third quarter of 2008 compared to 50% in last year’s third quarter.

Our cancellations as a percentage of beginning backlog however continued to improve. The rate was 22% in the current quarter, down from 33% in the second quarter of 2008 and 29% in the third quarter of 2007. In fact this is the lowest rate we have experienced since the first quarter of 2006.

We entered the third quarter with 6,233 sold homes in backlog and we converted 2,788 or 45% of our beginning backlog to revenue during the period. This compares to a conversion ratio of 42% in the third quarter of 2007.

Our backlog remains geographically diverse with the largest portfolio on a value basis located in our West Coast and Southeast regions.

We incurred a net loss of $145 million or $1.87 per diluted share in the third quarter including pre-tax non-cash charges of $82 million for inventory and joint venture impairments and $10 million associated with the early redemption of our senior subordinated notes and the amendment of our credit facility.

During the quarter we also recorded a $58 million charge for a deferred tax asset valuation allowance. We delivered 2,788 homes in the third quarter of 2008, down 51% from the year earlier quarter reflecting our reduced community count and the very challenging market conditions that have hampered our net orders for the past several quarters.

Each of our regions delivered fewer homes compared to the year earlier quarter with decreases ranging from 42% to 63%. We expect our community counts to remain at reduced levels through the end of the year.

Our third quarter average selling price fell 10% to $239,700 from $267,700 in the year earlier quarter. The most substantial decline occurred in our West Coast segment where the average selling price fell 20% year-over-year amid expanding foreclosure rates that continued to fuel intense pricing pressure.

Average selling prices in our Southwest and Southeast homebuilding regions fell by 13% and 11% respectively with our Central region up slightly. In general our lower average sales prices reflect both declining market prices and our efforts to address affordability over the last several quarters.

Our housing gross margin in third quarter of 2008 rebounded to a positive 3.9% from negative 28% in the third quarter of 2007. The higher margin was directly attributable to lower impairment charges relative to a year ago. Excluding those charges the margin was 9.6% in the current quarter compared to 13.9% in last year’s third quarter.

On a sequential basis however, we saw an improvement from 8.7% margin excluding impairments we reported in the second quarter of 2008. We expect margins to remain compressed throughout the fourth quarter.

Selling, general and administrative expenses in the third quarter were down $64 million or 32% from a year ago. Reducing overhead is a major priority for us. We continue to take actions to better align our overhead with reduced delivery volumes. In previous quarters we have exited underperforming markets and/or consolidated operation.

This work continued in the third quarter. We consolidated our West Coast region operations into to divisions, Northern and Southern California, and we are in the process of emerging some divisions in other regions as well. We believe these additional steps will produce better financial comparisons in future quarters.

Our basic approach in these consolidations is to maintain our primary division with small business units to help service a wide area. The strategy is to preserve a solid foundation that can support growth and expansion as market conditions become more favorable.

In essence we are maintaining an expandable operating presence in all the markets that generated our peak year results of 30,000 deliveries.

We also made further reductions in our employee count during the quarter. As Jeffrey mentioned we have reduced our workforce dramatically from its peak level in 2006. The financial impact of our overhead reductions were partially offset in the quarter by associated costs. We incurred about $14 million or approximately 200 basis points of non-recurring severance and lease termination costs in the quarter as a result of the recent division consolidations and reductions in workforce.

Savings should become more evident in our future results. Our SG&A as a percentage of housing revenues was 19.9% in the third quarter, up from 12.9% in the year earlier period. Because of the steep and rapid decline in our revenues the ratio does not reflect the progress we have made.

We are not satisfied with this result and we will continue to work relentlessly to pare back our overhead in proportion to our revenues.

Our homebuilding pre-tax loss for the third quarter totaled $157.7 million including a pre-tax charge of $82.2 million for inventory and joint venture impairments. About half of the impairments were associated with [inaudible] joint ventures.

Our regional breakdown of the charges is as follows: West Coast $7.4 million; Southwest $53.7 million and Southeast $21.1 million. We hope that we have turned the corner on impairments. The current quarter charge was 88% lower then the total impairment and abandonment charge recorded in the year earlier quarter and the charges have decreased sequentially for the last four consecutive quarters.

The financial services business contributed pre-tax income of $6 million in the third quarter of 2008. Our Countrywide KB Home Loans and Mortgage Banking joint venture has remained profitable throughout the recent turmoil in the mortgage market. The joint venture structure has worked well for us and provides for lower risk.

