KB Home (KBH) 2010 Q2 法說會逐字稿

Good day, everyone, and welcome to the KB Home's second quarter earnings conference call. Today's conference call is being recorded and webcast on KB Home's web site at KBHome.com. The recording will be available via telephone replay until midnight on July 5th by calling 719-457-0820 or 888-203-1112, and using the replay passcode of 3914926.

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 materially be 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 may 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 other Regulation G required information is provided in the Company's earnings release, which is posted on the Investor Relations page of the Company's website under Recent Releases, and through the financial information news releases link on the right-hand side of the page.

Now it is my pleasure to turn the conference over to Mr. Jeff Mezger. Please go ahead, sir.

Thank you, Kelsey. Good morning,everyone, and thank you for joining us today for a discussion of our second quarter 2010 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. I would also like to welcome Jeff Kaminski, our Executive Vice President and Chief Financial Officer, who joined the KB Home team earlier this month. We're very pleased to have Jeff with us and we look forward to the value he will add in the years ahead. I will begin with an overview of today's housing market environment followed by a summary of KB Home's operating strategy within this context. Next, I will provide a review of our second quarter results along with our actions to grow revenues and improve our business results going forward. Finally, I will comment on our outlook, and competitive position for the remainder of 2010 and beyond.

A combination of both positive and negative factors continue to impact the housing market. On the positive side, affordability remains at incredible levels. By taking advantage of lower prices and historically low interest rates, home buyers, especially first time buyers, are finding they can now afford to buy the home they want in their preferred location. In fact, as a result of today's low prices and interest rates, mortgage payments on a median-priced home have dropped below 20% of median household income. This is the lowest level on record dating back to 1971, according to the State of the Nation's Housing Report released last week by the Joint Center for Housing Studies of Harvard University. This extraordinary housing affordability has helped to spur activity, clear inventory, and even stabilize prices in many areas.

At the same time, however, the disappointing employment report in May served as a reminder that all is not yet well in the larger economy. Additionally, the month of May proved to be particularly challenging for the housing industry. The Commerce Department reported this week that new home sales in May were at record lows, resulting primarily from the expiration of the federal home buyer tax credit on April 30th. The confluence of these indicators and events has produced an overall market that lacks much-needed stability. We are undoubtedly in a petter position than we were a year ago, and housing is on the road to recovery, but the recovery remains uneven, while the market is, in many ways, still finding balance. As we continue to move past the tax credit period, we know that demand will eventually come back and return to levels consistent with household growth.

Before I share the results of the second quarter, I will quickly summarize where we see our Company's future within this environment. Utilizing our KB Built to Order business model, KB Home has been executing a consistent strategy of operating our business as efficiently as possible, and maintaining a healthy and liquid balance sheet while transforming our operations and product offerings. This integrated strategy started several years ago and remains in place today. At the first signs of the downturn, we set a course to build and preserve cash, streamline our operations to cut costs and reduce our inventory. We also developed the Open Series innovative line of homes to lower our cost to build and compete effectively with resales and foreclosures. Because of these actions, we have continuously improved our business as evidenced by our second quarter results. We narrowed our net loss for the eighth consecutive quarter, improved our year-over-year gross margins for the seventh consecutive quarter while strategically lowering the price point of our product offerings, and maintained ample liquidity. In fact, year-over-year deliveries in our second quarter increased for the first time in more than three years. While we are encouraged with these results, we recognize that we still have more work to do, and the KB Home team is energized to achieve our objectives.

We believe we have the right strategy in place to grow our business and return to profitability in the current environment. We are positioned in the most attractive product segments, targeting first time, move-up and active adult buyers within the most dynamic geographic areas. When you combine our strong market position with solid and predictable per community sales rates, improving margins and an increasing community count, a normalized profit picture comes into view. Moreover, as our top line grows we are committed to additional cost reduction measures in order to further leverage SG&A and expand our operating margins. When we look specifically at the selling environment in the quarter just ended it is difficult to read too much into it, or even analyze it in the context of where we are in these economic times because of the extraordinary impact of the home buyer tax credit, and its expiration on the entire quarter. We knew that the tax credit would result in stronger demand followed by a drop off in May. What we saw in May, which is historically one of our better selling months of the entire year was that homebuyers who missed the deadline seemed to step out of the market entirely and put their home buying plans on hold for the time being. As a result, post tax credit traffic levels and sales were significantly impacted.

At the beginning of the quarter, we have strategically started a limited number of spec homes in select markets to take advantage of the tax credit, but by April, we had sold the majority of these, and our Built to Order homes were at a disadvantage because they could not close in time to qualify. The tax credit represented a temporary disruption to the marketplace in which the consumer ultimately favors the value and choice that our Built to Order model provides. As the market resets following the government's stimulus, we are confident our Built to Order approach is the right one to compete in the current housing market.

