KB Home (KBH) 2006 Q4 法說會逐字稿

Good day, everyone, and welcome to KB Home's fourth quarter earnings conference call. As a reminder, today's call is being recorded and webcast on KB Home's website at www.kbhome.com.

KB Home's discussion today may include certain projections and forward-looking statements regarding KB Home's business future actions and expected results. These are based on management's assessment of the Company's current business and assumptions about future operating conditions, but should not be considered guarantees of future performance. Please be aware that KB Home's actual results may differ from those that are expressed or implied by the projections and forward-looking statements that may be made today due to risks, assumptions, uncertainties and other risks and events outside the Company's control and that the differences may be material. Many of these risk factors are identified in the Company's periodic report filed with the SEC, including the annual report on Form 10-K to be filed later today and the Company urges you to read them.

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

Thank you. Good morning, everyone. Thank you for joining us today to discuss the financial results for our fourth quarter and fiscal year ended November 30, 2006. With me this morning are Dom Cecere, our Executive Vice President and CFO, Bill Hollinger, our Senior Vice President and Chief Accounting Officer, and Kelly Masuda, our Senior Vice President of Investor Relations and Treasurer.

I want to thank everyone for their understanding and patience while our independent committee of the board diligently worked to complete their stock option review. Today, we are pleased to resume our regular communication of KB Home's quarterly results to shareholders, investors and analysts. During this board review period, I can assure you that all of us at KB Home kept focused on our customers and our business and am very happy to report that we will file our third quarter 10-Q and 2006 10-K today, bringing our financial reporting up to date.

We are also very pleased to share with you our financial performance for 2006, given the challenging market conditions. Our results are driven by our customer-focused business model, which reflects on all the employees of KB Home who execute the fundamentals of KBnxt every day. While I am honored and humbled to have been selected by the board as our Company's Chief Executive, I am also very proud to be leading the amazing group of employees at KB Home. Your investment is a vote of confidence in our future, and I promise you our organization will continue to earn the trust you have placed in us.

Now, let me share some of the financial highlights with you. We posted solid top line revenue growth in the fourth quarter, with revenues of $3.5 billion, up 13% over the fourth quarter of 2005, and for the year reached $11 billion in revenues, up 17% on a year-over-year basis. We entered the fourth quarter with a strong backlog of sold homes, and we delivered 12,553 new homes during the quarter, up 5% over the fourth quarter of 2005. This performance was the result of converting 53% of our backlog to revenue, the highest conversion level we have been at in some time, and as compared to the 43% converted in the fourth quarter of 2005.

Housing gross margin in the fourth quarter, excluding non-cash charges for impairments and land option contract abandonments, was 18.8% of revenues, reflecting a healthy margin for a difficult quarter where we faced a spike in cancellations and intense pressure on pricing.

We took a non-cash charge of $343 million to earnings in the fourth quarter to align our inventories and land pipeline to market value and to demand. Lots owned and controlled in the U.S. was reduced by 38% from approximately 180,000 lots at this time last year to 111,000 at fiscal year end 2006. Of this total, we own approximately 64,000 lots and have an option to buy an additional 47,000 lots. As a result, we are positioned very well as we enter 2007, having the ability to carefully reload our pipeline of owned lots at lot prices that support our minimum return on investment hurdles when each market begins to show signs of stability.

At our Investor Day meeting in New York in May of last year, we shared with you the actions we were taking to reduce overhead, lower inventory levels, and focus on free cash flow in preparation for the industry slowdown that we began to see unfold. At that time, we had already commenced actions to reduce our investments in new-- new land and land development and also in right-sizing our overhead levels. The benefit of these actions came to light in the fourth quarter. Inventory was reduced by $1.4 billion from $7.9 billion at the end of the third quarter of '06 to $6.5 billion by year-end. We delivered more homes year-over-year, lowered the overall number of homes under construction, reduced land purchases, and delayed or curtailed land development.

In addition, we took a non-cash charge to earnings to reflect the decline in fair market value of owned land and walked away from unprofitable lot option contracts that no longer generated viable returns. As a result of these actions, we generated over $1.2 billion in free cash flow in the fourth quarter, ending the year with $639 million in cash and nothing outstanding on our revolver. These results position us to reduce our debt net of cash by 33% from $3.7 billion at the end of the third quarter to $2.5 billion at our fiscal year end.

