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Operator
Good morning.
My name is Page and I will be your conference operator today.
At this time I would like to welcome everyone to the D.R.
Horton Inc.
America's Builder third quarter 2006 earnings release conference call.
All lines have been placed on mute to prevent any background noise.
After the speakers' remarks, there will be a question-and-answer session. [OPERATOR INSTRUCTIONS].
Thank you.
I will now turn the call over to Don Tomnitz, President and CEO.
Please go ahead, sir.
- President, CEO
Thank you, Page.
And thank you for joining our call this morning.
Joining me on the call this morning is Sam Fuller, our Senior Executive Vice President of Finance;
Bill Wheat, Executive Vice President and CFO; and Stacey Dwyer, Executive Vice President and Treasurer.
Before we get started, Stacey?
- EVP, Treasurer
Some comments made on this call may constitute forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995.
Although D.R.
Horton believes any such state statements are based on reasonable assumptions there is no assurance that actual outcomes will not be materially different.
All forward-looking statements are based upon information available to D.R.
Horton on the date of this conference call and D.R.
Horton does not undertake any obligation to publicly update or revise any forward-looking statements.
Additional information about issues that could lead to material changes in performance is contained in D.R.
Horton's Annual Report on Form 10-K and the most recent Form 10-Q both of which were filed with the Securities & Exchange Commission.
Don?
- President, CEO
Thank you, Stacey.
And, again, thank you for joining the third quarter conference call of D.R.
Horton, America's Builder, the largest home builder in the United States.
We would like to start off by thanking our people for their hard work during a time when the market conditions are more difficult in the homebuilding industry.
We've experienced a changing home sales environment since the beginning of the calendar year which became much more evident during our third quarter.
The current housing environment is characterized by an increase in the use of sales incentives in certain markets, higher than normal cancellation rates, and an increase in the supply of new and existing homes for sale.
It also reflects a decrease in consumer sentiment.
As some home buyers are fence-sitters today pending price stabilization and respective markets.
Stacey?
- EVP, Treasurer
Our net sales orders for the third quarter decreased 4% to 14,316 homes, $3.8 billion, compared to 14,980 homes, $4.1 billion in the year-ago quarter.
This lower sales rate was due in part to our cancellation rate rising during the quarter to 29% which was higher than our second quarter at 23% and exceeded our historical range of 16 to 20%.
Net sales orders for the first nine months of fiscal year 2006 increased 6% to 41,550 homes, $11.4 billion, compared to 39,282 homes, $10.9 billion in the year-ago period.
The Company's backlog of homes under contract at June 30, 2006, increased 4% to 24,956 homes, $7.4 billion, compared to 23,916 homes, $7 billion at June 30, 2005.
Don?
- President, CEO
Our assets are concentrated in six states.
The percentage of our assets in these states are as follows: California, 25%;
Texas and Florida with 12% each;
Arizona, 9% ;
Nevada, 8%; and Colorado, 7%.
Our total sales dollar changes for the third quarter in these six states are: California, down 25%;
Texas, up 20%;
Nevada, down 11%;
Arizona, up 11%;
Colorado, down 12%; and Florida, down 23%.
Sam?
- SEVP-Finance
Our third quarter Homebuilding revenues increased 9% to $3.6 billion from $3.3 billion in the year-ago quarter, with home sales revenues also increasing 9% on 13,377 homes closed.
Our average closing price for the quarter was $267,700, essentially flat compared to 267,100 in the year-ago quarter.
Homebuilding revenue for the nine months ended June 30, 2006 , increased 16% to $10 billion from $8.6 billion in the year-ago period with home sales revenues increasing 17% on 35,838 homes closed.
Bill?
- EVP, CFO
Our gross margin on home sales revenue in the third quarter excluding write-offs related to land option contracts was 23.7% down 280 basis points from a prewrite-off margin of 26.5% in the year-ago period. 235 basis points of this decline was due to core margin deterioration resulting from less price appreciation and increased use of incentives relative to last year.
The remaining 45 basis points decline in prewrite-off margins is primarily due to changes in our geographic mix of home closings.
We have been focused on adjusting our land option contracts relative to current demand which resulted in cancellations of a number of option contracts during the quarter.
This activity resulted in about $57 million in write-offs of earnest money deposits and preacquisition costs related to land option contracts during the third quarter which reduced gross margins by 160 basis points in the quarter compared to a 20 basis point impact from routine due diligence write-offs in the year-ago quarter. 65% of this $57 million charge related to option contracts in the State of California.
These cancellations directly reduced our option land position by approximately 22,000 lots at a purchase price of about $1 billion.
Our reported gross margin, including earnest money write-offs was 22.1% in the third quarter down 420 basis points from 26.3% in the year-ago period.
We have reduced our supply of land and lots at June 30th to approximately 340,000 lots owned and controlled, down from 396,000 lots at March 31st. 57% of these lots are owned and 43% are option.
We will continue to review our option contracts each quarter to insure that we are holding the appropriate level of land and lots to meet our future needs.
Sam?
- SEVP-Finance
Homebuilding SG&A expense for the quarter was 9.9% of total Homebuilding revenues compared to 9.1% a year ago.
For the nine months ended June 30, 2006, our Homebuilding SG&A was 10.5% of revenues compared to 9.6% last year.
We began fiscal year 2006 with the infrastructure in place to support the delivery of over 58,000 homes.
Since our projections have been revised to 50,000 homes closed, we are adjusting our SG&A infrastructure to this reduced level of closings.
Our continuing goal is to have our SG&A at 10% or less, but with the reduced closing projections this will be more challenging this year.
Other income for the current quarter and for the nine months ended June 30th is primarily related to interest income and the change in the fair market value of our interest rate swaps.
Our income tax rate for the quarter was 38% down from 38.5% last year, reflecting the tax benefit we expect to realize from the American Jobs Creation Act of 2004.
Bill?
- EVP, CFO
Financial Services revenue for the quarter increased 22% to $74.2 million from 60.7 million in the prior year and for the nine months ended June 30th, Financial Services revenue increased 32% to $206.6 million from 156.5 million in the year-ago period.
Financial Services pretax income for the June quarter increased to $27.5 million from 27.1 million last year, and for the nine month period, Financial Services pretax income increased 16% to $74.7 million from 64.3 million last year. 94% of our mortgage company revenue was captive during the quarter reflecting our focus on supporting our Homebuilders business, and our companywide capture rate improved to approximately 67% from 63% a year ago.
Our average FICO score this quarter was 718, flat with the year ago quarter.
Sam?
- SEVP-Finance
For the quarter, our consolidated net income decreased 21% to $292.8 million from 371.7 million last year.
Diluted earnings per share for the quarter also decreased 21% to $0.93 per share from $1.17 in the year-ago quarter.
For the nine months ended June 30, 2006, consolidated net income increased 5% to 955.6 million from $906.7 million last year.
Diluted earnings per share for the nine month period increased 6% to $3.02 per share from $2.85 a year ago.
Bill?
- EVP, CFO
Our Homebuilding leverage ratio, net of unrestricted cash at June 30th was 46.4% compared to 42.4% a year ago.
As we have previously stated our goal for our 2006 fiscal year end Homebuilding debt-to-cap ratio is to be in the low 40s.
At June 30, 2006, we had approximately $780 million available on our Homebuilding revolving credit facility.
We are also adjusting our residential inventory to be in line with our revised closing projections.
At June 30, 2006 approximately 40% of our homes under construction are speculative; however, we anticipate that percentage will decrease to the low to mid 30s by fiscal year end.
Our overall unit inventory will also decline as we deliver our backlog and continue to reduce our starts to reflect our current sales environment.
Stacey?
- EVP, Treasurer
The Company's diluted earnings per share guidance for the year-ended September 30, 2006, is approximately $3.65 per share or greater on approximately 317 million diluted shares.
This guidance is based on approximately 50,000 homes closed and approximately $14 billion in consolidated revenue.
We're projecting that our fourth quarter backlog conversion rate will be lower than historical levels due to a more difficult selling environment and higher than normal cancellation rates.
This guidance provides for possible additional gross profit margin declines due to a geographic mix shift, increased incentives, additional earnest money write-offs on land option contracts, if necessary, FAS 66 profit deferral adjustments, and average sales price declines that we could experience in our fourth quarter.
We also redeemed $144.8 million of our 10.5 Senior Sub Notes on July 15th which will result in a $3 million charge of interest expense during the fourth quarter.
Don?
- President, CEO
Thank you, Stacey.
We recognize that we are operating in a more difficult and challenging environment.
We are grateful to our employees for the strong effort they extended in the third quarter relative to the industry but we are not pleased with our third quarter results relative to our historical performance.
We are, however, working hard to improve our performance going forward.
What's changed?
The impact of speculators and investors, creating higher inventory levels of new and existing homes.
Increased use of incentives which increased cancellation rates causing some buyers to become fence-sitters.
This has resulted in higher inventory levels of new and existing homes.
What are we doing?
Decreasing our SG&A, adjusting for a lower level of demand.
Our belief is: It is better to overreact and overcut than it is to underreact and undercut.
Focusing on driving down our cost to goods purchased from both vendors and subcontractors.
Reducing both land and lot inventory, and residential inventory.
Maintaining liquidity and a strong balance sheet.
Downturns typically last longer than most people expect.
We are positioning the Company for a flat or declining volume level and perhaps a more challenging gross margin environment in fiscal year '07 than in fiscal year '06.
Finally, we are disappointed in our Q2 performance and the reduction of our [FO] at fiscal year '06 guidance; however, we must remind ourselves that fiscal year '06 will be the second most profitable year in our history.
I guess I'm having a tough time with the second most profitable year in our history.
Anyway, that completes that part of our conference call and we'll entertain any questions that you may now have.
Operator
[OPERATOR INSTRUCTIONS].
We will pause for just a moment to compile the Q&A roster.
Your first question comes from the line of Stephen Kim with Citigroup.
- Analyst
Hey, guys.
- President, CEO
Good morning.
- Analyst
Good morning.
I had a question for you regarding your inventory breakdown.
It looked like your inventory grew in both your finished homes and construction in progress.
I imagine that's due to the impact perhaps of cancellations and your effort to sort of clear the decks here and so probably more spec stuff in the channel.
But your land and land under development also grew sequentially.
Can you give us a sense for why that occurred and what we can expect to occur in the next couple of quarters?
- EVP, CFO
Yes.
Our land did grow a bit incrementally from the third quarter , and that's basically related to still selective, very selective land purchases and markets where our supply is short, and we're still seeing very good returns.
But we do want to emphasize we are being very selective in our land purchases at the current time.
- President, CEO
And we anticipate by Fiscal Year End '06 that our land purchases will be less in '06 than they were in '05.
- EVP, CFO
And one other element of the land portion that you probably want to be aware of is that does include our any development work, any improvements that we are putting into property that we own and so certainly, a good portion of that increase is going to be related to development work.
- President, CEO
And a lot of it, some of it is also associated with the fact that we're just building out our backlog.
- EVP, CFO
Right --.
- EVP, Treasurer
On the residential side our backlog is up 4% in terms of unit.
- Analyst
Yes, no, absolutely.