This anomaly combined with fewer communities and a generally weak economy resulted in a negative year-over-year order comparison we experienced. We generated 2,244 net orders in the second quarter of 2010, versus 2,910 in the same period last year, a decrease of approximately 23%. Having said that, net orders were up 17% sequentially from the first quarter, and our overall net sales per community in the second quarter remained solid. It is still too early in the third quarter to determine where demand will go from here. In the short term, the market is bouncing along the bottom, but it is only a matter of when, not if, things are going to improve.

In recognizing the pull-forward effect of the tax credit, we are now working diligently to refill our pipeline of potential buyers in order to set up our fourth quarter deliveries and gain momentum into 2011. The second quarter of 2010 marked the first time in 14 quarters we have seen a year-over-year increase in the number of homes delivered and we ended the quarter with a backlog of 3,175 homes. Higher year-over-year deliveries should continue into the third quarter due to our compressed cycle times, higher levels of backlog conversion, and tax credit sales closing by the end of this month. On a side note, as the June 30th closing deadline approaches, we have not experienced mortgage or construction delays in our targeted closings, contrary to some reports in the media about the industry in general.

Our optimism for our approach to competing successfully in today's housing market is based on the data we are seeing at our individual communities. Indeed, KB Home sales on a per community basis have been and continue to be among the highest in the industry. The broad array of new home designs from the Open Series are appealing to a range of homebuyers whether they are first time, move up, or active adult buyers. These Built to Order floor plans flex to incorporate expanded living spaces, higher bedroom counts, and numerous other design choices that are tailored to each buyer's wants, needs and budget. This customization, combined with the energy efficiency, 10-year limited warranty and compelling price points, are just some of the numerous advantages of these new homes when compared to our largest competitor, resale homes. We now have six quarters of favorable customer response from the Open Series, and continue to expand our offerings of these designs across all our markets.

Each region is unique, and is settling at its own pace. Some are performing well, while others are taking more time. But even in this unpredictable environment, our current sales results on a per community basis give us confidence in our growth strategy as we work to increase our community count across our regions. Our community count was down 7% year-over-year in our second quarter, and we anticipate that the third quarter of 2010 will also be down compared to the same period last year. As we endeavor to open more communities, we have been closing out approximately the same number, bringing our average community count for the year down slightly from 2009. With our strategic land investment over the past three quarters, however, we expect year-over-year community count growth in 2011 for the first time in a number of years.

To support our community count and topline growth, in the second quarter, we secured approximately 4,300 owned and controlled lots that met our financial and strategic guidelines. We are seeing more deal flow, and remain disciplined in our investment parameters, favoring options over outright purchases with the latter being reserved only for finished lots in top locations that we know we can bring to market quickly and generate attractive returns. In many cases, we are able to go from closing on the lots to delivering homes in approximately six months. Future investment activity will continue to be subject to our stringent underwriting criteria which include a sensitivity to current market conditions. The majority of the lots secured in the second quarter were located in Texas, California, and Las Vegas. For example, we secured finished lots in northwest Houston near one of our very successful existing communities that is approaching sellout. This acquisition will create continuity in that proven neighborhood. We were able to open this new community quickly and efficiently by selling the same product out of our existing Open Series models, and will generate deliveries as early as the fourth quarter of 2010.

We also recently announced an exciting land deal in Southern California with the Lewis Group of companies with whom KB Home shares a more than 20-year working relationship. This phase takedown purchase involves 664 home sites in two prime master planned communities located in the Inland Empire, one of the best-selling areas of the country. In all, as a result of this transaction, eight new communities featuring the Open Series product, and targeting first-time and move up buyers will open for sale late in 2010, and begin delivering homes in early 2011. In Las Vegas, we acquired finished lots in seven communities in the second quarter, all in highly desirable locations with attractive price points and solid margins. One example is our Remington community in which we acquired the lots in the second quarter, will open models in the third quarter and will have first deliveries in the fourth quarter. This underscores the very local nature of housing which explains how we can operate successfully in a city as hard hit as Las Vegas by offering the right product at the right price point and in the right locations within that market. These examples illustrate our strategy of securing finished lots in great locations that meet our return hurdles, fit well with our popular Open Series product line, and can quickly be turned into revenue producing communities.

At the end of the second quarter, we owned our controlled almost 40,000 lots, a more than 2,500 lot increase over the end of the first quarter of 2010. This represents a four-year supply, and the first quarter to quarter sequential lot count increase in four years. Additionally, approximately $1.2 billion of our $1.7 billion in inventory is related to homes sold and in backlog and finished or nearly finished lots. Our land position allows us to continue to be nimble and opportunistic in today's market.

