Hovnanian Enterprises Inc (HOVNP) 2012 Q3 法說會逐字稿

Good morning, and thank you for joining us today for Hovnanian Enterprises' fiscal 2012 third-quarter earnings conference call. An archive of the webcast will be available after the completion of the call and run for 12 months. This conference is being recorded for rebroadcast, and all participants are currently in listen-only mode. Management will make some opening remarks about the third-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 website at www.KHOV.com. Those listeners who would like to follow along should log onto the website at this time. Before we begin, I would like to turn the call over to Jeff O'Keefe, Vice President of Investor Relations. Jeff, please go ahead.

Thank you. I'm just going to read a forward-looking statement very quickly. All statements during this conference call that are not historical facts should be considered as forward-looking statements. Such statements involve known and unknown risks, uncertainties, and other factors that may cause actual results, performance, or achievements of the Company to be materially different from any future results, performance, or achievements expressed or implied by the forward-looking statements. Although we believe that our plans, intentions, and expectations reflected in or suggested by such forward-looking statements are reasonable, we can give no assurance that such plans, intentions, or expectations will be achieved. Such risks, uncertainties, and other factors include, but are not limited to, changes in general and local economic and industry and business conditions, and impacts of the sustained homebuilding downturn; adverse weather and other environmental conditions and natural disasters; changes in market conditions and seasonality of the Company's business; changes in home prices and sales activity in the markets where the Company builds homes; government regulation, including regulations concerning development of land; the homebuilding sales and customer financing processes, tax laws, and the environment; fluctuations in interest rates and the availability of mortgage financing; shortages in and price fluctuations of raw materials and labor; the availability and cost of suitable land and improved lots; levels of competition; availability of financing to the Company; utility shortages and outages or rate fluctuations; levels of indebtedness and restrictions on the Company's operations and activities imposed by the agreements governing the Company's outstanding indebtedness; the Company's sources of liquidity; changes in credit rating; availability of net operating loss carry-forwards; operations through joint ventures with third parties; product liability litigation; warranty claims and claims by mortgage investors; successful identification and integration of acquisitions; significant influence of the Company's controlling stockholders; changes in tax laws affecting the after-tax cost of owning a home; geopolitical risks, terrorist acts, and other acts of war; and other factors described in detail in the Company's annual report on Form 10-K for the year ended October 31, 2011, and the Company's quarterly report on Form 10-Q for the quarterly period ended April 30, 2012. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances, or any other reason. With that out of the way, I'll now turn the call over to Ara Hovnanian, our Chairman, President, and Chief Executive Officer. Ara, go ahead.

Thanks, Jeff. And thank you all for participating in this morning's call to review the results of our third quarter and nine months ended July 2012. Joining me today from the Company are Larry Sorsby, Executive Vice President and CFO; Brad O'Connor, Vice President, Chief Accounting Officer, and Corporate Controller; David Valiaveedan, Vice President of Finance and Treasurer; and Jeff O'Keefe, Vice President of Investor Relations.

On slide 3, you can see a brief summary of our third-quarter results and comparisons to the prior year's third quarter. All in all, we had a solid quarter by every metric. Our net contracts increased 32% on a dollar basis, and the number of contracts were up 19%. Although we opened 22 new communities during the quarter, our community count declined slightly to 194, compared to 202 at the end of July last year. This decline was primarily due to selling through communities much more quickly than we anticipated with our solid sales pace. Compared to this year's second quarter, we had a decrease of five communities sequentially.

The dollar value of our contract backlog and total revenues both rose more than 35% during the third quarter. Our land-related charges were significantly lower at less than $1 million. Our gross margin increased 290 basis points, and SG&A as a percentage of sales decreased 390 basis points. As a result, our pretax income improved dramatically, just shy of breakeven, at a loss of $1.8 million, compared to a pretax loss of $56 million the year before. Our net income for the third quarter was positive $34.7 million, compared to a net loss of $50.9 million last year. The current year includes a $37 million reversal of state tax reserves related to previously uncertain tax positions that have effectively been settled.

Slide 4 shows recent contracts on a monthly and average weekly basis. Each month during the third quarter held pretty steady, with just over 500 contracts. If you look on an average weekly basis, you see that our July pace was slightly lower, but our weekly pace bounced right back in August. Frankly, the normal seasonal pattern would be to show a slight decline each month from the peak spring selling month of March, right on through the summer. As this slide indicates, our sales pace held steady this year, bucking the normal seasonal decline. Given the quality and steady flow of traffic that we have seen in our sales centers, we are feeling pretty good about our sales pace and the prospect for continued success. On slide 5, we show net contracts per community on a monthly basis. Since the beginning of the fiscal year, we had more net contracts per community every month this year than we did over the same month of the prior fiscal year.