I understand.
I was just hoping to get maybe a year-end target or something for maybe those two divisions -- those two segments or in total.
- President, CEO
We can get with you later on that.
- EVP, CFO
But we already certainly do expect our inventory in total to reduce from the June level to where we'll be in September.
The biggest portion of that reduction will be coming out of our residential inventory, and then the land over time, that will adjust a bit more slowly.
- President, CEO
And as we look forward to fiscal year '07 we expect our inventory to be flat or less in '07 than what it was in '06.
- Analyst
Okay.
I missed the Operator -- are we limited to two questions?
- President, CEO
Go ahead, Steve.
- Analyst
No, okay, well, I just wanted to ask you about your negotiations of options.
I mean, I know you wrote-off a bunch of options here in the quarter, and you indicated they were mostly in California.
I guess I was curious though, for the stuff we can't see which would be renegotiations of options.
Can you, one, I guess give us a sense for of the land that you've purchased or you've taken -- you've actually -- where you've exercised the options over the last let's say six months, how -- what percentage of them would you estimate?
You actually renegotiated before you purchased them?
And can you give us a sense just sort of qualitatively how your conversations are going on the renegotiation front with the options that you did not walk away from?
- President, CEO
Well, first you'll find that we closed a significantly less land in -- I guess as you look at the financials, we closed a lot less land in June than we did in the other month in the quarter.
So to answer your question directly, we're renegotiating everything that we've got to close right now.
It doesn't make any difference whether we're short land in that market or not.
We're basically using the excuse that the market is softer across the U.S.
And all of our division presence are trying to negotiate the price of land deals downward.
In some markets we're demanding a bigger decrease than we are in others, but across-the-board we're asking for decreases in our land prices.
- EVP, CFO
Right.
And just to clarify one thing, the 57 million in write-offs we would like to share the breakdown of that.
- Analyst
Sure.
- EVP, CFO
35 million of the 57 million related to earnest money deposits, and the remaining 22 million related to preacquisition costs.
Typically, in a period when we're not canceling as many contracts, any write-offs that occur would typically be due diligence costs on a project we decide not to go forward with.
- President, CEO
The other reason for our larger earnest money write-offs this quarter were also the fact that we realized that even though the option wasn't maturing and that we still had more time to do our due diligence on the property, we chose to not close the piece of land and the cutoff our due diligence expenses on that piece of land because we did not need that land inventory associated with that deal so we didn't want to spend anymore due diligence money on that contract.
- Analyst
Right, that's an important point.
Okay, so these weren't things that were expiring and were signed like two -- or gotten into two or three years ago?
You're sort of proactively going and cutting it off because you can sort of see ahead?
- President, CEO
Proactive is a very correct word, yes.
- Analyst
I'm going to -- I could -- I would be remiss if I didn't ask you one last question regarding share repurchases.
You have in the past indicated that because of cash flow and timing, timing of cash flow that probably you weren't going to be interested in revisiting the share repurchase situation until maybe after your fiscal year end.
In light of what you've given us here in terms of reduced expectations for spec building and so fourth, one might think that you might be in a situation perhaps at the end of the year to be more aggressive on share repurchase.
I'm not asking a specific question because I know you're going to do it before you tell us.
But I was wondering if you could give us an indication for how share repurchases, the issue of share repurchases perhaps is changed in your mind as you've made a lot of other changes in your forward look?
- President, CEO
Well, clearly it's moved up the scale given where our current stock price is today.
I don't want anyone to forget though that there are several uses for our cash and we're focusing on being free cash flow positive in fiscal year '07.
We are certain that we'll be there based upon our reduced land spend.
But those cash uses includes such thing as continuing to call certain debt instruments that or debt issuances out there that are too high interest rate.
We also want to be very focused, Steve, and one of the reasons we're culling our land deals today is as the land prices begin to work their way down we want to be able to take advantage of opportunistic land prices as we see them in the marketplace today, and obviously where the low stock price like we are, that's moved up the scale.
- Analyst
Okay --.
- EVP, Treasurer
Another thing that's moved up our scale as well though, Steve, is in a more disciplined environment we are focused on maintaining liquidity on our balance sheet probably to a greater extent than we have in the past.
And one thing to think about in conjunction with our slowing inventory growth is also that we lowered our closing target significantly which changed the amount of cash inflows that we would expect this year as well.
- Analyst
That's right.
No, I noticed that.
Okay thanks, guys.
I've taken up enough of your time.
Thanks.
Operator
Your next question comes from the line of Margaret Whelan with UBS.
- Analyst
Good morning, guys.
- President, CEO
Good morning, Margaret.
- Analyst
I think Steve has asked everybody's questions at this point and can you give us a sense for your rate of growth in the community count, what it was in the quarter and what it might be for the next 12 months?
- EVP, Treasurer
In the quarter we were in the high single-digits in terms of community growth, and we haven't really specifically said anything for fiscal year '07, although if we're expecting our inventory dollars to remain flat to be slightly down I wouldn't expect significant growth in our community count.
- President, CEO
But having said that, Margaret, clearly moving forward we are focusing on doing smaller land and lot deals.
So our community count could go up just simply because of the fact that we would have smaller deals that we're bringing on board because we want to move through the land at this time even more expeditiously than what we have on a historical basis.
- Analyst
And relative to your goal of being free cash flow positive in '07, do you expect that to be sustainable through the next cycle or is that just a near-term goal?
- President, CEO
Right now, I'm projecting for fiscal year '07 in my mind, that's -- even for me that's a long projection so I wouldn't like to speak any further than that if you don't mind.
- Analyst
Okay.
And in terms of your land position right now, are you going to be owning rather than optioning more of the land or are you going to have to sale pull-down lots even if you can't sell them?
- President, CEO
Well clearly -- what was the last part of your question?
- Analyst
Just -- I'm trying to figure out as you've caught your unit to delivery target do you still have to pull-down the lots you had negotiated with your sellers?
- President, CEO
No, we do not.
We have option contracts.
We have specific performance on just a miniscule amount of those contracts.
It's a rounding area how many contracts we have specific performance on and even on those deals we're back renegotiating the land price, so no.
- EVP, Treasurer
Yes and our target, Margaret, is going to be get to the owned and optioned back into approximately a 50% range on each and we will do that by not increasing our land position going forward until we've worked through some of the land we have.
- President, CEO
Clearly the reason our option lots have -- or our own lots have increased as a percentage of our total lots is because we cancelled the number of option loans.
- Analyst
Yes.
I'm just wondering how easy or difficult it is to negotiate with the sellers.
Can you give us a sense for the potential for impairments on the rest of your land?
- EVP, CFO
Yes, right now, we don't see anything that's close to that point, but that's certainly something that we continually monitor , project-by-project, and if we see any indications then we'll deal with that.
But right now, in the near term, we don't see any significant issues there.
- President, CEO
And I guess to answer your question on how strong a position we have with our land sellers, it's very similar, Margaret, to the way [inaudible] we know we have today with our vendors and subcontractors.
We don't need to start nearly as many homes as we've anticipated and we also don't need to have as many lots as we've anticipated.
So we are negotiating, we believe, from a very strong position and clearly our write-off of over $30 million in earnest money should send a message to our land sellers that the first loss is the best loss and we're going to walk away if we can't get the land price correct.
- Analyst
Okay, just one last one.
As you have cut the unit delivery target given the current environment, which is probably going to be short-term, do you still have the goal of being the largest builder in the country over the long-term and do you still have this 100,000 unit goal?
- President, CEO
We have 100,000 unit goal and clearly we will be delayed in our expectation of getting there.
I think we said by this decade.
- Analyst
Yes.
- President, CEO
And we still have that goal and we still have the goal of maintaining ourselves as the largest builder in America.
Although, we clearly want to be the largest builder with the highest property -- operating margins.
And we are very proud of our higher-than-industry operating margins of the past, and as you and I have talked last week, we're clearly focused on trying to maintain or regain that.
But that's our goal, to become -- maintain our size as well as to increase our profitability.
And our goal right now is to get our profitability back where it was vis-a-vis our SG&A cuts and the other thing that we outlined to you.
- Analyst
At what point will you consider M&A?
- President, CEO
Well we consider M&A every day and clearly, I think that's the best thing that I can say.
We're analyzing deals on a weekly basis.
Stacey is in charge of that, and as the deals become more attractive, it's certainly something that we've done a lot of in the past and I would not preclude us doing that in the future.
- Analyst
Is the pipeline improving?
- EVP, Treasurer
The pipeline of deals that we're seeing?
- Analyst
Yes, in terms of the size and the pricing, the relative value?
- EVP, Treasurer
I would say not significantly at this point.
- Analyst
Okay.
Thank you.
Operator
Your next question comes from the line of Michael Rehaut with JPMorgan.
- Analyst
Hi, good morning.
- EVP, Treasurer
Good morning, Mike.
- Analyst
I was wondering if you could go into a little bit more detail on the drivers for the fourth quarter with regard particularly to EBIT margins.
It looks like roughly you're implying a -- I'm coming up with something like a 6.5 to 7% EBIT margin which is a pretty dramatic decline and acceleration and more than some other builders are looking for their comparable August or even November quarters.
You mentioned several items driving that including mix and incentives, option write-offs, and a couple of ASP declines.
I was wondering if, number one, you could sort of prioritize what are the biggest drivers of the lower margin in the fourth quarter?
And second, which one of those drivers is just -- you're making much more dramatic assumptions relative to what you've seen in the third quarter where you only have a -- by comparison margins are down more on the order of 400 basis points?
- President, CEO
Well, Mike, first of all this is Don Tomnitz and I'm very glad you asked that question because clearly one of the things that we struggle with around here is our conservative nature both on the upside and the downside.
And currently our conservative nature on the downside has a number of people backing into the same gross margins or EBIT margins that you're talking about.
And clearly, what we're looking at on a going forward basis is, one, our current backlog which increased but nevertheless as Stacey said we do not have a double-digit sales environment which no builder has, which we've had in the past, and also we have significantly higher cancellation rates which all builders are experiencing.
So when we look at our fourth quarter, what we're trying to do is give you an absolute bottom line number that we can hit or exceed.
And I guess I don't want to get into any other builders in this conference call but I get confused when I look at some of the numbers that I'm hearing other builders produce and report and it reflects margins staying the same in the next two quarters, and that's just not out there.
And if it's out there, we'll be glad to be the beneficiary of that, but we're not going to assume that.
Now, I'll let Stacey go on or Bill go on if you have anything more to add to that.
- EVP, Treasurer
No, I would just say that as we look out there, two of the bigger drivers will be some of the geographic mix shifts.
You're seeing that in our current sales.
We're seeing higher sales out of Texas in terms of the percentage increases year-over-year when Don was going through our different markets than we're seeing out of California and Florida so that will change our margin expectations some.
And right now in the current environment I'd say increased use of incentives, we're not seeing that change right now.
So that would be another of the top two items.
- Analyst
And so this would be a much more dramatic impact even obviously versus the current quarter?
- President, CEO
We gave you a number which would incorporate a more dramatic change in the fourth quarter than what we experienced in the third quarter because of one thing, we do not want to have this conversation again and that's why we gave the guidance of 365 or greater.
