Hovnanian Enterprises Inc (HOVNP) 2006 Q2 法說會逐字稿

Good morning and thank you for joining us today for Hovnanian Enterprise's fiscal 2006 second quarter earnings conference call. By now, you should have received a copy of the earnings press release. However, if anyone is missing a copy and would like one, please contact Donna Tesche at 732-383-2200. We will send you a copy of the release and ensure that you are on the company's distribution list.

There will be a replay of today's call. This replay will be available after the completion of the call and run for 12 months. The replay can be accessed by dialing 888-286-8010, pass code 88647875. Again, the replay number is 888-286-8010, pass code, 88647875. This conference is being recorded for rebroadcast. All participants are currently in a listen-only mode.

Management will make opening remarks about the second quarter results and then open up the line for questions. The company will also be webcasting a slide presentation along with the opening comments from management. The slides are available on the investors page of the company's Web site at www.khov.com. Those listeners who would like to follow along also should log onto the Web site at this time.

Before we begin, I would like to remind everyone that the cautionary language about forward-looking statements contained in the press release also applies to any comments made during this conference call and to the information in the slide presentation.

I would now like to turn over the conference call to Ara Hovnanian, President and Chief Executive Officer of Hovnanian Enterprises. Ara, please go ahead.

Thank you. Good morning, and thanks for participating in today's call to review the results of our second quarter. Joining me today from the company are Larry Sorsby, Executive Vice President and CFO; Paul Buchanan, Senior Vice President and Corporate Controller; Kevin Hake, Senior Vice President and Treasurer; and Brad O'Connor, Vice President and Associate Corporate Controller.

We reported earnings of $1.55 per fully diluted common share for the second quarter, ended April 30. Our results are just above the high end of the most recent quarterly guidance, due in part to more favorable tax rate in the quarter, which we'll explain more in a moment. For the trailing 12 months, we posted an after-tax return on beginning common equity of 33.8%, and an after-tax return on beginning capital of 19.4%. These returns measure positively against our peers, and the home building industry continues to outperform most other industries, although you certainly wouldn't suspect that in view of our PE multiple.

Slide 1; total revenues for the second quarter of '06 increased 30% to $1.6 billion, up from $1.2 billion in the '05 second quarter. Slide 2; total deliveries, including unconsolidated joint ventures, increased 26% in the second quarter of '06 to 5,167 homes. Based on our current sales backlog, we are reaffirming our guidance for the remainder of '06 with full-year EPS projected in the range of $7.20 to $7.40 per fully diluted common share. We are also reaffirming our projection of consolidated deliveries of about 19,000 homes in fiscal '06, yielding total revenues of about $6.6 billion. We expect more than 2,000 additional home deliveries in unconsolidated joint ventures, bringing our total deliveries to over 21,000 homes.

Slide 3; we are positioned to achieve our projected '06 deliveries given our strong contract backlog of 13,384 homes at April 30, with a sales volume of $4.8 billion. That's up over 20% from last year. Though our contract backlog remains healthy, previous delays in our home deliveries will contribute to a back-end waiting of our fiscal '06 earnings, with more than 40% of the profits for the year anticipated to be realized in the final quarter. Our ability to achieve projected deliveries is supported by the fact that more than 80% -- excuse me, 85% of expected closings are derived from homes either delivered in the first six months of the year or contained in contract backlog at April 30, and scheduled to be delivered over the balance of fiscal '06. These estimates include unconsolidated joint venture deliveries.

Our second-quarter results, combined with our projection for the remainder of '06, reflects smaller year-over-year profit increases than we had previously anticipated due in part to; one, a slower sales pace over the recent months in many of our markets, particularly as the spring selling season has unfolded; two, due to higher cancelation rates; three, due to more pronounced use of concessions and incentives; four, due to some increased material costs; and five, due to continuing production delays in several markets, causing us to postpone some deliveries. It has clearly been a more challenging environment.

Let me talk about market conditions for a moment. Although our backlog remains strong and we feel confident about earnings for the remainder of '06, our net orders, including unconsolidated joint ventures, declined 19% for the second quarter to 4,342 homes. Based on dollar volume, orders declined 18%. Our net contracts in May have continued at a slow pace. The market clearly cooled significantly and quickly from our first quarter, when we reported sales which were up 22% over the prior year's first quarter. Not only has the sales pace changed, but as the competitive environment for sales have intensified, the use of concessions has intensified in many markets, as well.

Our reported level of net contracts has been further impacted by an increase in our cancelation rates over the past few quarters. As you can see on slide 4, over the past three years, our second quarter has experienced the lowest cancelation rates of the year. That seasonal pattern was not evident this year as our absolute level of cancellations rose, offsetting the pick-up in gross sales. Our cancelation rate in the '06 second quarter was 32%, significantly higher than the '05 second-quarter rate of 21%. Traffic has been reasonable in most of our markets, although down, and our gross orders in the second market, also down, were still respectable, as well. However, after accounting for the above average cancelation rate, second-quarter net contracts were clearly disappointing.

We don't believe that the current slowdown in housing is driven by interest rates. Rates have moved up, but the increases have been moderate, and mortgage rates remain very attractive by any historical measure. The slowdown is also not driven by the lack of job growth. The economy continues to prosper and add significant jobs. It's also not driven by an abrupt reversal of population growth. The trend continues to be very positive in demographic terms. Rather, it seems to be that the slowdown is being driven by two primary factors. First, investors. Investors have largely withdrawn from the market, thereby reducing demand. In addition, they have added to the supply of available homes by listing their recent purchases for resale. This has resulted in a significant growth of the resale listings in many markets. Second, buyer sentiment. Buyers have been bombarded by the media predicting a housing bubble, and now they are seeing builder advertisements touting a variety of concessions and incentives. Not only has the buyer urgency receded, but buyers now believe that a more cautious, slower approach toward a new home purchase may result in a better opportunity. The question is, how long will this excess inventory and buyer sentiment prevail?

