KB Home (KBH) 2009 Q4 法說會逐字稿

Good day everyone and welcome to KB Home's fourth quarter and year end earnings conference call. As a reminder, today's conference call is being recorded and Webcast on KB Home's website at KBHome.com. The recording will also be available via telephone replay until midnight on January 22nd. You can access this recording by dialing 719-457-0820 or 888-203-1112 and entering the replay pass code of 3687634.

KB Home's discussion today may include certain predictions and other forward-looking statements that reflect management's current expectations or forecasts of market and economic conditions, and of the Company's business activities, prospects, strategies and financial and operational results. These statements are not guarantees of future performance and due to a number of risks, uncertainties and other factors outside its control, KB Home's actual results could be materially different from those expressed in or implied by the forward-looking statements. Many of these risk factors are identified in KB Home's filings with the SEC which the Company urges you to read with care.

KB Home's comments today will also include non-GAAP financial measures as defined in Regulation G. The reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures and the other information required by Regulation G is in the Company's Earnings Release which has been posted on the website's Investor Relations page under the recent releases link and is archived with their other releases under the financial information news releases link on the right hand side of the page. 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.

Thanks, Matt. Good morning, and happy new year. Like to thank you for joining us today for a review of our 2009 fourth quarter and full year results. With me this morning are Bill Hollinger, our Senior Vice President and Chief Accounting Officer, and Kelly Masuda, our Senior Vice President and Treasurer.

Looking back at 2009, KB Home substantially achieved our operational and financial objectives, ending the year with positive momentum that we look to build on in 2010. Throughout the year, we focused on generating cash and strengthening our balance sheet, improving our business operations, carrying out strategies that will enable us to successfully compete against the resale homes that dominate today's housing market, and positioning ourselves to restore profitability. Despite very challenging housing market conditions, we concentrated on the areas of our business that were within our control, optimizing our performance for the current economic climate, while also positioning ourselves to opportunistically capitalize on a housing recovery.

By successfully executing against these commitments, we are in a significantly better position as we head into 2010 than we were last year. In the fourth quarter, our overall pretax performance improved by 69%. When we exclude inventory related charges and the losses incurred from land sales, KB Home posted a pretax profit of approximately $24 million in the quarter. We attribute much of this success to our KB Next operating model, the strategic transformation of our business and our financial discipline.

As a result, we now operate in markets that meet our criteria for both short and long-term housing growth. We have right-sized our business. We introduced new home designs that meet the needs of today's buyers. We achieved sustained operational traction as seen in our reduced cycle times, sales pace, and improving margins, and we have generated the cash necessary to capitalize on growth opportunities. Our objective for 2010 is to build on these strengths, and position KB Home to achieve consistent and sustainable profitability.

And, as the financial and operational fundamentals of our business continue to improve, we are now putting more of our emphasis on preparing to grow our top line. If the housing market stabilizes at current levels, we believe we are positioned to achieve profitability in the latter half of 2010. That being said, it remains particularly challenging to forecast the 2010 housing market, given the volatility that still exists. Among the more positive trends, housing affordability remains at record highs, and is forecasted to remain at such levels throughout 2010. As a result, we have seen total housing inventory steadily contract from year-ago levels and we are now down to a nationwide average supply of about 6.5 months. And, in many of KB Home's key markets, inventory levels are well below this national average. It is encouraging to see the market working through available inventory, which remains a prerequisite to price stability and a broader housing recovery.

At the same time, we are prepared for further volatility before there is a more widespread recovery, as a number of external factors could still have a significant impact on inventory levels, pricing, employment, and consumer confidence. As we sell through the spring season, we should have greater visibility on the direction of the market and overall economy, and we can then be in a better position to plot the trajectory of our return to profitability. Regardless of whether markets stabilize at today's levels, take another step down, or trend upwards, we enter 2010 with the same resolve we held throughout 2009, to maximize our own business performance, operational capabilities, and market opportunities, regardless of conditions that are beyond our control.

We attribute the steady improvement in our results to a sharp focus on our core business strategy, as we more closely target first time home buyers and directly compete with resale homes. This strategy has been built on the strengths of our KB Next operating model, which has given us the capability to quickly adapt to changing market conditions. Our business model has been the driving force behind the development of the Open Series, which in turn has been key to improving sales pace, substantially reducing cycle times, increasing margins, and maximizing the differentiated Built to Order experience we offer to our customers.

The KB Home team achieved top notch execution of our business model during the fourth quarter and throughout 2009. In the fourth quarter, we increased our net orders 12% year-over-year, even as we operated with significantly fewer communities than we had a year ago. We were able to generate net order growth, despite the potential expiration of the first time home buyer tax credit. Before the credit was extended in November, we suffered a temporary competitive disadvantage versus resales and the spec inventory of other builders, because our buyers would not be able to purchase and close on their Built to Order homes in time to take advantage of the credit.

We've now produced year-over-year net order growth in three of the past four quarters. While normalization of the cancellation rate has played a role in our net order growth, we believe the principal reason is the considerable appeal of the end-to-end KB Home value proposition. Home buyers continue to respond positively to the customization available through our Built to Order home buying experience, the many choices they have at the KB Home studios, the quality we build into every home, and our money saving energy efficient features. We deliver all these benefits at a very affordable price, with payments in many cases lower than the rent prospective buyers currently pay. At these levels of affordability, there really has been no better time to buy a home.

We historically experience a reduction in our community count between the fourth quarter and the first quarter, and that pattern will follow for 2010. Over the course of the year, we will continue to push the pace of our grand openings, and steadily expand the number of communities featuring the Open Series. From the standpoint of unit volume, based on our current community count, we expect to deliver somewhere in the range of 8,000 to 9,000 homes in 2010. If market conditions strengthen, we will have a greater opportunity to increase our community count to further position KB Home for solid growth in the future.

In addition to re-establishing sales pace, a fundamental strategic principle behind our product transformation has been to enhance our capability to increase our margins within a price constrained housing environment. Consequently, we are very encouraged to see our fourth quarter margins, excluding inventory related charges, increase by more than 500 basis points year-over-year to 19%, even as our average selling price declined 12% over the same period. This represents our fifth consecutive quarter of year-over-year margin growth, reflecting our intense focus on reducing our cost to build without sacrificing the quality of our homes. We anticipate that our gross margin improvements on a year-over-year basis will continue into 2010.