Turning to our financial results, we again narrowed our net loss for the quarter to $31 million, a 61% improvement over the prior year's period net loss of $78 million. On a per share basis, we posted a net loss of $0.40 for the quarter, versus $1.03 a year ago. We reduced our quarterly net loss significantly despite our revenues decreasing about 3% on a year-over-year basis to $374 million. We had no asset impairment or land option contract abandonment charges in the second quarter of 2010 compared to almost $50 million in the same quarter last year. We delivered 1,782 homes in the quarter, a slight increase compared to the second quarter of 2009. This reflected increases of 49% in our Southwest region and 5% in our Central region partly offset by decreases of 12% in both the West Coast and Southeast regions.

The average selling price for the quarter of $207,900 was down 4% from a year ago but included increases of 3% in our West Coast region and 6% in our Central region. Our second quarter average selling price increased 5% from the first quarter of 2010, and was up sequentially in three of our four regions. Margins held up well throughout the quarter, enabling us to mark our seventh straight quarter of year-over-year margin improvement. Our housing gross margin in the quarter was 17.7%, a nearly 16 percentage point increase over 2009. Excluding impairment and abandonment charges from the prior year, our second quarter housing gross margin was up 500 basis points on a year over year basis. This track record reflects our comprehensive work over the past few years in transforming our business and product offerings. We continue to expect our housing gross margin for the full year 2010 to be higher than in 2009.

Reducing our selling, general, and administrative expense ratio continues to be a top priority. At $83 million, or 22.4% of housing revenues, these expenses remained elevated in the quarter, compared to $73 million, or 19.1% of housing revenues in the year earlier quarter, primarily due to increased legal costs and higher advertising expenses related to expanded marketing efforts and opening new communities. On last quarter's earning call, we mentioned that legal costs would continue to have an adverse impact on our SG&A into the second quarter. Despite these additional expenses, we made progress in reducing the year-over-year gap in our SG&A ratio to 3.3 percentage points in the second quarter from 7.4 percentage points in the first quarter of 2010. For the full year, we are still targeting an SG&A ratio in the 18.5% range. We expect this ratio to improve further in 2011, primarily as a result of our anticipated top line revenue growth, driven by an increase in the number of homes delivered.

Our balance sheet remains healthy and liquid, and we ended the second quarter with approximately $1.1 billion in cash. Our cash balance decreased during the quarter, mainly reflecting our investments in land opportunities across our regions, and the repayment of debt. We still expect to end the year with a cash balance in excess of $1 billion.

As many of you have asked, I would like to give you an update on the status of the SEC's investigation which is still in process. While we cannot speak on behalf of the SEC and cannot be certain as to the scope of its review, the information requests we have received from the SEC relate to our impairments of communities and joint venture investments. We have a robust, disciplined, fact-driven process to evaluate our inventories and investment in joint ventures for potential impairments, and we remain confident in our consolidated financial statements. Of course we will continue to cooperate with the SEC and cannot predict the outcome of its review.

Before I summarize our longer-term outlook for the Company, I would like to share our progress in the quarter related to our My Home, My Earth environmental program. Our commitment to becoming a leading environmentally friendly national company is far more than a branding initiative. It can be seen in every aspect of our business. From lowering our costs by reducing wastes and increasing operational efficiencies to differentiating our homes to compete effectively with resale homes in the marketplace, it is the right thing to do, not just for the earth, but also for our business and our customers. We recently partnered with the US Environmental Protection Agency to be the first national homebuilder to participate in its new WaterSense for new homes, water efficiency program. According to EPA, WaterSense new homes use 20% less water than conventional new homes and can save homeowners more than 10,000 gallons of water each year. KB Home is already a leader in building all of our communities to Energy Star guidelines, and we believe that, just as EPA's Energy Star program has raised awareness of energy efficiency among consumers, the WaterSense program will do the same for water consumption. KB Home is proud of its position as one of the greenest production homebuilders in the US. Our earth-friendly homes conserve natural resources and lower monthly utility bills without raising the price of the home for our buyers, and without materially impacting our cost to build. This distinction is not only important to us, but to our home buyers, and serves as a great differentiator compared to a resale or foreclosure home.