Slide 5 displays the level of monthly resale listings over the past few years for the Orange County market in southern California. We believe this market went through a glut of resale listings in the summer of '04, as you can see from the slide. It took about five months to burn through this excess inventory to a more normal level. Unfortunately, it has built up once again, as it has in other parts of the country. Based on our '04 experience, we believe the market can correct relatively quickly, particularly with positive job growth in a supply-constrained market. Buyer sentiment, as we've learned, can shift quickly in both directions.

Slide 6 shows the same data for the greater Washington, DC market, which we think is in the midst of working through investor sales, as well, particularly on the Virginia side. This influx of new homes being resold has significantly increased the supply of homes for sale, competing with a new home market and cannibalizing new home sales. Similar resale conditions exist to varying degrees in most of the regulated markets where significant price increases were occurring, thus luring in investors, including markets like San Diego and most of the Florida markets. It's difficult to say whether the excess inventories will burn off as quickly as they did in Orange County in '05, but a positive economic environment with solid job growth is clearly going to help. One positive note. Sometime around October of last year, investor home purchases began to drop dramatically. In fact, by the beginning of this calendar year, investors were virtually gone from the market. While painful from the demand standpoint, it's unlikely that investor resale listings are going to increase since they stopped buying the homes to resell.

We aren't sure how long the softer markets will last, but we are taking actions as though the slower conditions will be the norm for a while. So let me just quickly mention some of the actions that we are taking in a variety of categories to react to the current market. First, with respect to our land pipeline; for our existing land option contract, we are reevaluating the economics of many of our transactions and renegotiating wherever it's appropriate, based on the market absorption pace or pricing. We've achieved some success in negotiating -- renegotiating many of our contracts, but we've also walked away from some contracts that we couldn't renegotiate to a price or pace that made sense for us. The total amount of pre-tax charges that we incurred in the second quarter related to foregone land transactions was approximately $5.6 million, equivalent to about $0.05 per fully diluted share of net earnings. We found most sellers to understand the market situation and are working with us to renegotiate for realistic terms.

Renewed land transactions that are under consideration; we are applying current net prices, current sales paces, and current construction costs. If it meets our IRR hurdles in those conditions, then we are proceeding. Each land deal has got to work based on today's selling environment, and if obviously, the conditions improve we'll do a little better than our hurdle rates. But we are making transactions that work in today's environment. The good news is that land sellers are finally becoming more reasonable in many cases, terms are getting better, prices are becoming more negotiable. That was a correction that has been long needed on the land side. Private builders are pulling back significantly. And in some cases, feeling pressured to sell properties because of cash flow issues.

In a completely different area, we're also taking steps to enhance our sales by marketing homes aggressively and competitively. These steps include increasing our sales training. This is no longer an environment where salespeople are just taking orders as buyers walk into the sales centers. Larger builders with an established training infrastructure are in a better position to do this. Where appropriate, we're taking more -- or making more aggressive use of incentives, concessions, or repricing. The decision to trade off some amount of price incentives versus velocity is one that we make on a community-by-community basis every week as we monitor our traffic patterns, sales contracts, and the sales of our competitors in the market. Another way we are driving increased traffic to our communities is by increasing our advertisements. Unfortunately, you can see that in our increased SG&A. When buyers are scarce, you have to advertise a little more to make sure you're getting your share of a smaller buyer universe.

A third area that we're taking action is with respect to costs. We are operating with tighter management review of all of our overheads at all levels. In addition, we're focused on a number of ways to reduce our construction costs. These methods include further value engineering of our home designs. It also includes reducing specifications in some areas for finish items on homes. During the strong markets with extremely low rates, buyers were piling on features and options like marble countertops and upgraded cabinets, and we began to include many of these items as standard features in some models and communities. We're now reversing that process in certain locations and making them options again to enhance the affordability of our homes. Another way we are reducing our construction costs is by renegotiating with our subcontractors. We believe there is definitely a significant opportunity in this area. Like the home builders, subcontractors enjoyed great margins during the last few years. They, too, will have to reduce their expectations. As the smaller, private builders are beginning to stretch out payments to the subcontractors because of cash flow issues, the subcontractors are pursuing the business of the better capitalized public builders even more aggressively with favorable pricing.

Why do we believe the markets will come back? We believe higher cancelation rates and the increased resale listings and sales incentives are conditions that will self-correct in time as those markets absorb the increased level of available resale homes, and as consumers become convinced that the correction has occurred. Despite the negative impact these conditions have had on new home sales over the past six months, we remain encouraged that the long-term fundamentals of housing remain solid, supported by job creation and household formation. One of the reasons that we remain optimistic is because of the strong economy. Historically, job creation and GDP growth have been very important to the health of the housing industry. As you can see on slide 7, every major downturn in housing activity since 1970 has been associated with an economic recession, as indicated in the shaded years. This was also true prior to 1970. While economists have different estimates for where unemployment and GDP growth will be over the next several years, few economists are predicting a significant slowdown or recession. The most recent data for GDP growth for the quarter was a very healthy 5.3% increase over '05 on an annualized basis. Many investors interpret this as bad news for housing because they believe it will lead to more pressure on mortgage rates, but they're missing the fact that a stronger economy generally bodes well for housing.