We hope to create [forward] at the 365 level, but the market is constantly changing on a day-to-day basis.
California continues to get softer and incentives continue to increase.
You can see by our sales decrease in Florida which has been a very good market, it's 25% down.
That market is still experiencing increasing incentives and even though our Arizona market, our Phoenix market was up 11 %, I can tell you that market is going to get softer going forward.
So we're looking at this future market with very very clear vision with no rose colored glasses on and we don't want to paint a picture of anything else other than what we're actually seeing in the marketplace out there.
And if we're going to get punished and we're going to get pummeled because of the fact that we're being more accurate than some people think we need to be, so be it.
- Analyst
Well I certainly appreciate that and I guess just the last question on this area.
The 6.5/7% EBIT margin it brings you all the way back to the mid '90s essentially.
Is that the type of normalized operating margin that you would expect your Company to make or is this something more of just like you said you're trying to flush things out, be very very conservative, and perhaps you can move higher from there?
- President, CEO
We would be very disappointed if that were our ongoing margins in the years ahead.
I do believe you have a correct statement when we are saying we're trying to flush it out.
Clearly, the industry has excess inventory.
We are slowing our starts dramatically.
I believe the rest of the homebuilders in the industry are slowing their starts also.
As we all slow our starts and reduce our existing inventory levels I think that we're at three quarters to four quarters of working through this excess inventory, flushing it out and then getting back into a more reasonable inventory level where we can experience some stability in prices, delete the incentives, and have more pricing power than what we currently have.
- Analyst
Okay, thank you very much.
- EVP, Treasurer
Thanks, Mike.
Operator
Your next question comes from the line of Dan Oppenheim with Banc of America Securities.
- Analyst
Thank you very much.
Just to follow-up on the last comment there about slowing starts dramatically, was wondering how much -- what percentage of current starts you're looking at in terms of starting on spec at this point?
- President, CEO
Well, actually what we're planning on doing is reducing our spec level between the beginning of this quarter and the end of this quarter down from a level of about --.
- EVP, CFO
Around 40% down to the low 30s.
- President, CEO
So we're starting fewer specs.
- Analyst
Got it.
And so presumably specs are still relative to [high based] on cancellations, unfortunately, at this time; is that fair?
- President, CEO
Say that again?
- Analyst
Because of cancellations the true level specs is a little bit higher than what started because --?
- President, CEO
Absolutely.
If you look at -- I guess we could go into the number that -- for the quarter.
And basically our specs are increasing because our cancellation rate is increasing.
- Analyst
Right.
And then -- okay, thanks.
Just one other question.
Just wondering about the lower lot inventory.
Do you have any goals for that in terms of what you would like to achieve in terms of reducing the lot inventory and would that occur from land sales?
Are you planning on any in fiscal '06 or '07 that we should know?
- President, CEO
Well, clearly our stated goal is to keep our land and lot inventory both owned and optioned under a five year supply.
If you do a run rate on where we are today, we're higher than that, so our goal is to continue to reduce that.
And I think that their own percentage, as I said earlier to someone, will continue to increase as we cancel option contracts, but our goal is to get our land and our owned and option loss back to 50/50.
As to land sales?
I think the greater fool theory applies right now.
Land sales are great when the markets increasing.
Today with the market softening across the country, the prospect of land sales in Q4 and going forward into '07, I believe are negligible just simply because the greater fool is not out there to buy it.
- Analyst
Got it.
Thanks very much.
- President, CEO
Yes.
Operator
Your next question comes from the line of Richard Paoli with ABT Investments.
- Analyst
Hey, guys.
I appreciate getting on the call.
I have a couple questions and I'm not really a homebuilding expert, so bear with me.
Perhaps you can just talk about your gross profit margin by region, the regions you outlined in your package today in the Midwest, Mid Atlantic and so fourth?
And I have a follow-up question.
- EVP, CFO
In general, we see higher than Company average margins.
- Analyst
No, I was asking in specific.
You gave the gross profit margin for the entire Company --.
- EVP, CFO
Yes.
- Analyst
-- before the write-offs and I was wondering if you could break that down by each region, please.
- President, CEO
We do not disclose our gross profit margins by regions nor have we ever reported that information.
- Analyst
You don't track it?
- President, CEO
Well, of course we track it.
- Analyst
Okay.
So why won't you give it to a potential investor to kind of assess where things are with respect to your backlog going forward?
- President, CEO
Well because I would say on a market-by-market basis; for instance, the gross margins in Orlando and the gross margins in Atlanta are in a region because it's the same thing with sales.
Because the gross margins in Atlanta don't necessarily drive the whole gross margins for that particular region nor for the whole Company and that's the same way we don't release monthly sales because a month the quarter doesn't make.
So the margins in Orlando don't necessarily make the margins for the Southeast region and they don't make the margins for the Company.
That's why we're geographically diversified into 27 states and 83 markets.
Operator
Our next question comes from the line of Greg Gieber with A.G. Edwards.
- Analyst
Good morning, guys.
Could you go into a little bit more detail on the write-off you took during the quarter?
Where precisely in California were those located?
I mean where places like -- were one places like Bakersfield or closer in like San Diego County?
And could you also tell me -- tell us when on average those options were acquired?
- President, CEO
Okay.
First of all I can tell you that in the State of California, we have San Diego County, which is a very very weak market for us currently, and we did write-off a number of our deposits in San Diego over the course of the last 60 days, primarily the last 30 days.
Sacramento is also the second weakest market in California, and we wrote-off options in that market.
If you take a look, Greg, at the rest of California and going from Orange County to the Inland Empire, on up to Ventura and Oxnard and those areas, Simi Valley, as well as the Bay Area , those markets are still good for us, not as good as they were last year.
So most of our write-offs, frankly, have occurred in Northern California in that Sacramento area and Southern California in the Sacramento area and also --.
- EVP, CFO
San Diego.
- President, CEO
-- San Diego market, and also that's primarily where the write-offs are taken.
Bill?
- EVP, CFO
And as far as the time frame on when those contracts were initiated, about 70% of the contracts that we cancelled were associated with the write-offs were contracted in the last 24 months, so they were very more recent contracts in general.
- Analyst
If you could, give us a rough idea of the total lots you have under control, how many were acquired in the last 24 months?
- President, CEO
We don't have that number.
- Analyst
Okay.
Obviously you're scaling back your production machine there.
Can you give us just some quantified idea as to just how much you're scaling it back in terms of your total billed rate?
- President, CEO
Well, we're scaling back our production machine simply because our sales machine is scaling back.
I don't want to get into the specific in terms of our SG -- we have specific dollar cuts that we've already assigned to each one of our three COOs and our six regional Presidents where they have to cut their SG&A by X number of millions of dollars.
And their goal is to get most of those cuts in place by the end of this quarter, the fourth quarter, so that we can enter fiscal year '07 lean and mean, and basically get our SG&A levels back to a level that will support current closings.
And if you go back to fiscal year '05 where we closed 51,172 homes, and we're basically looking forward to this year of 50,000 homes then I think you can sort of back into our SG&A levels and our overhead and that sort of thing that were at fiscal year '05, and clearly that's what our goal is to get back to FY '05 cost levels.
- Analyst
Okay.
Suppose the market turns out.
I mean you've obviously used very ugly assumptions in giving us this, the floor on your earnings for the fourth quarter.
What happens if that actually turns out to be precisely where you're at, everything comes true and it looks a little bit even worse three months from now than what you've outlined now.
How fast does it take you to scale back your operations?
- President, CEO
Well, I would tell you that, frankly, it's taking us between one quarter to scale back significantly on our SG&A, and so that answers your question.
It takes us about a quarter to react to where the market is.
- EVP, Treasurer
If you --.
- Analyst
No, I mean on your start process?
- President, CEO
Sir?
- Analyst
And on starts?
- President, CEO
On starts, we're slowing those day-to-day based upon existing sales in each one of our markets.
I think you met David Auld from -- who is our Southeast Regional President who runs Florida and Georgia and Alabama, and basically, one of the things I was trying to explain or did explain to Margaret earlier is that in Orlando, we visited with our subcontractors about 30 days ago about our reduced start level and we did not get their attention on the cost that we wanted.
And now all of a sudden they've come back to us and we're having a meeting either today or tomorrow and they're saying where are our starts and we said we don't need any starts and we're not going to start any homes until we get our cost in line.
So right now with our inventory of 40,000 units out there, which we're trying to scale back to 30 to 35,000 units by the end of the fiscal year, we don't need to start as many homes and we're just not starting them and it's a day-to-day start based upon what our sales are.
- EVP, Treasurer
One follow-up on the SG&A, Greg, if you actually looked at our total dollars spent on SG&A in Q3 versus Q2 even on increased closing volume in Q3 our SG&A dollars were less.
- Analyst
Okay.
As you look forward to next year, what are your thoughts on just your capital allocation by regions?
Are you going to shift it some?
Are you just going to cut back across-the-board as you sort of take this step back during this ugly environment?
- President, CEO
Well, we have on a historical basis allocated our inventory increases to each one of our three operating areas equally.
This year, in fiscal year '07, our California region will receive less than their normal allocation, so it won't be a pro rata allocation because, frankly, we're sitting right now with about, I think 25% of our inventory in California.
And our goal would be like -- we would like to have that somewhere closer to 20% at the end of fiscal year '07.
So we're allocating inventory dollars not necessarily pro rata as we have in the past.
- Analyst
Okay.
Just one last question in your spec -- number of spec logs, you say 30/40,000 going down to -- how many specs do you have right now?
- EVP, CFO
We have 40,000 units in inventory.
- President, CEO
Total inventory about --. [multiple speakers].
- Analyst
And that's -- you want 35 by the end of the year?
- EVP, CFO
35 -- 30 to 35 by the end of the year.
- Analyst
Okay.
- EVP, CFO
About 40% of the total are specs right now and we want that percentage to go down to 30 to 35 by the end of the year.
- Analyst
Okay, --.
- President, CEO
But just to be clear, we're trying to reduce -- our current inventory is 40,000 and 40% specs.
By the end of the fiscal year we're trying to get down to 30 to 35,000 units with a spec count of 30 to 35%.
- Analyst
Okay, very helpful.
Thank you.
- President, CEO
Yes, sir.
Operator
Your next question comes from the line of Timothy Jones with Wasserman & Associates.
- Analyst
Are you trying to hide from me? [Laughter].
Okay, let's go.
A couple of questions.
First of all, can you give me the percentage of sales that really that you gave in either discounts or preadd-ons or anything?
I think it was 6 -- about 5.5 for Ryland and about 7.1 for -- a percent of sales for Lennar.
What was it for you?
- President, CEO
I'm not sure I -- you were breaking up.
What was the first part of your question, Tim?
- Analyst
You're -- basically you're -- the purpose -- how much of your sales was either due to discounts?
Either reducing the price of the home or adding goods at no cost or whatever it was?
- President, CEO
Well, --. [multiple speakers].
- Analyst
Margins.
- President, CEO
I've been on record from the very beginning when Ivy Zelman started asking this question and I will say the same thing. 24/7, 365 and D.R.
