KB Home (KBH) 2008 Q3 法說會逐字稿

Good day everyone and welcome to KB Home's third quarter earnings conference call. As a reminder, the conference is being recorded and webcast on KB Home's website at KBHome.com. The recording will also be available via replay until midnight on October 5th, 2008. You can access this recording by dialing 719-457-0820 or 888-203-1112 and entering the replay pass code of 1423691.

KB Home's discussion today may include certain predictions and other forward-looking statements. These statements may cover market or economic conditions, KB Home's business and prospects, its future financial and operational performance and/or future actions or strategies and their expected results. They are based on management's current expectations and projections about future events and its business condition, but are not guarantees of future performance. Due to a number of risks assumptions, uncertainties and events outside its control, KB Home's actual results could differ materially from those expressed in or implied by the forward-looking statements. Many of these risk factors are identified in the company's periodic reports and other filings with the SEC, which the company urges you to read with care. Now for opening remarks and introductions, it is my pleasure to turn the conference over to KB Home's President and Chief Executive Officer, Mr. Jeffrey Mezger, please go ahead, sir.

Thanks, Kelsey. Good morning and thank you for joining us today for a review of our third quarter results. With me are Dom Cecere, our Executive Vice President and Chief Financial Officer, Bill Hollinger, our Senior Vice President and Chief Accounting Officer and Kelly Masuda, our Senior Vice President of Investor Relations and Treasurer. By now, you have probably had the opportunity to read our earnings release. In a few moments, I will turn the call over to Dom who will go through the numbers in greater detail. Then of course we will open it up for your questions.

But first, I would like to offer my own perspective on the state of the industry, our quarterly results, and how KB Home's strategic decisions are enabling us to manage successfully through these very difficult market conditions and to emerge from the downturn a more nimble company, well-positioned to seize attractive growth opportunities as they arise. The past few weeks have been truly historic and certainly represent the most drastic change in the capital markets that I have seen in my lifetime. While it will be some time before the impact of any comprehensive government intervention will be fully understood, we welcome any steps that help to stabilize the mortgage markets and increase consumer confidence. However, it should be noted that the current proposal provides no direct relief for housing, despite the fact that policy makers recognize that once again, housing will be a cornerstone for the broader economic recovery.

For the time being, difficult market conditions persist. Lending standards are tightening further in the mortgage market, and consumer confidence which remained low prior to the recent news may decrease even further. At 6.1%, unemployment stands at the highest level in five years and inventory of both new and existing homes remains bloated. While resale inventory driven in large part by the spike in foreclosures now stands at 4.26 million, we are encouraged by the uptick in activity in some markets. This increased sales activity, however, is driven by extraordinarily low pricing levels as local markets seek to reach an equilibrium between supply and demand. Markets will eventually stabilize, and when they do, new normals will be set for pricing, demand, and credit terms, against which future housing market performance will be judged. We should not expect a snapback to the pricing and credit dynamics we saw a few years ago, even after the current downturn comes to an end.

We believe success in today's environment calls for an integrated and disciplined approach to balance sheet and profit management, centering on three strategic imperatives. First, maintaining a strong cash position and balance sheet. Second, restoring operational profitability. And third, positioning ourselves to capitalize on a housing market recovery when it occurs. When we first embarked on these imperatives in 2006, our initial objective was to generate cash and reduce inventory levels. At that time, we were among the first builders to recognize the importance of having a strong balance sheet with plenty of cash on hand during a downturn. The benefits of this choice can still be felt today as we enter the third quarter with reduced debt levels and a sizable cash balance of $942 million. We expect to be cash flow positive for both the balance of and full year 2008, with over $1 billion in cash and no cash borrowings outstanding on our unsecured credit facility at year-end. This positions us well to weather the continued downturn and capitalize on investment opportunities when they arise. Although, until the markets stabilize, we will remain conservative with our spending and investment decisions.

Having accomplished our primary objective of a strengthened balance sheet, we are now focusing our efforts on maintaining this position while restoring profitability and we are making progress toward this goal. Our net orders in the third quarter declined 66% to 1,329 homes, driven in large part by three factors. First, we enforced price discipline in the face of some very powerful downward pressures. Because of our cash position, we do not have to sell and build homes at a loss just to generate cash. Second, our community count was down by 38% year-over-year and over 50% from the 2006 peak. We will continue operating with fewer communities until we believe investments in new communities will deliver financial results with acceptable returns. Finally, we accelerated a major product transition strategy, which slowed the sales pace in a number of our communities in the short term. These three factors will exert downward pressure on our net orders in the fourth quarter, as we position ourselves for restoring profitability going forward.