Within the joint venture our retention rate was 80% for the third quarter of 2008 compared to 73% a year ago. Buyers also continued to use more fixed rate product. Just 4% chose an adjustable rate mortgage during the quarter. Government and conforming loans were used in 95% of our third quarter deliveries.

At the end of the third quarter approximately two-thirds of our backlog of sold homes were qualified with an FHA or VA loan.

The third quarter period reflected a $58 million deferred tax asset valuation allowance charge. While the deferred tax asset valuation allowance is a non-cash item, it did impact our balance sheet and book value. Since recording the valuation allowance in the fourth quarter of 2007, we have $780 million of deferred tax assets fully reserved as of August 31, 2208.

To the extent we generate taxable income in the future to utilize these tax benefits, we expect to reverse the valuation allowance and decrease our effective tax rate on future income. However to the extent we generate future operating losses, we will be required to add to the valuation allowance and our income tax provision will be adversely impacted.

The valuation allowance on our deferred tax assets is a significant relative to the current equity and could have a meaningful impact on our book value per share and our leverage ratios when it is realized.

Over the past few quarters we have streamlined our land position significantly reducing inventory and community counts while consolidating operations and exiting underperforming markets. At August 31, 2008 we had $2.6 billion in inventories compared to $3.3 billion at November 30, 2007 and $4.4 billion at August 31, 2007.

At the end of the quarter we owned or controlled approximately 52,700 lots, down 72% from a peak of 186,300 lots in the first quarter of 2006 and 36% from 82,600 lots in the third quarter of 2007.

Our current inventory represents about a three-year supply based on trailing 12-month deliveries. Of the 52,700 total we own less then 37,000 lots and have approximately 15,700 controlled via land option contracts.

Homes in production are down almost 71% from the peak in the third quarter of 2006 and 55% from the third quarter of 2007. We currently have approximately 5,189 homes in production with 18% or 938 homes unsold. This is one of the lowest spec production levels in the industry. We had approximately 481 finished unsold homes in inventory at quarter end.

We had total debt of $1.9 billion at August 31, 2008 which was $284 million lower then the balance at August 31, 2007. In July we used a portion of our accumulated cash to redeem all $300 million of our 7 ¾ senior subordinated notes, ahead of the scheduled 2010 maturity.

The early redemption resulted in a charge of $7 million in the third quarter of 2008 with a payback in less then five months and [$70 million] in savings in 2009. During the third quarter we also worked closely with our banks to amend our unsecured revolving credit facility. We are pleased with our banking associations and the effective working relationship we have with these important business partners.

The recent amendment reduced the aggregate commitment under the facility from $1.3 billion to $800 million and modified the intangible net worth and certain financial [inaudible] we are required to maintain.

The facility’s November, 2010 maturity date remains unchanged. We wrote off $3 million of unamortized costs in the third quarter due to the reduction in the commitment amount of the facility. There were no cash borrowings under our current unsecured revolver facility at August 31, 2008.

We expect to have no outstanding cash borrowings under this facility at the end of the year. As of the end of the third quarter our debt net of cash totaled approximately $935 million compared to $1.5 billion a year ago. The 38% reduction in net debt in the last 12 months reflects the third quarter redemption of our senior subordinated notes and our higher cash balance at August 31, 2008.

We have generated positive cash flows from operations in the last 12 months and expect our operations to produce positive cash flows in the fourth quarter. We expect to end the year with over $1 billion in cash. Our net debt to total capital ratio was approximately 45% at the end of the third quarter compared to 31% at year end 2007 and 36% at August 31, 2007.

The increase in this ratio from year end was due to the impairment and abandonment charges and the deferred tax allowances recorded in the first nine months of the year which reduced our equity.

Looking ahead to the first quarter of 2009 we have $200 million of 8 5/8% senior subordinated notes scheduled to mature. We expect this to be offset with a tax refund of approximately $220 million coming in the quarter. After these notes mature our next bond does not come due until 2011.

With $942 million of cash at quarter end and about $614 million net of letters of credit available under our banking revolving credit agreement our liquidity at August 31, 2008 was in excess of $1.5 billion.

We believe we have ample liquidity to navigate the current environment and capitalize on opportunities as they arise. As of August 31, 2008 we had approximately $250 million invested in about 30 unconsolidated joint ventures of which around 20 are active.

This is down from $369 million one year ago. Our investment in unconsolidated joint ventures have continued to drop due to impairments, renegotiations with partners and buyouts. We have been actively working to reduce our joint venture investments and expect we will see further reductions in the fourth quarter and next year.