As stated, despite the difficult market conditions, we concluded 2006 with $11 billion in revenues, up 17% on a year-over-year basis. Excluding the non-cash charges for impairment of inventory and option abandonments, we generated $1.1 billion in pre-tax profits, with a pre-tax profit ratio of 10.3%.

We are maintaining our discipline as a build-to-order home builder, authorizing the start on the vast majority of our homes only when we have a qualified buyer, and while providing these qualified buyers the opportunity to customize their homes with extensive choice at our studios. We continue to maintain that our choice value approach with a pre-sold builder is a far better model than spec building and then forcing our choices and values on the eventual buyer through the use of incentives.

We entered 2007 with 17,384 sold homes in backlog, one of the largest in the home building industry. We've taken the actions necessary to continue to generate significant free cash flow in 2007, with the land pipeline and overhead structure that has been realigned based on our backlog position and sales rate expectations. We are operating in an environment where there continues to be an imbalance of supply, demand and affordability to varying degrees in each market. Once markets have stabilized, we will have the financial flexibility to quickly reinvest in our core business as opportunities present themselves.

Now, I will ask Dom to take you through the financial highlights for the fourth quarter.

Thank you, Jeff. The average sales price of homes delivered in the fourth quarter of 2006 increased 4% to $273,400, from $263,700 in the fourth quarter of 2005. In the U.S., the average sales price in the fourth quarter was up 1% over the prior year.

Our cancellation rate entering the fourth quarter improved slightly to 22% of beginning backlog, entering the fourth quarter from 25% on a comparable basis in the third quarter. We believe the continued high level of order cancellations experienced in the fourth quarter were driven by high levels of unsold homes available in the market and heavy incentives being offered by competitors to move finished unsold homes.

We average 444 active selling communities in the U.S. in 2006, which was up 2% on a year-over-year basis, both for the year as well as for the fourth quarter. We are curtailing community count growth in submarkets where there's an excess supply of finished lots and returns on invested capital are below our targeted return threshold. For 2007, we are currently forecasting approximately 423 active selling communities, down 5% from the 444 averaged in 2006.

Housing gross margin, excluding non-cash charges to inventory, was 18.8% this quarter, down 830 basis points from the all-time high of 27.1% in the fourth quarter of 2005.

SG&A as a percent of housing revenues in 2006 was 12.7% compared to 12.5% in 2005. Excluding the expensing of stock options, our SG&A ratio was about the same as 2005, having absorbed the one-time cost for right-sizing our overhead and for the one-time cost related to the stock option review. As we enter 2007, we have our SG&A and other fixed costs in line with the deliveries based on our order backlog of sold homes. We expect our SG&A expense ratio to remain flat in 2007, despite significantly fewer unit deliveries compared to the prior year.

Pre-tax profit margins before the $431 million of inventory impairments and land option cost write-offs taken this year were approximately $1.1 billion, or 10.3% of revenues in 2006 compared to $1.3 billion, or 13.7% of revenues in 2005.

Our EPS for the year was $5.82 compared to $9.32 in EPS on a restated basis in 2005. EPS in 2006, excluding the $431 million of non-cash charges, was approximately $9.42, just slightly above a record 2005.

Debt to total capital net of cash at quarter end was 46%, a 900-basis point improvement from the end of our third quarter. We generated in excess of $1.2 billion in cash in the fourth quarter, ending the year with zero drawn on our revolver and $639 million in cash.

Company-wide, we had approximately 131,000 lots owned and controlled at November 30, 2006, including France, compared to 191,000 lots one year ago. In the United States, we own and control 111,000 lots, which represents less than a full year's supply of land on a forward-looking basis with 64,000 lots owned and approximately 47,000 lots optioned. Of the 64,000 lots owned, 15,000 are on the west coast. 12,000 are in the southwest, 20,000 are in the central region, and 17,000 are in the southeast.

In 2006, we took $431 million in non-cash charges associated with inventory impairments and land option contract abandonments. Included in the $431 million was $144 million for option abandonments, $229 million for inventory impairments and $58 million for joint venture impairments. On a regional basis, 49% of the charge was in our west coast region, approximately 30% was in our southeast region, primarily in Florida, 9% was in the southwest region and 12% in our central region.