We also continue to realign our business to operate efficiently in this environment. In the third quarter, we consolidated the operations of seven of our divisions. While taking steps like this to become as lean as possible, we are also staying mindful of our strategic growth platform. The markets where we operate today are the same markets where we delivered over 30,000 homes at the housing peak. We expect these markets to lead the housing recovery and we will be ready to mobilize when they do. These division consolidations produced one-time charges that hit in the third quarter. As a result of these moves, and other reductions in our workforce, our employee count is now 66% below the 2006 peak, including an 18% reduction in the current quarter. As much as we have already done, our SG&A is still at unacceptable levels, and cost reductions in this area will continue to remain a top priority.

Perhaps our most significant move in the quarter was accelerating the transformation of our product line. As we sharpened our focus on the first-time buyer, we recognized that many of our product offerings were not aligned with their current needs and affordability levels. Our houses were too big, included too many costly features, and as a result, were too expensive for our core customer. So we began down sizing and down specking our homes. For example, last year in California's Inland Empire region, we quickly moved from building 3400-foot homes that sold for $450,000, to building 2400-foot homes that sell for $300,000. That worked for a time but the market continued to move away from us. Now, we have introduced a new line of homes that start at three bedrooms and 1230 square feet for just over $200,000, a price that is very competitive with today's resales, including foreclosures. The market has responded very favorably. Even in the Inland Empire, arguably one of the most difficult housing markets in the country, we are seeing more than two sales per week in the communities where we have introduced these new plans. I share the detail behind this success story because it typifies our strategic direction company-wide.

We are heavily focused on competing with resale price points in every market. As you know, KB Home does best when we focus on our core market of first time home buyers. These buyers are especially important in these times because they are not burdened with the need to sell a home before making the buying decision. We continue to differentiate the customer experience by offering built to order homes that give buyers the power to choose exactly the features and upgrades they want in their home. And even with the pressure on pricing, the sales and margins at our KB Home Studios, where our buyers can personalize their homes, have held up quite well.

Environmental leadership is also an increasingly important differentiator and we have a stated goal of becoming a leading environmentally friendly national company. During the quarter, we released our first sustainability report, a comprehensive review of our current initiatives and commitments. The report is part of our larger My Home, My Hearth initiative that among other things helps drive costly waste out of our business. As I have noted on earlier calls, the country's long-term economic and demographic outlook remains very encouraging for the housing industry.

Even with the disruptions in the larger economy, we do not see the fundamental desire for home ownership diminishing. Harvard University's Joint Center for Housing Studies has projected the annual increase of housing needed between now and 2020 at 1.4 million units, as the US population continues growing, and social trends create more single person households. Our job now is to navigate our way carefully through today's economic cross-currents, so we are well-positioned to serve this market on the other side. I will now turn the call over to Dom to discuss our results in more detail and then I will have a quick final comment before we open it up to Q&A. Dom?

Thanks, Jeff. Net orders of 1,329 new homes in the third quarter were down 66%. The decline was largely due to our reduced community count, down 38% from a year ago, and our strategic decision to hold firm on pricing and reduce the use of sales incentives. In addition, we designed and are introducing new, more affordable product at several of our communities that is better tailored to the needs of today's first time home buyer, and is more cost-effective to build. As we make this transition, we are shutting down some communities for a short time and consequently are experiencing a temporary lag in orders in other communities where our current product will be discontinued. We expect to have our new, more affordable product online by the first quarter of 2009, which should have a positive impact on net orders going forward.

We had 232 active selling communities in the third quarter of 2008, down 38% from 372 in the third quarter of 2007. Our community count was lower across all four of our regions, with decreases ranging from 33 to 41%. Clearly, our highest operating priority remains increasing our margins and returning profitability. For now, that means operating at reduced volume and corresponding SG&A levels. As conditions change, however, we will continue to review and adjust community counts as appropriate to maximize our performance in each region. Third quarter order cancellations as a percentage of gross orders was essentially flat at 51% in the third quarter of 2008, compared to 50% in last year's third quarter. Our cancellations as a percentage of beginning backlog, however, continued to improve. The rate was 22% in the current quarter, down from 33% in the second quarter of 2008 and 29% in the third quarter of 2007. In fact, this is the lowest rate we have experienced since the first quarter of 2006. We entered the third quarter with 6,233 sold homes in backlog, and we converted 2,788 or 45% of our beginning backlog to revenue during the period. This compares to a conversion ratio of 42% in the third quarter of 2007. Our backlog remains geographically diverse with the largest portion on a value basis located in our West Coast and Southeast regions.