Our cycle times also continue to compress. As I mentioned last quarter, we are now down to 4.5 months between contract and close in many of our markets and this time frame includes loan approval, the option selection process, and securing the building permit, all prior to start of construction. Faster cycle times not only improve our asset turn, they make our Built to Order homes more competitive with resales. Looking ahead, as homes from the Open Series comprise a larger share of our product offering, reduced cycle times should continue Company-wide. It is a very positive development, and demonstrates that we have the ability to operate at a pace well below our historical six month backlog cycle.

We continue to strengthen our balance sheet, which increases our flexibility to capitalize on housing market recovery. We projected a year ago that we would be cash flow positive for 2009, and we exceeded our goals for the year. We generated positive operating cash flows of nearly $350 million even after paying down debt, we ended the year with a cash balance of approximately $1.3 billion. Additionally, we expect a $191 million tax refund to be received in the first quarter of 2010, bringing our pro forma cash balance at year-end to nearly $1.5 billion. With this liquidity, we can be increasingly opportunistic in our served markets.

We will prudently manage this cash position, while investing appropriately as we prepare to open more communities within our existing footprint. As we build through older communities, we are reloading with new lots where we can produce higher margins and higher returns. We have increased the pace of our land acquisition activity, with the majority of our total 2009 purchases occurring during the fourth quarter, where we closed on lots in all of our regions. The focus of our land acquisition is on finished lots, that meet our rigorous return hurdles, and that are strategically aligned with the markets and demographics of our core business strategy. The markets where we currently operate delivered more than 28,000 homes at the peak, indicating considerable growth potential as markets stabilize.

As I have previously discussed, throughout the year we have developed a core competency in rapidly opening up new communities and generating revenue after we acquire land. A recent experience in Houston provides an example of this. We approved a land purchase in a top tier submarket in September, opened models within a matter of weeks afterwards, and should begin delivering homes next month. This plug and play approach is possible, only because of our product transformation and Company-wide business model, and we are replicating it wherever possible across the Company. As we accelerate the flow of deals in our land pipeline throughout 2010, we can leverage this core operational strength and maximize the improvement of both our top and bottom lines.

Thank you. And now I'll turn the call over to Bill for the financial recap.

Good morning, everyone. As Jeff discussed in his opening remarks, 2009 was another challenging year for the home building sector, in terms of both broad industry data and our own operating experiences. Throughout the prolonged downturn, though, we have been strategically transforming our business and managing our financial resources to navigate effectively through these times.

As we entered 2009, our management team knew that we had three absolutely vital financial goals ahead of us. One, ensuring KB Home's financial stability and liquidity. Two, restoring profitability. And three, maintaining competitive strengths to strategically position KB Home for an eventual market recovery. Having now reached the end of 2009, we clearly have made substantial progress towards these goals.

During the year, we were focused on generating positive cash flow from operations and taking other steps to fortify our financial position. We ended the year with a strong conservatively leveraged balance sheet and a robust cash position that will enhance our ability to capitalize on emerging opportunities. At year end, KB Home had nearly $1.3 billion in cash and a net debt-to-capital ratio of just under 43%. We also pursued several initiatives throughout the year to restore the economic equilibrium of our home building operations against the backdrop of excess new and resale homes and falling home prices.

These initiatives included actions to enhance our productivity and to rethink and redesign our core product lines to provide a better value of today's more cost conscious buyers. Our results demonstrate our substantial financial progress in each quarter of 2009, expanding our housing gross profit margins and reducing our pretax losses from the prior year, despite significant decreases in our Average Selling Prices and revenues.

Our strong financial performance extended through the fourth quarter, when we narrowed our pretax loss by 69% from a year ago. For the first time in nearly three years, we reported quarterly net income. In the fourth quarter, we generated net income of $101 million, or $1.31 per diluted share, due to a reduction in our pretax loss and an income tax benefit of $192 million, primarily resulting from recently enacted tax legislation. In the year earlier quarter, we reported a net loss of $307 million or $3.96 per diluted share.

On a pretax basis, our fourth quarter financial results improved largely due to lower inventory related charges. In the 2009 fourth quarter, KB Home posted a pretax loss of $91 million, a $202 million reduction from the loss of $293 million reported in the same period of 2008. Our fourth quarter pretax loss was mainly due to impairment and abandonment charges of $77 million, and losses on land sales of $38 million. In the 2008 fourth quarter, asset impairments and abandonment totaled $309 million. Excluding these charges, we would have generated a fourth quarter pretax profit of $24 million in 2009, up from $16 million in 2008, on significantly lower revenues. We hope to continue the favorable trend in our pretax results going forward into 2010.

Our home building operations generated revenues of $671 million in the fourth quarter of 2009, down 27% from the year earlier quarter. This reflected a decrease in housing revenues, partly offset by an increase in land sales. The decline in housing revenues was driven by a 22% decrease in the number of New Homes delivered and a 12% decline in average selling price. The number of active communities we operated also dropped by 34% year-over-year. As we anticipate our community count to remain relatively flat in the near term, we expect our homes delivered in 2010 to fall within a narrow range of what we delivered in 2009.

Our average selling price fell to $203,400 in the fourth quarter of 2009, due to downward pricing pressures in the marketplace and an increased proportion of lower price, value engineered product delivered during the quarter. Our fourth quarter prices were lower across the country with our West Coast region down 7%, the Southwest region down 26%, our central region down 16%, and the Southeast region down 13%.

Turning to our margins, the housing gross profit margin rose 15.4 percentage points to a positive 6.8% in the fourth quarter from a negative 8.6% a year ago. This improvement reflects substantial decreases in inventory related charges. During the fourth quarter, we recognized $76 million of inventory impairment and abandonment charges, compared to $205 million in the year earlier quarter. Excluding these charges, in both periods, our housing gross profit margin increased to 19.0%, up 510 basis points from 13.9% a year ago. We were also particularly pleased to see this margin expansion in light of the decline in our overall average selling price.

We have now generated year-over-year improve in our housing gross profit margin, excluding inventory related charges for the last five quarters. In our most recent quarter, our housing gross profit margin expanded as the impact of our new more competitive products reduced direct construction costs and greater operating efficiencies become more pronounced. We also significantly benefited from impairments required to be taken in previous quarters. Our housing gross profit margin, excluding inventory related charges, also increased on a sequential basis, improving 440 basis points from 14.6% in the third quarter of 2009. In 2010, we expect further improvement in our housing gross profit margin, as we continue to execute and expand on our strategies.