We strategically manage our joint venture assets like any other assets and evaluate the best use for them among the available alternatives such as bulk sales, building through and [inaudible].

Of our active joint ventures we have six with loan to value maintenance guarantees. If the values of these projects fell all the way to zero, our total estimated exposure under those guarantees would be less then $100 million.

We are currently working with our bank partners to find solutions for a handful of our unconsolidated joint ventures in the Southwest, the Mid Atlantic area, and the Southeast region. Although we cannot discuss any details we continue to work with our select partners and banks to find the best solutions for us and our stockholders.

Additionally we are opportunistically unwinding certain joint ventures. For instance, the past quarter we executed the buyout of the equity position of a joint partner in [Villa Peters], California, at a substantial discount which attractively enhanced our returns.

The [position] was held by our Wall Street investment bank. Furthermore in the fourth quarter we have already purchased the equity position of our joint venture partners in two other projects. Now let me turn it back to Jeffrey.

Jeffrey Mezger

Thanks Domenic. Before I make my final comments I want to take this opportunity to thank all the employees of KB Home. They are an extraordinary team and I consider myself fortunate to work with such creative and dedicated professionals every day.

Each of you did not join this call to learn about the difficult economic environment that the country is facing and these truly are historic times in that regard. You also did not join the call to learn about the headwinds in the housing industry. There is no question that these are challenging economic times and that the policy makers are addressing the national economy.

There is also no question that the long-term prospects for housing are favorable driven by strong demographics. Someone once observed tough markets don’t last forever, tough people do. We do not control the market dynamics, nor do we control the timing of when those dynamics will improve.

What we do control is how we act in these times and at KB Home we are responding to this tough market by taking aggressive steps that are repositioning our business to take advantage of opportunity.

I would like to recap for you what I would like you to take away from this call.

First KB Home is well positioned with a strengthened balance sheet. We will end the year with over $1 billion in cash and no borrowings outstanding on our revolver.

The over $1.5 billion in liquidity represents ample dry powder to run our business and to be opportunistic. Our goal for 2009 is to manage the business with neutral cash flow and have set a target of over $1.5 billion in liquidity for year end 2009 as well.

Second, we are working to improve our sales results which were impacted to a large degree by steps we have taken whether it is pricing for margin over volume, a reduced community count or the product transition that I shared.

We are pushing to open our new product line communities as quickly as possible but many will not have a material impact on sales rates until the beginning of 2009.

We believe we are taking the right steps to properly position our selling efforts as we head into the new year.

Next, while maintaining a sound balance sheet we are diligent in our pursuit of restoring profitability. We will pace our sales rates with a balance between margin and asset management and be relentless in further reductions in SG&A.

It is imperative that we continue to realign our overhead, to drive our SG&A ratio below historical levels, irrespective of the revenue levels we are generating.

We also continue to reposition KB Home for the future in a number of ways. We have intensified our strategic commitment to primarily first-time homebuyer communities. We continue to drive lean business structures while retaining our growth platform in those markets where we have performed well historically and that have favorable growth projections.

And we are transfiguring our product lines to be more value engineered and in line with the needs of our customer while competing more favorably with current resales.

Finally we continue to execute on the many differentiators that are unique to KB Home. Things like our brand recognition and marketing approach, our partnership with Martha Stewart, our built-to-order business model featuring value and choice in our studios and our sustainability initiative.

All of these attributes are competitive advantages for our company and they all resonate well with our consumer. As the markets stabilize I am confident the value of these differentiators will become even more apparent.

We also recognize that it will be a very different world for the homebuilding industry even after we experience market stability. We will have to operate in a way that is consistent with significantly readjusted home prices, mortgage terms and availability, and by our preferences.

In summary, the true imperative for KB Home today is in essence to be KB Home. The ability to be successful in this market is deeply coded within our cultural DNA and now 52 year history. Our ongoing challenge is to execute our proven business model enabling us to take advantage of any future business opportunity that presents itself, now and in the future.

Thank you very much and now we will open the call to questions.

Question-and-Answer Session

Operator

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

Dan Oppenheim – Credit Suisse

In your opening comments you talked about how you don’t any direct help for housing from this Bill, just wondering and you said that this was going to pressure sales this fall, I was wondering what you’re hearing about potential for any sort of second stimulus package whether it’s a tax credit, return of down payment assistance, are you hearing anything about that?