Horton's land is somewhere --.
- Analyst
I understand that.
What do --. [multiple speakers].
- President, CEO
-- and well, let me --.
- Analyst
-- with the spec order as opposed to a year ago?
I mean most offerings --.
- President, CEO
We're offering --.
- Analyst
-- are up about 400 basis points.
- President, CEO
We're offering more incentives now than we were last quarter or any other previous quarters to date.
- Analyst
Can you give me a number?
- President, CEO
No, I can not give you a number.
I can just tell you -- Stacey?
- EVP, Treasurer
Actually in the conference call Bill talked about the 235 basis points decline in our core margins being from a combination of less price appreciation and increase use of incentives, so --.
- Analyst
Okay, how much is that -- let's go back with that way.
How much of it was the use of incentives rather than less price appreciation?
- EVP, Treasurer
Tim, they are one in the same in today's market.
I mean we're not raising prices and we're giving incentives and it's because of the increased inventory out there and less consumer demand.
So it's one or the other.
I mean we could raise the base price and then offer $5,000 in incentive off the increased sales price, so to us it's transparent.
Just what's the impact on our margins and that's the --.
- Analyst
I'll go with that --.
- EVP, Treasurer
-- 235 bids.
- Analyst
Okay, I'll go over a little bit with you later on.
You said that you wanted -- you actually wanted 3.5 years.
I mean you had four -- first of all you had 400,000 lots at the end of last quarter and in the conference call you said you wouldn't take $10,000 a lot over.
Now, obviously, things have deteriorated rapidly.
But I mean a lot of people think that all -- homebuilder's book values are actually overstated.
Would you still say that you're -- maybe it's not a $10,000 number because that comes to $4 billion -- but would you still say that your lot position is understated?
- President, CEO
Obviously, we did not have any land impairments in the quarter.
We don't anticipate as we said, in the land impairments in the next quarter.
So we're very happy with our land and lot position, especially our own land and lot position, and clearly the ones that we have been working through the due diligence on the options side.
We were more satisfied with our own portion than we were the option portion coming at us.
- EVP, CFO
Right.
Any possible impairment would require further deterioration in the market than what we saw this quarter.
- Analyst
That's good.
Why were you more satisfied with your own land as opposed to your option land?
I would think it would be just about even --.
- President, CEO
Well, --.
- Analyst
-- or is it because when you develop your own land and you can get into some better deal or something?
- President, CEO
-- on our own land we have a lower cost basis relative to the market because that's the way we underwrite the deals.
And the option deals have always been when you're buying land or lots on an option you're typically buying them at the market value.
And even though the land prices we've been trying to work down with a number of the option buyers, they're still not eroding the margin that we have and the owned lot portion of our land and lot inventory.
- Analyst
So you're saying basically you've got the -- you got -- you were able to get a little bit better land and also you have the construction margin in that land --?
- President, CEO
Yes, that's correct.
- Analyst
-- margin?
- President, CEO
That's correct.
And I think somebody, the other day, in the last week or so had some impairment on option deals, and so it's clear to me that we own a number of our lots.
We've tried to keep it as low as possible but as you can see it's up to 53%.
But we do have the margin and the owned portion which preserves our down time.
- Analyst
Lastly, how much -- how long -- how low will you take this land position?
I mean you can do the math.
I mean you don't want to multiply three or five years times 50,000 because you obviously have some -- hopefully some projected growth going on after next year.
But would you take it down to 250,000 or maybe stop at around 300,000?
- President, CEO
I don't think the number is as important, Tim, as what the run rate is, and clearly, if -- right now we have in our estimation, too many lots relative to a 50,000 unit run rate and we're anticipating that we'll be flat in '07.
So we're probably going to be canceling more option contracts -- possibly that's one of the things that our guidance provides for in the fourth quarter.
But right now, we're trying to take our land and lot position down from where it is to get it in under five years.
- Analyst
[inaudible].
Does your projection of 365 imply some further option write-downs in the fourth quarter?
- EVP, Treasurer
It does not imply any specific option write-downs in the fourth quarter because we took at the end of Q3 all the ones that we knew to take.
However, if market conditions do change and we continue to evaluate that 50,000 on a run rate may not be what we want, we will go back through our option contracts and adjust our option position to a revised closing number.
- Analyst
I think a lot of other people should be doing that.
Thank you.
Operator
Your next question comes from the line of Ivy Zelman with Credit Suisse.
- Analyst
Yes, one question related to your changing the infrastructure to accommodate the lower sales volume.
We hear a lot of, I guess, manufacturers indicating that they don't expect to feel pressure from you guys with realizing your margins down that you might go back to them and try to give them to give you some discounts on their products.
Would you say that that is going on already or do you anticipate that that, like they're claiming is not going to be an issue?
That's the first question.
- President, CEO
The answer to your question is yes, we are working them hard currently and we'll continue to work them hard and we are getting discounts and better pricing relative to current demand.
- Analyst
Would that be across-the-board like; for example, not to name companies, but is it easier to get it from let's say the trim guys that are installing versus a branded product where you don't have a lot of alternatives where you can't -- well I know there's like three brands in a market?
Or can you say that you're getting it on all types of products that go into the home?
- President, CEO
I believe at this time other than things that -- I know in Florida we've got a little bit of a -- there's a concrete issue supposedly surfacing the state down there.
Something on that, Ivy, we're not going to get any discount at all today.
When supply and demand gets back into line we'll get it but on most of our items we are getting it.
- Analyst
Okay.
Secondly, Don, I'm trying to understand the differences in strategies with the builders and everybody is trying to figure out who is the A homebuilder versus the B or C homebuilder.
And one of the things that you guys have chosen to do is you've had a lot more specs than some builders that choose not to spec and you've been proud of that and it's worked for you.
And as you look at communities where the parcels are easily replaceable, your goal is to sell those and incentivize and discount whatever you have to do to move the inventory and part of it, you've explained is because land doesn't get better with age.
And I think that makes sense.
Why is it that some of the other public builders who claim that even though we know that their parcels are also easily replaceable choose to take on a different strategy where they don't have to blow through inventory and are actually pointing fingers at you and saying that you're spiraling the market downward?
I mean are those guys going to take the pain later are they going to have to write-off the land?
I mean can you help us understand the difference in strategy?
- President, CEO
Clearly, that's a controversial question and I'll do the best I can without slamming our competitors because we're all in this together.
But Horton and I have lived through the tough times in Texas in the late '80s and we've lived through also the tough times in the DC market in the early '90s and we're very familiar with what went on in California.
And as I know, as you know I was with a different company 27-years ago and went through some very difficult times in the early '80s.
So what we see clearly is that the best thing for us to do is to work through our land as expeditiously as possible, save and accept.
As I mentioned to you I think earlier, I went through our Virginia, our Northeast markets, and I was in Virginia and we have a project out there called "Rippon Landing" and we are discounting the heck out of townhomes to move them and it just was ridiculous because that land -- well, first of all our discounts were ridiculous, and secondly, that land is irreplaceable.
In a year or two that land -- we'll be selling townhomes there for full value.
So what we focused on in this Company is analyzing each one of our subdivisions and saying as you said, Hey, can we replace this land and if we can, we're going to move through this land and we're going to hopefully buy it at a cheaper price the next time.
On our other side, we've got subdivisions we call "gross margin" and that's like Rippon Landing in Virginia.
We can't replace that.
So we're not going to succumb to discounting in that market because we can't replace those lots.
As to what everybody else has seen on the marketplace.
I have a hard time understanding that.
We've been very conservative, very clear.
We say the market right now is weak.
We think the market could get weaker going forward and we've given you a number of 365 or greater saying it could get weaker in the fourth quarter, but we're going to position ourselves for a flat '07 over '06 and we're going to assume that it even gets tougher in '07.
And as you and I have talked privately one thing that I know, every time we've gone into a downturn in the homebuilding industry they've always been longer and deeper than we've all imagined so we're preparing for the worst, and we think this one will be longer and deeper than just the last six months.
- Analyst
Okay, Don, thanks for that.
Two questions.
One an easy one.
Have you guys laid off with getting the infrastructure down?
I assuming that would incorporate some layoffs and, if so, what the magnitude has been and what you expect it would be going forward?
- President, CEO
To answer your question, and it's a very sensitive subject, we have laid off people and we will continue to adjust our staffing relative to the demand in each one of our divisions.
And --.
- Analyst
Yes, that's fair.
This one is a little tougher to ask without hopefully not offending anyone at your Company, but realizing that you sat in New York on May 15th and you still thought at the date of my conference that you were able to hit 58,000 units, is it possible given the size of the Company that the information flow from the division to the region to the corporate has a little bit of fuzziness or clogs in the system that maybe division presidents are worried that if they give you the bad news and they're holding back -- it just seems like your communication flow based on the May 15th versus when you preannounced, you seem like it was a two different guides.
You were very high level conviction.
Admittedly you were saying things were tough but you were still hopeful to get to the 58,000.
So I was just wondering if there's some clogs in the system that you since worked out?
- President, CEO
I would say we have -- we always have some clogs in the system, but I think our visibility into our field operations is equal to or greater in terms of clarity of any other company simply because of the amount of time that I spend, as well as Stacey and others from our executive management and even Don Horton has been in the field.
So I think we're very very much abreast of what is happening in the marketplace.
Having said all that, our sales in Q1 were up 19%.
Our sales in Q2 were up 9.5% and our sales in May were stronger than our sales in April, which we don't disclose monthly sales.
June absolutely fell off the richter scale for us and that's at the point in time when we said, Gee, regardless of what our division presidents think they can do, June they didn't do it, so now we need to address the issue.
- Analyst
Great.
And then just real quick lastly on your layoffs -- I know it's sensitive -- but are they sort of the subs more or is it coming from internal?
Are you also laying off subs like saying, hey, you trim crew we don't need you anymore?
- President, CEO
Well, actually it's --.
- Analyst
So it's not just Horton people, it's the subs.
How much -- what percent of your subs are you saying, Sorry we're hurting right now and we can't give you guys work?
- President, CEO
Actually, the subs it's a market-by-market situation and we don't really have to lay them off.
We're just having fewer starts so they don't have as many crews employed with Horton as they once had.
- Analyst
I guess that's what I am trying to get at.
Are the crews down 10% or would you say the crews are down like in Phoenix even more than 10 or Sacramento or San Diego?
- President, CEO
Well, clearly in San Diego it's down a heck of a lot.
But it's not something -- we don't track that on a market-by-market basis.
But clearly where our starts have declined dramatically then our subs have a lot less work than what they had before.
- Analyst
Great thanks a lot, guys.
- President, CEO
You're welcome.
Operator
Your next question comes from the line of Stephen East with SIG.
- Analyst
Good morning, everybody.
- President, CEO
Good morning.
- Analyst
The land purchases that you talked about, could you talk about where you think you'll wind up '06 and how that compares to '05?
And then you mentioned that '07 will be down from that, so just maybe a rough thought process there?
- EVP, CFO
Yes, to give you a kind of a relative view of our land purchase flow, year-to-date through the third quarter our land purchases are actually up 15% versus last year, but our current projection by the end of the year through September for the 12 months we're projecting our land purchases will actually be down versus last year.