With our continued focus as a build-to-order home builder, we had only 734 completed unsold homes in inventory at quarter end. We currently have approximately 10,000 homes under construction in the U.S. 83% of these homes are sold and only 17% are spec. While 17% is higher than normal for KB Home, it is still by far one of the lower percentages of spec homes in production in this industry.

Our backlog at the end of the fourth quarter of 17,384 sold homes valued at $4.4 billion was lower than one year ago by 32% in units at 34% in dollars. On a forward-looking basis, we still have a six-month order backlog of sold homes, one of the largest in the industry, as a foundation for even flow production and optimization of construction cost efficiencies.

In summary, revenues for the fourth quarter and total year of $3.5 billion and $11 billion were up 13% and 17%, respectively. Pre-tax income, excluding non-cash inventory charges for the fourth quarter and total year, were $216 million and $1.0 billion, 6.1% of revenues in the fourth quarter and 10.3% of revenues for the total year. We entered 2007 with our lot pipeline, the number of homes under construction, SG&A, headcount and fixed overhead all right-sized to the realities of today's housing market. We generated in excess of $1.2 billion in free cash flow this past quarter, demonstrating the controls that we have put in place to turn inventory faster, deliver homes on time, control land purchases, and control the flow of expenditures for land development.

Now I will turn it back to Jeff for the wrap-up of our fourth quarter conference call.

Thank you, Dom. We are encouraged by the number of potential home buyers that are visiting our communities and also the success we are having in our co-branded communities with Martha Stewart, where sales and margins continue to demonstrate that choice, quality and brand are more important than price concessions. We are also encouraged by the national statistics for new housing permits and housing starts, which indicate that home builders are reducing housing starts, which will eventually reduce the excess supply of unsold new and resale homes that still exists in the market today.

We continue to focus on our KBnxt operating model, as a build-to-order home builder, featuring choice and value with a six-month order backlog, an experienced management team and world-class training tools essential to creating value for our shareholders.

We are staying very selective in land purchases until markets become more stable and the cost of land gets in balance with today's home prices. With only 64,000 lots owned in the U.S., we are well positioned to begin purchasing land at lot prices that will provide better margins and returns than we are experiencing today.

We are reducing the cycle time from the sale of a home to close through our even flow production focus, which reduces costs and improves inventory turns. In many of our businesses, we have already experienced over a 30-day reduction in the cycle time to deliver a home.

We are driving additional direct cost savings to our KBnxt initiative called Pathfinder. In fact, in many of our new communities, in the once supply-constrained coastal markets, we are seeing an 8% to 10% reduction in the cost per square foot to build. Our Pathfinder initiative applies to our overhead structure as well, where we have quickly positioned ourselves this year to comparable SG&A ratios, as in '06, on lower projected revenues. We believe that in 2007, these actions will provide significant free cash flow, a healthy balance sheet and streamlined operations, which will deliver above average shareholder returns through the current slowdown, and the ability to aggressively improve profitability when the fundamentals driving housing demand return to more normal conditions.

As you know, we don't typically share sales and traffic data before quarter end. However, we are two weeks away from the end of our first quarter and in these fluid times, we want to be as current as possible in our communication. Quarter to date, we have seen cancellation rates return to more normalized levels. As planned, community counts in the U.S. are down 8% from the first quarter of 2006. Traffic volume is down 10% for the total Company, and net orders are also down approximately 10% quarter to date compared to one year ago. While this is modestly good news, we are just now entering the peak selling season and we will have a much better feel for our financial outlook for the year in another 10 to 12 weeks. We expect the next two quarters to be challenging, with continued pressure on pricing until supply and demand become more in balance.

In the first half of the year, gross margin on housing and earnings per share will continue to moderate. In the second half of the year, when many of our cost control initiatives are in full swing and we have closed out many of our underperforming communities, there is opportunity for housing gross margins to rebound and earnings may improve, assuming market conditions and pricing stabilize. Until then, we are focused on generating free cash flow from operations, carefully reloading our lot pipeline and maintaining a healthy balance sheet.

We will now open up the lines to take your questions.

Thank you. The question and answer session will be conducted electronically. [OPERATOR INSTRUCTIONS] We'll go first to Michael Rehaut with JP Morgan.

Hi. Good morning.

Good morning, Michael.