Jeffrey Mezger

There is a lot of noise in the hallways, but the majority of the Bill right now is focused on fixing Wall Street issues. I’m not aware of anything that’s being talked about in these proposals that’s going to create housing demand or stabilize housing markets.

We’re heading toward the election and in turn a new Congress in January, and its unclear whether they’ll be able to push anything through that would stimulate housing between now and next January.

Dan Oppenheim – Credit Suisse

Interesting comments on the shift in product offering and how in the communities you’ve opened in the Inland Empire, and you’re seeing some decent sales trends, have you had any other communities open outside of there, other markets, can you comment about trends there or if not, where are the next markets that you’re going to be opening communities with these new products?

Jeffrey Mezger

We’ve actually opened this in three locations just in the Inland Empire and we’re moving this product concept across the country. Right now as we track it about 25% of our communities are involved in this transition and it was a strategic decision that the price points on resale are down so much now and there’s so much inventory out there you can’t sit and wait for the market to come back to you.

You have to retool your product and get down to a price point where it’s the old trade off of new versus used where it’s a small premium for new versus some of the larger premiums we saw in the heat of the market.

Our goal is to continue to move this across the country. We’ve already seen positive experience in other markets but not significant because we haven’t gone as radical as we did in the Inland Empire. But between now and January it’ll be as much as 25% of our communities.

Operator

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

Ivy Zelman – Zelman & Associates

On the impairments realizing that you are benefiting in the P&L from previously taking assets that you already impaired running through the P&L so looking at the fact that you still had a core loss excluding new impairments, I’d like to understand why that would mean that you’ve properly impaired the book when you’re still losing money on the core and then you have $370 million of capitalized interest right now which is 14% of your inventory, and realizing that we’re hearing from accountants that there might have to be an allowance taken for capitalized interest given the environment, I’m just curious if that’s something that you would reserve for or have any thoughts responding to that.

Jeffrey Mezger

As to the impairments when we take an impairment it doesn’t take you to a normalized profit margin. Impairments are IRR based so in our model is we’re doing these impairments that typically results in a 9% to 11% gross margin. So it doesn’t get you back to profitability and after you take the impairment if there are pressures in the marketplace on the price side, it’ll squeeze your margin a little further.

From time to time we get investors that ask, hey you took these impairments doesn’t it fix you and you’re now profitable and it really doesn’t do that. The way to get back to profits is to cut our costs further, do a little bit, whatever we can on pricing, cut our costs to build, and keep finding other ways and to date what we’ve seen is we continue to whittle away at costs, we’ve had to use those savings to offset what’s going on with the pressure on pricing.

Ivy Zelman – Zelman & Associates

That’s totally fair and I think that you’re doing a great job on the cost front relative to a lot of your peers, but what it would mean is that you took very minimal impairments this quarter but yet prices were down year-over-year pretty substantially especially out West and it just looks as if you’re going to have to obviously reevaluate your portfolio of assets owned because there’s been further pressure maybe since the quarter last time you reviewed.

Jeffrey Mezger

The review is real time this quarter with this quarter’s pricing. So none of us have any idea what’s going to happen in the marketplace going forward. We’ve had a favorable trend on impairments where they’ve come down now four quarters in a row. As we booked the impairments this quarter it was based on our current margin and run rate projections and we’re comfortable with what we did.

William Hollinger

We haven’t heard anything specific to what you mentioned on putting up any kind of allowance against the capitalized interest per se, however having said that when we do our impairments we actually do it against the land base so the interest is just as though it was a, capitalized to the whole land and land development and so we don’t really take impairments specifically against the interest itself and have heard nothing from the outside accountants that there is any need to do anything at the allowance level within interest. And so at the end of the day though the net net number is all one and the same, it’s just what component of cost, whether its interest or land at the end.

Operator

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

Michael Rehaut - JP Morgan

You talked about sales trends during that you were encouraged in certain markets so could you just drill down on that a little more and talk about throughout the quarter what you were seeing and also if you could talk about specific markets like Texas, the Carolinas, California, etc.

Jeffrey Mezger

When I referenced the uptick in sales it was tied to resale activity. As you saw from the new home sales side, the report that came out yesterday, its still continuing to soften a bit on a national level. But there are many of the markets that ran up so fast where the repossessions have created a large resale inventory overhang. They’re now being sold at a price where they’re selling fairly rapidly and it tells you that pricing on the resale side is now at a level where the underlying consumer can afford it again.