Slide 8 shows the ratio of job growth to housing permits nationally for the past 20 years. Whenever this ratio is above one, meaning more than one new job per every new building permit, it's a good indication that the market needs to produce more housing to keep up with underlying demand. Historically, the correlation between job growth or GDP growth and housing activity is very strong. The two big dips on this chart are associated with economic slowdowns which normally would have also been tough times in the housing industry. The first on this chart started in the late 1980's and bottomed out in 1991. During this period, housing starts fell each year from the peak in '87 through '91. These were very difficult times for the US economy and also for the housing market. The country was in the midst of a national recession, and the housing market was distressed as jobs fell, reducing demand, and pressuring home sales and pricing. Other negative factors aggravated the housing downturn, including the 1986 Tax Act, and the actions of the RTC aggressively dumping residential product on the market. Excess supply in that cycle was exacerbated by lax thrift industry lending standards and easy developer money in which little equity was required.

In contrast, the '01 recession was milder on a national basis, as housing was spared from the downturn that would have otherwise occurred, we believe largely due to the accommodative actions of the Fed in lowering rates to historical trough levels following both the tech-related downturn and the events of 9/11. In addition, the more regulated housing markets were protected by a fundamental undersupply which buffered the effects of falling demand created by job losses. However, certain low barrier markets where job losses were more severe like North Carolina, Texas, and Denver experienced declines in housing starts and very competitive pricing to attract buyers. These conditions prevailed in those markets through '03 and '04, even as the national press was generally conveying the impression that all housing markets were booming during these years. The graph shows that we are in an up-cycle for job creation on a national basis, providing an underpinning of support for housing demand. This economic backdrop is one of the reasons for the confidence we've expressed in our outlook for the balance this year and beyond.

In addition, long-term housing demand is driven primarily by the demographics of household formation, which is -- which are projected to be strong for at least the next decade. Most independent forecasters, like the Harvard Joint center for Housing Studies and at Brookings Institute, agree that new housing units in the range of 1.8 to 2 million annually are required to meet the population growth and associated household formation, along with a certain predictable level of demolition and replacement of older housing stock. These are levels that are higher than prior demand of the prior decades. So we do not view today's market conditions in the same light as prior housing downturns associated with economic contractions. We believe that many of the more regulated markets will return to a healthy sales pace once the overhang of investor resales dissipates over the coming year and buyer sentiment switches back.

Our companywide sales pace of net contracts in the second quarter was still almost 11 contracts per community, just a bit less than one contract per week. The quarterly comparison with last year was quite a bit off because in each of the past two years, we experienced an extraordinary pace of 16 contracts per community in our second quarter. Those extremely strong sales conditions were driven by a variety of factors including low rates, fervent consumer sentiment, and, unfortunately, by investor purchases in many markets that were driving excess demand marketwide, even while the bigger builders were taking actions to limit such sales in our communities. I believe investor activity, which is very difficult to track accurately, was far greater than anyone expected.

The point is that sales have declined, but they haven't stopped. Buyers are continuing to buy houses at a reasonably healthy level, although it is clearly more competitive than it was in the past. And in this environment, we can continue to achieve healthy margins and returns, just not at the levels that we realized with the tailwind we've had over the past several years. We believe we can continue to hit or exceed our minimum return hurdles targeted for our new land acquisitions, which means that our return on beginning equity should still be above 20%. While that doesn't match the 40% returns we were getting, it would still be well above the average for the S&P 500. In fact, our projections for '06 still imply a return of -- on beginning equity of almost 30%.

As we look out at our plans for communities that will open over the next six months, we expect to have approximately 440 communities open for sale by the end of fiscal '06, as shown on slide number 9. Our future growth will come as we expand our community count through further product segmentation, expansion of our active adult product to new markets, and further geographic penetration of our stronger markets, even though we are selling and delivering fewer homes per community. Many of those new communities were -- were purchased under option contracts dating back several years, so they are projected to generate solid returns, even with sales paces below the peaks -- and sales prices below the peaks that were realized six months or a year ago. These markets provide -- these market corrections provide excellent land opportunities for those well capitalized public builders who will likely accelerate market share gains.

I'll now turn it over to Larry Sorsby to discuss the financial performance and projections in greater detail.

Thank you, Ara. We provided a fair amount of detail on our second quarter results in our press release and on our Web site, so I'm not going to spend a lot of time going over all of the specifics. Our second quarter results are summarized on slide 10. Despite a 30% increase in total revenues, our second quarter earnings per share declined 4% due primarily to lower home building gross margins, which were 23.7% for the second quarter prior to interest and cost of sales, compared to a very strong 26.4% in last year's second quarter. We had anticipated this decline in second quarter gross margins in our budget at the outset of the year. We also experienced an uptick in total SG&A as a percentage of total revenues at 11.3% in the second quarter versus 10.1% in last year's second quarter. I'll give you some more color on these factors in just a moment.

If you'll turn to slide 11, I'll make some additional comments on our projections for fiscal 2006. Details of our summary projections for fiscal '06 are already available on the financial information page of the Investor Relations section of our Web site at khov.com, and we have been -- and they have been posted there since we updated our 2006 guidance at the beginning of May. Our projections were set at that time, and the details that I will provide were factored into the $7.20 to $7.40 EPS range that we've been projecting for this year. We anticipate that the average sales price per home, excluding unconsolidated joint ventures, will be between $335,000 and $338,000 in fiscal '06, compared to $318,000 last year. The expected increase in average sales price in our markets is primarily the result of geographic and product mix of our deliveries, rather than an ability to increase home prices. This price range also takes into effect incentives offered on contracts and backlog and currently being offered for the homes we anticipate selling and delivering in the remaining six months of the year.