We incurred a net loss of $145 million, or $1.87 per share, diluted share, in the third quarter, including pretax non-cash charges of $82 million for inventory and joint venture impairments, and $10 million associated with the early redemption of our senior subordinated notes and the amendment of our credit facility. During the quarter, we also recorded a $58 million charge for a deferred tax asset valuation allowance. We delivered 2,788 homes in the third quarter of 2008, down 51% from the year earlier quarter, reflecting our reduced community count and the very challenging market conditions that have hampered our net orders for the past several quarters. Each of our regions delivered fewer homes compared to the year earlier quarter, with decreases ranging from 42 to 63%. We expect our community counts to remain at reduced levels through the end of the year.

Our third quarter average selling price fell 10% to $239,700 from $267,700 in the year earlier quarter. The most substantial decline occurred in our West Coast segment, where the average selling price fell 20% year-over-year amid expanding foreclosure rates that continue to fuel intense pricing pressure. Average selling prices in our Southwest and Southeast homebuilding regions fell by 13% and 11% respectively, with our central region up slightly. In general, our lower average sales prices reflect both declining market prices and our efforts to address affordability over the last several quarters. Our housing gross margin in the third quarter of 2008 rebounded to a positive 3.9% from negative 28% in the third quarter of 2007. The higher margin was directly attributable to lower impairment charges relative to a year ago. Excluding those charges, the margin was 9.6% in the current quarter, compared to 13.9% in last year's third quarter. On a sequential basis, however, we saw an improvement from 8.7% margin excluding impairments we reported in the second quarter of 2008. We expect margins to remain compressed throughout the fourth quarter.

Selling, general and administrative expenses in the third quarter were down $64 million or 32% from a year ago. Reducing overhead is a major priority for us. We continue to take actions to better align our overhead with reduced delivery volumes. In previous quarters, we have exited underperforming markets and/or consolidated operations. This work continued in the third quarter. We consolidated our West Coast region operations into two divisions, Northern and Southern California and we are in the process of merging some divisions in other regions as well. We believe these additional steps will produce better financial comparisons in future quarters. Our basic approach in these consolidations is to maintain our primary division with smaller business units to help service a wide area. The strategy is to preserve a solid foundation that can support growth and expansion as market conditions become more favorable. In essence, we are maintaining an expandable operating presence in all the markets that generated our peak year results of 30,000 deliveries.

We also made further reductions in our employee count during the quarter. As Jeff mentioned, we have reduced our workforce dramatically from its peak level in 2006. The financial impact of our overhead reductions were partially offset in the quarter by associated costs. We incurred about $14 million or approximately 200 basis points of non-recurring severance and lease termination costs in the quarter, as a result of the recent division consolidations and reductions in workforce. Savings should become more evident in our future results. SG&A as a percentage of housing revenues was 19.9% in the third quarter, up from 12.9% in the year earlier period. Because of the steep and rapid decline in our revenues, the ratio does not reflect the progress we have made. We are not satisfied with this result and we will continue to work relentlessly to pare back our overhead in proportion to our revenues.

Our homebuilding pretax loss in the third quarter totaled $157.7 million, including a pretax charge of $82.2 million for inventory and joint venture impairments. About half of the impairments were associated with unconsolidated joint ventures. Our regional breakdown of the charges is as follows. West Coast, $7.4 million. Southwest, $53.7 million, and Southeast, $21.1 million. We hope that we have turned the corner on impairments.

The current quarter charge was 88% lower than the total impairment and the abandonment charge recorded in the year earlier quarter, and the charges have decreased sequentially for the last four consecutive quarters. The financial services business contributed pretax income of $6 million in the third quarter of 2008. Our Countrywide KB Home Loans mortgage banking joint venture has remained profitable throughout the recent turmoil in the mortgage market. The joint venture's structure has worked well for us, it provides for lower risk. Within the joint venture, our retention rate was 80% for the third quarter of 2008, compared to 73% a year ago.

Buyers also continued to use more fixed rate product, just 4% chose an adjustable rate mortgage during the quarter. Government and conforming loans were used in 95% of our third quarter deliveries. At the end of the third quarter, approximately two-thirds of our backlog of sold homes were qualified with an FHA or VA loan. The third quarter period reflected a $58 million deferred tax asset valuation allowance charge. While the deferred tax asset valuation allowance is a non-cash item, it did impact our balance sheet and book value. Since recording the valuation allowance in the fourth quarter of 2007, we have $780 million of deferred tax assets fully reserved as of August 31st, 2008. To the extent we generate taxable income in the future to utilize these tax benefits we expect to reverse the valuation allowance and decrease our effective tax rate on future income. However, to the extent we generate future operating losses, we will be required to add to the valuation allowance and our income tax provision will be adversely impacted. The valuation allowance on our deferred tax assets is a significant relative to the current equity and could have a meaningful impact on our book value per share and our leverage ratios when it is realized.