A good example would be right here in California where Southern Cal sales or even the Central Valley sales were up but it’s at a significantly reduced price because it’s influenced so heavily by repos. The challenge is how do you get your pricing down on new product so you can make money at these lower levels and that’s what we’re working on.

As to any regional color I don’t know of any markets that we’re in today where you would say that the sales have ticked up on the new home side. Some of the markets have held well earlier in the year like a Charlotte, or a Raleigh, or even Austin and San Antonio, we’re starting to see some pressure there on inventory levels. Sales rates are off and I think you’ll see those markets soften. They relate to the cycle but I think they’re turning now just like they have everywhere else.

Michael Rehaut - JP Morgan

As far as what’s going on with land deals, I know we’re obviously still a little bit ways off until things are getting attractive, but have you seen any type of increase in quality as to the land deals you’re being offered or are you still seeing that the banks are very reluctant to mark it down appropriately?

Jeffrey Mezger

You’ve heard I’m sure of the portfolios that are being shopped and most of those have been to buy the debt and we really don’t play in that market because we don’t want to take over a loan and then have to clear out the borrower. But in those portfolios that we’ve looked at they are predominantly C minus locations, maybe C plus or at price points that we certainly wouldn’t want to play at. We’ve seen a trend where they may be going from a C plus up to a B minus, but still nothing that’s compelling.

We are starting to see more offered at lower prices so it is moving but it’s still not to a point where we’re ready to reinvest that way.

Operator

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

David Goldberg – UBS Securities

Regarding the pricing on these smaller homes that you’re putting forward, lower spec units that you’re putting forward relative to the existing home prices, are you referencing them being closer or near the price with foreclosure existing prices or a non-distress sale and maybe if not foreclosure, where are you relative to foreclosure pricing?

Jeffrey Mezger

The resale pricing in every market is the blend of traditional resale I’ll call it plus the foreclosures and the example in the Inland Empire I think the statistic was that about 50% of the resales are foreclosures today and our product is now priced down competitively with that blended price. We’re at a premium to it but its 5%, 10% premium not 30% or 40% like we were with the older product and if you think through the numbers that I shared, the choice is you either keep with our downsized 2,400 foot home and whack the price even though the product is not what the consumer can afford today, or you figure out a different way to get your prices down. And that’s what we did through smaller product.

It’s a combination of really value engineering the product, adjusting your spec level to what the buyer wants and then building a smaller home.

David Goldberg – UBS Securities

Just trying to understand, with the new smaller product line what are the margins look like on those homes maybe relative to the building times, the building cycles and then with that do you think you attract a clientele with that home that’s still as interested in the design studio and maybe putting as much in terms of options into the house to generate the same margins to justify the design studio concepts.

Jeffrey Mezger

The studios actually continue to perform well on this product. We’re seeing no real shift in the percentage of revenue per unit. The consumer really values choice and you’re giving them an opportunity to build their own custom home and that’s something that is extremely compelling for the consumer at any price point. Our prices are down in my example, down $100,000 so you’re attracting a different consumer but that consumer will still spend $20, $25, $30,000 on the upgrades they want in their home. Its one of the ways we compete with resale.

Operator

Your next question comes from the line of Stephen East – Pali Research

Stephen East – Pali Research

You mentioned in your comments that you expect a cash neutrality in 2009; you’ve got significant 2006 taxes that you could capture with some type of land sale in the fourth quarter that would obviously be recognized in the first quarter of next year. You’ve got some JV issues particularly I guess in Vegas etc., could you talk about what went into your forecasting there and specifically on those two items?

Jeffrey Mezger

I’m not sure what you’re referring to with the land sale and capture in 2006, the tax refund that we’re expecting here in the first quarter is already in the queue based on events that have happened and that will cover the bond that matures in December.

We’re in the middle of our planning process for 2009. We’ve got some preliminary looks and we’re still finalizing it. There are assumptions in there for land acquisition and development that won’t occur if the markets don’t get better because we’re not going to invest at this time and our strategy right now, our goal, is to be cash neutral inclusive of anything that we may have to do on the 15 or 20 JVs that are out there to be addressed in 2009.

So all of these components you raise are already in our assumption.

Stephen East – Pali Research

Okay, and what I was talking about on the land sales, you earned quite a bit of money in 2006 but I guess what I’m wondering is do you foresee any more land sales either primarily in this fiscal fourth quarter that you then might get the tax refund for in 2009?

Jeffrey Mezger

We don’t see any of that right now.