Slide 6 shows that based on the first nine months of the year, our annualized net contract pace is 28.7 homes per community. This represents a 35% improvement over 2011 levels, but still far off from a normalized sales pace of about 44 homes per community per year between 1997 and 2002, neither boom nor bust years. So, while 28.7 feels a lot better than 17.7 that we experienced just a few years ago, there's still further to go before we are back to normal. Read this as lots of upside opportunities to come. We ended the third quarter with 194 active selling communities, as seen on slide 7. It's slightly lower than where it was at the end of the second quarter. Due to the industry's rebound and our increasing sales pace, our communities are selling out more quickly and clearly caught us without being able to replenish as fast as we'd like. While this faster sales pace drives increased revenues and profits, as well as improvements in inventory turnover, we're still working hard to increase our community count so we can grow our top line even faster, and we're making some progress.

If you turn to slide 8, we continue to look for new land opportunities throughout all of our markets. Our land acquisition associates have been very busy, which has resulted in a full Land Committee calendar here at corporate. During the third quarter of 2012, we optioned 2,200 lots, bringing the total new land controlled since January of '09 to 19,500 lots in 344 communities. During the third quarter, we spent $117.6 million on land and land development. To put this in perspective, we spent only $118 million in land and land development for the first six months of the year. We're not stretching or reaching in order to buy more land deals during the third quarter. The increased land spend was a function of finding more land deals that underwrote to a 25% plus IRR based on the current sales pace and the current sales prices. The improvements we have seen in home prices and sales paces around the country are justifying higher land prices. This, in turn, causes more land sellers to consider selling, which creates more opportunities for us to buy land while maintaining our IRR underwriting criteria.

Let me now turn to our operating performance, which has improved during the third quarter. Slide 9 shows our quarterly gross margin for the past six quarters. The gross margin was 18.2% for the third quarter of 2012, a 290-basis-point improvement over last year's third quarter. This was the fifth consecutive sequential increase in gross margin. Additionally, the 18.2% gross margin was the highest we've reported for any quarter since the fourth quarter of fiscal 2006. During the third quarter of 2012, there was $17.3 million of impairment reversals related to deliveries, compared to $25 million in the third quarter of 2011.

Some of this 290-basis-point improvement in gross margin is attributable to more of our deliveries coming from newly identified land. During the third quarter, 67% of our wholly owned deliveries were from newly identified land. Given the fact that 85% of our wholly owned open-for-sale communities are from newly identified land parcels, gross margin should continue to edge up as we realize deliveries from these communities. This 290-basis-point improvement gets us even closer to a normalized gross margin. If you look at slide 10, you can see the 20% gross margin that we reported in 2000 and 2001, again neither boom nor bust years, and it's closer to what we consider normal. While we don't expect the sequential increased trajectory that we've seen for the last five quarters to continue quite so steadily going forward, we do expect the gross margin to gradually improve and get back to the 20% to 21% range.

We also made great strides in lowering our SG&A as a percentage of total revenues. The right-hand side of slide 11 shows that in absolute dollars, total SG&A increased by $1.6 million in the third quarter of 2012 compared to last year's third quarter. However, total revenues for the third quarter increased by more than $100 million. So SG&A as a percentage of total revenue for the third quarter, which we show under the bars on the right-hand side, decreased significantly to 12.4%, compared to 16.3% last year. Once again, this illustrates that as we increase the volume of deliveries, thereby increasing revenues, our total SG&A has only minimally increased, giving us tremendous leverage as we grow deliveries. The left-hand side of this slide shows the normalized percentage, which should be in the 10% to 11% range. Over time, we expect further improvements in this operating metric, and we expect to see it get back to these more typical levels. As we look forward, we expect continued improvements on our gross margins and SG&A, which will push us even further down the path of returned sustainable profitability.

On slide 12, we show a rising trend for the total revenues for the past three quarters. On the next slide, slide 13, we see gross margin improving, total SG&A as a percentage of total revenues declining, interest expense as a percentage of total revenues declining, and our pretax loss before land-related charges and gain on extinguishment of debt declining to just under breakeven. When looking at this data, you should focus on the fact that as our revenues, gross margins, and SG&A and interest percentage have improved sequentially, our pretax losses have quickly diminished. Given our high sales pace and backlog, we expect to continue this trend of higher revenues in the fourth quarter.

The key to maintaining sustained profitability for us is to be able to control enough land so that we can continue growing our deliveries and our revenues. We're working hard to replenish our land inventory. While new communities never open quickly enough for our liking, we are having good success with solid new land acquisitions. However, because we're selling through communities more quickly than we originally anticipated, 2013 deliveries are likely to be weighted toward the second half of the year, when our newly acquired land parcels will begin delivery. Now I'll turn it over to Larry, who will discuss our inventory, liquidity and mortgage operations, as well as a few other topics.

Thanks, Ara. I'll discuss the changes in our newly identified land position during the third quarter. The bottom right-hand side of slide 14 shows that total additions during the quarter were 2,200 lots. We also walked away from about 400 newly identified lots. The net result for the third quarter was that our total lots purchased or controlled since January 2009 increased about 1,800 lots sequentially from the second quarter of 2012. An important take-away here is that we are replenishing our land faster than we're using it. In fact, our total owned and optioned lot position increased sequentially by 674 lots in the third quarter.