So just wanted to make sure I understood that correctly regarding your comments on quarter-to-date trends. When you said the can rate returning to normal levels, as I've looked over the last couple years, it appears that the normal can rate for KB is maybe in the high 20s to low 30s. Is that type of level that you saw quarter-to-date?

That's correct, Michael. We will be changing the way we report our cans to go to a percent of backlog at the beginning of the quarter, but at our quarter end call, we'll clarify that but as we sit here today, our can rate as we've historically reported it is flat with '06.

That's great. And in terms of the orders, you said down 10%. Were there any regions that were positive year-over-year or were most still negative?

Interesting question, Michael. I appreciate it. We actually are seeing positive sales comps on the coasts, both California and on the east coast. Our sales are off in the central region in large part because our community count is down significantly where we've lowered our investment due to not obtaining our required returns.

And just last question, on the order ASP that we noticed for 4Q, down about 25%, I was wondering if you could give some color on that. It appears that there might have been in part a mix shift, but for example in the Southwest, you're down to, we calculated 155,000 per unit per order, but many regions you're still looking at a pretty sizable decline. So if you could talk about if it's mix and also I assume there's a lot of pricing action going on as well.

Yes, Michael, let me refer to Dom on that question.

Mike, you're backing into it by looking at the backlog entering the year in the backlog at the end, and since you have adjustments to the backlog in pricing, when they come to the table, it distorts the orders. I would tell you that the average price is probably down about 4% or 5% entering 2007 from the fourth quarter. The fourth quarter prices were up 1% year-over-year. We'll be down 4% or 5% as we enter 2007.

I would also like to tell you, Mike, just so you understand, that as we bring in new communities with lower square footage and a lower spec level, our prices will be coming down without impacting margins so that is happening as, on an ongoing basis, starting in the second half of last year.

I appreciate that. And when you said the 4%, that's on a nominal basis, correct?

Yes.

Okay. Thank you.

And next we'll go to Margaret Whelan with UBS.

Good morning, guys.

Good morning, Margaret. How are you?

Perfect, thanks. Congratulations on the promotions, both of you.

Thank you.

Thank you.

Okay. So here's the first question I have for Dom. If you think that your SG&A is going to be flat, does that mean that you're going to maintain this kind of focus on margin strategy and not chase volume whatsoever?

Well, our SG&A is going to stay flat and volume will come when we start to see some demand in the market pick up. So the answer is we're focusing still on maintaining our margins and taking volume where we can get it.

Okay, but you're just not going to compete on price. You're not going to be discounting as much as some of your peers, sounds like?

Well, I think I would agree with that.

Yes, Margaret, we're focused on returns and it's a per community analysis. We'll set a run rate and a margin rate to give us the most cash back. And then we hold to that and get to sales and if we can't get our returns, we're not going to keep chasing the units.

Okay, good.

I mean the good news, Margaret, in the first quarter was that our community counts were down 8%. However, our orders were only down 10%.

Yes.

So sales per community were actually doing pretty good on a year-over-year basis.

If I'm thinking about that right, then you have about 24,000 houses in backlog, is that it, 17 plus about, 7,000 orders to date?

Well, no, because your deliveries, also. We have about 18,000 homes in backlog. We have 17,700 going into the year and then you deliver homes and pick up orders, and that hasn't changed much.

Okay. So what kind of-- ?

At the end of the first quarter, I would guess it might be up slightly, the backlog.

Your backlog. Okay. Did Jeff say you have 111,000 lots?

We have 111,000 lots in the U.S. 64,000 of those are owned.

Okay.

And the 47,000 are optioned, and we have 20,000 lots in France.

Okay and then, so that's about four years of supply. At what point would you be buying dirt? It seems like you're more liquid than a lot of the other big caps here.

We definitely are, Margaret, and with the dry powder we have, we can be selective and opportunistic. We have the lots to achieve our business plan for '07 and frankly '08 so we don't have the urgency to go do something. We will, as we sense each market stabilizes, and we see opportunities in the market, we're going to go after them at that time, but it's not something we're going to rush out and do in the next month or two.

Are you seeing anything that's pencilling right now, any-- ?

Yeah, we're actually approving a few deals in our land committee process, and it's mostly easy options in markets that haven't depreciated as much, but not a lot, very little.