Historically, the spring selling season sets up our fourth quarter deliveries and full-year results. As we look at 2010, however, the extraordinary circumstances of the tax credit dynamics, have added another element of uncertainty to the mix. We continue to sell for fourth quarter deliveries as our reduced build times are setting up stronger than ever backlog conversions and allowing us to lengthen our selling season further into the year. In fact, many divisions will sell Built to Order homes in August that we'll deliver in the fourth quarter. Having said that, a lack of predictability in the overall sales environment will likely impact our full-year deliveries and could potentially extend our outlook for profitability by a quarter or two. Given the current environment, and in light of the fact that orders in the second quarter were off, we now anticipate full-year 2010 deliveries to be in the range of 8,000 to 8,500 units.

Regardless of whether we cross the threshold of profitability during 2010 or shortly thereafter, our strategic vision for 2011, and our clear path on how we can get there remain unchanged. As we look ahead, we believe our success at the community level is creating a strong platform for increased momentum coming out of 2010, and a trajectory for topline growth in 2011. In fact, our projections call for community count growth of over 25% in 2011. To get there, we are following a straight-forward path based on the fact that our Open Series product line is selling more predictably and new communities are achieving healthy margins. As we underwrite new land deals at today's home prices, and establish a solid sales pace with our well-received new product offering, we are getting the expected results on a per community basis. We must now continue expanding our community count through strategic land acquisition while relentlessly cutting incremental costs in our business to further leverage our overhead and sales pace.

While the tax credit dynamics disrupted the gradual recovery process, the market will stabilize. It is just a matter of when. Long-term demographics, household formation and population growth continue to signify a positive course ahead for the home-building industry. Even the low-end estimates in the Harvard study put household growth at about 1.25 million annually over the next ten years. This is on par with the pace from 1995 through 2005, and should support average housing completions, manufactured home placements of over 1.7 millions units per year over the coming decade.

A home is not an ordinary purchase, it is a milestone. The primary reasons for buying a new home remain the life events that are constant in our society. Events such as a marriage, a new baby, or an empty nest. Moreover, buying a home is always about affordability and desirability, and buyers are still finding both at KB Home communities across the country. While some challenges and uncertainties persist in the short-term, the intrinsic demand for housing in America is undeniable, and our long-term growth strategy to capitalize on this demand is on track. I've been in this business long enough to know that good companies come out of these cycles even stronger, and better able to take advantage of the tremendous opportunities that the recovering market will present. We are closing in on our goal of restoring profitability, and I would like to thank our employees for their hard work and accomplishments. As we continue to execute our proven strategy, and KB Built to Order business model within the context of a gradual market recovery, KB Home is an excellent position to gain market share and achieve substantial future growth.

Now we will open it up for your questions.

(Operator Instructions). We'll go first to Michael Rehaut with JPMorgan.

Thanks, and good morning, everyone. First question, I just wanted to drill down a little bit on the differences in gross margin and also SG&A. I appreciate some of the commentary you provided, Jeff, on the SG&A in particular. But a two-parter. On the gross margin, can you review some of the puts and takes as to the sequential decline when you exclude the charges from first quarter to second quarter of about 110 bips, and what you expect to see in the back half of the year? And then also with the SG&A, the second part of the question, you certainly have some wood to chop in the second half in terms of the ratio to get to 18.5, and I was wondering if you could give us a little more granularity in terms of what costs you expect to fall out of the picture in the back half.

Okay. Sure, Mike. I'll speak to the gross margin side, and then I'll ask Bill to give you a response on SG&A. On gross margin, as I shared in our prepared comments, we did have our seventh consecutive quarter of gross margin improvement. In fact, over last year, it was 500 basis points and 17.7%. The slight decline from first quarter resulted from two things, really. Product mix a little bit, and buyer closing costs increased due to some of our first time buyers need of cash to close. On a per unit basis, the dollar margin per unit was the same, but due to the two things I mentioned, it is down a percent. And as we go forward, and you look at our business, margins will range where they're at to tick up slightly, depending on mix, and the better way for us to grow margin is through top line and units. Bill, you want to cover SG&A?

Yes, thanks, Jeff. Notwithstanding the levels of our SG&A in the quarter, keep in mind, though, we do have a relentless focus on reducing our SG&A expenses and percentage, and so we do believe at these elevated levels, they will improve as the year unfolds,, and as we move into 2011. It's important to keep in mind that at our current low revenue levels, that changes in expenses can have a dramatic impact on our SG&A percentage. If you'll recall last year, we had a much flatter trajectory in our SG&A percentage, in that we started the year of last year at 20.1%. We ended the year at, I think for our full year, of 17.2%. We're starting this year at 27.5%, and, as you saw in the second quarter, we brought it down already 510 basis points to the 22.4%. We see that gap continuing to narrow into the third quarter, as we hope to target the 18.5% at the end of the year. So you'll just see a much steeper decline in our ratio, and one coming much more into a normalized level.