So that gives you a view of to how restrictive we're being on any land purchases right now.
And as certainly as we look forward to '07 we expect '07 land purchases will certainly be below the '06 levels.
- Analyst
Okay.
Do you have any -- it sounds like you don't want to give an actual dollar amount.
Could you give just a rough range of what you're talking about here?
- EVP, CFO
No, in actual dollar amounts?
- Analyst
Right.
- EVP, CFO
Last year through the six months -- or through the nine months we spent $2.1 million -- $2.1 billion.
This year we spent $2.4 billion.
For all of fiscal 2005, we spent $2.9 billion, and we will be -- we will certainly be south of that $2.9 billion this year.
We'll be somewhere between the 2.4 and the 2.9.
- Analyst
Okay.
And then on -- you mentioned in your release FAS 66 issue is going to come up again.
Can you just talk about what type of impact that's going to have in the 4Q?
- EVP, CFO
It's a little difficult to predict the exact amount, but any quarter in which we have a higher volume and our mortgage company is processing more loans, you have certainly the potential for a greater profit deferral balance.
And so as last year in our fourth quarter we had a substantial profit deferral, we would expect that this year relative -- in the fourth quarter relative to where we've been in Q2 & Q3, we would have an increase in the profit deferral.
Little difficult to predict the amount exactly because it's not just the quarterly volume it's really the volume right at the end of the quarter.
- Analyst
Okay.
And then, Don, one last question.
To get to 50,000 units, the conversion rate, you're implying for your backlog is significantly below anything you've seen in the fourth quarter over the last six/seven years that type of thing.
How much of that is driven by what you perceive to be the increased cancellation rates?
- President, CEO
I think quite a bit of it is.
But also, we've been a double-digit company, always increasing our sales at a double-digit level, and clearly, we're down 4% in units in the third quarter.
So it's two factors really.
It's a significantly slower sales pace.
We don't believe -- we're not counting on sales being significantly different in Q4 than what they were in Q3, but we'll have to see.
And also, the cancellation rate has gone from 20% to 23% to 29%, and if that trend continues, obviously we continue to need to sell more homes just to be prepared to be with where we need to be.
So I think it's a combination of those items.
- Analyst
Okay.
If you looked historically in the fourth quarter just sort of how much or what percentage do you think of your closings that occur, you actually sign a contract and deliver in the fourth quarter, just roughly historically?
- President, CEO
Roughly that's a number right around about 30%.
- Analyst
Okay.
All right thanks.
- President, CEO
You're welcome.
Operator
Your next question comes from the line of Kenneth Zener with Merrill Lynch.
- Analyst
Good morning.
- President, CEO
Good morning.
- Analyst
I'm interested to see when you think you can hit your land supply target which you've outlined now is about five years.
Is that going to be by the end of '07?
- President, CEO
It could be but it's a moving target and I'm not committing a specific date to when we can get to that number.
Clearly, we're slow in our land purchases.
We're slow in our starts and it's just an internal goal to drive it to that year supply as quickly as possible.
We'll see how we move.
- Analyst
All right.
And then you said you're matching your starts which would obviously be a portion of specs to your sales rate; is that correct?
- President, CEO
Well, let's say this clearly, we are -- we've scaled back our starts dramatically and just because we sell one doesn't necessarily mean we're going to start one, but we are aligning it much more closely with our sales base.
We may have starts that even lag our current sales base because in a specific market, we may not want as much inventory in that market going forward.
- Analyst
Well, I think that's a good thing.
This is my last question in regarding your guys spec level.
If you have about 40,000 units in backlog of which 16 about are spec and you guys are showing 30% of your year-end balance will be spec.
That's roughly 10 to 12,000 units?
Is what you guys are saying?
- President, CEO
Yes, we said we would -- right now we have 40,000 homes in inventory as opposed to backlog and those 40,000 homes that are in inventory about 40% are specs and our goal at the end of the fourth quarter is to have 30 to 35,000 homes in inventory of which about 30 to 35% are specs.
- Analyst
And how does that compare really against last year in terms of the percent spec as well as the absolute number?
Because I'm just trying to understand where that will set you in at this spring selling season.
- President, CEO
Well percentage wise I can tell you spec wise, we're not significantly higher today over a year ago.
What is significantly different is what we look upon as our forward demand, because our sales are less than what they were and that's one of the reasons we're scaling back our specs and scaling back our starts.
So our spec percentage is not significantly different at the beginning of this fourth quarter than it was the year ago fourth quarter.
But the potential for sales going forward are not as great as what they once were and the cancellation rates are higher than what they were a year ago.
- Analyst
Right.
So is this -- how about the stage of spec because that's certainly a big margin impact is if your spec is just in the first month or two?
Are these specs more geared towards homes that someone is just not showing up?
- President, CEO
Well, let me say first of all, we have tracked specs from inception and 90% of our specs are sold before they're completed.
Most importantly, we age our inventory every month and currently, we have a total out of 40,000 homes of inventory, 53 homes which have been built and unsold for a period greater than a year, so I would say to you currently, we do not have a spec problem.
- Analyst
Okay, so you hold it at that year, not at six-month issue ?
- President, CEO
Well we age our inventory at 30 days, 60 days, 90 days, 180 days and a year.
I'm just saying that if we have 53 homes in inventory that have been completed and unsold for a period greater than a year and almost all of those were model homes.
By definition when we put a model home up for sale then it gets it back in our inventory and typically they've been completed for over a year, so most all of those are model homes.
- Analyst
Thank you very much.
- President, CEO
Yes.
Operator
Your next question comes from the line of Carl Reichardt with Wachovia Securities.
- Analyst
Man, I must really want to talk to you guys to wait this long. [Laughter].
- President, CEO
You must have gotten up late.
- Analyst
Yes, right.
Hey, Don, per an earlier question from like 45 minutes ago, on this inventory mix that you have now you're shifting California about 20% of inventory, that's kind of your internal goal for '07.
Do you have a couple of other states where you would see either a significant increase or decrease in what that inventory mix might look like in '07?
- President, CEO
Well, clearly just to give you a couple of states, the State of Washington and we just entered our -- what our 83rd market -- when we went into Bellingham, Washington which is between Seattle and Vancouver, the State of Washington is doing incredible and Seattle and the suburbs are doing incredible largely driven by surprise, surprise, job growth, with Microsoft and Boeing hiring I think trying to hire about 2000 employees each every month.
Clearly, Hawaii is doing very well for us and the coastal Carolinas.
And I will tell you I just came out of Chicago three weeks ago with Doug Brown and he has a number of deals on the books in Chicago and I told him we would support everything he has got on the books that he wants to buy up there because Chicago is a very solid market.
No big peaks.
No big valleys.
And his returns are better than the company average and he's just a good consistent operator.
So those are markets that I see us continuing to grow.
- Analyst
But you would expect maybe to shrink Florida, say or Arizona?
- President, CEO
I will say to you that right now, Arizona is pretty much flat and I would say to you Florida is flat, but I look at Florida and I say that's an evolving market.
Southwest Florida is a tough market today, and the rest of Florida seems to be doing very well for us.
It depends upon how much Southwest Florida moves into the rest of Florida but we are focusing very clearly on Florida right now.
- Analyst
Okay.
And final question: Just a clarification.
When you got 40% or so specs in inventory, but you guys count that 40% as what we started spec and what we started build to order but got cancelled, that turns into spec; is that right?
- EVP, Treasurer
That's correct.
It's a point in time any house under construction that doesn't have --.
- Analyst
That doesn't have an order?
- EVP, Treasurer
-- a contract on it.
- Analyst
Okay.
Terrific, thanks, guys.
- President, CEO
Wow, Carl.
- Analyst
Yes.
- President, CEO
The last thing I would like to say is -- and not to compare ourselves to anybody else in the industry -- but we have the most conservative accounting for specs I believe of anybody in the industry and that is as soon as we pull a permit if it's unsold, even if it's unstarted we count it as a spec.
- Analyst
Okay, I'll ask it.
At what percentage of those specs then are permitted not yet started then?
- President, CEO
That's a number we can get back to you on.
- EVP, CFO
Yes, we would have to get back to you on that.
- Analyst
Fine.
Okay, thanks, guys.
Operator
Your next question comes from the line of Jordan Sherman with Satellite Asset Management.
- Analyst
Well, certainly thanks for staying this long to hear my question.
- President, CEO
You're welcome.
- Analyst
I was trying to say, you just want to follow-up on the comments you made earlier about positioning yourself for a flat fiscal '07.
Are we talking about sales, margins, earnings?
What actually are you referring to?
And then I guess if it's any of those above, are we then positioning ourselves for the third or fourth most profitable year in your history?
- President, CEO
Well, I will say to you, sir, it's an evolving market currently.
We are positioned -- what guidance we're giving you is that we're going to be on units.
Volume in '07, we're anticipating to be flat with '06 and then we will be able to give more color to you on '07 once we see what kind of margins we run in the fourth quarter of '06.
- Analyst
Okay.
And then just to follow-up on the permitted specs.
Order of magnitude?
Just -- I mean you said you would get back to Carl on the -- on how many.
On just order of magnitude, what would be just simply, we haven't started it but we pulled the permit?
- President, CEO
We've got Mike Murray who is our Controller over here giving me a hand sign somewhere between 5 and 10%.
- Analyst
Okay so that's roughly.
And it's obvious that -- do you think part of the margin -- it's obvious that the specs might have caught you short with the market that's sort of imploded in June, but do you think that part of the margin decline you're referring -- you're talking about in the fourth quarter is a reflection of the spec policy, your spec policy which seems to be different than others?
- President, CEO
Well, I would only say to you about the latter part of the that question, we are really forthright on our specs and we are very conservative in the way we define a spec.
And to answer your question in terms of, have we been caught with too many specs which someone implied in an earlier write-up?
The answer to that question is no because we clearly said that our spec percentage of our total inventory is pretty much in line with exactly where it was a year ago.
Now, with the demand that tailed off dramatically on us in the month of June, we have more specs and more units in inventory than we would like and so that's why we've described that our proactive plan is reducing our inventory level of 40 to 30 to 35 in our specs accordingly.
So given what we know today, we have obviously maybe 5 to 7,000 too many specs.
We've got a plan to reduce it, but frankly, we have 19% up sales in Q1, 9.5% up sales in Q2 and our May sales were better than our April sales, so we thought we were exactly positioned for the market.
- EVP, Treasurer
Yes, really the great thing about our spec strategy is a strategy that's very easy to adjust quickly and because we can react to what we're seeing in the current sales environments by simply adjusting our start.
If we're seeing stronger sales we increase our starts and if we see slower sales we decrease our starts.
- Analyst
Right.
- EVP, Treasurer
Since our built-on is four to six months, again, it's a very short adjustment period.
- Analyst
And I could -- I just want to comment that our markets doesn't seem to appreciate your forthrightness in trying to sort of mark the bottom and it seems to have preferred others who have guided down multiple times.
I just want to say I do appreciate that and hopefully we are marking the bottom with the guidance.
- President, CEO
We -- believe me, sir -- we are hopeful of that also.