And so last question from me. What is your priority on use of cash? Should we expect any buybacks this year? Then any plans to divest France in '07?

As we've always said, Margaret, we have a balanced approach to cash. We've been the largest buyback company over the last few years. We want to wait and see how the business shapes up for the year so we have a firm understanding of our cash projections for the end of the year. If we think there's opportunities in acquiring assets, we'll go that way. If we don't see those opportunities, we could take our debt down or we can go buy back more stock. We do have 4 million authorized on our buyback by the board today, but we want to, again, wait and see how the year unfolds.

Relative to France, as I keep saying it, it's a world class situation to be in. We have a great business over there. We're the second largest builder in France. I've known Guy for 14 years. I visited Paris in December to gain his commitment and trust in our relationship. They have a great year projected for '07. They are very profitable, very tenured. It's a low risk for us, but it also may be an opportunity so we haven't finalized any strategic analysis yet on what to do.

And next we'll go to Stephen Kim with Citigroup.

Thanks. I was wondering if you could elaborate a little bit on your comment about the gross margins. I thought I heard you say that in the first half of next year-- well, I guess this year, you anticipate that the gross margins would continue to moderate and then in the second half, there was opportunity for rebound. Could you talk a little bit more about what you meant by continuing to moderate, moderate year-over-year, moderate sequentially, some sort of order of magnitude, that sort of thing?

Stephen, I would say moderate sequentially. The fact is we still are under pricing pressure. There's still an excess supply and therefore we believe in the first half-- and by the way, margins in our business, because deliveries are stronger in the second half than the first half, always start out the year lower than they were in the third and fourth quarter, in the first and second quarter. So all of those trends are going against us and the fact is that as we begin to swap out old communities with new communities, and, by the way, by the time that we get through this year, we will probably have replaced two-thirds of our communities with new communities with lower square footages and better price points, which will help our margins overall. All of these things are going to start to really, we'll start to see the full benefit of in the second half of 2007. So we got a couple more quarters where we think where pricing and margins will be under some pressure until we start to see some of the dynamics move more in our favor.

And you were saying that you saw the opportunity for a rebound in margins in the back half, not just a stabilization, I guess, right?

I did say that, right.

Right. Okay.

Actually we said they could improve if the market stabilized.

Exactly, right. Okay. And in terms of your subdivision count, I think you indicated that your subs are down about 8% here in the, well, currently, and curious as to whether you had a projection for where that might be later this year.

Yes, we said overall for the year that we would be at around 423, down 5% from the 444 that we averaged this year, and actually being up on both coasts, but down in the central, some in the southwest.

And next we'll go to Ivy Zelman with Credit Suisse.

Hi, guys. Good morning. Congratulations.

Good morning, Ivy.

-- relative performance, obviously doing very good. Can you kind of talk a little bit about some of the buyers today? What's your requirement on deposits for today's buyer on average when there-- ?

It will vary by market, Ivy, but it's about 2%.

2%, okay.

Yes.

And one of the things that I'm sure you guys are focused on or worried about as your comments have been very balanced, Jeff, with respect to the expectation on '07 and if, then, could, I like those words. I think they are carefully chosen. When you think about the lending environment today, we're hearing from the mortgage originators out there that some of the sub-prime blowup is spilling over into the conventional prime markets with clearly tightening going on with the documentation. First thing we're seeing is low doc loans or no doc loans are starting to no longer be easily underwritten and even pulled back entirely. Seconds are being eliminated by some mortgage originators. Fremont announced that they are not going to do seconds anymore so there's a lot of concern that even prime and conventional mortgages are going to start to be impacted, 100% LPDs, IOs. Is this something that you're factoring into your outlook and clearly the demand improvements that you might be seeing today, some of those underwriters, can you talk about what the mortgage portfolio of your buyers looks like? How much of it is 100% LPD? How much of it has seconds? I guess that's the same thing. How much of it is interest-only? Kind of walk us through it so we can understand where the demand or how the demand is shaping out.