Selling, general and administrative expenses in the fourth quarter of 2009 fell by $36 million, or 30% from the year earlier quarter. As a percentage of housing revenues, these expenses were 13.8% in the 2009 fourth quarter, up slightly from 13.3% a year earlier, primarily due to the drop in our housing revenues. Nevertheless, we made substantial progress in cutting our overhead cost during 2009. We will continue to manage these costs to be in line with a reduced size of our business, with an ongoing focus on disciplined spending and productivity to maintain a lean, efficient structure that can easily be leveraged to support future growth.

Entering 2010, we believe our organizational infrastructure is appropriately sized and strategically positioned in markets that have attractive prospects. Therefore, we do not anticipate major reductions in our overhead costs as we had in 2009. Instead, we expect future declines in our SG&A ratio to occur once market conditions stabilize and we generate increased unit volume revenues. Overall, we reduced our fourth quarter home building operating loss by $160 million in 2009, versus the same quarter of 2008. We recorded a home building operating loss of $82 million in the quarter, including inventory related charges of $77 million, and land sale losses of $38 million. The losses from land sales reflected the disposition of certain nonstrategic land positions to generate cash and further strengthen our financial position.

These sales generated about $50 million of cash during the quarter, and as a result of the NOL carryback will also produce $30 million of cash in the first quarter of 2010 as part of the tax refund. The new tax legislation provided a unique opportunity to monetize certain land positions in the fourth quarter. As a result, we do not anticipate such significant land sale activity in 2010. In last year's fourth quarter, our home building operating loss was $242 million, including $206 million of inventory related charges, and a $43 million goodwill impairment charge.

On a percentage basis, our home building operating margin improved by 14.3 percentage points to a negative 12.1% in the fourth quarter of 2009, from a negative 26.4% in the year earlier period. If we exclude the asset valuation and abandonment charges from both periods and the land sale losses from 2009, we would have generated home building operating income of $33 million in the fourth quarter of 2009, versus $7 million a year ago on greatly reduced revenues. Also, our home building operating margin would have improved to 14.9% compared to 0.8% a year ago. This represents the highest home building operating margin excluding charges we have posted in some time.

These results also underscore that KB Home is moving closer to the goal of returning to profitability. Our financial services segment generated pretax income of $8 million in the fourth quarter of 2009, compared to $7 million in the year earlier period. This growth was primarily due to higher earnings from our unconsolidated mortgage banking joint venture, KB Home Mortgage. In the fourth quarter of 2009, 86% of our home buyers used our joint ventures as a loan originator versus 81% in the year earlier quarter.

All in all, our mortgage banking joint venture has performed quite well during the housing industry downturn. The business has consistently remained profitable, despite the declining volume of loan origination and sales. Furthermore, due to the joint venture structure, our mortgage business operates at a lower risk and has not experienced significant loan losses as others in the mortgage banking industry have. Overall, KB Home's 2009 fourth quarter financial performance demonstrated a measurable progress on the march back to profitability, particularly as we achieved these results with little improvement in housing market conditions and despite a decrease in the number of homes delivered and lower revenues. Having posted better financial results amid challenging times, we appear well positioned to attain profitability as the markets stabilize.

Now let us take a look at our financial position. KB Home generated $237 million of positive cash flows from operations during the fourth quarter, boosting our year end cash position to nearly $1.3 billion. This was well above the $1.1 billion projected on our last call. In addition, we are due to receive a federal income tax refund of $191 million, related to recently enacted tax legislation that extended the permitted NOL carryback period for up to five years. This legislation has enabled us to carry back our 2009 net operating loss to previously profitable years. The favorable impact of this NOL carryback is evident in the net income of $101 million we generated in the quarter. We have already filed an application for the tax refund and expect to receive the full amount in the first quarter of 2010.

Moving down the balance sheet, we ended the fourth quarter with an inventory balance of $1.5 billion, down 29% from $2.1 billion a year ago, and down 21% from $1.9 billion last quarter. A portion of this decrease was due to our shifting $73 million from inventories to other assets during the quarter, due to the conversion of a multi level residential building to a rental operation. Another similar property is currently under construction.

We had 1,883 homes in production at the end of the year, down 26% from last year. Approximately 15% of those homes, some 287, remained unsold. By comparison, 29% of homes in production were unsold a year ago. In addition, we had 139 finished unsold homes in inventory at the end of the year, compared to 543 last year. This is less than one finished unsold home per community at year end.

Going into 2010, we own or control 37,500 lots. About 76% or 28,400 of these lots were owned and 24% or 9,100 were controlled under land option contracts. Overall, our total lot count was down approximately 20% from the prior year. As Jeff mentioned earlier, we are actively pursuing land acquisitions to replenish our pipeline. Our main objective is to integrate new land positions into our existing land portfolio, in order to facilitate growth in our community count, homes delivered and revenues, restore profitability and improve our overall returns. With our substantial liquidity, we are well positioned to seize opportunities as they arise and remain optimistic that deal flow will increase as the markets improve.

Now let me update you on our unconsolidated joint ventures. For several quarters, we have been actively monitoring and evaluating each of our joint ventures to determine their condition and best course of action. In that regard, we continue to make progress. In the fourth quarter, we reduced our number of joint ventures by three. Consequently, we ended the year with $120 million invested in 13 joint ventures, down from the $178 million invested in 25 joint ventures at the end of 2008. Our unconsolidated joint ventures held total assets of $922 million, and total debt of $514 million at the end of 2009. The assets are down 27% from $1.3 billion a year ago, while the related debt dropped 41% from $871 million. We continue to watch our unconsolidated joint ventures carefully and expect further reductions in the future.

Regarding our deferred tax assets, we ended the the fourth quarter with $751 million on the balance sheet, almost all of which has been reserved. Our deferred tax assets and associated valuation allowance were reduced during the fourth quarter, largely due to the tax benefit from the net operating loss carryback. The remaining deferred tax assets can be carried forward for 20 years, and applied to offset future taxable income. To the extent we generate sufficient taxable income in the future to utilize the tax benefits, we expect our effective tax rate to decrease as the valuation allowance is reversed. At November 30th, 2009, our deferred tax assets equated to approximately $10 per share of book value.