Over the past few quarters, we have streamlined our land positions significantly, reducing inventory and community counts while consolidating operations and exiting underperforming markets. At August 31st, 2008 we had $2.6 billion in inventories, compared to $3.3 billion at November 30th, 2007 and $4.4 billion at August 31st, 2007. At the end of the quarter, we owned or controlled approximately 52,700 lots, down 72% from a peak of 186,300 lots in the first quarter of 2006, and 36% from 82,600 lots in the third quarter of 2007. Our current inventory represents about a three-year supply based on trailing 12-month deliveries. Of the 52,700 total, we own less than 37,000 lots, and have approximately 15,700 lots controlled via land option contracts. Homes in production are down almost 71% from the peak in the third quarter of 2006 and 55% from the third quarter of 2007. We currently have approximately 5,189 homes in production, with 18% or 938 homes unsold. This is one of the lowest spec production levels in the industry. We had approximately 481 finished unsold homes in inventory at quarter end.

We had total debt of $1.9 billion at August 31st, 2008 which was $284 million lower than the balance at August 31st, 2007. In July, we used a portion of our accumulated cash to redeem all $300 million of our 7 3/4 senior subordinated notes, ahead of the scheduled 2010 maturity. The early redemption resulted in a charge of $7 million in the third quarter of 2008 with a payback in less than five months and a $16 million in savings in 2009. During the third quarter, we also worked closely with our banks to amend our unsecured revolving credit facility. We are pleased with our banking associations and the effective working relationship we have with these important business partners. The recent amendment reduced the aggregate commitment under the facility from $1.3 billion to $800 million and modified the tangible net worth and certain financial ratios we are required to maintain. The facility's November 2010 maturity date remain unchanged. We wrote off $3 million of unamortized cost in the third quarter due to the reduction in the commitment amount of the facility. There were no cash borrowings under our current unreserved secured revolver facility at August 31st, 2008. We expect to have no outstanding cash borrowings under this facility at the end of the year.

As of the end of the third quarter, our debt net of cash totaled approximately $935 million, compared to $1.5 billion a year ago. The 38% reduction in net debt in the last 12 months reflects the third quarter redemption of our senior subordinated notes and our higher cash balance at August 31st, 2008. We have generated positive cash flows from operations in the last 12 months and expect our operations to produce positive cash flows in the fourth quarter. We expect to end the year with over $1 billion in cash. Our net debt to total capital ratio was approximately 45% at the end of the third quarter. Compared to 31% at year end 2007 and 36% at August 31st, 2007. The increase in this ratio from UN was due to the impairment in abandonment charges and the deferred tax allowances recorded in the first nine months of the year, which reduced our equity.

Looking ahead to the first quarter of 2009 we have $200 million of 8 5/8% senior subordinated notes scheduled to mature. We expect this to be offset with a tax refund of approximately $220 million coming in the quarter. After these notes mature, our next bond does not come due until 2011. With $942 million of cash at quarter end, and about $614 million net of letters of credit available under our banking revolving credit agreement, our liquidity at August 31st, 2008 was in excess of $1.5 billion. We believe we have ample liquidity to navigate the current environment and capitalize on opportunities as they arise. As of August 31st, 2008, we had approximately $250 million in invested and about 30 unconsolidated joint ventures, of which around 20 are active. This is down from $369 million one year ago. Our investment in unconsolidated joint ventures have continued to drop due to impairments, renegotiations with partners, and buy-outs. We have been actively working to reduce our joint venture investments and expect we will see further reductions in the fourth quarter and next year. We strategically manage our joint venture assets like any other assets, and evaluate the best use for them among the available alternatives such as bulk sales, building through the moth balling.

Of our active joint ventures, we have six with loan to value maintenance guarantees. If the values of these projects fell all the way to zero, our total estimated exposure under those guarantees would be less than $100 million. We are currently working with our bank partners to find solutions for a handful of our unconsolidated joint ventures in the Southwest, the mid-Atlantic area and the Southeast region. Although we cannot discuss any details, we continue to work with our select partners and banks to find the best solutions for us and our stockholders. Additionally, we are opportunistically unwinding certain joint ventures. For instance, the past quarter, we executed the buyout of the equity position of a joint partner in Milpitas, California at a substantial discount, which attractively enhanced our returns. The position was held by a Wall Street investment bank. Furthermore, in the fourth quarter we have already purchased the equity position of our joint venture partners in two other projects.

Now let me turn it back to Jeff.