Okay. I can share with you, Ivy, because the question was raised earlier this week. For starters, we have a great partner in Countrywide, very sophisticated, very, very stable long-term company. When I was getting ready this morning, I heard that another sub-prime company out here in California closed yesterday so it's the classic case of a mortgage industry tightening up. The quality performers will stay. Those that were opportunistic and didn't run so well are now going away. In the terms of sub-primes within our venture, it's about 12% of our business, primarily in the central region. The coastal buyers are more conventional, high FICO scores, solid incomes. They do have a lot of 100% loans. I think Dom has the numbers here. But if sub-prime were to go away, my point is it may impact our markets where we have lesser margins in the first place and a little lower quality buyer profile than some of the higher priced product we have on the coasts.

I think the good news is that FICO scores of buyers still remain slightly above 700, so they can qualify for a loan and the more we can do when we open new communities to lower the price point, the more affordable for the buyers and that's our focus.

No, and I appreciate that. I guess what I'm trying to understand is how much of your business is 100% LTV and then clearly even with Countrywide, realizing that the environment is changing, they may make it a little bit tougher to underwrite someone who might be a 7%, a 700 FICO score with only a 90% LTV or 100% LTV, so clearly demand could be negatively impacted by what's happening in the mortgage arena. I'm just wondering if you look at the people that are in current backlog, can you give us sort of a profile of that buyer? How much is 100% LTV? You gave us the FICO score. How much is interest-only? How does that interest-only break down years in terms of resets?

Ivy, I'll get that for you. I honestly don't have that from Countrywide in front of me.

Okay.

But I mean I can't argue the fact that these will all cause some level of demand -- impact on demand. The good news is that for three straight quarters, our traffic in our communities have only been down about 10%. You didn't see it in net orders the last half of last year because we had cancellation rates, but now when those cancellation rates subsided, we're now seeing orders being in line with traffic.

I do think, Ivy, it's a fair comment that if sub-prime tightens up and underwriting tightens up, it's going to restrict demand. If it's not new, it's resale and we'll have to cycle through that. These large lenders have been creative for years and whenever one program goes away, they have quickly come up with another program that replaces it, maybe more conservative, but still has flexibility, so I think that's what you'll see. But certainly could affect affordability in the short run. As to how much, we don't know.

[OPERATOR INSTRUCTIONS] And next we'll go to Dan Oppenheim with Banc of America.

Hi, this is Mike Wood. Can you characterize the improvement that you've seen in the first quarter so far with the less of a decline in orders in terms of -- ? Is this primarily the result of pricing or are you seeing a pickup in demand, just if you could give us some color on that?

I think a good data point, Mike, is that our traffic levels are tracking with our community count and tracking with sales so there's buyers in the market. There's affordability pressure and we've told you that our margins have moderated some and I think it's part the spring selling season. I think it's part what we have done to sell homes. That's why we're cautious about the year because it's unclear at this point in time how strong the spring selling season is going to be and in another 10 or 12 weeks, we'll have a very clear picture on where the markets are headed and where our year is headed.

We also think that KB's price point-- at the price point, will there be more in demand than the second move-up to luxury buyer.

Okay, and can you just also give us a sense of the, with the homes sold, I guess so far this quarter and last quarter, just how that breaks out generally with spec homes and pre-sales.

Well, we have only in our production, and this has been pretty consistent. 83% of the homes we have under construction are sold and only 17% are spec. So we have been-- and that's probably one of the best production spec levels in the industry, so based on and that's been that way for several quarters. So the vast majority of the homes that we have in construction and are selling are sold.

Okay. Thanks.

And next we'll go to Stephen Fockens with Lehman Brothers.

Thanks, guys. Hey, as you look forward and when business starts to moderate a little bit, what are your thoughts about ongoing redeployment of cash and maybe being ongoing more consistent generator of cash, free cash, I guess I should say?

I think going forward, Steve, you'll see us focus on a balance of, in normal times, we would want to have a 10% top line and generate cash every quarter, and we think we can do both.

Remember, we -- I think the footprint would say, hey, we generated $1.2 billion in cash in the last three months, and we're not expanding community counts for growth. We're curtailing community counts until we see the market demand more communities and by curtailing community counts, you're not putting more into land and land development going into the year. So we have a plan in place that will continue to generate free cash flow and we'll use some of that free cash flow to invest in land if the opportunity arises that's a good opportunity and the markets have stabilized and it's a market by market look. But right now we're free cash flow generator.

Great. Thanks very much.

And next we'll go to Timothy Jones with Wasserman and Associates.

Good morning.

Good morning, Tim.