Turning to our capital structure, we ended 2009 with total debt of $1.8 billion, roughly flat with the third quarter, and down from $1.9 billion a year ago. The change from last year is particularly noteworthy as we reduced our debt level, despite the consolidation of joint venture debt during the year. Our debt balance, net of cash totaled $531 million at the end of 2009, a drop of $224 million from the third quarter. This was primarily due to the positive operating cash flows generated during the fourth quarter.

Our net debt to total capital ratio improved to 42.9% at November 30th, 2009, compared to 45.4% at year end 2008. Assuming the inclusion of the $191 million income tax refund in our year end cash balance, our net debt to total capital ratio would have improved significantly to 32.5%. At year end, we had no borrowings under our revolving credit facility and were in compliance with the covenants. In December, based on our current and expected future cash position, we notified the lenders participating in our revolving credit facility that we were voluntarily reducing the aggregate commitment under the facility to $200 million from $650 million. This decrease will reduce the ongoing bank fees. Given that we have no plans to borrow under the facility, it was appropriate to reduce the fees in this manner. The facility now primarily supports our outstanding letters of credit which total about $175 million at our year end. The November 2010 maturity date and the other terms of the facility remain unchanged.

With an ample year end cash balance and a substantial tax refund expected in the first quarter of 2010, we believe we have adequate liquidity to satisfy our current and reasonably anticipated future requirements for funds. Now for a few brief closing comments. Throughout 2009, our focus has been on financial prudence and cash conservation, operational excellence, and productivity, and investment in the future when and where warranted. Against a backdrop of a difficult housing environment we have made measurable progress each quarter in reducing our losses and restoring the economic viability of our home building operations.

We also successfully fortified our financial position with positive cash flows from operations during the year. The transformations we have made within our business have left us with a sound balance sheet, with ample liquidity and a streamlined asset base. Entering 2010, we are much stronger and better positioned than we were a year ago. While profitability remained elusive in 2009, we believe it is within our reach as housing markets stabilize and eventually rebound. Our gross profit margins are on a trajectory for further improvement and our organization and cost structure are lean but able to be leveraged to support future growth and to derive profitability. While we are prepared for continued near term volatility, we believe our relentless focus will lead us through the current environment and into a sustained recovery.

Now let me turn the call back to Jeff for some final remarks.

Thanks, Bill. I would like to clarify one number in Bill's prepared comments in the fourth quarter operating margin. He stated 14.9. It was actually 4.9. Still a nice number, and the highest we've had in quite some time but it was 4.9.

Before we take your questions, I want to summarize where KB Home is positioned heading into 2010. We continue to sharpen our operational execution. As demonstrated by our improved margin performance, lower cost structure, shorter cycle times and solid net order growth. At the same time, our careful financial management has given us the the flexibility to become increasingly opportunistic in our markets.

With these improving fundamentals, we believe we are well positioned to restore consistent profitability. While we continue to keep a close eye on our costs, our principal point of emphasis for restoring profitability going forward is to grow our top line, primarily through a focused land acquisition strategy. We recognize that the direction of the housing market in 2010 remains uncertain. If it stabilizes at today's levels, our current operational tempo positions us to restore profitability at some point during the second half of the year. But even if the housing market weakens, we believe we can still compete effectively. We are confident that our business model enables us to be nimble and opportunistic in any market environment.

We're also confident that our competitive landscape has changed favorably. There are now far fewer choices available for home buyers who prefer a new home over an existing home. The new home industry has contracted sharply over the past few years as smaller builders have exited the market and the larger builders scaled back. As a result, the inventory of single family New Homes is down to its lowest level in nearly 40 years, even as the US population has grown by 50% over the same period. In most of our markets, there are only a handful of builders left who are building at any scale.

We are in a good position, regardless of the timing of a housing market recovery. We have the right strategy in place, the right products for these times, and the right markets for growth. Above all, we have the right team to achieve our 2010 goals and I would like to thank the people of KB Home for their passion and hard work. We all share a commitment to optimizing our performance in order to generate more value in 2010.

Thank you again, and now we would be happy to take your questions.

Thank you, Mr. Mezger. (Operator Instructions). And the first question today will be from Dan Oppenheim with Credit Suisse. Please go ahead.

Thanks very much. Was wondering if you could talk about the delivery guidance of 8,000 to 9,000 homes in 2010, that's basically in line with what it was in 2009. Does that reflect basically anything in terms of a lower community count, caution in terms of the absorption, can you just give a little more color on that?

Dan, as Bill touched on in his comments, as we sit here today we're projecting a community count for the year that ranges about the same from 2009 to 2010. We're working to grow the community count and are hopeful as the markets stabilize that we can grow the community count coming out of 2010 but the average for the year will be about the same. Our per store sales continue at our normal levels, so we think we're being realistic in that range. It's not conservatism or optimism, either way. It's just realistic based on our community count.

I guess second question, relating to the comments about the slowdown after the -- or the tax credit and the impact at the start of the quarter, with the tax credit extended this year, have you thought about the strategy and what to do to make sure that you can get orders through April 30th this year? Would you start some specs, have a policy against that in general, but how do you look at that, the extension of the tax credit here?

Dan, that's a great question. We remain firmly committed to our Built to Order business model. As Bill shared, we had less than one spec per community entering 2010. We shared on the third quarter call and I again touched on it today, we were at a disadvantage, primarily to resales when our customer couldn't take advantage of the tax credit last fall.

We're analyzing strategies. We haven't finalized it yet. But in our stronger submarkets and stronger communities, we think there's merit to positioning some homes through sheet rock and holding them there in April, so that a consumer at that time could still purchase and make the choices in our studio before they then in turn close in time to get the tax credit. We will have some type of strategy to avoid the situation we were in last fall.

Great. Thanks very much.

And the next question will be from Michael Rehaut from JPMorgan. Please go ahead.

Hi, thanks. Good morning everyone.

Good morning, Mike.

First question, you had said that -- well, first question I just want to get back to Dan's comments regarding community count and how you answered that, and more focusing on the order pace, with community count -- I just want to make sure I understand. If you're assuming kind of a stable count, would that also infer we should also deduct from that that the year-over-year declines would steadily decrease throughout 2010, and at the same time, do you think you can still do better on a year-over-year basis in terms of sales per community?

Mike, what were you referring to as the steady decline? Is that sales? Community count?