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

Each of you did not join this call to learn about the difficult economic environment that the country is facing. And these truly are historic times in that regard. You also did not join the call to learn about the headwinds in the housing industry. There's no question that these are challenging economic times. And that the policy makers are addressing the national economy. There is also no question that the long-term prospects for housing are favorable, driven by strong demographics. Someone once observed, tough markets don't last forever, tough people do. We do not control the market dynamics, nor do we control the timing of when those dynamics will improve. What we do control is how we act in these times. And at KB Home, we are responding to this tough market by taking aggressive steps that are repositioning our business to take advantage of opportunity.

I would like to recap for you what I would like you to take away from this call. First, KB Home is well-positioned with a strengthened balance sheet. We will end the year with over $1 billion in cash and no borrowings outstanding on our revolver. The over $1.5 billion in liquidity represents ample dry powder to run our business and to be opportunistic. Our goal for 2009 is to manage the business with neutral cash flow and have set a target of over $1.5 billion in liquidity for year end '09 as well. Second, we are working to improve our sales results, which were impacted to a large degree by steps we have taken, whether it is pricing for margin over volume, our reduced community count, or the product transition that I shared. We are pushing to open our new product line communities as quickly as possible, but many will not have a material impact on sales rates until the beginning of 2009. We believe we are taking the right steps to properly position our selling efforts as we head into the new year.

Next, while maintaining a sound balance sheet, we are diligent in our pursuit of restoring profitability. We will pace our sales rates with a balance between margin and Asset Management, and be relentless in further reductions in SG&A. It is imperative that we continue to realign our overhead, to drive our SG&A ratio below historical levels, irrespective of the revenue levels we are generating. We also continue to reposition KB Home for the future, in a number of ways. We have intensified our strategic commitment to primarily first time home buyer communities. We continue to drive lean business structures while retaining our growth platform in those markets where we have performed well historically and that have favorable growth projections and we are transfiguring our product lines to be more value engineered and aligned with the needs of our customer, while competing more favorably with current resales.

Finally, we continue to execute on the many differentiators that are unique to KB Home. Things like our brand recognition and marketing approach, our partnership with Martha Stewart, our built to order business model, featuring value and choice in our studios and our sustainability initiative. All of these attributes are competitive advantages for our company and they all resonate well with our consumer. As the markets stabilize, I'm confident the value of these differentiators will become even more apparent. We also recognize that it will be a very different world for the homebuilding industry, even after we experience market stability. We will have to operate in a way that is consistent with significantly readjusted home prices, mortgage terms and availability, and buyer preferences.

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

Thank you, so much, Mr. Mezger. (OPERATOR INSTRUCTIONS). We'll go first to Dan Oppenheim with Credit Suisse.

This is actually Mike on for Dan. Jeff, in your opening comments you talked about how you don't see kind of any direct help for housing from this bill. Just wondering, and you said that this is going to pressure sales this fall. I was wondering kind of what you're hearing about potential for any sort of second stimulus package, whether it's a tax credit, return of down payment assistance, are you hearing anything about that?

There's a lot of noise in the hallways, Mike, but the majority of the bill right now is focused on fixing Wall Street issues. I'm not aware of anything that's being talked about in these proposals that's going to create housing demand or stabilize housing markets. We're heading toward the election and in turn a new Congress in January and it's unclear whether they'll be able to push anything through that would stimulate housing between now and next January.

Thanks. And then just kind of a follow-up. Interesting comments on the shift in kind of product offering and how in the communities you've opened in the Inland Empire you've seen some decent sales trends. Was wondering, have you had any other communities open outside of there, other markets, can you comment about trends there or if not, where are kind of the next markets that you're going to be opening communities with these new products?

Well, you asked a lot of questions there, Mike. But we've actually opened this in three locations, just in the Inland Empire, and we're moving this product concept across the country. Right now, as we track it, about 25% of our communities are involved in this transition. And it was a strategic decision. The price points on resale are down so much now and there's so much inventory out there, you can't sit and wait for the market to come back to you. You have to retool your product and get down to a price point where it's the old trade-off of new versus used, where it's a small premium for new versus some of the larger premiums we saw in the heat of the market. So our goal is to continue to move this across the country. We've already seen positive experience in other markets but not significant because we haven't gone as radical as we did in the Inland Empire. Between now and January, it will be as much as 25% of our communities.

Our next question will come from Ivy Zelman with Zelman and Associates.

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

I can respond to the first part and I'll leave the second part to the accountants, Ivy, because I'm not sure. But as to the impairments, when we take an impairment, it doesn't take you to a normalized profit margin. Impairments are IRR based. In our model as we're doing these impairments, it typically results in a 9 to 11% gross margin. It doesn't get you back to profitability. After you take the impairment, if there's pressures in the marketplace on the price side it will squeeze your margin a little further. So from time to time we get investors that ask hey, you took these impairments doesn't it fix you and you're now profitable? It really doesn't do that. The way to get back to profits is to cut our costs further, do a little bit, whatever we can on pricing, cut our cost to build and keep finding other ways and to date, what we've seen as we continue to whittle away at costs, we've had to use those savings to offset what's going on with the pressure on pricing.