We've run every scenario that we can in this Company and we believe there's no way we can hit 365.
- EVP, Treasurer
Thanks, Jordan.
- Analyst
Thank you.
Operator
Your next question comes from the line of Alex Barron with JMP Securities.
- Analyst
Great.
Thank you.
I just want to start off by congratulating you guys on your long streek of year-over-year growth even though, I guess, it's --.
- President, CEO
You had to bring that up, didn't you Alex? [Laughter].
- EVP, CFO
Oh, Alex, I'm going to buy you a beer, buddy. [Laughter].
- Analyst
But well, nobody else did it, so anyway.
I guess you sort of answered my first question which was I wanted to get a feeling for how much in your fourth quarter guidance was due to just margin compression versus further land write-offs or whatever you want to call them.
But it seemed like you guys weren't expecting or haven't incurred anymore since June 30th.
- EVP, Treasurer
That would be a fairly true statement, Alex.
If we expected anything else at June 30th, we would be required to record it.
So, we have recorded everything we know about it based on the current market conditions and that's the wild card for us.
So as we look forward, we try to layout for you what the factors were that we consider in our guidance.
We haven't really signed any weight to them simply because we don't know exactly what the conditions are going to be throughout the fourth quarter.
- Analyst
Okay.
And then I guess on the spec building issue, I was kind of wondering why is it -- I know it's kind of turning a ship, but why -- just kind of target the mid 30s as opposed to 10% or something really small or basically nothing?
- President, CEO
Well, let's remember that we do very little advertising in this Company, and for that we bond with realtors across the country who sell a large percentage of our homes for us, and realtors, one typically, would like to get their commission as quickly as possible.
But, secondly, they also have a number of relo buyers, relocation buyers, who need to get their buyers or clients and their families into homes more quickly.
So we have typically averaged 3 to 5 specs per community across the country.
That saves us a lot on our operating expenses because we know we don't pay a realtor until we actually close on the transaction and get our money and we can tract how effective that is.
Secondly, if we go out and spend $25,000 in the Fort Worth Star Telegram for a big color ad on the weekend, it's very difficult for us to determine how many buyers we're attributed to that, the same way with a television ad or radio ad.
So we believe that our most effective advertising campaign out there is to have a few number of specs in each community and to bond with our realtors who bring us great qualified buyers.
- EVP, Treasurer
There's a couple of other advantages to specs too.
If we have homes that are available to close in a month or two month time frame, that lets us compete not just with other new homes in the area and also lets us compete with existing home markets.
And really the other thing it does is it helps us to keep our overhead down because instead of modeling four to five floor plans in every community we'll only model one to two but we'll have homes under construction where we can actually walk people through and let them see what the floor plan looks like built instead of just on a piece of paper.
- Analyst
I think -- I mean I guess it seems like all those things seem reasonable in a stable or normal environment.
It just seems like right now given all the high level of inventories and resales by speculators, I guess it's a little bit different environment.
And I thank you for answering the question on whether you paid realtors on closing versus on contract.
I guess the other question I wanted to ask you on it, it seems I guess you guys haven't really discussed one market versus another, but I was hoping you could shed some light on which two or three markets you guys find the most challenging at this point and kind of where you see prices going in there or what your strategy is on brand new communities that you're rolling on in those three -- two or three challenging markets?
- President, CEO
Alex we've known one another for a long time and I was going to ask you that question based upon your write-ups on Phoenix and Florida recently.
I figured that you probably know as much as we do at this stage.
To answer your question directly, California continues to be a challenging market for us.
It continues to be a small percentage of affordability out there.
Although I will say to you that California is -- there are two different markets in California.
There's San Diego and Sacramento which we consider to be -- Sacramento is not as bad as San Diego.
San Diego is our worst market in California.
But the rest of our division presidents in California including our Sacramento division president is doing well, but just not as well as we projected he was going to do.
But if you look at Simi Valley, Ventura County, the Inland Empire, all of those markets are doing very well for us and even some of the stuff out in the desert is doing well for us.
Phoenix, our markets are good there.
They're profitable there.
Our cancellation rates have increased in the Phoenix and the Tucson market this third quarter over second quarter.
I think our people have a real challenge in the Phoenix market in the fourth quarter and even in the first quarter of '07 because I think that market has stayed up longer than other markets and maybe stayed up longer than it should have.
But there is still good job growth and good demand in that market but there are a lot of builders in that market with a lot of inventory.
Texas is doing very well for us.
The Texas market has always done well for us and it is continuing to improve for us.
Clearly, we entered into a smaller market Baton Rouge and Baton Rouge is doing very nicely for us.
I told you Chicago, it's unfortunate that there are only two markets in the Midwest, that's Minneapolis and Chicago, and Minneapolis is struggling.
We have -- we are reducing our starts in Minneapolis/St.
Paul market.
The job growth numbers are good but they're not great.
Chicago is coming off a really really tough comps and we haven't lined about that, but they had a tremendous project, Pingree Grove, that opened a year ago and they had tremendous sales in that the project that took us about three to four years to get it entitled.
And they had awesome sales last year and they haven't been able to repeat those sales this year, but the Chicago land area, very good solid stable market for us.
Coastal Carolinas is doing well.
There's more, there are more cancellation in that market than what there has been in the past and I think that's because I think there have been second home buyers in that market and that's caused some of the cancellations.
And then you get down into Florida.
Florida has been very good for us this year.
They are going to have a fantastic year this year, but their sales trailed off in the third quarter and I think that indicates they could have a more difficult comp in fiscal year '07 than they did in fiscal year '06.
Georgia, on the other hand, and Alabama are doing very well and someone asked us where we're putting assets and we're definitely putting assets with Scotty Bob and Andy Oxley in that Georgia/Alabama market because we have got a great operating team there and we're increasing our margins daily there.
And ever since Scott Stone went to Atlanta four years ago, five years ago and has increased our gross margins significantly there.
He's got a great team of people and we're planning on growing that part of the Southeast.
- Analyst
Great.
I appreciate the thorough -- going through all the markets.
Thank you very much and look forward to you guys doing well going forward.
Thanks.
- President, CEO
Thank you, Alex.
- EVP, CFO
Thanks, Alex.
Operator
Your next question comes from Jim Wilson with JMP Securities.
- President, CEO
Jim?
Operator
Mr. Wilson, your line is open.
There is no response from this line.
We'll then move to the next question.
Your next question comes from the line of Larry Taylor with Credit Suisse.
- Analyst
Good morning.
A couple of things.
One is with the contraction in specs and the reduction in land purchases, I wonder if you can give us a sense of how much you would anticipate you would be able to generate in terms of free cash flow in the fourth quarter this year?
- EVP, CFO
It would essentially proximate about what our net income is and any reduction in inventory that we would see in the fourth quarter.
So I'd hate to put an exact number on it but clearly, we always see positive cash flow in our fourth quarter.
- EVP, Treasurer
Yes, a floor for that would be our earnings, Larry, because we clearly said we would bring our inventories down.
- Analyst
Okay.
And I guess I'm trying to -- if I'm able to -- sort of thinking about order of magnitude, if you're talking about 5 to 7,000 in terms of reduction in specs plus a postponement of land purchases or slowdown in land purchases whether or not that number might have the potential to be substantial or is that not likely to be the case?
- EVP, Treasurer
I think in Q4 the number has the potential to be substantial.
- EVP, CFO
But for the year we will still show negative operating cash flows for fiscal 2006.
- President, CEO
Our land purchases for the fourth quarter will be much smaller, just like they were in June of our third quarter.
April and May -- April we purchased more land than we did in May and in May we purchased more land than we're going to purchase in June, but June is definitely down dramatically from what May and April were.
We expect that trend to continue into the fourth quarter.
- Analyst
Okay.
That's helpful.
And in terms of the opportunity in terms -- as far as SG&A cuts are concerned, have you thought about it in terms of magnitude of dollar amount?
- President, CEO
Yes, we have, and basically we've identified over $200 million in SG&A cuts that we are underway today accomplishing.
- Analyst
And those would be primarily available by the end of this year into next year?
- President, CEO
Yes.
We're not going to accomplish all of that in the fourth quarter but our goal is to get everything in place either accomplished or in place in, as I said, in the fiscal year '07 to the extent that we have remaining goals to accomplish on that $200 million.
That they're done very very quickly so that '07 we're focused on very clearly having an overhead that's no higher than fiscal year '05 because we want to get our SG&A clearly in line with the level of production that we expect and we think that's going to be close to what it was in '05.
- Analyst
Okay, great.
And then lastly, I understand this is going to vary a lot by market, but as you look across all of your regions and think about this sort of character of cancellations and whether that's changed over the last quarter; in other words, the reasons why people are canceling.
I'm just trying to get a sense of to what extent you think this is something the market is going to have to live with for several quarters or a year going forward or whether some of this may abate.
What is your sense of that?
- President, CEO
My sense is there's three to four quarters of inventory adjustments by the large builders and that as we all slow our starts, and we're focusing on slowing our starts, that is the inventory will come more in-line with what the current demand level is.
So I would look for the next three to four quarters of decreasing inventories and hopefully decreasing incentives and getting some confidence back to the consumers out there because right now I truly believe that there are a lot of fence-sitters out there.
They don't have to buy because of the fact that depreciation is not like it has been over the last two or three years, so if they don't buy today they're not going to miss an uptick in the house price.
So there's not really much motivation for them to buy unless they really need a home.
So I believe over the course of the next three to four quarters the inventory will be reduced and we'll get back to a more normalized pricing environment than we're experiencing today.
- Analyst
But you think it's that lack of confidence is leading to a lot of cancellations in terms of people just deciding to walk away?
- President, CEO
Yes, as well as I still think that we're sifting investors and speculators or whatever you want to call them out of our backlog, all of us.
And to the extent that pricing in a subdivision is not going up and they're not closing because they were only closing many times, one of it was for an investment, they certainly wanted to have a good investment.
Where a good investment by most definition is, it's less than what they can buy it for today or as a speculator trying to flip it and if the prices are flat or they are increasing incentives there's no opportunity for the speculator to flip.
So, I think they're canceling because the pricing in most of our markets is flat or even you could decline -- you could say the incentives are up, so they don't have the incentive to close.
- Analyst
And obviously it varies by region but when you look across the regions those types of investors are speculators is the order of magnitude, what percentage do you think that is of your cancellations?
- President, CEO
Oh, I haven't -- I really couldn't put a figure on it because --.
- EVP, Treasurer
It's really hard to identify Larry because in general we would not have sold to them in the first place had we identified them as an investor because people aren't necessarily forthright with us for their plans for the house when they enter the contract.
So we really haven't quantified it that way, but it's certainly part of the 10 percentage increase that you see in our year-over-year cancellation rates.
- Analyst
Okay, thank you very much.
Operator
Your next question comes from the line of Steve Fockens with Lehman Brothers.
- Analyst
Hey, guys, just one quick question.
D.T. to the extent that you think over the next three to four quarters you're going to work on bringing your own inventories more into line with demand and hopefully the other big builders do the same, what are your thoughts on how the privates are reacting in this environment from an inventory perspective?