Turning to slide number 15, you'll see our owned and optioned land position broken out by our publicly reported segments. Based on our trailing-12-month deliveries, we own 3.9 years worth of land. However, if you exclude the 6,826 mothballed lots, we only own 2.3 years of land based on the delivery rate of the past four quarters. At the end of the third quarter, 74% of our optioned lots were newly identified lots, and 26% of our owned lots were newly identified lots. If you exclude mothballed lots, 45% of our owned lots are newly acquired. When you combine our optioned and owned land together, 45% of the total lots that we control today are newly identified lots. Excluding mothballed lots, 60% of our total lots are newly identified lots. Our investment in land option deposits was $40.6 million at July 31, 2012, with $39.4 million in cash deposits, and the other $1.2 million of deposits being held by letters of credit. Additionally, we have another $4.6 million invested in predevelopment expenses.

Turning to slide 16, we show our mothballed lots broken out by geographic segment. In total, we have 6,826 mothballed lots within 54 communities that were mothballed as of July 31, 2012. The book value at the end of the third quarter for these remaining mothballed lots was $128 million, net of an impairment balance of $465 million. We are carrying these mothballed lots at 22% of the original value. Since 2009, we have unmothballed 3,400 lots within 58 communities, including 200 lots in one community during the third quarter of fiscal 2012. Looking at all of our consolidated communities in the aggregate, including mothballed communities, we have an inventory book value of about $922 million, net of $702.7 million of impairments, which we recorded on 111 of our communities. Of the properties that have been impaired, we're carrying them at 24% of their pre-impaired value.

On the balance sheet, you may have noticed the increase in consolidated inventory not owned. The increase was primarily attributable to a land banking relationship that we entered into with GSO Capital Partners LP, the credit arm of The Blackstone Group, during the third quarter. We received $37.1 million from GSO for the initial phase of the land banking arrangement for six parcels of land consisting of 620 lots. GSO has agreed to fund the remaining land-development cost and to deliver these as finished lots to us on an agreed-upon quarterly take-down schedule. The gross margin on these GSO communities are not impacted by the transaction. Despite selling these 620 lots to GSO, under GAAP, the agreement is considered a financing, because we previously owned the land and because of our ongoing involvement.

As such, the inventory remains on our balance sheet as inventory not owned, and the premium paid to acquire the lots will be reflected as other interest expense on our P&L. GSO has also agreed to fund acquisition development cost on additional land parcels totaling up to $60 million. We have already identified and are in due diligence with GSO on sufficient land parcels to fully fund the second phase of our GSO land banking arrangement. In fact, during August, we closed on one additional 136-lot land parcel that is part of this second phase of our GSO land banking agreement.

Last quarter, we received a lot of positive comments regarding the slides we showed that compared our gross margin to the most recent quarter of the other public homebuilders' gross margins on an apples-to-apples basis. So we are showing a similar comparison again this quarter. Slide 17 shows gross margins for us and our peers on an unadjusted basis and therefore does not reflect an apples-to-apples comparison. The gray arrow indicates the year over year change in gross margin for each public builder, and you will note that our 290-basis-point improvement was one of the highest increases amongst our 12 peers. Unfortunately, not all public builders report gross margin the same way. Pulte, NVR, and ourselves include commissions in the cost of sales, while the remaining public builders include all or a portion of those costs in SG&A.

Turning to slide 18, we have attempted to compare all public builders' gross margins on an apples-to-apples basis. To do this, we reduced the gross margins of KB Homes, Lennar, MDC, M/I Homes, Meritage, and Standard Pacific by the same 3.5% that our sales commissions totaled in our third quarter. For builders who publicly report sales commissions or responded to industry surveys, we reduced their gross margins per the amounts contained in their SEC filings or per the estimates we footnoted on this slide. As you can see, once these adjustments are made, our 18.2% gross margin puts us in the middle of the pack. To be fair, we also need to show you a similar apples-to-apples comparison to our peers for SG&A for the most recent quarter. Turning to slide 19, as footnoted on the slide, we reduced SG&A amounts by the same adjustments we made on the previous slide for all public builders who include all or some portion of these sales commissions in SG&A. Once these reductions in SG&A costs are made for our peers, our 12.8% SG&A is just slightly above the 12.4% average for our 12 peers, and we expect to reduce our SG&A ratio even further during our fourth quarter. While we still have further improvements to make in order to return both our gross margin and SG&A ratios back to normal levels, we're pleased with our progress to date.

Now turning to slide 20, the number of started unsold homes, excluding models and unconsolidated joint ventures, increased slightly from the second quarter. We ended the third quarter with 761 started unsold homes. This translates to 4.3 started unsold homes per active selling community, which is lower than our long-term average of about 4.8 unsold homes per community. Another area of discussion for the quarter is related to our current and deferred tax asset valuation allowance. At the end of the third quarter, the valuation allowance in the aggregate was $909.1 million. Our valuation allowance is a very significant asset not currently reflected on our balance sheet, and we've taken steps to protect it. We expect to be able to reverse this allowance after we generate consecutive years of solid profitability and can continue to project solid profitability going forward. When the reversal does occur, we expect the remaining allowance to be added back to our shareholders' equity, further strengthening our balance sheet. Today, we could issue approximately 100 million additional shares of common HOV stock for cash without limiting our ability to utilize our NOLs.