Kelly, your main number isn't working. Maybe some people who are listening on the internet would like the backup number, 866-558-6905, just to let you know. Okay. That first question, O&D, the lot count. Could you give the owned and optioned last year with the 180,000?

Oh, the last year I believe it was around 54% optioned and 46% owned. I'm close.

Okay. Close enough. Okay. 46. 46% owned, right?

It's, yes, it was 54%. 54/46. That was pretty good.

Okay. The-- I want to make sure of something you just said. Do you say today that your homes -- that your spec homes are 17% of your homes under construction because there's no other builder that's under 25% and there's a number of them that are at 50%?

That's exactly right. That's why we are a build-to-order home builder, not a spec production builder. And to do that, you have to have a backlog.

Tim, philosophically, we believe strongly in our business model and the senior management team is driving starts through having a pre-sold backlog. We are not going to chase our business plan by building a bunch of specs and hoping the buyers show up so much more predictable.

And next we'll go to Susan Berliner with Bear Stearns.

-- with some comments on some of your larger markets in California, Las Vegas, et cetera. And also I was wondering, with the sizable amount of cash you have sitting on your balance sheet, if you thought about taking out your 9.5 callables.

Do you want to talk to --?

Well, the 9 and 9.5 callables, we have thought about taking back and probably will do that before the year's out. Jeff will give--

As I shared in my comments, Susan, we're actually seeing positive sales comps in the east coast and the west coast. We're off in the southwest and central, in part due to community count, and in the case of Vegas or Phoenix, while we're seeing signs that it's starting to stir, they are still pretty challenged and competitive so we are not seeing a big sales boost out of Las Vegas or Arizona. Within California, it's spotty. We actually have communities where we hit the price points that target what I call the local demographic, the incomes in the area and the job levels in the area. When you can hit those price points today, you actually can still have campouts for your product and we've had that in an area in the Inland Empire where we brought a product to market around 400,000, which believe it or not is a first-time home buyer, and had campouts in the community so if you can get to the price point in any market, there is underlying demand there. Where it gets slow is when you're above that and it's just an affordability issue.

Are you having better-- do you think the markets will rebound faster in Las Vegas or Phoenix?

I-- Phoenix is not as land-constrained.

Right.

There's a lot more inventory on the ground, which will probably put pressure on pricing. I think my hunch, and this is a crystal ball, would be that Vegas would rebound ahead of Phoenix. But both of them, that's still to be told.

Great. Thanks very much.

And next we'll go to Carl Reichardt with Wachovia Securities.

Hi, guys. How are you?

Good morning, Carl.

Made my way into the call. Susan didn't just ask this question because I missed part of it. But can you talk a little bit about your net community openings in the first quarter and second quarter of the year relative to last year in terms of sort of pricing and square footage, Jeff? I'm sorry if that was just asked.

Well, Dom can give you the net community number. As to square footage, Carl, there's really three buckets that we're chasing to lower our costs and lower our price to the buyer. One is by building smaller homes. As the markets were so strong over the last few years, you could make more money by building a bigger home on the same lot and our average size home in many communities was up 300 to 400 square feet. So we're quickly retooling product on our new openings to go to smaller product. In some cases, we can lower our spec level by $20,000 to $30,000 from what was in the larger product, and then third would be whatever we can get back from the subcontractor base in the way of savings. Between the three, you could potentially lower your price $50, $60, $70,000 and not impact your margin, and that's where we're headed with our new community openings in '07.

Dom, do you have the number for him?

Yes, in '07, we're going to open 180 new communities. It's about 42% of the average communities that will have opened this year, and it's 80 in the first half and 100 in the second half. Last year it was about 260 communities, and, again, that was about 150 that came in the second half. So we've been able to at least at that level be able to, on those new ones that opened the second half of the year look at reducing the cost of the square footage and making them more affordable.

Terrific. Okay. I appreciate that very much, guys. Thank you.

Thanks.

And next we'll hear from Ken Zener with Merrill Lynch.

Good morning.

Good morning, Ken.

I'm just-- if you could quantify, you are facing some pricing pressure. I realize, Jeff, you talked about your guys' ability to offset the cost input, but could you kind of give us a little more sense of what you mean by moderating margins in the first few quarters here sequentially relative to the fourth quarter?

I will defer that to my good friend and running buddy, Dom Cecere.