Specifically, when you highlighted the legal costs, are some of those going to pull back, or do you have identifiable dollars on that line that you expect to decrease?

Yes. We are expecting going forward that the legal costs should abate some.

Okay. Second question, if I could. On just order trend throughout the quarter, and as we sit here in June, you alluded to the fact that you pulled back on spec a little bit, or sold out sooner than you expected during the second quarter. I was wondering if you could just give us a sense of month to month order trends on a year-over-year basis. Yesterday Lennar saw that June improved a little bit for them on an orders basis, also a traffic basis. I was wondering if you could provide any color to that, to this month that we're in right now, as well.

Mike, I couldn't tell you what the monthly comp is year-over-year, and we also don't want to get into the specifics of the month to month track during the quarter. As I shared in the prepared comments, May was off significantly post tax credit. Getting back to our strategy and how we set up our business heading into this tax credit expiration, we remained a pre-sold builder. We're firmly committed to our business model. As we look back on what happened with the last tax credit, we were totally at a disadvantage because we had no inventory to take advantage of the deadline, and it did hurt our sales. Post tax credit last year, there was definitely a lull in sales, just like you're seeing now.

As we looked forward to this tax credit expiration, we did put some limited inventory on the ground in markets with price stability where the community targeted first-time buyers. And what was interesting for us is a big chunk of those spec starts actually sold as the foundations were being poured, and the buyers still had the opportunity to go to the studio and make all of their selections, other than the floor plan and the exterior elevation. But we did not have a huge spec inventory out there. What we did start, we covered, and then as April unfolded, our buyers could no longer, once again, take advantage of the tax credit, because we couldn't get the home built by the end of June, so we were once again at a competitive disadvantage. So the tax credit, while it absolutely helped to clear inventory and it did create some incentive for our consumer, it also created a disruption to our business model. And now that we're moving past the tax credit period, we're looking forward to things getting to a more stabilized supply and demand environment where the strengths of our business model can once again emerge.

On the June sales front, we're not going give any color on that either, because it's too early in the month, and as things bump along, we don't want to over react to a one week or two-week activity. So we'll share more color at the end of our third quarter.

Our next question will come from Dan Oppenheim with Credit Suisse.

Thanks very much. Jeff, just wondering if you can talk a little bit more. You spent a lot of time talking about the growth strategy and that demand is going to return. We understand that and it's something we can all look at for the past few years, but given the declining trends in May and what seems to still be weak conditions in June, how are you responding to the current market and adjusting your plans, understanding you don't want to alter the long term strategy. But what do you do differently here at the end of June than you would have done if we had seen strength in the market?

Are you referring, Dan, to our investment strategy, or our sales strategy?

Both, whether you'll alter the land purchases and also what you are thinking about in terms of sales.

As I mentioned in my prepared comments, our biggest competitor is resale. And resale pricing is fairly stable. In most of the markets we're in, it's fairly stable. In some cases, it's actually been ticking up for many months like in California. We are all watchful and everybody has their own crystal ball on what's going to happen post tax credit environment here. But we look at each community specifically. We're competing with resales in that market, and we'll take whatever steps we need to balance a sales rate with a margin with the asset and the investment there. So we are not doing anything dramatic as a result of what happened to our May sales. We'll be watchful and deal with each community based on the dynamics in that location.

On the investment side, again the communities that I used as examples, and we could have picked more, they're all priced very competitive with resales, they're all selling at points comparable to product that's already been selling for many months in those locations. So we're comfortable with our underwriting and our investment decision. Wherever the selling environment takes us, and whatever happens to supply and demand in that location would influence our investment strategy going forward, but we're chasing 5 million resell units. So there's a lot of places we can go to compete and continue to grow the business.

Great, thanks. And if you can talk a little more in terms of the comments on closings, and also SG&A. The guidance for SG&A assumes a significant improvement in terms of closings in the back half of the year. What are the assumptions in terms of when demand does return? And then also in SG&A, how significant was the improvement in SG&A that occurred unfortunately based on the decline in stock price during the quarter? I imagine that was probably a couple of hundred basis points.

I can let Bill speak to that side, Dan. But again, as I shared in my comments, we're continuing to see great progress in compressing our cycle times. In fact, for the quarter, our average build time was 86 days. You've covered us for quite some time, so you know that in the old days, quote unquote, our business model was a six-month cycle time. We're now down in many divisions running below four months because of the simpler product to build and the sub base we have and our business model. So we're able to sell deeper into the year and still hit our deliveries for the year. So I've given you the range of units for the year, and assume we hit that range, and that's where we're targeting right now, we'll hit the SG&A ratio that we guided to. We'll continue to chip away at our costs while we push the top line, and we're expecting higher conversions because of a shorter cycle time going forward.