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

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

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

Moving on to Michael Rehaut with JPMorgan.

Hi. This is Jen Consoli on the line for Mike. My first question, you talked about sales trends during -- that you were encouraged in certain markets. So I was wondering if you could just drill down on that a little bit more and talk about maybe throughout the quarter what you were seeing and also if you could give us any color on specific markets like Texas, the Carolinas, California, et cetera.

Jen, when I referenced the uptick in sales it was tied to resale activity. As you saw from the new home sales side, the report that came out yesterday, it's still continuing to soften a bit on a national level. But there's many of the markets that ran up so fast where the repossessions have created a large resale inventory overhang. They're now being sold at a price where they're selling fairly rapidly, and it tells you that pricing on the resale side is now at a level where the underlying consumer can afford it again. A good example would be right here in California where Southern Cal sales or even the Central Valley sales were up but it's at a significantly reduced price because it's influenced so heavily by repos. And the challenge is how do you get your pricing down on new product so you can make money on these lower levels and that's what we're working on. As to any regional color, I don't know of any markets that we're in today where you would say that the sales have ticked up on the new home side. Some of the markets that had held well earlier in the year like a Charlotte or a Raleigh or even Austin and San Antonio, we're starting to see some pressure there on inventory levels. Sales rates are off. And I think you'll see those markets soften. They were late to the cycle but I think they're turning now just like they have everywhere else.

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

You've heard I'm sure of the portfolios that are being shopped and most of those have been to buy the debt and we really don't play in that market because we don't want to take over a loan and then have to clear out the borrower. But in those portfolios that we've looked at, they're predominantly C minus locations, maybe C plus or at price points that we certainly wouldn't want to play at. We've seen a trend where they may be going from a C plus up to a B minus but still nothing that's compelling. We are starting to see more offered at lower prices so it is moving but it's still not to a point where we're ready to reinvest heavily.

Moving on to David Goldberg with UBS.

Good morning. Jeff, I want to maybe start with a little clarification/comment on an earlier question you had about the pricing on these smaller homes that you're putting forward, these [spec] units that you are putting forward relative to the existing home prices. Are you referencing them being closer or nearly in price with foreclosure existing prices or kind of a non-distressed sale and maybe if it's non-foreclosure, where are you relative to foreclosure pricing?

Well, the resale pricing in every market is the blend of traditional resale, I'll call it, plus the foreclosures and the example in the Inland Empire, I think the statistic was that about 50% of the resales are foreclosures today. And our product is now priced down competitively with that blended price. We're at a premium to it but it's 5%, 10% premium, not 30% or 40% like we were with the older product. If you think through the numbers that I shared, the choice is you either keep with our down sized 2400-foot home and whack the price even though the product is not what the consumer can afford today, or you figure out a different way to get your prices down. And that's what we did through smaller product. It's a combination of really value engineering a product, adjusting your spec level to what the buyer wants and then building a smaller home.

I guess my question, my follow-up question would be, just trying to understand with the new smaller product line, what are the margins look like on those homes, maybe relative to the building times, to the building cycles? And then with that, do you think you attract a clientele with that home that's still as interested in the design studio and maybe putting as much in terms of options into the house to generate the same margins to justify the design studio concept.

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

Next question comes from Stephen East with Pali Capital.

Good morning, guys. You mentioned in your commentary that you expected a cash neutrality in '09. I guess a few issues surrounding that. You've got significant '06 taxes that you could capture with some type of land sale in the fourth quarter that would obviously be recognized in the first quarter of next year. You've got some JV issues, particularly I guess in Vegas, et cetera. Could you talk about what went into your forecasting there and specifically on those two items?

I'm not sure what you're referring to with the land sale and capture in '06. The tax refund that we're expecting here in the first quarter is already in the Q based on events that have happened. And that will cover the bond that matures in December. We have -- we're in the middle of our planning process for '09. We've got some preliminary looks and we're still finalizing it. There are assumptions in there for land acquisition and development that won't occur if the markets don't get better because we're not going to invest at this time. And our strategy right now, our goal is to be cash neutral inclusive of anything that we may have to do on the 15 or 20 JVs that are out there to be addressed in '09. All of these components you raised are already in our assumption.

What I was talking about on the land sales, you earned quite a bit of money in '06. I guess what I'm wondering is do you foresee any more land sales either primarily in this fiscal fourth quarter that you then might get the tax refund for in '09?