We ended the third quarter with total shareholders' deficit of $404 million. If you add back the total valuation allowance, as we've done on slide 21, then our shareholders' equity would be $505 million. Let me reiterate that the tax asset valuation allowance is for GAAP purposes only. For tax purposes, our tax assets may be carried forward for 20 years from occurrence, and we expect to utilize those tax loss carry-forwards as we generate profits in the future. For the first $2 billion of pretax profits we generate, we will not have to pay federal income taxes.

Now let me update you briefly on our mortgage operations. Turning to slide 22, you can see here that the credit quality of our mortgage customers continues to be strong, with a average FICO score of 744. For the third quarter of fiscal 2012, our mortgage Company captured 73% of our non-cash home-buying customers. Turning to slide 23, we show a breakout of all the various loan types originated by our mortgage operations in the third quarter of fiscal 2012 compared to all of fiscal 2011. 26% of our originations were FHA during the third quarter of fiscal 2012, compared to the 34% we saw during all of fiscal 2011. We believe that this decline in FHA business is primarily related to the increased MI cost FHA adopted in April 2012. Our conforming conventional originations increased to 55% during the third quarter, compared to 47% during all of fiscal 2011.

Regarding the make-whole and repurchase request received from various banks, we continue to believe that the majority of these requests that we've received are unjustified. On slide 24, you'll see our payments from fiscal 2008 through the third quarter of fiscal 2012. During the first nine months of 2012, our repayments were only $1.3 million on nine loans. During the third quarter of 2012, we received 15 repurchase inquiries, which was higher than the average of 10 repurchase inquiries for all of 2011, but lower than the 22 requests we got in the second quarter this year. Any losses resulting from repurchase and make-whole requests have been adequately reserved for in previous periods. At the end of the third quarter, our reserve for loan repurchases and make-whole requests were $7.4 million, which we believe is adequate for our exposure. To date, mortgage repurchases have not been a significant problem, but we will continue to monitor this issue closely.

Now turning to our debt maturity ladder, which can be found on slide 25. During the third quarter of 2012, we used $1.5 million of cash to repurchase $2 million face value of bonds. At the end of the third quarter, we have approximately $132 million of restricted payment capacity left to repurchase additional bonds. Additionally, as you may have seen with the 8-Ks that we filed during the third quarter, we have entered into several 3(a)(9) debt-for-equity exchanges. During the third quarter, we exchanged 5.4 million shares of common stock for approximately $21 million of debt. That brings the total exchanges to date to 8.4 million shares exchanged for $33.2 million of debt. As we look forward, we have only $47 million of debt that matures before 2015, and an additional $82 million of debt that matures before 2016. So far this year, we've reduced our debt by $169 million, and since the end of fiscal 2008, we have reduced our debt by $1.1 billion. Since we announced our second-quarter results, we have been pleased to see all of our bonds trading at higher and higher prices. Our 10.625% secured notes through 2016 are trading well above par at over 105, and the yield at worst is in the mid-8% range. We will continue to opportunistically take steps to better position our balance sheet going forward.

As you can see on slide 26, after spending $117.6 million on land and land development, we ended the third quarter of fiscal 2012 with approximately $252 million in homebuilding cash, including cash used to collateralize letters of credit. This is the second quarter in a row where we had sequential growth in our cash position. Although this level of cash exceeds the high end of our cash target range of $170 million to $245 million, as we have stated on prior calls, we remain comfortable operating at the low end of the range. We continue to look for land deals in all our markets, and we'll continue to put dollars to work in land deals that meet our 25% IRR hurdle rate. We expect our land spend during the fourth quarter to be at similar levels to that of the third quarter. Our ability to increase our cash balance to $252 million clearly demonstrates that we can maintain our liquidity while we remain active in completing land development and replenishing our land position for future growth. That concludes our prepared remarks, and we'll open it up for any questions you might have.

(Operator Instructions)

Michael Rehaut, JPMorgan.

Hi, this is actually Jason Marcus in for Mike. The first question is regarding the dollar value of the orders versus the unit growth. Was hoping you could maybe comment on the increased spread that we saw in the third quarter? And it looks like that accelerated in August to 49% versus only 26% for the unit. Is this a trend that you think -- that you expect to continue, or is it perhaps more related to geographic mix or something a bit more temporary?

I think it's a combination of geographic and product mix, with a sprinkling in of our ability to increase prices. So, I think it's all three of those things that are impacting it.

Okay. And you expect that to continue?

Hard to predict what the mix is going to be from one quarter to the next, but that's what's been causing it. We certainly hope that the price increases that we've been able to do continue.

I will say, overall, given the very low interest rates, we're definitely seeing a bias toward customers picking the larger houses. I think the logic is, with rates so low, the incremental monthly cost is not particularly great. So, if they have good credit scores, recently we've seen a little bit more leaning toward the larger model homes than the average one that we had been experiencing.