Moving on to Ivy Zelman with Zelman & Associates.

Good morning, everybody. I think just to follow up a Dan's comments, recognizing that you don't have a crystal ball, but I think your confidence in holding margins going into the back half of the year, improving margins, having a hard time digesting that, given the weakness we're seeing in order trends currently. I know builders talk about low levels of inventory for new homes, but as you pointed out, Jeff, you're really competing against existing homes. And we recognize that you have to sell houses in order to cover G&A anda to obviously generate revenue. So how do you feel as confident as you do that you won't need to accelerate incentives in order to, whether it be closing costs, as you experienced in the second quarter with respect to more people needing the down payment that you needed to fund to close, or closing costs, I mean. I just don't understand where your confidence comes from. And I am also perplexed that you're using the Joint Center's long term housing forecast to talk about what's going on given that today we have so much excess inventory in the market from an existing home standpoint, as well as a lack of formations, households being formed today that are actually almost non-existent. So hopefully you're not running your business on the Joint Center, and you can give us more of an understanding of how you actually think about opening new communities. How many new communities will you open in Q3 and Q4, or how many would you postpone possibly if, for whatever reason, demand doesn't pick up without government providing stimulus as they've done for the past year? So I'm a little confused and concerned.

You just asked like 15 questions, Ivy. I'll try to answer as many as I can recall from what you just rattled off. We're using the Harvard data to illustrate that in the long run, this is still a very vibrant industry. And some of the lack of household growth right now that was actually shared at the Harvard board meeting is people that are customarily home buyers are staying in the nest, where people are actually getting married but not moving out from underneath the parent umbrella because of uncertainty or lack of confidence in their job, or whatever. So household growth is still occurring, and population and demographics are going to drive our industry in the long run. So that's what I was sharing it for.

At the same time, this is a very local business, and I walked through a couple of examples here of communities where we're selling well in those areas today, and we're reinvesting to have more lots and to continue or open new communities in those specific sub markets. In those case, if there was a lull in sales for a while, we're still going to open the community because it's positioned extremely well relative to resells.

I don't recall that I guided margins up for the rest of the year. We ranged them because it's our business model range of gross margin is 18% to 20%. I think you and I have actually talked about normalized margins in our industry over the years as the normalized range. Everybody has a crystal ball, and everybody has a different view on whether the May drop in activity is one month, three months, five months. Everybody is going to have a different opinion, but everybody agrees it's going to come back. It's too early in this thing. Just like when the last tax credit expired, there was this lull, and then it slowly rebuilt, and we think that's the trajectory that you'll see as the economy gets on firmer ground. Now, if the markets were to go south, we're going to have to do some things that could impact our margin. So I'm not saying that it's going up, I'm not saying that it's going down, I'm saying we'll react to whatever market conditions we face at that time.

We'll now hear from Stephen East with Ticonderoga.

Thank you. If we could go back to the SG&A a little bit. Last quarter you said about $12 million was from non business -- I think the phrase you used was non business expense and legal and the long term cash comp, et cetera. What was it this quarter?

I don't think we really want to get into the detail. Again, I think what you need to take away from this is that we are focused on the SG&A. We will bring it down. We think it will more normalize as we get into the second half. And again, we think it will be about 18.5% by the time we end the year, which is really up only about roughly 1.5 points from where we were last year, not the 740 basis points that we were in the first quarter, or the 500 basis points that we were in the second quarter. So again, I think we really want to focus more on where this is headed, not where it is that we are.

As we shared, Stephen, we are always looking at ways to cut costs, and we'll chip around the edges. We've guided that the costs will ease for the second half of the year, and at the same time we expect the leverage from more topline to lower the ratio. That's why we're comfortable guiding at the 18.5% right now.

Okay. I appreciate that sequentially you typically don't want to talk about it, and month over month. I think generally that's a good policy, but given that this quarter did have the expiration of the tax credit, all of us are trying to understand for all builders what May really looked like year-over-year, and what that means as we climb out of this hole. So if there's any more color you could give on May and how much it fell off year-over-year. And also, then, on the gross margin you talked about product mix, pushing it down. Your gross margin has come down two quarters in a row. So I want to understand, is there something going on that from a product mix standpoint will continue, or what should we expect moving forward there?

I think on a product mix, it's not just product mix, it could be product mix and it could be geographic mix, timing of communities, making deliveries. I think the point is that if you look at our gross profit contribution on a per unit basis, it is flat sequentially, and up more than $9,000 year-over-year.

We'll now hear from Joshua Pollard with Goldman Sachs.