Operator

Your next question comes from the line of Kenneth Zener – Macquarie Research

Kenneth Zener – Macquarie Research

Your new orders, especially in the Southeast, dropped precipitously, can you talk a little more in detail, I know you’re talking about community reshifts, but it dropped to 280 from what had been about 1220 last year.

Jeffrey Mezger

I think it’s for the reasons that we raised. Its community count, last year we were closing out some of the remaining communities and the markets we exited like Treasure Coast or Fort Myers, so you have a little bit of that phenomenon. We were much larger in Atlanta then we are today. So community count is down in Atlanta but I think it’s primarily due to the factors that I raised in my comments.

Kenneth Zener – Macquarie Research

As you do that then, I noticed just looking at your segment operating margin ex charges, by region that was obviously one of the poorer performing areas; do you expect some type of benefit simply because you’ve taken down activity so much in what had been one of your worst markets on a margin basis?

Jeffrey Mezger

It’s certainly part of our emphasis to restore profitability by focusing on communities or marketplaces that will give us the best return so I don’t know if there’s a specific city I could target for you and say we made no money there and we shut it down and our results will be better but overall that’s our intent.

Kenneth Zener – Macquarie Research

Okay and then it sounded like you had talked about 200 basis points related to one-time charges in SG&A, that’s about it sounds like about $13 or $14 million, is that correct?

Domenic Cecere

That was correct.

Operator

Your next question comes from the line of Chris Hussey – Goldman Sachs

Chris Hussey – Goldman Sachs

On the JV investments, how much cash did you have to invest in the JVs either by taking it down or by putting new equity in the quarter?

Domenic Cecere

Very little in this quarter.

Jeffrey Mezger

We have a total of 30 JVs, only 20 are active and the vast majority of those 20 are performing just fine. We had six of them that have an LTV maintenance guarantee and those are the ones that we’re managing through. But each of them on their own is not a significant cash drain. We don’t have huge exposure to cash drain relative to our overall business.

Domenic Cecere

The whole year was around $60 million that was invested in JVs cash.

Chris Hussey – Goldman Sachs

On the construction costs, in this new product you’re going to build a smaller product and so are you finding that your construction costs you could scale into that smaller product that’s allowing you to maintain construction margins and are you doing anything to rezone some of the properties to get better density for a smaller product?

Jeffrey Mezger

First off, the costs savings with this value engineered product is significant. Where we’re rolled it out and got our budgets locked down, it’s as much as $10.00, $12.00, $15.00 a foot from where we were a year ago. So in our cost to build, in our old product we were already tracking cost reductions of 12%, 13% for the year. Now you layer on this next level and it brings it down significantly due to the designs and the value engineering.

So between the two you’ll see our costs go down. We actually in my Inland Empire experience that I shared, the margin is up from where it was on the bigger product on the same lot basis so we’re able to lower the price, attract a different consumer, compete with resales and foreclosures and still improve margins. So it’s a great combo that we’re hopeful we can execute across the country.

Where we can, we’re going to work to rezone properties. Right now where we’re transforming the product lines it’s where we have finished lots. We’re not looking to take raw land, invest dollars in improvements and go address those communities just yet. It’s on the finished lot progress. So anything we do on rezoning will take some time and would play out end of 2009 or beyond that.

Operator

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

Timothy Jones - Wasserman & Associates

Critical question here, you’ve obviously been hit very strongly on holding prices, reflecting your cancellation and new orders, but what I don’t understand is that the units you’re closing, that you’re only making 9.6 and 8.7 gross margin which is about half your competitors who have not had the drop of 66% in orders. Why if you are holding prices are your margins so much below many of your competitors?

Jeffrey Mezger

I can’t speak to all the competitors, in our business model it takes time for the margin to go up because we’re presold. And I’m not here telling you our margins are going to spike up in Q4 because we’re continuing to rustle with how fluid the marketplace is. I can tell you that prices are continuing to decline in just about every market we’re in and if we peg a margin at 10 with an impairment its hard to believe margins are going to increase in markets where prices are continuing to drop the way they are.

Timothy Jones - Wasserman & Associates

Can I get a clarification on that new product you have, is it a single family or a multi family and what’s the lot size?

Jeffrey Mezger

It’s all single family and it’s on traditional lots. It can be 40 foot wide in parts of California to 70 foot wide.