Okay. Then the next question is -- was wondering if you could talk a little bit about pricing and incentive trends as they occurred throughout the quarter? And also, maybe if you could comment a bit on recent raw material costs, and how that may have impacted your gross margin?

Yes, net pricing, which is all we really care about, has definitely been improving in most of our markets, at many of our communities. There have been very few that have gone the other way.

And the second part of your question is on material costs. They definitely have been creeping up. But needless to say, as it's clear from our margins, we've been able to get price increases that have been outpacing any cost increases that we've experienced.

Great. Thanks.

Dan Oppenheim, Credit Suisse.

Hi, this is actually Mike Dahl on for Dan. Hoping to drill down into the land banking agreement a bit more. Could you talk about the composition, both geographically and by product, of the portfolio that you've already sold? Because if I look at the $37 million that you received in cash, plus the $65 million of development costs, that seems to imply quite a high finished-lot price.

I think your math is wrong. There's not $65 million-plus of development cost. The acquisition and development cost is estimated to be $65 million on that initial phase that we did with Blackstone/GSO.

Larry, I think he's referring to the -- maybe the remaining land development cost --

No, I don't think so. $60 million on the remaining, Ara. So, $65 million is related to the first phase of the $125 million. So, we did $37.1 million was the cash proceeds. They're agreeing to fund the remaining development cost on that phase. And then in addition to that, they've agreed to fund additional land parcels for total acquisition development cost of $60 million.

But to more fully answer the other part of your question, it's broadly dispersed geographically, as well as by product type.

Okay. Thanks. I guess I may have some follow-ups offline on that one. And then strategically, with this agreement, since you will be taking it down in quarterly finished lot take-down, should we think of this as freeing up additional working capital in the meantime to go out and pursue additional lot deals?

Yes.

Or is this more like a near-term preservation of capital?

We've not changed our cash-balance targets. So, you should consider that it allows us to buy even more land parcels and grow even more.

Thanks.

Ivy Zelman, Zelman & Associates.

Good morning. Good quarter, guys. I just have a few questions. Realizing, Larry, your backlog conversion is currently running at 63%, versus a year ago 77%, can you give us an idea if that backlog conversion is -- sort of where you are thinking going forward? And we're seeing a lot of constraints in Texas specifically, and other markets, on labor. I'm wondering if you're seeing delays on the ability to close homes, and if you can talk about what we should be using as guidance for 2013? Or at least not '13, but thinking about it near- and intermediate-term?

And I think the other thing we'd love to hear your thoughts are, in Phoenix where you operate, looking specifically at sales trends there, as we've seen some slowing there maybe greater than other market slowing, and wondering if it's that you ran out of lots? And do you see any reason that there's anything else going on there? Or is it just a function of absorption pace is much faster, and a lot of guys are kind of waiting to open new communities more in a favorable climate or seasonality opportunity?

You're pretty good at getting a lot of questions in on your first question --.

I've done it a long time, Larry.

Yes, I know. Both of us have done this for a long time, as has Ara. But, Ivy, I'm going to take a shot at some of it. I'm sure Ara will take a shot at some. And then you'll probably have to remind us of the ones that we forgot to answer.

In fact, refresh my memory on your very first comment. Backlog conversion rate. Backlog conversion rate is just not something we track. We have better insights into what we expect to deliver, and it's just not a metric that we've tracked historically at all because we do a bottoms-up budgeting, and every month get new data from our divisions on what they expect to close. So, I can't really comment on the change in that.

I wouldn't -- although we've heard some comments from our divisions recently about some concerns about labor, none of them are indicating that it has impacted their ability to get things closed timely at this point. So, I don't think it's related to that particular issue, which is what I think you were really pulsing on.

Ara, you want to touch base on Phoenix?

Yes, just the other additional comment on backlog conversion. Again, as Larry said, it's not something we track. But I think what's basically happening is we are just -- with the increase in sales environment, we are selling further out ahead. And I think that translates to what you're focusing on, maybe a slightly lower backlog conversion.

Phoenix -- obviously, we're in the dead of Summer, or just finished the dead of Summer, which is their slow season as they get up over 100 degrees all the time. Generally speaking, Phoenix is rock solid, and we've been enjoying really good and steady price increasing in many of our communities there. So, we haven't seen any slowing whatsoever there right now, other than the obvious Summer selling season, which is typical.

Well, great. Thank you for both those answers. One other follow-up. Larry, as we talk about a little bit on the raw materials side, and Ara, you answered the question by saying you're able to at least pass through home-price appreciation to mitigate inflation in raw materials. Looking at going forward when you're underwriting ground, what kind of assumptions do you guys use for raw material inflation or labor inflation to get to those 25% hurdle rates?

Our historical and current practice -- and we've done it this way for many decades -- is we're not smart enough to know what's going to happen to home prices, and we're not smart enough to know what's going to happen to raw material and labor prices. So, when we underwrite a land parcel, we assume then-current home prices, home paces, and then-current cost to construct. Historically, whenever we've seen times that we've had increases in labor or raw material cost, we've been able to offset them by having home price increases. We don't know whether that will be the case in the future or not, but we certainly hope so.