Quick question on your strategy. You are, as far as I can tell, solely building homes to order. And over the two most recent upticks in housing, that's led to some under penetration on the new home side. My thought process is, interest rates are likely to rise as an economic and housing recovery stage. So do you think that the time that it takes or the time that consumers want to actually get a home delivered has shortened, at least for a couple of years, and it may be worthwhile to revisit this strategy to build homes that are not to order?

Josh, I think you and I have actually talked about this. I shared on my prepared comments that we will be selling homes in late August that close in November that are sold, the buyer goes to the studio, we get the loan approval, and then we start the home and we will close it in November. So it's a 95, 105, 120-day turn. You've heard the horror stories of consumers getting frustrated trying to buy short sales, foreclosures. I think the normal resale cycle is 45 to 60 days, and these foreclosures and short sales is well longer than that, so we actually think we're very competitive now. Would you wait an extra 30 days to get your own custom home versus going through the headaches of foreclosure or resale. So we think what we have done strategically is absolutely the right place to be.

Understood. The other question I had was can you actually quantity what you're looking for community count growth in 2011? And if you would be willing to give a trajectory for the second half of 2010, that would be helpful as well. Thank you.

Josh, I think for the remainder of 2010, we think community counts will be slightly down in Q3. For the year, it will be slightly down, which implies some growth in Q4. And as we said in our prepared remarks, we're projecting community count growth of 25% in 2011.

Our next question will come from Jonathan Ellis with Bank of America, Merrill Lynch.

Thank you. First question I wanted to ask about the profitability guidance that you offered up. I'm wondering, just to help create some framework around that, any guidance you can give with respect to what percentage of homes would need to be sold through the Open Series product line and/or percentage of homes sold on new or recent land purchases in order to meet that profitability target?

John, I'll have Kelly respond on the Open Series percentage. But on the market, again, this tax credit has created an interesting disruption in our normal business flow, in that you have this deadline now in June where we will have a spike in deliveries in June that we normally don't see. And as we go forward through the balance of this year, we shared our deliveries will be up in Q3. Our fourth quarter deliveries are going to be tied, frankly, in part to how sales materialize over the next eight to ten weeks. So as we shared in our comments, we are approaching profitability. You can see it. But there's a variable now of what happened to the market and what happens with our delivery sequence. Having said all of that, we still think we're positioned at a gross margin and with the top line growth we're positioning for next year that we'll be profitable.

And John, as far as the Open Series, it's represented more than 50% of our deliveries for the last four quarters. So I think part of our profitability equation is related to two things. One is the Open Series is becoming a bigger portion of our deliveries, and secondly, as we start rolling out new communities on new land with Open Series, we expect to move closer to normalized margins.

Great. And my second question, just in terms of the order declines, particularly in the California market, in the context of the tax credit that California has in place right now, can you talk about what you saw specifically on the West Coast market this past quarter? Did the state tax credit seem to provide any stability in May or was it just a function of so many macro factors that led to the slowdown in orders on the West Coast?

Jonathan, at any time the government offers a tax credit incentive, to me, in part, it's a message to the consumer that now is a good time to buy a house. And that's always helpful with the consumer psyche. When you compare this year's tax credit in California to last year's, last year's worked extremely well, this year's has been much more muted in that the pay back this time around is over three years, whereas last year it was received right back in the same year. And for our consumer in California, we're not seeing it as a primary motivator. Now, prior to April, if they were a federal tax credit buyer and a state tax credit beneficiary,I think it would be a positive impact, but it hasn't been a real driver before or after April 30th.

Our next question will come from Michael Smith with JMP Securities.

Good morning. Just a couple of quick things. One is on what you're talking about with the color with the specs and the disadvantage you guys are out, I'm wondering if you can quantify that? Can you give us what percentage, approximately -- you can give me a quarter, a half, or whatever -- came from specs in March and April and how that actually compared with, say, February and January?

You're talking our sales?

Your sales, yes, your orders.

As I shared in the comments, it was a limited number. In some communities as I said, where we had price stability and it's first-time buyer product, we may have thrown one months worth of sales in the ground earlier in the year. So you're talking four, five, six, eight homes, no more in that location, and it wasn't company-wide. It definitely helped our sales for the quarter, because we may not have otherwise received a sale, but it wasn't the lion's share of our sales by any means. I don't know if we have the number broken out that way.

That's helpful. Does that mean then, is it safe to assume, are you hearing about good traffic coming through in March and April and then people leaving for the subdivision down the street because maybe they have more specs, or leave to buy an existing home? Is that what we're talking about where people are actually coming and were interested and then turned away because you guys don't have specs on the ground?