We don't see any of that right now.

Our next question will come from Ken Zener with Macquarie. Your line is open. Please go ahead, sir.

Sorry about that. Your new orders especially in the Southeast dropped precipitously. Can you kind of talk a little more in detail, I know you are talking about community [resales]. But it dropped to 180 from what had been 1220 last year.

I think it's for the reasons that we raised, Ken. It's community count. Last year we were closing out of some of the remaining communities in the markets we exited like Treasure Coast or Fort Myers. So you have a little bit of that phenomenon. We were much larger in Atlanta than we are today. So community count is down in Atlanta. But I think it's primarily due to the factors that I raised in my comments. I don't know if there's anything --

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

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

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

That was correct.

Chris Hussey with Goldman Sachs has the next question.

Thank you. Can you hear me okay?

Yeah, hear you fine, Chris.

I was on a cell phone. Question first on the JV investments. How much cash did you have to invest in the JVs, either by taking down or by putting new equity in the quarter.

Very, very little in this quarter.

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

And the whole year was around $60 million that was invested in JVs, cash.

$60 million year-to-date in the JVs? Okay. On the construction costs, in this new product you're going to build a smaller product and so maybe following up on another question, are you finding your construction costs could scale into that product that's allowing you to maintain construction margins and are you doing anything to rezone some of the properties to get better density for a smaller product?

Chris, you were breaking up a little bit. I'll take a shot at where I think you were headed. First off, the cost savings with this value engineered product is significant. Where we've rolled it out and got our budgets locked down, it's as much as 10, 12, $15 a foot from where we were a year ago. So in our cost to build in our old product we were already tracking cost reductions of 12, 13% for the year. Now you layer on this next level and it brings it down significantly due to the designs and the value engineering. So between the two, you'll see our costs go down.

We actually in my Inland Empire experience that I shared, the margin is up from where it was on the bigger product, on the same lot basis. So we're able to lower the price, attract a different consumer, compete with resales and foreclosures and still improve margins. So it's a great combo that we're hopeful we can execute across the country. Where we can, we're going to work to rezone properties. Right now where we're transforming the product lines, it's where we have finished lots. We're not looking to take raw land, invest dollars in improvements and go address those communities just yet. So it's on the finished lot programs. So anything we do on rezoning will take some time and would play out end of '09 or beyond that.

We'll now hear from Timothy Jones with Wasserman and Associates.

Good morning. A critical question here. That nobody asked. Is you obviously been hit very strongly on holding prices, reflecting your cancellation of new orders. But what I don't understand is that the units you're closing that you're only making 9.6 and 8.7 gross margin which is about half your competitors who have not had the drop of 66% in orders. Why, if you are holding prices, are your margins so much below many of your competitors have recently reported?

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

Before I ask my second question, can I get a clarification on that new product you have? Is it a single family or a multi-family and what's the lot size?

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

And the second question I have is -- just a second. I just -- oh, yes. Obviously by trying to maintain your prices, you're getting very high cancellations. But you have basically 481 finished units right now which is two per community which the average for most builders is one and for you to be dramatically lower than that. Does this imply that you're going to have to take some severe cost cuts to get rid of this standing inventory in the fourth quarter?

No, it doesn't imply that, Tim. Let me clarify a couple of things for you. Our can rate on backlog was the lowest it's been since first quarter of '06. So we're not seeing a spike in cans because we're working on margin. They don't tie together like that. That would affect your gross a little bit but not your can rate. And if you look at our production pipeline, I think you'd find that our percentage of production sold is the highest or one of the highest in the industry. We don't have a bloated inventory position compared to our peers. We are up a little bit in standing from where we normally are at one community and there is always that house that shows up or that buyer that doesn't perform and frankly, our specs are the hardest thing for us to sell because our whole business model is conditioned around presales and it takes a little longer to sell them but we don't go and heavily discount an inventory unit over a presell. We'll just continue to work through them.

So Tim, we had 5200 homes in production and 82% was sold.

We'll now hear from Josh Levin with Citi.

Hey, good morning. I wanted to follow up on the cash flow question. Your goal is to be cash flow neutral in '09. What assumptions about volumes and prices would have to be realized for you to achieve that goal? Would volumes have to be where they are now? Would they have to be higher or lower?

As I said, we're continuing to work on the plan and the assumptions for next year. For pricing our margins we assume what we have today. We're not going to take a wild stab that it's going to get better. As to unit count, still to be determined based on our sales as we end this year and go into next year. But we have whatever the unit count assumption moves up or down to, we would adjust the land acquisition development at the same time. So it's part of the balance we'll maintain through '09.

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

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

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

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

We'll go to Joel Locker with FBN securities.