Great. Thanks again, guys.

David Goldberg, UBS.

Good morning. It's actually Susan for David. You guys noted that you have already identified 136 lots -- I think it's 136 -- to put into the second phase of the GSO deal. I'm wondering how do you decide what lots to buy through that? Does that process differ at all significantly from your traditional acquisition criteria? Does GSO have any say in it? Have they put any terms around a certain geographic or product standpoint?

GSO's been very flexible. They're willing to look at almost any geography and almost any product type. And our underwriting criteria has satisfied their underwriting criteria to-date on the parcels that we've submitted them, with very few exceptions. So, we -- the main criteria is that it be a large enough parcel to go through the extra work involved in putting it into a land bank, and that it has sufficient shelf life that makes sense to do it as well.

Okay. Do you feel like there's enough -- that you can -- the GSO deal's large enough to service the current growth rate that you're seeing?

I mean, we have our own cash, too. We're not doing everything through GSO, by any stretch. So, we think this is additive to the growth we anticipated without GSO.

Okay. Okay. And then just one more question. In terms of the land that you're taking out from being mothballed, if we think about the parcels that are still in there, what percentage of that approximately would you say is higher quality, where you could develop it over the relative near term and generate an acceptable return on capital, versus what percent would, say, be lower quality and maybe where the profitability is still somewhat weaker?

I think, by definition, when it's mothballed, it probably means that it's not hitting a hurdle rate that makes a lot of sense from our perspective and, therefore, we've put it on the shelf. And as we've already unmothballed 58 communities, we constantly assess it and look to bring them back on when it makes sense in that particular micro market. So, we're constantly looking at that, and hope to continue to bring some of that mothballed back on in the future.

As the market improves overall, I think the value and the attractiveness of everybody's mothballed lots looks a lot better. I think, in general, the industry will see some pleasant surprises in the coming periods regarding mothballed lots.

Okay. Thanks.

Joel Locker, FBN Securities.

Hi, guys. Getting back to the direct cost, what do you expect for them, or can you quantify what you think they'll be in the fourth quarter versus, say, a year ago fourth quarter, including labor and material?

I don't think we have clear data points that I can give you any precision on that. But I think they've inched up a little, would be my reaction. We've avoided increases, certainly on the branded products. We have a lot of national contracts that have helped us a lot during this period of time. And then on certain things, we've taken big increases. We talked in the past about the increases that we saw in wallboard. There's been other -- in individual markets where we've seen increases. But I can't quantify. I don't know, Ara, whether you have a sense at all what it is. But we don't have any kind of way of giving you any precise answer to that, other than to say maybe it's inched up a little bit.

Right.

On the whole, what we can say is we're comfortable right now that any cost increases are at least being offset by home-price increases. Basically, what happens is, as the markets heat up and there's more activity, the subcontractors try to take advantage of that by inching up the prices. By definition, if it's happening in markets that are heating up, the homebuilders typically have the opportunity to raise prices in that environment, too. So, it's been a balance, which has actually been slightly in our favor.

Right. And do you expect that trajectory to increase now that you have a higher backlog, and now they'll be even busier trying to deliver homes going forward on the labor side, and same with the materials side?

Everything is relative. Putting it in perspective, the average national housing starts were at 1.6 million per year. Even at this improved pace, we're at 780,000 per year, let's say, as an industry, so we're way below normal. On the other hand, it's about a 30% improvement from last year. So, I think there will be pricing pressures, but it doesn't concern us too much because of the home-pricing opportunity right now.

Right. On the corporate expense going forward, do you expect that in the $12 million range, as you've kept it relatively low, even though you increased revenues? Or do you think some stock comp will start working in there where that will start increasing also?

We don't make any projections of -- precisely on corporate overhead. I think sitting in your chair, the best you can do is just assume it's going to stay at the levels that we've been running.

Right. All right. Thanks a lot, guys.

Nishu Sood, Deutsche Bank.

Thanks. Wanted to ask first about your gross margins. Ara, you showed that chart, very impressive-looking chart from, I think, last six quarters from in the 14% range to now over 18%. Certainly one of the better charts if we did that for the whole group amongst the builders. If we were to think about the causes of that over the last five months, your legacy land communities, that's been a shrinking percentage. You've had some home-price increases, obviously maybe some operating leverage, and some leverage in the gross margin line. I know you can't quantify it exactly, but I just wanted to hear your thoughts on what you think has been most important in driving the gross margin trend over the past six quarters?

It's really been a little bit of everything. I can't point to any one thing. But we certainly -- our continued focus on new land acquisitions has been helpful. The product mix orientation has been helpful. I think we've really done a good job on the purchasing and design side, and our ability to get some price increases through have helped. So, it's been a little bit of everything, no one particular thing.

Okay. And next thing, a question on the land banking arrangement, just a point of clarification. The remaining $60 million that is going to be directed into that, is that from your balance sheet, or is that third -- or is that land purchased in the market?

Could be either. Everything we've done to-date we owned and then sold to them. But we could do land that we identified, and then they buy it instead of us buying it. So, just depends.