No, so if you're talking about the average community count being roughly the same year-over-year in 2010 versus 2009 or that number to be perhaps steady by the end of the year or sequentially, how do we think about quarter by quarter in terms of the community count? Right now it sat at a decent decline year-over-year. Should that decline just narrow? And at the same time in terms of sales per community when we're thinking about orders, are you still expecting a higher year-over-year absorption per community?

Mike, in terms of the community count trajectory, we think we'll be slightly lower in the first half of the year and slightly higher in the second half of the year as we bring on more communities. But the average for the year will be about the same. When you get back to sales pace, we're hesitant to give guidance because we don't know what the spring selling season will bring with all the variable factors that are in play, as I mentioned in my prepared comments. So we're not managing the Company right now to push volumes and generate cash. We're managing the Company to improve margins and get back to profitability. So rather than chase more units, we'll chase how do we make money on a per community basis.

Okay.

We'll manage to normalize sales rates and keep pushing our margin up a little bit and grow the top line as we introduce more communities.

Okay. Thanks for that. And then on the comments about gross margin and also profitability, you had said that you expect or hope to have gross margins up year-over-year in 2010. I just wanted to know if that comment applies, that expectation applies to every quarter of the year that you expect it to be up year-over-year? And also, when you talked about restoring profitability at some point in the second half of the year, just want to make sure we understand, does that mean that at this point you expect just given the way revenues would flow through, particularly from an SG&A side, that just given the way you have leverage work that in the first half it's more likely that you would still be running at a loss?

Yes, that would be our view. We're not going to make money in the first quarter. And the second half of the year, depends on what happens with the spring selling season. You touched on leverage. Our gross margin and our SG&A margins were very favorable in the fourth quarter, in part because of leverage. And in our normal year, margins come down in Q1 and 2 and then ramp back up with leverage, and our guidance was that we expect our Q1 margins in 2010 to be higher than they were in the first quarter of 2009. As to what range, we're not going to give you guidance on how much higher.

We'll take the next question from Carl Reichardt from Wells Fargo Securities.

Morning guys, how are you? I'm curious you mentioned, talked a little about the easing competitive landscape from I think you mentioned both resale and other builders. Obviously many of your public peers have been moving -- private peers have been moving price points downstream pretty aggressively, especially over the last six to nine months and I'm curious whether or not you think that's impacted your sales rate at all or may in 2010? How do you expect to -- what do you see your strategy for fighting against their move downstream, is it any different than it was nine months ago when they weren't offering product like that?

I think every community has its own story, Carl. Our prices were down a little bit in Q4, but I don't think it was because of brand X across the street or down the street. It's how we position our product primarily to be competitive with resales. And if resale prices hold where they're at, I think our prices will hold and sales will be fine. If resale prices go down further, that's what I think would pressure our prices down. What's the number right now? 250,000 New Homes for sale and 6 million resales. So the resale pressure is much stronger than the new home pressure.

And if we look at your cycle times just on Open Series, and just as a side note, be curious what percentage of your deliveries you think 2010 Open Series will be, but also how far do you think you can take the cycle times down. What's the reasonable maximum you can do if you don't build spec and get to sort of a Company wide cycle time and how far away are you from that?

Well, as we shared through 2009, we projected that coming out of 2009, over 50% of our deliveries would be from the Open Series product and we accomplished that and we expect that percentage to go up in 2010. There's some communities we're in as we shared where we can't change product and we can't introduce Open Series so the percentage wouldn't get close to 100 for some time but it will be higher than 50 in 2010 and head north from there. Our cycle time as a Company, while many divisions are down in the 4.5 range, there's others that are at 5.5. I think overall, we could probably shave another three to four weeks off, best case, no more. I mean, there comes a point where you're running the engine just too hot. But we're pretty comfortable at the 4.5 month pace right now and as backlog builds and sales grow it will probably extend a little bit back from there and that would be a nice problem to have. Go ahead, sorry.

Go ahead with your comment. No, no, that's -- three to four weeks sounds like a reasonably good amount. That's all I wanted to say. Thank you, Jeff.

And the next question will be from Ivy Zelman with Zelman & Associates.

Hi, guys. Good morning, everybody. Thanks for taking the question. I think you guys have done -- congratulations on really doing a good job improving your profitability, and I think a lot of people want to understand of course what that trajectory looks like and you don't have a crystal ball any better than the next guy does on what demand will be and certainly the risks associated with some of the headwinds out there related to the stimulus after the tax credit expires or if FHA were to tighten.

I think that looking at your community count growth, the question would be if you actually had a really strong spring selling season, much better than anticipated, what's the flexibility of the community count going up and not being flat, actually growing and like is there a possibility that community count could actually grow 10% and absorptions are higher so you could wind up actually having like a 20% type revenue growth number in a best case scenario or should I say volume as opposed to ASP. That's sort of the first question. The second question is you opened your new communities and you bring them on, recognizing that it's a great IRR. You're getting a huge return sounds like plug and play.

At some point that probably is more challenging in the right locations as market demand is so strong for the best finished lots and so you start to get this situation where you actually have to put some cash into the ground and put a shovel in the ground and start to look at getting ground to a finished lot completion and the time it takes. So if you were looking at modeling, which is what we're ultimately trying to achieve, what type of trajectory with respect to revenue growth on a sort of two to three year out type of thought process could you see coming to fruition in a best case scenario? Some analysts might say oh, there's going to be a huge snapback in home building demand and housing starts are going to go up and new home demand is going to be up and certainly that's a possibility. But are there limitations on what a Company can efficiently do in terms of opening new communities, managing the people, getting those communities open, and certainly there's costs associated with them, so can you help us, Jeff, walk us through the prudent or realistic best case scenario on what that might look like?

I can try. That was a long question, Ivy, so I'll try to touch on all the points you raised. As to the first one, I shared the Houston example, and we've shared many others in the past year where we can quickly build models open for sale and deliver homes. So we have the capability to open communities very quickly and could still identify things today that could generate deliveries in the second half of this year. The pause is for a couple of reasons. One, we're being diligent. We're only chasing lots that are aligned with our product strategy. So you won't see us go back into second move-up lots and there's some of those out there.