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

Joel, I don't know where your number comes from but there's 4.2 million total for sale.

But 4.4 comes with rental, vacation all those vacancies, the rental rates, there's an extra 1.1 million there. This is based on a 10.75% historic rate versus 14.27 now multiplied by 128 million houses.

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

That's the 10.75%. That's the 50 year average.

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

Right, right, I understand. Just a follow-up question, do you have a dollar amount of the 5200 homes in construction of what percentage of the $2.56 billion in inventory that is?

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

Around 70%. Okay, thanks a lot.

Nishu Sood with Deutsche Bank has the next question.

Thanks. Hello, everyone.

Good morning.

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

I think it's all of the above. We feel we have the ability to run the business and retain enough cash to be opportunistic and reload at the right time. And when I say reload, part of our strategy is whenever the large reload, if you will, when it's time to really go because all the markets have stabilized, we're not just going to write checks, we're going to have created some partnerships or alliances with others. It's one thing if we can tie up lots on a rolling option which is not cash intensive and it's out there in most of our markets today. But if we were to make a major play, we're not just going to write a check. So it's a more prudent preservation of our balance sheet than we typically have done in the last runoffs. We do have land acquisition budgeted in our cash plan for next year. We won't spend it unless it makes sense.

Got it. Okay. So next question I just wanted to ask about was the smaller floorplans, the ones that are yielding the kind of two a week sales pace you were talking about, kind of thinking about the Inland Empire, where has that been successful? Are we talking about outlying areas like Victorville, Marietta, or something like that or are we talking about closer in areas like Corona or something?

Not to Victorville. Good example is in Beaumont, if you know where Beaumont is. So it's not as far as Victorville but it's not as close as Corona.

Megan McGrath with Barclays Capital has the next question.

Just a couple of quick modeling questions. The deferred tax or the tax refund you're expecting next year of 220 will pretty much reduce your deferred tax asset. I'm thinking to zero. How does the accounting work there? Do you anticipate you'll be able to write up any of your valuation allowance in '09 in anticipation of a fiscal 2010 refund?

You're correct, that the 200 will reduce our deferred tax asset. But we will not be able to restore any deferred tax assets until we return to profitability.

Okay. Thanks. And then my follow-up is on the JVs. Your corporate impairments went down this quarter but your JV impairments went up. So just curious if you think that the impairments at the JVs have been as rigorous as your own impairments and if you could just remind us how that works, are you running those impairment analysis or is someone else running them?

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

Okay. Thanks.

Moving on to Wayne Cooperman with Cobalt Capital.

I don't think I had a question. Thank you.

Thank you so much. We'll move on to Susan Berliner with JPMorgan.

Hi, thanks. I just had a couple of follow-ups. I guess the investment in joint ventures, I know you took an impairment but I was wondering if you could give us any color on where the joint ventures you have the investment, the $250 million are located.

Take that one, Kelly.

You know, Sue, it's primarily in the Southwest, as well as in the mid-Atlantic is where our biggest joint ventures are and then we have a number of attached joint ventures in California.

Great. And then just a follow-up I guess on all the cash flow questions, I think last quarter you had given a land spend number of $700 million. Can you give us any I guess thoughts as to how you're looking for the fourth quarter and what kind of a cutback in land spend you're contemplating for next year?

Sure. We -- when we shared the number in the second quarter, it was a budget for the year between land ac and development of around $700 million as I recall. Part of what we're trying to do is communicate that we're still in the game and prepared to be opportunistic when something comes our way. It actually blew up on us because some of the investors and analysts were questioning why we would spend money on new deals in this time. We're not going to spend that much in '08. No where near that kind of level. I don't know what our current level is but it's significantly under that $700 million that we shared and our projections for '09 are $600 million for land ac.

$500 million to $600 million.

$500 million to $600 million.

For land and development combined.

Thank you very much.

Ladies and gentlemen, we have time for one more question. It will come from Alex Barron with the Agency Trading Group.

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

Give us a call later, we'll give you the breakout we don't it with us.

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

Yeah, right.

Yeah, I was just trying to figure out how much of it was homes under construction primarily. My other question had to do with this quarter in terms of your margins, wondering what kind of benefit you guys received from previous impairments in terms of dollars or something.

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

It's very difficult to track over the long run.

That's all the time we have today for questions. So Mr. Mezger, I'll turn it back to you for closing or additional remarks.

That thank you very much, Kelsey. Appreciate all of you joining us today on the call. We look forward to speaking with you again in the future and have a great day. Thank you.

Thank you.

Thank you, Mr. Mezger. Ladies and Gentlemen, again that does conclude our conference for to today. On behalf of KB Home, I would like to thank you for your participation. Enjoy the rest of your day.