Got it. And then a real quick one on the state tax reserve. I think we've seen that from some of your peers as well. I was wondering if you could just give us a little bit more color on that. What triggered that? It's a pretty material amount, obviously. Is there further reserves that could be reversed? Some more details on that, please.

Primarily the passage of time is what allowed us to reverse it, and I wouldn't expect anything of substance on the state tax going forward.

Okay. Thanks.

Adam Rudiger, Wells Fargo Securities.

Hi, thank you. I was wondering if you could follow up on some of your comments on closing out of communities faster, and your goals of aggressively trying to open new ones? If you could provide us any guidance or thoughts on what next year's community count should look like? And also tie in some of your comments about closings being more weighted to the back half of the year? If you could -- anything you could help us to think about that would be -- (multiple speakers)

Community count is probably one of the most difficult things to project, because it's a function of not only opening new communities, which can be impacted by how quickly you can get through regulatory process, but also by the pace of sales in existing communities. Are they slower than you expected, or are they faster than you expected? Or are they right on target? It's not something that we're going to provide any clarity or guidance on, beyond the fact of Ara's comments already that we're working hard to try to add to our community count, as we -- evidenced by our activity in the land market is probably the best projector you have sitting in your chair as to how well or poorly we're doing in that regard.

Okay. And then if I could, if I look at slide 31, which is one that shows your sold and unsold homes in process by dollar amount, and I compare that to your backlog, the growth rates in backlog have been -- in the last couple quarters on a year-over-year basis have been a lot faster. And it suggests that your inventory, your WIP, isn't keeping pace with that. Can you -- how should we interpret that?

You should interpret it -- what we've been saying for a number of quarters now is we've been focused on trying to increase our inventory turns, so that we can actually do more deliveries with the same amount of inventory or less inventory. And we've been very focused on that, and it's showing you that we've actually been achieving that.

Okay. So, we shouldn't interpret that at all that there's underspending right now on WIP?

No, you shouldn't interpret it. That would be a complete bad assumption on your part.

Yes, it's definitely a concerted, focused effort on our part to turn our inventories more, keep WIP and inventory down while our revenues are growing, and it's part of our overall formula. And so far, so good.

Great. Thank you.

Susan Berliner, JPMorgan.

Hi, good morning. Just a couple questions. One, I was wondering if you could talk about specific markets, such as Texas, California, DC, and Chicago, and what you're seeing there?

Let's see. Texas has been very solid, both -- we're only in Houston and Dallas, and they're both very solid. The DC market has been very solid. We're having, on the Maryland side, some qualification challenges in the Prince George's County area, perhaps more than some others. Overall, that market has been steady.

And you mentioned one other market, what was it?

No, California and Chicago.

Chicago has been interesting. Most of our peers are reporting a challenging environment. We happen to be in some pretty good niches in affordable housing, just more value-oriented, which seems to be making the mark there. We also have some good infill locations. I'd say the market wouldn't tell you Chicago's doing well, but we are doing well in Chicago.

And I apologize, you asked me --?

California.

California, yes.

California is definitely very strong in Southern and Northern California, and it's one of the places we'd really like to replenish our land supply more quickly.

Great. My other question was I guess for Larry. The non-recourse mortgages went up again this quarter, and I was wondering -- is that more model homes being secured?

What it is, and we'll have a little detail on this in the Q, Susan, but there was a JV that had non-recourse financing as a component of it. And we ended up buying out our partner's interest in that JV, which brought the debt along with it.

Okay. Great. Thanks so much.

Michael Kim, CRT Capital Group.

Hi, good morning. Thanks for taking my question. Where were the 200 lots that were unmothballed during the quarter located? And are you seeing any trends by geography in unmothballing land?

I think those were in a community in New Jersey.

New Jersey. Okay. And could you describe the anticipated take-down schedule of the 620 lots from the first phase of the GSO transaction by geography and timing? Of the six land parcels from the first phase, are any of these projects going to be taken down by phase, or is it just going to be evenly split over six take-downs --?

It is not evenly split. Each community has its own take-down schedule, and the take-down schedule is -- was tied to our expected sales absorption pace. And our expected sales absorption pace was directly tied to what we were currently experiencing in that market. So, it's trying to be kind of a just-in-time take-down of finished lots.

And when do you expect it --?

Generally speaking, if you looked at an overall average, it's probably somewhere around three lots a month, the equivalent of nine months -- nine lots a quarter probably is a pretty representative sampling. Some will have higher absorptions, some lower, but that's probably pretty typical, once they get to be developed lots.

And when do you expect the first take-down to occur?

They've already occurred.

It already occurred. Okay. And as my last question, will the land banking agreement with GSO be filed with SEC?

No.

Or be shared publicly? It will not?

No.

Thank you.

(Operator Instructions)

Andrew Casella, Imperial Capital.

Hi, thanks for taking my question. Larry, when you talked about opportunistically addressing the balance sheet, could you walk us through how you're thinking about that? Is it a matter of putting up a few more strong quarters and then looking to address the 10.625% with the coupon trading and where it is? Or if you could shed any light on that would be helpful.