And it has to be in a submarket where we're comfortable that prices have stabilized. We don't want to catch the falling knife and I think that's still a wild card in that we don't know where the economy's headed in the spring. If things stabilized where they are today, there's a lot of opportunity out there to acquire finished lots. One of the unknowns is the hundreds of thousands of lots, finished lots that the banks have, at what price and at what pace do they put them back on the market. We're seeing deal flow from banks or from sellers and it is picking up from where it was even last summer or last fall. But it's not -- there hasn't been the flood yet if you recognize how many lots are being held by the banks. And I think if markets stabilize, the banks would start to release some of that inventory back into the marketplace and that's where the lots will come from.

That has to occur before you would see us all start investing in raw land, pay cash, develop lots and bring those to the market. If you look out over time, as we've stated on this call, the markets we're in today, we delivered 28,000 houses at our peak. So we have significant upside in our served markets to take it as fast as we could. Now, do we have the infrastructure today in place to deliver 28,000 houses? No, we don't.

Do we have the ability to quickly leverage ourselves up from where we are today? Absolutely. So if things were stable and you're moving along, I think 20 to 30% growth rate is realistic in units. But it's a combination of everything has to line up for you to get there, for a snapback to double your size in 18 months, I don't think that would happen.

That's exactly what I was hoping you would help me understand. Thank you very much.

And the next question will be from Stephen East with Pali Capital. Please go ahead.

Good morning, guys. If I could first follow up on the profits. You talked about if you -- are you comparing -- when you say that you won't be profitable until the latter half of 2010, even though you were profitable on the housing operating margin front, are you comparing that, 2010 result, to what you were talking about on your op margin for housing in the fourth quarter?

In the guidance for 2010, Stephen, one of the differences would be that we don't expect the impairment level we had in 2009. So the earnings we would project in the latter half of 2010 would be after impairments.

Okay. After. All right. That helps. And then if we switch gears and look at pricing, what you're seeing in your markets, the Southeast and West were big surprises in opposite directions for me. Can you talk about, one, what's going on in your markets and two, what are your strategies as you move through 2010 on the pricing?

Well, as has been the case, it's really a mixed bag right now, Stephen. California prices have held well for several months now, six or seven months, and we in fact have seen some price increase in California where we've had successful openings of our product.

Are you moving the product offering up.

Excuse me?

Are you moving the product offering up as well as pricing or is it just purely pricing?

Purely price. Purely price. It's the same product and you push 1,000 here and 1,000 there and get what you can. So while we've seen price stability and it appears the market's stable today in California, the wild cards are the things that we've been talking about and where things are headed in the spring selling season. As you go across the country, Texas is soft but stable, I'd say. Parts of Florida we're still seeing price pressure. Carolinas we're still seeing price pressure. Vegas, we're still seeing price pressure. There aren't a lot of markets that we would view as stable and ready to move up. They're all kind of wobbly out there so it's a little tenuous.

And your strategy then to focus on pricing, are you worried about some of those markets giving up a lot of the demand side of the equation?

Yes, I don't know that demand right now is going away. If you look where prices have dropped the most, like a Phoenix or a Vegas, resale numbers are very strong. So there's a lot of sales occurring at those prices and it's what happens to price, for instance, when the shadow inventory comes on the market, is the current price sufficient to clear the inventory like it has been for the last few months or does inventory go up and therefore price goes down a little more. If you get back to our business model, we don't forecast price increase in our guidance to you, so we're assuming if markets stay where they're at today, then our pricing would hold where it is today.

Okay. And just one last question. Any update on the SEC investigation?

Not really at this time. We're cooperating. There's nothing new to share.

Okay. Thanks.

Next question will be from Nishu Sood with Deutsche Bank. Please go ahead.

Thanks. I just wanted to get some color, some numbers on the fourth quarter land activity. You had $50 million of land sold, so I just wanted to get the number of lots there. You also said you purchased a lot of -- most of your purchase activity was in the fourth quarter so same numbers, kind of quantity and dollars for the fourth quarter. And then qualitatively, I wanted to get a sense of with the movement in and out of the land pipeline, what were you effectively doing in the fourth quarter? Were you swapping for example raw lots for finished lots? Larger communities for smaller communities? Outlying areas for closer in areas? So just want to get some color on the land activity.

Okay. Nishu, on the land sales, we're not going to give you the specific details of each transaction, but in summary, we were able to dispose of some nonstrategic assets. In one case, move up finished lots that weren't part of our business strategy. In other cases, in submarkets where it's either a C location or a submarket that's not that strong, we were able to dispose of lots, generate cash, take advantage of NOL, improve our balance sheet. It was a very nice move for us. It's not something we see -- we anticipate a lot of that activity going forward.

On the community count side, we did tie up more lots than we did in the previous quarter in more locations, in all regions, primarily rolling options, and it's part of what will allow us to grow our community count coming out of 2010. But we're hesitant every quarter to give you guys what I call the weather report, because every community's got its own story relative to status of the lots, how quickly can you get to deliveries and we don't want to start getting into that kind of detail. But when we do the K, when we distribute the K, it will have the detail for what lots we own and control by region, so you'll be able to back into how the lots moved in and out with deliveries, land sales and acquisitions.

Okay. Great. And taking a step back for my second question, if I contrast some of your peers, kind of management commentary with what I'm hearing from you today and in your prior quarters, one contrast you could detect is that some of your peers are putting land acquisition front and center. So almost a stance like a land fund would have, a distressed opportunities that could end up being transformative for the organization. If I listen to your commentary, operations, revenue growth, profitability are front and center and land is just an input. So if there are opportunities, there's opportunities. I wanted to get a sense. This could just be an issue of communication and how you're communicating your strategy. Is there a difference between how you're viewing the landscape from some of the more opportunistic stances that I'm describing, and if so, what kind of drove that strategic difference?

Yeah, I don't necessarily think there's a big difference, Nishu. I like being a merchant builder, making margin on finished lots versus taking land risk. If you look at what we've shared today, pro forma, we have $1.5 billion in cash. We don't need a land fund to go be opportunistic and acquire lots and we're definitely out in every market today, combing for things that are consistent with our business model and give us returns. There's hundreds of thousands of lots out in the landscape out there, depending on which city you're looking at.

So you don't need to go acquire big parcels and big communities and create value through entitlements and improvements today. We would rather stay focused on picking off the finished lots in the markets we're in and grow our business that way. The strategic alliance funds are out there for everyone. We just haven't announced anything and right now we're focused on the core business, let's go pick off lots and grow the business. But it's definitely in an opportunistic mode. We think with our business model and our price points and our product that we can quickly as I call it plug and play and grow in a hurry when each of these markets stabilize.