Timothy Jones - Wasserman & Associates

Obviously by trying to maintain your pricing you’re getting very high cancellations, but you have basically 481 finished units right now, which is two per community which the average for most builders is one and for you to be dramatically lower then that. Does this imply that you’re going to have to take some severe cost cuts to get rid of the standing inventory in the fourth quarter?

Jeffrey Mezger

No it doesn’t imply that. Let me clarify a couple of things for you. Our can rate on backlog was the lowest it’s been since first quarter of 2006. So we’re not seeing a spike in cans because we’re working on margin. They don’t tie together like that. That would affect your gross a little bit but not your can rate and if you look at our production pipeline, I think you’d find that our percentage of production sold is the highest or one of the highest in the industry. We don’t have a bloated inventory position compared to our peers.

We are up a little bit in standing from where we normally are at [one] community and there’s always that house that shows up or that buyer that doesn’t perform and frankly our specs are the hardest thing for us to sell because our whole business model is conditioned around presales. And it takes a little longer to sell them but we don’t go and heavily discount an inventory unit over a pre-sell. We’ll just continue to work through them.

William Hollinger

We had 5,200 homes in production and 82% was sold.

Operator

Your next question comes from the line of Josh Levin – Citi Investment Research

Josh Levin – Citi Investment Research

On the cash flow, so your goal is to be cash flow neutral in 2009, what assumptions about volumes and prices would have to be realized for you to achieve that goal? Would volumes have to be where they are now, higher or lower?

Jeffrey Mezger

As I said we’re continuing to work on the plan and the assumptions for next year. For pricing or margins we assume what we have today. We’re not going to take a wild stab that it’s going to get better. As to unit count, still to be determined based on our sales as we end this year and go into next year but we have, whatever the unit count assumption moves up or down to we would adjust the land acquisition and development at the same time. Its part of the balance we’ll maintain through 2009.

Domenic Cecere

The way we looked at it is we’ve done a preliminary plan and when we looked at what is the risk to the volume, what’s the risk in price, what’s the risk in the amount of cash flow out and in, and the result of that we think we have an opportunity to remain cash flow neutral for the year and be able to go into 2010 with still $1.5 billion of liquidity. We think that’s the right thing to do in this environment until we see some certainly around a turnaround.

Josh Levin – Citi Investment Research

But you’re confident that you can achieve that goal because you have enough moving parts that you can adjust?

Jeffrey Mezger

It’s out stated goal right now and we’ll see how the year plays out but we have a plan in place to get there.

Domenic Cecere

We’re not [confident] if we go into a deep depression or something else happens that’s out of our control, but as we see it today, yes.

Operator

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

Joel Locker - FBN Securities

I wanted to ask more of a theoretical question based on eight months of job losses and then also 4.4 million excess vacant homes based on a 50 year run rate above the mean, just why would you want to try to hold prices in an environment like this when the obvious supply demand, more supply is getting pushed and you’re actually getting household destruction based on job losses?

Jeffrey Mezger

I don’t know where your number comes from but there’s 4.2 million total for sale--

Joel Locker - FBN Securities

The 4.4 comes with [rental], vacation, all those vacancies. Like the [rental] rates, there’s an extra 1.1 million there and this is just based on 10.75% historic rate versus 14.27 now and then multiplied by 128 million houses.

Jeffrey Mezger

But there’s always some level that’s available even in the best of markets.

Joel Locker - FBN Securities

Right, that’s the 10.75%, that’s the 50 year average.

Jeffrey Mezger

Is there more inventory today then we need? Yes. It’s starting to clear. The new homebuilders have done a good job of cutting back on starts to reduce the new home inventory and it’s kind of interesting if you go back and look at the bubble that we went through, what got lost in that is the core consumer couldn’t buy a home. The activity levels weren’t being driven by the young couple, the empty nester coming down, it was an extraordinary consumer and as we’ve, in the example I gave you in Inland Empire where we get product back to a price point that the consumer can afford and they’re in an apartment today, they’ll do what they have to in order to get to the American dream.

Joel Locker - FBN Securities

Do you have a dollar amount of the 5,200 homes in construction of what percentage of the 2.56 billion in inventory that is?

Domenic Cecere

It’s usually around 70% of our inventory dollar value.