Based on the homes that we plan to deliver between now and October 31, our home building gross margin should be in the range of 24% to 24.5% for the full year, prior to interest and cost of sales. This would represent a decline of 190 to 240 basis points from our 2005 gross margin. With our initial guidance for 2006, which we publicly disclosed in December, 2005, we projected the decline of 140 to 190 basis points in gross margin, as a result of not factoring in any further price appreciation and the sell-out and replacement of communities with inflated margins. We now expect an additional 50 basis points decline, due to more prevalent use of incentives and increases in land development and other costs. We expect our gross margin in the third and fourth quarters to be similar to the level we achieved in our second quarter.

I can also give you a bit more color on how we see the last two quarters of the year unfold in terms of deliveries and earnings. We expect earnings in the third quarter of approximately $1.40 to $1.50 per fully diluted common share, with a balance of the year's earnings projection in the fourth quarter. As we stated on our first- quarter conference call, a particularly large number of our annual deliveries, in the range of 30% to 32%, are projected to occur in the fourth quarter this year. We expect consolidated deliveries in the range of 4,600 to 4,900 in our fiscal third quarter.

As we anticipated in our prior public announcements, profits from land sales in the first half of the year were significantly more than the first half of fiscal 2005. For fiscal 2006, we are now projecting that total after-tax land sale profits within a range between $31 million and $33 million, compared to $21 million of after-tax profits from land sales in fiscal '05. This projected amount of land sale profits is included in our fiscal '06 guidance. The increase in land sale profits has to do with a few larger developments that we have undertaken where we have strategically decided at the outset to sell some portion of the community to one or more other home builders. These are typically locations with higher land costs so sales proceeds are becoming slightly more significant. Although we budget land sales, the specific quarterly timing of the closing of these land sales is often hard to predict. Our fourth quarter is a good example this year. We projected several land sales to occur in the final three months of 2006, totaling approximately $20 million in after-tax profits or about $0.30 per fully diluted common share net earnings. With these transactions expected to close in our fourth quarter, if some or all of these land sales slip a month or two, it will have an adverse impact on our full-year earnings.

We anticipate our total SG&A expense, including corporate overhead as a percent of total revenues, will be in the range of 10.2% to 10.5% of total revenue for the full fiscal '06, compared with 10% in fiscal '05. The modest increase in total SG&A expense we are experiencing is a result of a few issues; increases in professional fees, including Sarbanes Oxley compliance costs, stock option expenses under the newly implemented FAS-B rules, and increases selling, overhead and advertising expense, some of which is in reaction to slower market conditions, and some of which is associated with launching a number of new community openings.

For the remainder of '06, we continue to expect our effective tax rate to be approximately 38%. Our second-quarter effective tax rate was approximately 36%, as a result of the unanticipated resolution in our favor of a prior year's tax return item. This item equated to about $0.03 of earnings per fully diluted share in the quarter, and thus, is largely what allowed us to exceed the high-end of our guidance range for the second quarter.

For '06 second quarter, our income from unconsolidated joint ventures was $9.5 million, compared with $7.1 million in last year's second quarter, primarily due to income from the Town and Country joint venture which closed on March 1, 2005, and thus was not in place for the full 2005 second quarter. Our investment in unconsolidated joint ventures increased modestly in the second quarter to $212 million as of April 30, '06, from $196 million at January 31. While a good deal of our reported net contracts and deliveries in our unconsolidated joint ventures for the quarter came from our Town and Country joint venture with Blackstone, we've also had some significant individual community joint ventures, including certain highrise and midrise developments that have lumpy deliveries which will all occur in one or two quarters. The influence of these developments tends to cause significant variations in joint venture profits from one quarter to another. We are projecting total pre-tax income from unconsolidated joint ventures to be in the range of $25 million to $30 million in fiscal '06, versus $35 million that we reported in fiscal '05.

Our financial services operations continue to add to overall earnings. If you'll turn to slide 12, our pre-tax earnings from financial services increased 37% to $12.4 million in the first half of '06, compared to pre-tax earnings in the prior year's first half of $9.1 million. For the full year, we expect pre-tax earnings from financial services to be greater than $28 million. Turning to slide 13, our recent data indicates that our customers' credit quality remains quite healthy. We experienced higher FICO scores in the second quarter compared with all of fiscal '05. And we saw a declining use of ARM's at 32% of our originations, versus 40% for the full year in fiscal '05.

I'll now turn to our balance sheet and credit statistics, which remain very healthy. EBITDA decreased slightly during the second quarter and the first half of 2006. In this year's second quarter, we covered interest by 5.5 times, and we expect to cover interest by more than six times in fiscal '06. The ratio of total debt to EBITDA is expected to be less than 2.2 times as of the end of fiscal '06. EBITDA represents earnings before interest expense, income taxes, depreciation, and amortization. A reconciliation of our Company's consolidated EBITDA to net income can be found as an attachment to our quarterly earnings release.

We ended the quarter with a ratio of net recourse debt to capitalization of 50.6%, and the April quarter end is typically near our seasonal peak for our Company. We anticipate that our average ratio of net recourse debt to capitalization will be at or below 50% on average for the full year of '06. This level is in line with our targeted leverage goals. In short, all of our credit statistics remain at very attractive levels.