Got it. Great. Thanks a lot.

Next question will be from Dave Goldberg with UBS. Please go ahead.

Thanks. Good morning, guys. First question is trying to follow up a little bit maybe on Nishu's question, maybe asked a little bit differently. What I'm trying to understand is if you compare the lots that you're purchasing today on average, the finished lots that you put under option, I should say, where do you think the costs are of those lots relative to the lots that you're delivering after the impairments in the current quarter, maybe for 2009 generally? What I'm trying to get an idea of here is can you continue to keep your land cost at post impaired levels as you move forward for some period of time?

Yes, Dave, I think margins are up on the new assets we're bringing in, so your basis as a percent of revenue is actually lower than it is on our current book.

Okay. And then my second question, Jeff, kind of has to deal with some of the comments you made about the existing home inventories and competing against the existing home inventories. One of your peers noted last week that they felt like a lot of the foreclosure stock was not necessarily in some of the same areas as some of the new home communities and there was so little new home inventory out there that they felt like they were starting to get some pricing accordingly. I wanted to get your thoughts about that, if you feel like a lot of the foreclosures that are coming to the market now are really in different areas, different parts of communities relative to where your new communities are and if you really feel like they're as much competition for you today as they were for you let's say a year ago.

I don't want to speak to the comments from last week, Dave, but the markets we're in, there's foreclosures around us. I think there's a consumer that really values the benefits of a new home. And they're willing to pay more, or not have the foreclosure process aggravation, in order to pick their custom home with energy efficient features, and have a brand-new home of their dreams versus buying the five-year-old or 10-year-old foreclosure. If there is any price, it's either the value of the product we're offering, and the value equation to the consumer, or competitively in that submarket, there may not be a lot of inventory. But I think there's pretty broad spread of shadow inventory around the country and it's not just in the C minus locations. I think it's everywhere.

Fair enough.

Next question will be from Josh Levin with Citi.

Good morning. Let's assume that the spring selling season is strong and as you go through the spring selling season and as you thing about operational planning for the second half of 2010, how will you be able to distinguish genuine sustainable demand versus demand that might have been pulled forward by the tax credit?

Well, every market has a different balance of supply and demand, Josh, so if inventories, historical levels -- I mean, every submarket you'll have a different story. If there's no inventory out there, you may pull sales forward, who knows but there's more demand behind that so you would just keep going. At the end of the tax credit period, if there's still excess inventory in that submarket we're not going to go open up more communities there.

I wanted to ask about the weather. It's been unusually cold in the past two weeks in many parts of the country. Does that kind of cold have a material affect on traffic and sales and does it prevents you from starting homes?

Only in a very few communities, Josh. As you know, we're primarily in the Sun Belt and while people are complaining in Florida that it's in the 30s and 40s, they'll still go look at houses and we can build houses. Reno and Denver are the only two places we build that come to mind that the weather's any kind of an issue at all.

Thank you very much.

Moving along we'll hear from Megan McGrath of Barclays.

Hi. Thanks. I guess my first question I want to beat the profitability dead horse a little bit here because I'm still a little confused about what you're trying to say on gross margin. To see a year-over-year increase in the first half of the year, versus the 4Q level you put up, leaves us about 600 basis points to play with there. So I guess asking it this way, aside from any significant pressure on prices that you see, is there any reason why we should see a meaningful sequential decline in gross margins?

We always have a sequential decline from Q4 to Q1, Megan, because we don't have the volume leverage. So you will see gross margins drop in Q1. We expect them to be higher than Q1 of 2009 and you'll see SG&A lift because of the drop in volume.

How much of your gross margin would you say is variable? I was always assuming it was a pretty small percentage.

A couple points.

Couple points.

Couple points. I don't know.

Okay. And then in terms of your cancellation rate, seem to have bottomed in the May quarter and have crept up a little bit since then. I don't know if some of that is seasonal as well, but if you could give us any color on what you're hearing from your buyers, that would be great.

People that are making the home buying decision today are committed to the purchase and we have a very good filtering process, if you will, before we start the home. So our can rate after start is actually below 10% again, which is -- makes a very predictable business once we start the home. So it's dropped back to historical normalized levels. The consumer's confident when they make the decision. They recognize what a great affordability opportunity it is right now.

Thank you.

Moving along we'll hear from Joshua Pollard with Goldman Sachs.

Hey, good morning and thanks for taking my question. Another question on profit. I'm looking to get a better handle on your profit guidance. Do you expect the second half profits to offset the first half losses that you're speaking about?

A lot of the second half profits, Josh, will be the predicated on what happens in the spring selling season. Because we'll sell in the spring and deliver in the fall. But at this time, I don't think that the second half would cover the first half. It depends on what happens in the spring selling season.

Okay. That's very helpful. My other question was around land. Your goal was to spend $360 million in 2009. What did you actually spend? What is your goal for 2010? And then could you talk about what percentage of the lots owned that you have are still mothballed or you don't plan to build on them over the next I'll call it two years. Ultimately I'm trying to determine what portion of your inventory will likely stand idle for multiple years from here.

Josh, this is Kelly. We spent about $375 million in 2009 on land and land development. Our budget for 2010 is close to double that amount. And in terms of mothballed lots, if you look at our $1.5 billion of inventory, about 70% of it is related to backlog and lots that are more than 50% developed.

Next question will be from Stephen Kim with Alpine Woods.

Thanks, guys. Most of my questions have been answered, but you guys made a comment, I think Bill, you commented on your SG&A. I think you said that you're going to be in 2010 focused primarily on achieving or you expect to see any improvement in SG&A due to an improved increase in your top line and leverage from the top line as opposed to sort of dramatic cuts on an absolute basis. First of all, did I get that right? And if that's the case, that would suggest a degree of optimism around where volumes might be this year, which is a little greater than what your other commentary has been and so my question is first of all, did I get that right. And then secondarily, if I did, would it be fair to say that on the things that you can control at this time, that you are prepared to rise to a level of volume that is higher than a flat year-over-year comparison?