Operator

Your next question comes from the line of Nishu Sood – Deutsche Bank

Nishu Sood – Deutsche Bank

Regarding the liquidity target for the end of the year, a lot of other people have focused on the assumptions for how you generate that cash, I wanted to get a sense of your thinking for the deployment of that cash because if I listen to the things you’ve done in the last couple of months, you’ve gone back to a pricing discipline on the basis of less urgency to generate cash, so the way that I read that is that you’ve decided that $1.5 billion of liquidity is sufficient. Are you going to need that liquidity for supporting the scale of the business, the overheads, or investing in new land opportunities, or of course when things turn around, you would need that liquidity to support your inventory build in the sticks and bricks, so what was your though process behind those three buckets and coming to the conclusion that $1.5 billion is enough?

Jeffrey Mezger

I think it’s all of the above. We feel we have the ability to run the business and retain enough cash to be opportunistic and reload at the right time and when I say reload, part of our strategy is whenever the large reload if you will, when its time to really go because all the markets have stabilized, we’re not just going to write checks. We’re going to have created some partnerships or alliances with others. Its one thing if we can tie up lots on a rolling option which is not cash intensive and its out there in most of our markets today but if we were to make a major play, we’re not just going to write a check so it’s a more prudent preservation of our balance sheet then we typically have done in the last [run up].

We do have land acquisition budgeted in our cash plan for next year. We won’t spend it unless it makes sense.

Nishu Sood – Deutsche Bank

So the smaller floor plans, the ones that are yielding the two a week sales pace you were talking about, kind of thinking about the Inland Empire, where has that been successful? Are we talking about outlying areas, like Victorville, Murrieta, or something like that or we talking about closer in areas like Corona or something?

Jeffrey Mezger

Not to Victorville, a good example is in Beaumont if you know where that is. So it’s not as far as Victorville but it’s not as close as Corona.

Operator

Your next question comes from the line of Megan Talbott McGrath – Barclay’s Capital

Megan Talbott McGrath – Barclay’s Capital

The deferred tax or the tax refund you’re expecting next year of 220 will pretty much reduce your deferred tax asset I’m thinking to zero, how does the accounting work there? Do you anticipate you’ll be able to write up of your valuation allowance in 2009 in anticipation of a fiscal 2010 refund?

Domenic Cecere

You’re correct that the 220 will reduce our deferred tax asset but we will not be able to restore any of the deferred tax asset until we [at least] return to profitability.

Megan Talbott McGrath – Barclay’s Capital

On the JVs, your corporate impairments went down this quarter but your JV impairments went up so just curious if you think that the impairments at the JVs have been as rigorous as your own impairments and if you could just remind us on how that works? Are you running those impairment analyses or is someone else running them?

Jeffrey Mezger

Our impairment process and review is the same on a JV as it is on every asset that we own and we use the same process every quarter, the same assumptions and all of them are signed off by our external auditors.

Operator

Your next question is a follow-up from the line of Michael Rehaut - JP Morgan

Michael Rehaut - JP Morgan

The investment and joint ventures, I know you took an impairment but I was wondering if you could give us any color on where the joint ventures you have the investment, the $250 million are located.

Kelly Masuda

It’s primarily in the Southwest as well as in the Mid Atlantic is where our biggest joint ventures are. And then we have a number of cash joint ventures in California.

Michael Rehaut - JP Morgan

On all the cash flow questions, I think last quarter you had given a land spend number of $700 million, can you give us any thoughts as to how you’re looking for the fourth quarter and what kind of a cut back in land spend you’re contemplating for next year?

Jeffrey Mezger

When we shared the number in the second quarter it was a budget for the year between land acq and development of about $700 million as I recall. Part of what we were trying to do was communicate that we’re still in the game and prepared to be opportunistic when something comes our way. It actually blew up on us because some of the investors and analysts were questioning why you would spend money on new deals in this time.

We’re not going to spend that much in 2008, no where near that kind of level. I don’t know what our current level is but it’s significantly under that $700 that we shared and our projections for 2009 are $500 million to $600 million for land and development combined.

Operator

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

Alex Barron - Agency Trading Group

I wanted to ask in terms of your inventory that you show of $2.5 billion, is there a way you could break that down into how much is the value of homes under construction, land, options, etc.?

William Hollinger

If you look between backlog and finished lots, it’s a little over 70% of the dollars.

Alex Barron - Agency Trading Group

I was just trying to figure out how much was homes under construction primarily. This quarter in terms of your margins, wondering what kind of benefit you received from previous impairments in terms of dollars or something?

Domenic Cecere

We really don’t give that out. I don’t think it’s very meaningful.

Jeffrey Mezger

It’s very difficult to track.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Jeffrey Mezger

Appreciate all of you joining us today on the call. We look forward to speaking with you again in the future and have a great day.

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