- President, CEO
I think most of the privates don't have much of a decision to make because the banks are cutting back in the amount of financing that they're making to the privates, and so as a result, I think that their inventory that they're trying to put on the market will be scaled back also.
- Analyst
And in cases where you guys are not or are stepping back from land, are you seeing any of the sort of mid or larger sized privates stepping up to take your place?
- President, CEO
Not really.
I use a great example.
We honored a deal in the State of California, I won't say where, and supposedly went into escrow at more money than we paid twice and both times it busted out and right now there are no buyers out there for it at our price or whatever price it is.
So I don't see anybody being able to, one, justify the price or typically for the privates to come in and snap something up that the publics were focused on.
- Analyst
Great.
Thanks very much.
Operator
Your next question comes from the line of Douglas Pratt with Mesa Capital Management.
- Analyst
Thanks very much.
A couple of questions.
You indicated -- I came on a little bit late but it sounded like when I came on you were saying that essentially this is, in your opinion, a normal cycle, but that you thought it would be -- and I didn't catch the first time -- it would be equal to or better than or less than normal cycles?
- President, CEO
Well first of all --.
- Analyst
[multiple speakers] -- question.
- President, CEO
-- we did not say that and I would just say to you that everyone of these downturns in the industry are different.
I've lived through 27 years of them.
Each one has a little bit different characteristic to it.
So no, I haven't said this is a normal cycle at all.
- Analyst
No, I'm sorry.
That it's a cyclical event.
I didn't mean that you were characterizing the cycle.
- President, CEO
No.
And I didn't even really say it's a cyclical event.
I just believe that as the investors and the speculators have left the market that the industry has more inventory than what the current demand is, and as a result, we're dealing with excess demand in the marketplace and the way we're dealing with it at Horton is we're trying to -- if we cannot replace the land, then we're still holding our gross margins there.
If we can easily replace the land then we're moving through the land as expeditiously as possible by offering incentives to move the inventory and start over again.
- Analyst
Okay.
Well, it sounds like you're saying cyclical, but in any event, why -- one thing I don't hear and I haven't heard from any of the builders is any sense that pricing has simply gotten too extreme for the buyers.
It seems to be attributed mostly to a -- trying to get a better deal or buyer nervousness.
I mean prices have gone up at levels multiples of long-term historical rates.
I mean do you think any of this is simply just sticker shock and buyers are not going to come back until there's a significant reduction in pricing?
- President, CEO
I don't believe it's sticker shock, simply as much as it is an affordability issue.
And if you look at the State of California and we've tracked the statistic forever, Tom Noon , our Chief Operating Officer out there has been in the California homebuilding market for more years than he's been with us and he's been with us since 1993.
And one of the things that he tracks out there very closely is the affordability index.
And what's above 25%, things are great in California and when they start getting down into the 20%, low 20% levels you better be adjusting your product.
We adjusted our product.
We started doing more high density homes, more condos and podium projects and things of that nature.
Then it dropped down into the 18% and now, I don't even think it's in the teens right now.
So I think really clearly what's affecting the demand in a number of our markets is simply we've depleted the pool of affordable buyers by escalating real estate prices in a number of our markets and then that has been somewhat aggravated by the fact that interest rates have worked their way up.
Although, I will tell you interest rates don't have a hill of beans to do with our business in a large way.
If you're listening to somebody this morning, if you look at a 30 year mortgage rate, it's still one of the lowest it's been in the history of the U.S.
So it's not the fact that a less than 7% 30 year mortgage rate is not available out there.
I think it's a function of the fact that median homes priced -- median price of homes -- especially look at Las Vegas.
Two years ago, median price of a home went up 50% the next year it went up 25%.
What happened?
Pool of buyers dissipated.
So, what does the Homebuilding industry have to do?
What does Horton have to do?
We've got to work our way through our existing inventory.
The beautiful thing about our business is we can redesign our product and pull cost out of it and make it smaller and in three to six months we're right back out there in the marketplace with a more affordable product which then increases our pool of affordable buyers.
- Analyst
So I mean isn't that saying prices have to come down?
- President, CEO
Well, prices are going to have to come down but I think they are going to have to come down as a function of the product offerings.
I don't see -- I don't -- I'm not a proponent of our single family home prices -- for someone who bought a $250,000 home last year, is it going to go up 10 to 12% next year?
No.
Is it going to on a historical basis in this country continue to go up from 0 to 5% a year?
That's what I expect.
But I think that -- but I just don't think as large a percentage of buyers can afford the product because of the increase in the median price of the home.
- Analyst
Okay.
And then final question.
It looks like cost of goods -- across the industry, cost of goods per home -- in other words, input costs seem to be going up fairly steadily at somewhere between a 5 and 6.5% rate.
Is that part of the margin issue you think you face and is there any indication over the last few months that -- I know you're making efforts with your suppliers, but just currently , are you seeing any abatement in that level of cost increase?
- President, CEO
Well, I think the biggest cost increase that we've experienced at Horton, and I can probably speak for the industry are land prices over the last five or six years and that represents 25% of the cost of a home; sales price of a home.
So as a result, what we're focused on right now is bringing that land cost down.
That's the biggest driver of our cost.
If we can focus on one item is driving down land costs.
Now we're focused on the other cost clearly but the land is the most expensive single item that goes into a house.
- Analyst
But I mean it appears at least -- and I'm actually down in the Tucson area the -- cements on allocation down here, copper has been extremely high, I mean it's not -- and labor obviously has been a problem.
I mean it seems like it's a cost throughout the system, not just land.
- President, CEO
Well and yes we have costs increasing but at the same time because of our volume, we've been able to get a -- we believe -- a better price than most builders in the marketplace just simply because of our volume purchases whether it be on the labor side or the materials side.
So we have costs going up every day, costs going down every day but our focus is how do we continue to drive our costs down every year?
- Analyst
Okay, thanks very much.
- President, CEO
Yes.
Operator
Your next question comes from the line of Joel Locker with FBN.
- Analyst
Thanks, guys.
Just -- I want to talk a little more in depth about the material prices going forward just based on you mentioned the concrete shortage in Florida and wallboard, in particular, lumber you're getting a break on already.
But I was just wondering if when and if you saw the prices of say wallboard and cement coming down based on just the first six months?
Closings were higher than they were last year but in the third and fourth quarter of a calendar year, the September/December quarter it looks like closings for all the builders are going to be down significantly.
- President, CEO
Well, unfortunately, we're not in control on most of our commodity prices.
We can on a local-by-local basis deal with the concrete manufacturer, the dirt contractor, and we do have national contracts with certain manufacturers and vendors.
But world forces are driving concrete prices and lumber prices and a whole host of other prices, so we're just dealing with those price increases the best we can.
And then most importantly, trying to identify where we can significantly save money and that's what we're focused on more because we've got to be -- as the prices increase on the various commodities those really are not under our control so we've got to be trying to figure out where we can save money in our system.
And I think we've done a good job of that.
- Analyst
Right.
And just -- but it seems like the whole supply demand curve may be shifting based on homes closed, maybe being up 5% or maybe flat in the first six months whereas now with the big builders taking share it looks like they may be down 20 to 25%.
So, maybe all of a sudden your suppliers say well, we don't have anybody to sell anything to so then you have the upper hand maybe going into the end of the year.
- President, CEO
I clearly believe that the homebuilders are in a strong position.
The large homebuilders are in a strong position going forward because everyone is going to have to adjust to a lower level of demand and I don't care whether you're in the sheet rock business, whether you're in the toilet manufacturing business or whether you're in the roofing materials business there's going to be less demand going forward and everyone is going to have to adjust so we all can move together.
We experienced this time and time again.
Our subcontractors make a lot of money in the good markets and they are continuedly increasing their prices to us and we're dealing with that on a daily basis and then when the market starts to turn they know that they've got to get lean and mean just like we're having to get lean and mean.
And we are very proactive in terms of dealing and negotiating with our subcontractors, many of whom by the way have been with us for many many years and they've been to this movie before, so it's not the first preview for them.
- Analyst
Right.
And just on -- just real quick on land prices, I mean I've noticed or just at least from my sources coming down already in Sacramento and San Diego or some of the weaker California markets, but I was just wondering in recent weeks if you've seen land prices actually decline in some of your other markets?
- President, CEO
unfortunately, the land prices are not adjusting as quickly as some stock prices.
But to be specific we -- it's not necessarily a week-to-week or day-to-day thing for us.
It's more of a month-to-month thing even at that and it really depends upon where the piece of land is.
There are a lot of --.
- Analyst
Right.
- President, CEO
There are a lot of land sellers out there still in denial.
- Analyst
Right.
- President, CEO
The one piece that we dumped in California, those land sellers that I was referring to and I'm not going to be specific, is that seller is still in denial.
- Analyst
Right.
- President, CEO
They are going to keep the land hoping to sell it to someone else, and I sort of get back to the greater fool theory.
There's not someone out to pay more for that piece of land than they paid today.
- Analyst
Right.
Because I mean in another region I've heard of takedowns and owner option contracts lessening or I'll take down 30 lots instead of the original 100 or similar things like that.
But I was just wondering if any of other markets people were just backing away and say, all right, we're cutting prices here on land?
But you haven't really seen that here?
- President, CEO
Oh, I'm saying, no, we have seen prices decreases on land in a number of our markets but they are just not as significant as they need to be.
- Analyst
Right.
All right thanks a lot.
- President, CEO
Yes.
Operator
Your next question comes from the line of John Messenger with Morgan Stanley.
- Analyst
Hello, gentlemen.
I'm actually calling from London.
I'm sorry, you've been on this line a long time.
One very quick question if I could.
You highlighted the view that house prices are unlikely to fall from here.
That it will just be a case of settling back.
But when you look at the gross margin going back over history and as house prices go back, what sort of hurdle margin do you operate with when you're buying land?
Just to understand if that trapped inflation is unlocked to see what that comes back to.
- President, CEO
Well that's an interesting question because we have different hurdle rates for different markets and clearly in California today we have a higher hurdle rate on gross margins than we've even had for past deals in California just simply because of the fact that land prices begin to come down one of the things that we focus on is, one, as I said earlier, we may have more subdivisions next year but we may not have as many lots as we've had simply because we're focusing on smaller deals.
It's a great thing for land prices to begin to decline.
The only issue is that you don't want to buy today and six months from now or 12 months from now that that land is selling for less.
So that's one of the reasons that we're focusing on doing smaller deals today.
And we're also in markets like California we're demanding a higher return on those projects simply because we think those markets have the most potential for land price decreases.
- Analyst
Great.
But in terms of the quantity, I would have thought that there is still a degree in the margin that you produced for the three -- for the nine month period, a good chunk of that still reflects sort of trapped inflation on the land that you owned that you bought 2, 2.5 years ago when house prices were significantly lower and that would obviously unwind in the next 12, 18 months.
Is that fair or is it one of the reasons behind your continued sort of cautious expectations on margins?
- President, CEO
Well, I think the latter part.
I think it's clearly we -- I believe that we have embedded profits in our land and as a result on a going forward basis we may not -- as much of that may not flow through in the form of gross margins.
And I think the incentives are a function of that to the extent that the land prices are not -- the land profits are not as great as they were projected to be.