Steve, let me make a couple comments, then Bill can chime in. In a hold business you have your sales pace and you know where your revenue's headed. So you do what you can to adjust your overhead levels according to your sales pace. Part of what Bill was referring to is the big drops in SG&A are behind us. To get any more significant drop, you would have to probably leave some markets which we are not prepared to do right now. We like the markets we're in. We want to grow from where we are today and we think there's the potential for a spring coil effect where we can pop our top line without having to increase SG&A much at all, only the variable side, per unit. So the message is we're always going to be looking for reductions in overhead. But the significant drops are behind us. I don't know if you want to add any color to that, Bill.

I think, Steve, Jeff said it well. Where we dropped about $200 million year-over-year between 2009 and 2008, for what was about 40%, we think our absolute amounts for 2010 are going to really bounce right around the $300 million mark, again, correlated with our revenues, our volumes and so that's what I meant, that we don't really see any real further reductions absolute-wise. Our ratio leverage will come as, again, we grow the business through volume and revenues and so the percentage SG&A, again, will only improve as we get some more top line growth.

Okay.

I think also, Steve, shape it this way for you. We know that we can grow the top line out of our current markets and our current SG&A level. It's a question of timing. If the markets are stable, you'll see it sooner. If the markets stay wobbly and soften a bit, it will take a little longer before we get top line growth.

Okay. Great. Second question relates to land and opportunities within markets. Obviously we have not seen as many deals come actually -- come forward as we would have liked, but everyone's talking about the stuff that hopefully will be sprung loose here over the course of the next year or so. My question for you is as you look across the country and the markets that you really care about, and you're looking at the land deals in the areas that particularly get you interested, not the far-flung stuff but the stuff that's actually in areas that you really feel strongly that the demand's going to come back very quickly, can you give me an idea of how many lots fit that kind of description which are not yet maybe available, but you know they're there and you know that they're probably going to be coming at some point. In you any way that you choose to give that kind of size, description, maybe in terms of year supply in the market or what amount you would be interested in purchasing, like would that only amount to 20% of those lots? Just give me some help here in trying to figure out how many of those really prime lots are out there?

Steve, when we track the finished lots in every market, and what keeps getting the attention in the media is the broadcast bid that the bank puts with a broker and the the broker flips to an investor and here you go. And our success has been far more localized through our network where we'll go to ask sellers, whether it's a builder or a bank, and we'll preempt the broker broadcast and just cut a deal and it's tied to the relationships we have in all the cities we're in and also the fact that the sellers have confidence that we have the ability to build homes in a hurry. One of the things that's a wild card with investors looking for terms or flippers or all that, that they're not builders, and they don't have a story that they can bring with them as to the final disposition of the lot. There's a lot of people who want to sell to someone who has an appetite to build a home today and deliver it to a consumer today and get rid of the lots that way.

I couldn't tell you what the percentage is or the number is. I know we'll take every lot we can that's aligned with our strategy in the markets that we're in that hits our financial hurdles and there's lots on the ground in every city that we're pursuing and in talks with sellers today and I think there's a lot more behind us. So there's not a shortage of lots out there. It's having confidence that it's the right financial returns and the right market dynamic today to make a prudent investment.

Moving along we'll hear from Ken Zener with Macquarie Research. Go ahead.

Good afternoon. Split between your newer redesigned products and your older ones and how the margins held up versus your estimates as well as what percent of of closings you expect next year on that 8 to 9,000 from newly acquired lots?

I think I don't want to speak for Bill and Kelly, but we're pleased with our margins. I think they're actually a little higher than we thought they would be nine months ago. While we knew they would be better, we had a nice pop in Q4. We don't -- we're not going to track for you, Ken, how many deliveries in the fourth quarter are coming from new communities because it's too variable a mix based on how our existing communities sell and how many new communities we can load in in time to have deliveries in the third and fourth quarter.

I think the good news, Ken, is about 80% of our Q4 deliveries were to first time buyers. And we did achieve our goal that more than 50% of our deliveries were Open Series product line.

Okay. And then so if you look to 2010, since you gave and we appreciate it, at least the volume guidance, what percent of those closing do you expect to be on newly acquired lots within the last two quarters. And second question can you give us guidance for what you think interest expense will be in 2010, given the increasing investment in land?

The guidance we're sharing is based on lots we own and control today.

Right. I was saying closings for lots that you guys have recently acquired. If you can give that, as well as for your interest expense, how you think that will run into 2010, given that you're increasing your inventory investment?

Ken, it's Bill. We think the fourth quarter of 2009 is a good proxy for next year. So I think if you were modeling about $16 million a quarter or $64 million for the year is an appropriate range. If we were to acquire more dirt, in all likelihood we would be able to capitalize interest on that and thus don't see really interesting changing substantially from the fourth quarter run rate.

Thank you.

We have time for one more question. This will be from Joel Locker with FBN Securities. Please go ahead.

Hi, guys. Just on the material side, are you starting to feel some price pressure just because the commodity run-up, copper's more than double and oil's more than double from the beginning of this year.

A little bit, Joel, but not much. Lumber was bumping up. Now it's kind of flattened again. For everything that bumps up, there's something else bumping down. We are still able to achieve some overall savings in our cost to build. I do think there will be pressure on commodities going forward. I can share an interesting anecdote.

Because we have one business model and we're building the same products nationally, there's a lot of best practices coming out of our cost to build and just last week we had all our purchasing managers in the country together in one location comparing notes on what it cost to build for framing and plumbing and sheet rock and everything on the plans, 1622. And a lot of great ideas came out of it. So we're able to continue to find ways to lower our cost to build which will -- could either help margin or could offset any of the commodity prices that do go up. But I think until the economy gets some more traction, I don't think you'll see a lot of upward movement in the commodity prices overall.

Just some housekeeping questions. What percentage of your finished lots -- I mean of your lots, of the 28,400 owned were finished and what was your community count at the end of the fourth quarter and what do you expect it to be at the end of the first quarter.

Our community count average for the fourth quarter was 174. I think Jeff said that would be relatively flat, slightly down in Q1, 2010.

Your second question was on the finished lots?

Percentage of your owned lots that are finished of the 28,400.

Yes, I mean, it was about 70% of the dollars and about -- close to 18,000 lots were finished and in backlog or at least more than 50% complete.

Right. All right. Thanks a lot, guys.

That does conclude the question-and-answer session. I will turn things back over to Jeff Mezger for any additional or closing remarks.

Thank you again for joining us. We look forward to seeing you over the next few months. Everyone have a great day. Thank you.

And again, this does conclude today's conference call. Thank you for your participation.