I mean it's just what you have seen. We're into the -- going into the new year and we're only two weeks into the sales cycle. We still have pressures on pricing and therefore our best look today is that margins are going to moderate some until we see some demand pick up and we just want to make sure that the analysts understood that the margin improvement that will happen in this industry is really going to be a second half event, not a first half event. It's still going to be difficult to peg the margins until we understand what happens with pricing in the first quarter and the second quarter.

Right. I guess would you consider the 300-basis point decline third quarter to fourth quarter moderating?

No, I wouldn't. You have to remember, in the third quarter, there was significance cancellations starting in the industry. That ended up -- we ended up with a lot of unsold spec homes by builders being pushed through the system and when that happened, that really drove prices down more. So I think the fourth quarter was probably a tougher quarter. The first and second should not be as bad as the fourth as far as declining margins go.

Okay, and then in terms of the communities where you had the impairments, what is the margin that you're kind of resetting these communities to? And if you could kind of describe your thought process, and how much of the charges that you've taken in '06 will be benefitting '07 deliveries? Thank you.

I mean it's, it's by community. Each one can be different, but our net margins are only between 10% to 15% gross margins on these impaired communities. And in the-- what is it, Kelly? It's about 40% of that flows through the P&L in 2007?

Yes, in 2006 we had about 37 impaired communities and about 29% flows through '07, 43% in '08, and the remainder after '08.

Ken, we underwrite every quarter every community to a net present value on cash, and while we do that methodology, it defaults back to a margin that will range from 10% to 15%.

[OPERATOR INSTRUCTIONS] And next we'll return to Michael Rehaut with JP Morgan.

Thanks. I was wondering, Jeff, if you could address one of the, I think unique aspects of KB now that you're moving into the CEO seat, which is the France unit, and obviously from time to time, people ask about that in terms of if that's going to continue to be a core part of the business as most other U.S. builders concentrate domestically. What are your thoughts on that business and is that something that you might take a fresh look at over the next 12 months?

Well, Michael, I don't know if you were on the phone, but somebody already raised this question. We've been in France for over 30 years. We have a phenomenal business with a tenured management team, with succession plans in place. We've had a great growth track for the last two years. They now build in every province, so it's a very well run, very profitable business, with projections in '07 for more growth in revenue and earnings so we have this business that runs well. It's been part of our strategy for the years. I think we're the only U.S. public builder that has a success story in another country, and we're in no hurry to make a decision to do anything right now because we're-- it's running very well and we have a good relationship with our French management team so we'll continue to evaluate their results and opportunities in the future. Right now, we haven't cut a strategy.

Mike, it's a hidden asset we probably don't get enough credit for. I mean the KBSA has -- stock has rallied up 20% just in the last few weeks and it's currently -- market value is about $800 million. So one of the things that people should realize when they own KB Home is we've got an $800 million market value that I think is only on our books for $200 million. So from a book value perspective, it's a jewel.

I appreciate that and sorry I repeated the question there, but just switching gears for a moment, you mentioned some very good balance sheet shape, particularly in terms of spec. I was wondering looking into '07, in the first half of the year particularly, do you expect to continue to reduce your spec and also your lot count, and with the 10,000 homes under back -- under construction, only 17% without an order. I mean is that something that can continue to come down?

Over the years, Mike, our typical ratio is 90% sold, 10% unsold. With the cancellation spike in Q3 and Q4, that number went up even above 17, I think, at the end of the third quarter or early fourth quarter so we're going to continue to work that number down back to the 10 % range. And the market and the sales rates and everything we do per community will drive how big a construction pipeline we have and what our lot needs are on a go-forward basis.

And do you have an idea what the differential is between the cancelled homes that you're reselling now versus the new orders that you're writing today in terms of looking at the gross margins?

When we've looked at them, Mike, it's ranged from 500 to 1,000 basis points lower in price for a cancelled home that's resold versus a build-to-order home so it's a significant difference.

And that will conclude our question and answer session for today. I will now turn things back over to Jeff Mezger for any additional or closing remarks.

Thank you. Thank you for joining us today for our fourth quarter and total year 2006 earnings conference call. I hope to see many of you later this month at the Wachovia Homebuilding Conference in Las Vegas. Have a great day.

And that does conclude our conference. Thank you, everyone, for your participation.