We continuously monitor what's going on in the capital market. We've been probably one of the more active issuers over the last four or five years in the homebuilding space, and we just opportunistically take advantage of opportunities that make sense from our perspective. So, we just constantly monitor the market and decide when to do it. We don't have anything planned right this second. We're just monitoring the markets, and over time, whether it's buying back debt, exchanging more stock for debt, or doing some capital market transaction, we recognize that we have a ways to go to get our balance sheet back to healthier position, and we continue to take steps to do that.

Got it. Thanks. And to that point, is it your view that you would like to do something overall on a global basis, or kind of pick off different parts of the capital structure opportunistically?

I think we need to do both over time.

Got it. Great. And then a quick housekeeping item. What's the cash in your restricted group versus secured group of the two $150 million that you have as of the quarter-end?

I'm not sure any of us has that at our fingertips. You got it? Cash in the two different secured --?

Yes, so, the cash in the secured group for the 10.625% notes is $164.8 million, and the inventory, the real property that's collateralized is [$640.9 million]. And the new group, the cash is $86.4 million, and the inventory that's collateralized at $36.5 million. And there's investments in joint ventures with a book value of $46.4 million.

Great. Thanks so much.

Joshua Pollard, Goldman Sachs.

Thanks for taking my quick questions. First, you said you could issue 100 million shares without interrupting the NOL. Could you give us a quick reminder of what the limitations on the NOL would be if you were to exceed that level of issuance? I think there's some confusion amongst investors whether that limits your use of it for a very long time or if that's short? I want to understand what's the decision factors there.

If you trigger it, you eliminate your ability to ever use a very, very, very substantial portion of it.

And frankly, we haven't focused on the technicalities of what you can do, because we just have no plans of issuing 100 million shares or anywhere near that amount to trigger it. We don't feel like we have the need for that capital, so it's just not on our radar screen to focus on it.

Okay. That's very clear. The other question I have, it's actually two parts. One is on your gross margin improvement. You said you expect it to slow. You pointed back to the early 2000s in terms of where you think normal margins are. Are you already at normal margins in your backlog, given the increase in prices on your orders?

No.

No?

I think you misunderstood. We didn't say it was going to slow.

Improvement was slow.

We wouldn't keep the same trajectory. We've improved almost 400 basis points. If we did that again, that would get us over our normalized level.

But I'm sorry, you had -- the second part of that question?

Whether backlog -- we're not going to disclose exactly what gross margins are in backlog. We expect to continue to show some improvements as we deliver more homes from newly identified land, especially in markets where we have some ability to have some pricing increases as well. We think there will be modest improvements going forward. But we're not in a position to publicly give you the precise margin that is in our backlog.

Okay. My last one is one on the regional side. You saw that, including JVs, your orders are down 12% in the Northeast, down or call it roughly flat in the Mid-Atlantic. Were your number of communities in those areas per -- are those numbers down? And then, when you look at the inventory that's at GSO, does that still count when you measure how much interest is capitalized on your income statement? Thank you.

First, I'll comment on the Northeast. Frankly, of all the markets, the New Jersey market has probably bounced back the least of all the other geographies. It's not the case as you get very close to New York. And our only high-rise in our Company right now is selling very nicely and very steadily, overlooking New York City. But as you get further out, that market has definitely been on the slower side.

The DC market, it's been more oriented to getting enough communities open at the right stage, although as I mentioned, we did have a little bit of a challenge in the recent couple of quarters on the Maryland side in Prince George's County area, and that has slowed it down just a bit.

Regarding the capitalized interest, Brad or Larry?

I'll take that one. It's a great question, Joshua. We have been in discussions with our auditors, D&T, kind of working through that. There's not a firm answer yet, so I can't give you 100% clarity.

That's all right, Larry. I'll give you a call, and we'll talk about it more.

If you give me a call today, I could give you the same answer.

I'll give you a call in a couple weeks. All right, you guys be good.

Joel Locker, FBN Securities.

Hi, guys. On the other expense, you had actually a $3.1 million gain. What was that from?

We sold a apartment that was built originally as a senior rent-restricted kind of apartment that allowed us to get, 15 years ago, maybe 20 years ago, a for-sale component of land approved. And we sold it recently, and it's a gain on that sale.

Right. And what do you expect going forward on the interest expense, the actual -- it's been hanging around the low-$20s million, mid-$20s million, actually. Is that -- inventory's grown a little bit sequentially, but I mean, do you expect that still in the low-$20 million, mid-$20 million range for the foreseeable future?

Sitting in your chair, all you can do is kind of assume that it stays roughly the same.

Right. All right. Thanks a lot.

And ladies and gentlemen, this does conclude the question-and-answer portion of today's call. I'd like to turn the call back over to Ara for some closing remarks.

Great. Thank you very much. Needless to say, we're pleased with our quarter. We're pleased with the results on every metric, including liquidity, and we look forward to bringing you even more positive news in our next quarterly release. Thank you.

Ladies and gentlemen, thank you so much for your participation today. This does conclude our conference. Have a great day. All parties may now disconnect.