I'm also pleased to announce that just yesterday we successfully closed an increase in extension to our unsecured revolving credit facility. We increased the commitment amount of the facility to $1.5 billion, and we extended the maturity to five years or to May 31, 2011. Additionally, assuming no material changes in market conditions, in order to reduce outstandings under our revolver, we contemplate issuing senior notes in the very near term.

At April 30, 2006, as shown on slide 14, common shareholder' equity was $1.84 billion, a 34% increase from the $1.37 billion at the end of the second quarter '05, continuing a very healthy growth trend. Based on our current projections for fiscal '06, we expect common shareholder' equity to grow to approximately $2.1 billion by October 31, 2006, which is equivalent to about $34.50 of book value per share. Our shares are currently trading below projected year-end book value, as you can see on slide number 15.

Our current land position provides us with excellent visibility for our forward projections of deliveries and earnings. As slide 16 displays, we controlled at quarter end on a consolidated basis, 121,829 home sites in our various home building markets for future developments. This excludes 8,455 lots that we controlled through our unconsolidated joint ventures. Approximately 72% of our lots are controlled under option contracts, which minimize our risk exposure to any significant decreases in the value of land. Out of all the large public builders, we have one of the highest percentages of land controlled through options. We believe that this strategy gives us a tremendous competitive advantage of being able to renegotiate terms such as lot or phase takedown schedules with sellers or even the purchase price on the land if we're not able to achieve the sales pace or pricing that we anticipated in a particular community.

Turning to slide 17, it shows our aggregated option position for all of our lot options and the amount of aggregate deposit, which represents only 8.7% on average of the total purchase of the lot. Excluding model homes, we had 2,979 started and unsold homes at the end of April. Based on our recent sales pace, this represents only about a 10-week supply of started and unsold homes and is equivalent to only 7.2 unsold homes per community that have been started. Completed homes only represents a tiny fraction of that unsold inventory.

With regard to stock repurchase activity, we bought back 150,000 class-A common shares during the second quarter, and an additional 200,000 shares to date in the third quarter, bringing our year-to-date total to 500,000 shares. This leaves our current repurchase authorization at just under one million shares. We will continue to repurchase shares but only at a measured pace, which more or less offsets the shares that are issued either through options or stock plans that many of our senior executives participate in. Although our stock is severely undervalued, we intend to maintain the pace of share repurchase program at this time. Should we slow our land purchase activities, which will happen if we're not able to find adequate land opportunities that satisfy our hurdle rates given today's market conditions, we would generate excess cash, which we would first apply to reducing debt and deleverage a bit once we achieved a lower level of leverage with some excess room in event growth opportunities presented themselves again, we would consider allocating more capital to share repurchases.

I'll now turn it back to Ara for some closing comments.

Thanks, Larry. In summary, while the first half of '06 was not as strong as we anticipated last year, we believe that given the size of our backlog, the capabilities of our construction operations will allow us to achieve our projected growth in deliveries and EPS in '06. Beyond '06, a disciplined execution of our strategic plan will allow us to continue to generate healthy returns, even in the face of a slower sales environment. We understand that Wall Street is concerned about the slowdown in housing sales that has been occurring, but we believe the market has overreacted to the likely magnitude and effects of the slowdown in our current valuation of our stock price, as well as the stock prices of most of our peers in the industry. As Larry indicated, our shares are now valued below our projected year-end book value. We are currently trading at about 4.4 times this year's projected earnings. If the most dire outlook occurs and earning are cut in half next year, well below consensus estimates by the way -- even if earnings were cut in half, we'd be trading at about 8.8 times earnings. While returns for our industry will not continue at the same level they were, even at a slower sales and pricing environment, the returns should still look quite favorably -- favorable compared to the S&P 500. I believe our stocks will prove to be a great value.

That concludes our formal comments, and I'd be pleased to open up the floor for questions.

The Company will now answer questions. [OPERATOR INSTRUCTIONS] Your first question comes from the line of Michael Rehaut. Please proceed.

Hi, this is [Jen Consolly] on the line for Mike. Just a couple of questions regarding -- perhaps you can provide some more regional color as far as if you've seen any of the inventory levels pulled back in any specific markets?

Inventory levels in terms of resale listings or -- ?

Yes.

No. I'd say -- I think we are seeing them level off in some markets, but it's -- it's too early to tell that for sure. On the whole, I'd say the markets are somewhat similar. I think there is maybe more issues in the highly regulated markets that saw the biggest price increases, a little less issue in some of the less regulated markets like the North Carolinas or Texas', etc.

Okay. As a follow-up, can you detail some of the assumptions underlying your implied 4Q earnings growth, particularly in the area of gross margins?

I think I gave a lot of color on that in terms of our -- our outlook for the -- for the year, in terms of gross margins. I don't know that we can give much more color than we've already given.

Yes. Essentially, by the way, the gross margins, as we mentioned, most of it is in backlog, and our projection for the fourth quarter is basically driven largely from that. As you saw, we gave you the projections for the full year on gross margin. You know what they've been for the first six months. So it gives you relatively close guidance in that regard.

For the full year, we expect in the 24% to 24.5%.

Jen, this is Kevin, in case you missed, Larry did comment that we expect them in the third and fourth quarters to be similar to the level of what we just reported in the second quarter.

Okay. Great. That's helpful. Thank you.

Your next question comes from the line of Margaret Whelan. Please proceed.

Actually, it's [Dave Colberg] on for Margaret. Nice quarter, guys. My question was really about land purchasing, and to make sure I understand, are you currently seeing a slowdown in land purchasing? And if so, is that concentrated in certain markets that are not [pencilling], or is it kind of nationally?