If you think about it, Mike, and again we're competing more with the 5 million resales out there. If on April 15th a realtor takes a buyer to our community, and they like the home, but down the street there's a recently completed resale, they automatically have an $8,000 free benefit. So we were definitely at a disadvantage in that period of time. That's now gone.

We'll now move to David Goldberg with UBS.

Thanks, good morning, guys. Question here is on cancellation rates. You guys had expected to see the cancellation rate maybe drop off a little bit more, and talk about where people were canceling in the process. In other words, did that create any kind of inventory, or is it fairly early on?

David, to me, our can rates were right within the normal range that we typically run. As you know, in our business model, the preponderance of our cans occur before we start the home. Where you have the filtering process, you take the contract, and if they're unable to get their loan approved, or they change their mind, it happens prestart of construction. Our can rate post-start remains very low. So as I look back, I don't know that there was any extra influence on the can rate up or down, because it was a fairly typical quarter for us.

Got it. The follow up question is actually on the land market. And it's good to see you guys being pretty aggressive on the land market and finding opportunities. But I'm just wondering if you can talk about where the opportunities are coming from. We've been hearing increasingly that land prices are getting big up for certain, especially for quality lots, and there's a constraint on A quality or B quality lots in the market right now that are being able to be purchased at affordable prices. So I'm trying to get an idea of where you're getting access to lots. Clearly you think they're pretty high quality, and what that means as you look forward.

It's absolutely a mixed bag, David. We are not players really, in the large bank portfolios that are being shopped around, and that's what a lot of the media coverage is regarding, where prices are getting pushed up. You're only as good in each city as your land team, and it's tied to relationships you have on the ground. So our lots are coming from other builders, land developers, landowners, in some cases banks that are off-loading a single community of lots. And you have to be on the ground working the relationships there. So we're actually seeing, before the tax credit dynamic, we were actually seeing and continue to see an increase in opportunities out there, and a little less frenzy pushing price up.

Our next question will come from Nishu Sood with Deutsche Bank.

Hi, this is Rob Hansen on for Nishu. Just with the recent slowdown in May and June, have you seen any signs that builders are having second thoughts in terms of the land deals currently in the pipeline?

No. It's too early. Too early, Rob.

Okay. And then for closings this quarter, what percent were pre-sold versus specs?

I don't know that we track it that way, Rob, but my hunch is the preponderance would be pre-sold.

All right. Thanks very much.

And our next question will come from Buck Horne with Raymond James.

Just briefly on the SEC, I know you're limited here, but is there any way you could gives us an indication if the SEC is looking at your potential impairments, or the impairments you've take as you either didn't take enough in those communities, or were a little too aggressive. Any indication of which direction they were looking?

We've shared the comments that we can relative to the SEC. I wanted to touch on it because many people have inquired, butt it's ongoing and we just don't want to speculate.

Fair enough. Also, do you have the ending spec home count that you finished the quarter with? And also if you have it the number of finished model homes you might have?

Buck, we had 3,176 homes in production, of which 534 were not sold, and of that 534, there were 152 finished unsold homes.

And we'll now move on to Mike Widener with Stifel Nicolaus.

Good morning. Wanted to follow up on a couple of things. First, did I hear you right the guidance you gave for deliveries this year is 8,000 to 8,500 units?

Yes.

So that's a substantial increase in the second half, about 60% up from first half run rate. I do realize you have a June spike coming. But how should we think about that in terms of your assumptions on orders per community? It would seem to imply that you expect a big boost in orders per community going forward, even with the tax credit gone.

I'm not sure that that would be the case, Mike. Our orders per community in Q2 were 19, 18 per community. You can do the math with the units we've closed, where our backlog is and how many homes we still have to sell.

I was just doing the math and I come out to you need to deliver 100% of your backlog next quarter and then have a pretty strong order volume next quarter. If that's the math you're suggesting, then I guess that's the math you're suggesting. I was just trying to --

It's really not, because if you look at our community count, it's going to be slightly down in Q3, and slightly down for the year, which implies it's going to be slightly up in Q4. Our community counts were down more in Q1 and Q2. We expect a very strong level of backlog conversion in Q3, just given the June deliveries from the tax credit expiration.

Ladies and gentlemen, that is all the time we have today for questions. Mr. Mezger, I'll turn the conference back to you for closing or additional remarks.

Thanks, Kelsey. Thank you for joining us this morning. We remain confident in our strategy and enthusiastic about our long term outlook for housing and for our company. Thank you again, and everyone have a great day.

Thank you, Mr. Mezger. Again, ladies and gentlemen, that does conclude our conference for today. On behalf of KB Home we thank you all for your participation.