The way we're dealing with this is simply by offering incentives.
- Analyst
Right.
And just finally, when you look at the product mix, are you noticing a differential cancellation rates between your upper end and your start of home kind of units, just to understand this affordability issue.
Is that hitting the starter home guy who isn't buying a particularly expensive house, but just hasn't got the income stream compared with the upper end of the market?
Or is there any discernible trend either by state or across the group as a whole?
- EVP, Treasurer
I would characterize the cancellation rate changes being more geographic than reason specific.
I mean we still see a number of cancellations related to the financing.
That's always been the largest percentage historically and those cancellations typically happen at the first part of the contract and geographies where prices are going up and we're seeing fewer investors in those markets now.
We've seen an increase in cancellation rates as those people have moved out of our backlogs.
- Analyst
Great.
So that sounds like California and Florida. [Laughter].
- President, CEO
And to a certain extent, Las Vegas.
- EVP, Treasurer
Arizona.
- Analyst
Thank you very much gentlemen and lady.
- President, CEO
Thank you.
Operator
Your next question comes from the line of Wayne Sidel, Private Investor.
- Analyst
Yes, I'm in the Florida market and earlier you were saying that you wanted to squeeze as much money out of subcontractors as possible in order to bring your costs down.
- President, CEO
I don't think I said that exactly.
I said that our sub --.
- Analyst
I'm paraphrasing.
I apologize.
I'm just paraphrasing.
- President, CEO
Okay.
- Analyst
In any event, with them working on very thin margins as it is in material cost being as high as they are and China being as strong as it is, how would it be possible for those subcontractors to reduce their cost to you further than where they are right now?
- President, CEO
Well, I would suggest one way is the same way that we're doing it and that is, is that if you're a framing contractor and you have a crew member out there who is framing houses for you, he or she may not make as much per hour as what they made last year.
Or the plumbers helper may not make as much per hour as what they did last year.
- Analyst
So you think it's reasonable that you would be able to expect them to drop the thin margins they're working on currently then?
- President, CEO
Well, I would say to you that I wouldn't classify their margins as thin, and frankly, as the homebuilding industry has done very well over the last four or five years they have also done very well and I would characterize their margins as not thin.
They may not be fat but I can tell you that they, as well as we, all have room for improvement.
And to the extent that we are going to continue to be a leader in the industry and we have to get our SG&A and our cost in line if they are going to continue to be in business then they are going to have to do the same thing.
As someone once said, the quality, low cost producer always wins and that's what we tell our subs.
- Analyst
There's one without getting specific, a national very large publicly traded shell contractor who has continued to state that their numbers they feel they will stay in-line and that seems based on what you're saying that that would be impossible.
- President, CEO
Well, I'm not saying -- I can't speak specifically to shell contractors.
I will say to you that, in general, if you take all of our trades and all of the materials that we purchase as this housing industry slows and there's less demand, then there are going to be the majority of vendors and a majority of subcontractors who are going to have to adjust their prices downward.
There are always going to be anomalies.
There could be drywall shortages, there could be copper shortages, there could be concrete shortages, shell shortages, and as a result we might not be able to deal much with those people in terms of our costs.
But the vast majority of them as the demand slackens their costs have got to come down in order to meet the current level of demand.
- Analyst
So would you in turn deal where you have some contractors that come in and actually are -- for lack of a better word, a broker where they have several subcontractors working under them, would you then start to take bids directly from subcontractors?
For example, subcontracting the slab, subcontracting the block, the framing where you can eliminate a contractor that's somewhat of a broker?
- President, CEO
Well, frankly, what with every one of our markets has a slightly different supply chain, and what you're talking about doing is unbundling turnkey jobs and some markets turnkey is standard and other markets turnkey is not standard.
So we are always looking for ways to create more efficiency in the homebuilding process and to the extent that we can unbundle our cost and we can buy, as an example, our lumber separately and our labor separately than what our history tells us that in those markets where we have non-turnkey operations that are overall costs are less expensive.
So as a result, we have been focusing on that market-to-market but it's not an exactly easy thing to implement in certain markets.
- Analyst
Okay, but it clearly you've seen yourself that it's less expensive for you to deal with the individual trades versus one contractor that might bring several of them to the table and that's an area where you may be able to reduce your cost.
- President, CEO
That is correct.
- Analyst
Okay.
- President, CEO
Thank you, sir.
- Analyst
Thank you.
- President, CEO
Have a great day.
- Analyst
You too.
Operator
Your next question comes from the line of [Laurie Bilker] with [Dillon Capital].
- Analyst
Hi, guys, thanks for taking my call.
I just -- I don't mean to beat a dead horse, but with the spec homes, can you guys give us the inventory number and the percentage that was total specs at the end of the second quarter?
- President, CEO
We can call you back.
We don't have that number at our finger tips right now.
At the end of the second quarter?
- Analyst
Right.
- President, CEO
Okay.
We'll get back to that -- you on that number.
- Analyst
Okay.
That was it.
Thanks, guys.
Operator
Your next question comes from the line of Rob Manowitz with UBS.
- Analyst
Yes, hi.
Good afternoon.
I appreciate how long you have been on this call, so I will ask a very quick question.
I understand the free cash flow dynamics you're describing and I appreciate where you're going in terms of land and inventory.
And you've mentioned that as that reduces, you will pursue stock repurchases to some degree and you will also enhance your liquidity to pursue future opportunities whether they be land deals or acquisitions.
What you did not mention, and I wonder if it was just an oversight or intentional, is an absolute reduction of your debt balances.
- President, CEO
Well, let's back up very clearly because I will never ever say this again.
We will never promise that we're going to buyback stock.
It's something that we evaluate each and every quarter and as we've clearly said, many times over, when we purchase -- repurchase stock you'll read about it as opposed to us telling you about it.
- Analyst
Understood.
- President, CEO
Okay?
- SEVP-Finance
Rob, too, excuse me, we did mention that we do have a couple more callable debt issues with the high coupon, that would be one possible alternative use of free cash flow in the future.
- Analyst
Well, I think if my notes are right you said you would refinance higher costs, so I wasn't sure if that was refinancing by redeeming or refinancing with lower cost debt.
- President, CEO
Mr. Wheat?
- EVP, CFO
Right now we would be assuming refinancing.
As we go into '07 we're preparing for flat to slightly down year in '07, so right now we would expect our balance sheet would remain around the same size.
So to the extent that our balance sheets range around the same size we would expect our overall debt level staying at our target debt-to-cap to remain relatively flat to the extent that if we saw the need to actually reduce our balance sheet, make our balance sheet smaller than certainly debt would move along with that.
But right now, there's no current anticipation of actually reducing overall debt levels.
- Analyst
Right.
Thank you very much.
Have a good day.
Operator
Your next question comes from the line of Timothy Jones with Wasserman & Associates.
- Analyst
Hello, guys.
- President, CEO
Hello.
- Analyst
A couple questions.
One, you -- Bill said that you're going to spend about 2.5 billion on land and development costs this year and obviously you're going to cut it dramatically next year, and you haven't put a number out.
But it's big.
Could I say that your free cash flow could go up 1.5 billion?
Let's say you go from 2.5 billion to 1 billion.
And I'm not even sure you'll spend a billion.
- EVP, CFO
As far as free cash flow goes if you just assume, let's just assume inventories are flat next year, then free cash flow is going to proximate our net income, so whatever assumptions you're using on volume and margins and net income that would proximate your free cash flow.
So a billion is not out of the realm of possibility.
- Analyst
Wait a minute.
You're also going to cut your inventories of land dramatically.
- EVP, CFO
We're going to cut our spending on land certainly overall.
That's going -- been on our volume projections as to where their overall level of inventory or balances of inventory will come down.
- Analyst
Why wouldn't they come down ?
- President, CEO
Well, we might enter into fiscal year '07, Tim, and we might find the market recovering and we may want to start more homes.
And we may decide that we --.
- Analyst
Right, right, right.
- President, CEO
So I think the real key is that you just back into the number we think that we'll generate a billion dollars of free cash flow and fiscal year '07, which is a lot more than this Company has ever done.
- Analyst
[multiple speakers] Versus [inaudible] billion up this year, which might be 1.5 billion swing.
- President, CEO
One thing we're letting people do in '07 right now is we're trying to help you, but you're going to have to come to your own conclusion.
- Analyst
I understand.
I understood you've been burned.
That's good.
I'd rather be cautious.
The other one, I may have had a little epiphany here and one of you, probably Stacey or somebody go through this, you said you're going to reduce your spec building, spec homes by 3,000, going from 12 to 9,000, do the math between now and year end for the fourth quarter.
And if you back out on 50,000 you're going to do 17.5 thousand deliveries, roughly.
Maybe a little more, but that's close enough for government work.
If you put a 20% margin on the 14.5 and a 10% gross, which is a breakeven after SG&A on the specs, you get down to roughly that 18% number.
Is that sort of what is happening?
Because it's very important because once you get the specs down you're going to have a margin improvement just because of that.
- President, CEO
Tim, we don't build specs at lesser margin and even though we've got --.
- Analyst
Yes, but you may sale them at lesser margins.
- President, CEO
Well, that's true.
But to the extent that we've got five -- let's back up to our specs again.
If you look at Q -- the beginning of Q4 '06 versus Q4 of '05 as a percentage of our totally inventory we don't have any more specs substantially then what we had a year ago.
So as a result what we've got going forth is lesser sales.
- EVP, Treasurer
And the other thing I would add to that Tim is our guidance doesn't imply that we're going to be dumping our specs.
If we had planned to take that route we would have left the closing number at 58,000 and just continued to build them and dump them.
So, no, I would say that we kind of listed all the different things that we looked at.
We took our spec count into consideration when we were thinking about the levels of incentives we might have to offer.
But we didn't take the specs and it's not a specific percentage to them versus our billed jobs.
- President, CEO
As a matter of fact, the one reason that we're slowing our volume deliveries for this year and next year is so we can increase our gross margins as opposed to seller specs for us.
- Analyst
So you're not going to be giving the way that the specs debt roughly breakeven after SG&A is just the entire entity?
- President, CEO
Well, I don't think maybe -- I can say this Company has never had that as a plan.
- EVP, Treasurer
No.
- Analyst
Okay.
Thank you very much.
- President, CEO
Yes, sir.
- EVP, Treasurer
Thanks, Tim.
Operator
At this time there are no further questions.
Mr. Tomnitz do you have any closing remarks?
- President, CEO
Yes.
I want to thank all of our employees again, it was a tough quarter.
You extended a great effort out there.
We have a challenging quarter ahead of us.
And we have a challenging fiscal year '07 ahead of us.
It's a much more difficult environment as we all know.
And I think all of us need to understand that we all have to produce more with less and more is expected of all of us than what's been expected in the past.
I think we need to clearly focus on each one of your individual markets, focus on your deliveries, and your sales that you're budgeted to hit in fiscal -- in Q4 and move forward and hold your head high because this will be the second most profitable year in the history of D.R. Horton.
And we'll focus on next year in making that the most profitable year in the history of the company.
Thank you.
Operator
Thank you.
This does conclude the conference.
You may now disconnect.