I'd say we're seeing a current slowdown, really nationally, in new land purchases, which is good. But essentially, to make the numbers work today, it -- if you're really disciplined and apply a slower absorption and the lower net prices, sellers have to back off the price. They are slowly doing that but reluctantly and slowly. And that's why land purchases by us and others are slowing until the land market comes down to make reasonable returns for home builders.

So I guess the follow-up question would be, do you expect that you're going to be free cash flow positive this year, given that you're putting less money in land, and then -- ?

Well, keep in mind, as we contract land -- we don't typically enter a contract today for property that we're going to be buying the next quarter. There are often entitlement issues that take time. There is land development issues sometimes by the seller if we're buying developed lots. We don't anticipate a big change in our current land purchases. And we're fairly confident that the land market -- we've seen this many times before. The land market will correct, and we have enough of a land position that we think it's not going to interrupt our flow of properties as we need it. If the market does continue to be soft, then, yes, we would generate more excess cash flow and effectively we'd be delevering the company. And as Larry mentioned, in that delevered position, I think we'd, number one, keep some extra powder dry because we've seen this plenty of times. There are great opportunities that got created in these market conditions. So we don't want to be overly cautious and -- and not -- not have our equity available. But number two, if it does -- those conditions do prolong, we will get even more aggressive with our stock purchases, which at the -- at the moment are to the tune of a million shares a year if annualize what we've done so far.

And deleveraging.

Yes.

Right. I guess the question would be then, is it more a focus on M&A activity first, after you delever the balance sheet? It just seems like the stock is so cheap and it's selling below book value that maybe putting more capital -- delevering the balance sheet, you might be more focused on buying back shares -- more capital that way.

It is clearly something we think about. It is something that is tempting. I know a lot of people were pushing us to do it six months ago. Obviously, in light of what's happened with stock prices, I'm glad we didn't. But frankly, from the longer term perspective, we are convinced there will be opportunities created in this kind of environment. We're seeing -- and we want to keep plenty of powder available. If we buy back $100 million of stock, our equity goes down $100 million, and if you maintain one-one debt-to-equity ratio, that means we'd have to forego $200 million of investments. We think there will clearly be opportunities out in the marketplace.

Private home builders -- and as you know, we have been inquisitive, so we see the balance sheets of private home builders. There are many highly levered private home builders out there that are definitely feeling pressure from the banks and are getting some cash flow issues. That will create opportunities, both in land that they do not purchase, land that they're forced to sell, and, in some cases, they decide that life is too short, and they -- they may decide it's time to sell their companies. We are seeing more opportunities for small, private home builder sales than we've seen in a long time. At the moment, we're continuing to be particularly conservative in new Company acquisitions, but we can see ourselves being more aggressive in -- in the future, and we want to keep plenty of capital around for it. We think it's definitely a great time to increase our market share. And we think that will probably be true of all the public builders.

All right. Thank you.

Your next question comes from the line of Alex Barron. Please proceed.

Thanks, guys. Hoping you can give us your community count by region. I don't think that you did that in the presentation.

Normally do that, guys?

It's in the Q. I don't know if we have it available as we sit here.

Okay. I'll get from there.

We don't have it at our fingertips at the moment.

Yes. That's fine. Hoping you can elaborate on the margin drop this quarter. Was that something that was due to kind of incentives to move standing inventory? Or did you sort of have to reprice some of your backlog, or what was involved there?

No. Our business isn't rocket science. We projected at the beginning of the year, back in December when we put out guidance for the full year, that we anticipated lower margins. So that was really before the advent of incentives and concessions were taken into account. At that point, I think were 190 basis points was the projection, or so. Since that time, maybe there's been, at least in our projection for the full year, anticipated another 50 basis points or so of incentives and concessions. In terms of the second quarter, Alex, I think the only impact from incentives and concessions would be from cancellations that were resold and actually delivered in the second quarter. I don't think it was all that much in the second quarter from cancellations and that kind of thing. So the majority of it is just the fact that we have more expensive land that came through compared to a year ago.

Got it. And as far as the land write-offs and where you guys are kind of more focused on renegotiating your land options -- can you give us some color on what markets you guys are more focused on that?

Any market --

All markets. We're really taking this market opportunity to carefully revalue -- reevaluate all of our properties. And we think -- well, frankly, we've been successful in opportunities in renegotiating across the country.

Okay. Do a lot of your land options, are they just with land developers and -- and farmers and that kind of thing? Or are they -- to what degree are they with land bankers?

Very little is land bankers, historically. I think you can count on probably on two hands, maybe three hands of the 600 or 700 deals that we control across the country that historically have been with land bankers. So the vast majority have -- are with individuals that they inherited land or own land, or professional land developers in markets like Houston or North Carolina, that they take stuff through the approval process and have finished lots delivered to home builders.

Great. Thanks, Larry. I'll get back in the queue.

Your next question comes from the line of Dan Oppenheim. Please proceed.

Thanks very much. Was wondering, when you talked about renegotiating some of the terms on options over the last 12 months -- in the press release you then also talked about the write-down of some other options where you couldn't renegotiate those. Were those write-downs on options that had -- were sort of older than 12 months, that were closer to where you would actually start construction? And so just, if you could walk us through the difference terms, what was renegotiated and where the write-offs -- ?

Well, first of all, I think the ones we decided to write-off were relatively new options that had only been in place about 12 months or so. That means that they were purchased when the market was still strong and when house prices were quite strong. The older options, frankly, are in pretty good shape. The pricing was much more conservative then. It was underwritten at lower pricing. So there is less of an issue in those cases.

I think there was a second part to your question. I'm not sure I remember.

Been wondering -- you talked about May remaining slow in terms of the pace of sales. Have you seen that both from a gross order and from a cancellation standpoint?

Yes, I think that's a fair comment.

Okay. And what -- finally, what would it take in terms of the -- the market trends with slower sales to get you to the point where you would want to reduce debt and sort of just really slow down the land growth?

Well, I mean, I think that's a deal-by-deal, community-by-community decision that we make, as we analyze existing land deals that an option payment is coming due on or we look at a new land parcel, in terms of simply tying it up for the first time. If we're unable to achieve our 30% unlevered IRR rates, we won't pursue it. And if we don't pursue deals, we'll be a cash machine that's generating huge amounts of cash that we can pay down debt. But as long as we can continue, given the slower absorption rate assumptions or sales per community per month assumptions, for those of you that don't really understand absorption rates, that's what we mean -- increased incentives and concessions that are going in the market today, if we can't use those assumptions and generate our 30% unlevered IRR for a new land deal, we won't tie it up and, therefore, we won't use the capital to tie up land and have it available to -- to do other things such as pay down debt. But right now, we still see opportunities.

Okay. Great. And if I may, one last thing. Your comments about the higher land costs impacting margins this year was interesting, especially with the comments, just recently, in terms of the older options. If you look to fiscal '07, what sort of impact are you expecting from higher land costs, maybe not so much just to margins, but what would you say your average lot costs would be up year-over-year at that time?

I don't have a number in mind. But Dan, if you just think about it logically for a second -- for the last five years, I would say -- land that we controlled five years ago is worth X dollars a lot, land that we controlled four years ago is X-plus-Y dollars per lot, land that we closed -- controlled three years ago is X-plus-Y-plus-Z per lot, it was just going up. Older land that we controlled is cheaper than newer land that we controlled.

We can't give you a figure on '07 yet. It's a little early at the moment.

Thanks very much.

Your next question comes from the line of Carl Reichardt. Please proceed.

Morning, guys. How are you?

Good, thanks.

I'm sorry if I missed this. The $5.6 million in deposits write-off, specifically where was that, Larry?

There were -- primarily two parcels, one in -- in Minnesota and one in Florida. Both of which woe controlled within the last 12 months.

Okay. Great. Then I have a broader question for you, Ara. You walked through in some detailed, basic business strategy of dealing with the slower conditions. I'm curious where you think your strategy is specifically different from the other public home builders now, either more aggressive or -- or more, I don't know, liberal or conservative? What specifically do you think that you were doing that is different than the strategies the other public builders have undertaken to deal with the slowdown?

Oh, frankly, I think most of the public builders right now are dealing with the condition somewhat similarly. I mean, the larger publics, there is a difference I think in the larger publics versus the privates. The larger publics are clearly in a better position to deal with it. But I -- I'd say, we're all doing many of the same things.

Okay. I'm going to ask a third question, sorry. I just -- in terms of the cancellation rate generally, Larry, would you agree that the increase in cancellation rates -- just the time between the initial deposit and the time that the cancellation occurs is longer than it has been in the past, so the house is deeper into the construction process?

I think what I would agree with, because we don't track it exactly like you said, is that we're seeing later cancellations that surprise us. Some of them are cleverly disguised investors that we didn't think were investors that, in essence, fib to us. So yed, I think on average, your assumption is probably reasonable.

Okay. Terrific. Thanks a lot, guys. Appreciate it.

Okay.

Your next question comes from the line of Ivy Zelman. Please proceed.

Good afternoon, this is [Justin] on for Ivy. Just a few questions. One on your option contracts. How many of those did you renegotiate in the quarter? And how many did you walk away from?

Well, as we mentioned, we walked away from about two of the larger ones. There were some smaller ones. But we just don't track every single one that we renegotiate. So I can't have that statistic.

Okay. Was it, as a percentage of your total lots controlled, was it -- ?

It would be over, I don't know -- I mean --

It wasn't a dramatically high number. It really started to occur in the second quarter.

Yes. But we renegotiated a lot more than we walked from, let's put it that way.

Right. And how much, in terms of dollars and deposits did you put down on -- on these lots for 2004 or 2005?

Well, I -- I'll give you the average that's in the -- the backlog, and we do it every quarter. So that's about the best data that we can give you. Our average deposit was 8.7% for all 121,000 lots that we control. In some markets, we do a 2% or 3% deposit. In other markets, it's 10% or 12%. On average, it's 8.7% as of the end of April.

All right. In regard to your inventories then in the quarter -- how much of that was on raw, underlying land? And how does that compare to last year?

Again --

Something we don't track.

We just don't track that.

Okay. And --

The only thing we have is that you can look at what our planning number is on our balance sheet.

Right. Now when you look at that -- where are you buying land, is it -- can you talk about -- are you using your current, more conservative assumptions? Did you use those in the quarter? And maybe talk to some of those markets where there are compelling deals.

If we have a take-down requirement under an option, or if we're looking at a new land parcel to control for the first time, in both of those situations, we -- we look at it in light of today's market environment before making the decision whether to take down an existing option take or whether to tie up a new land parcel.

And in fairness on a -- we're stricter on a new land parcel, where we don't have any deposits up. And on an existing option, it may dip below our 30% hurdle, but given that we have deposits in it and things are proceeding and ready to go, we're more likely to move forward there. We'll still renegotiate depending on how far off it may be.

Right.

But we'll be more tolerant of returns that are below our hurdle there. If they're well below our hurdle, then we won't be so tolerant.

Okay. And just a question on the comment made in regard to investors. I think it was your belief that they had largely exited the market. Is there -- I mean, it's difficult to track, as you noted. How do you come to that conclusion?

Well, our -- in the past, we certainly have had -- our salespeople have had many sales inquiries. And just anecdotally, we're hearing a lot less inquiry on the part of investors. And I think a lot of it is, frankly, quite intuitive. I think as people are reading the media today, there is clearly just a lot less interest, a lot less confidence in the appreciation that did exist just a while ago.

Certainly, the amateur investors are out of the market. Some of the professional investors may actually have been out of the market while the amateurs were buying that are now saying maybe it's a much better time to -- to look at it or they may still be waiting. We certainly don't hear nearly the white noise in the last quarter or two about how much interest there are from investors in our homes.

Okay. My last question on the gross margin deterioration, how much of that -- how much of the deterioration was a result of purchase accounting?

I don't have that exact number, but it certainly impacted us. You can see how much we had in intangible write-offs as a line item. You can't see what the impact on gross margins were in terms of when we did the step-up. But it was not an insignificant amount.

Thank you.

Your next question comes from the line of Timothy Jones. Please proceed.

Good morning. Can you hear me? Hello?

Yes, hi.

You can hear me?

Hello. Yes, I can hear you.

Okay, thanks. A couple of questions. First of all, could you give me an idea of the last four months, how -- how the sales went? I mean were the -- did they deteriorate through the month? Did they bottom out during the quarter? And you said, of course, that May was also slow. Can you give me sort of a -- a trend of what's going on there?

I mean -- we don't give monthly data, Tim. We give quarterly data. That's what all the competitors are doing, I think it gives a pretty good indication. Things -- things have definitely slowed. And it changes abruptly. As I mentioned, first quarter we were actually up over 20%. So, you can see that it changed fairly --

But going to that, I mean, that is enormous. You had one of the best sales gains of any builders in the first quarter. Obviously, helped by your three acquisitions. But you still had those three acquisitions for most of the quarter. This -- why such a dramatic turn-off for you between the first and the second quarter? I would have thought the first would have been less. And --

I think the bigger question is -- is why did we do so very well in the --

That is the question.

-- the first quarter? And frankly, the acquisitions, helpful, were not there -- did not have that big of an impact. We just had a particularly strong first quarter. I'm not sure I can really answer why we performed so well compared to everybody else. I will say that our sales for the second quarter while down at 18% or 19%, for whatever reason, I'm sure there are many; we fared better than some reports you heard from other public builders. So we did a bit better in the first quarter. We did a bit better in the second quarter. It was down, but we did better than some of our competitors. And obviously, there are a variety of reasons why.

There's really only one acquisition that was there for the full quarter that -- that we got a benefit for the full quarter. That was our First Homes acquisition out of Fort Myers, Florida. The other two I think closed in -- in early March or even February last year. So they didn't have a full benefit from an acquisition perspective this quarter. And frankly, the Fort Myers -- of all the markets in the country, I would say that Florida is the one that's been the most impacted, in terms of slower sales activity. So that Fort Myers really didn't help us much at all for the quarter.

Yes -- I will say that I think our broad product diversification has helped us a bit. We have seen in a variety of markets, sometimes the high end is a little more slow for a while, sometimes. The condos are a little more slow. But we have a broad product array, and I think that, to some extent, has helped our performance.

I -- I love you saying this because I just bought a how last week in Naples. Anyways, you've also been saying on First Builders, that you were actively cutting back your orders because of the large backlog. Is that true or not?

We were able to stop actively cutting back. The market kind of did that. What I will say is our backlog there still -- frankly, we've got all of '07 in backlog. And unlike some backlog, there the majority of our customers have already closed on the lot, and we're doing construction for them. So they're very solid backlog homes.

But in any case, we were at a point there for a while, where we were selling 400 homes a month and delivering 150 homes a month, and the backlog was just getting out of control. So we -- I wouldn't say we purposely pushed it back. But let -- let's just say we took no steps to further encourage sales. And as sales slowed down a bit, unlike what we did in other markets and tried to respond and put in some incentives, we were much slower to react there. Just because we have so much backlog. And frankly, it's one of the only markets I can say that about that we haven't been reactive, and it's just because of the unusual circumstances there.

The other question is Larry, you said you took up your -- took down your gross margin by 50 basis points just in the last couple months, due to higher land and higher materials. Can you give -- give me some more color on that -- which is land, materials, whatever -- ?

That's not what I said.

Oh, I'm sorry.

I said that in December, when we gave guidance for the full year, we were projecting a 190 basis points decline in margin, roughly. That primarily was the result of higher land costs that were going to be coming in in '06 versus the land that we had in -- in '05.

Okay.

Now we've all assumed zero home price appreciation, and we were at that point, too. Not only have we not gotten home price appreciation, which would obviously cause -- the margin deterioration to have been less, which is what's been occurring in prior years, we now are faced with having to add incentives and concessions to sell our homes. And what I said was, that we increased the deterioration and margin projection from roughly that 190 to 240 basis points decline in margin projection. Primarily or almost exclusively due to the increased use of incentives and concessions.

Okay. I didn't understand it.

That's for the full fiscal year, not for a particular quarter.

Okay. I mean, you're just taking the incentives off the -- the price of the house. That's what will affect the gross.

Yes.

Thank you.

Yes.

[OPERATOR INSTRUCTIONS]

Great, well, thank you very much. We appreciate your participation. We look forward to reporting our next quarter in the near future.

This concludes our conference call for today. Thank you all for participating, and have a nice day. All parties may now disconnect.