KB Home (KBH) 2010 Q3 法說會逐字稿

Good day, everyone. Welcome to the KB Home third quarter earnings conference call. Today's conference call is being recorded and webcast on KB Home's website at KBHome.com. The recording will be available via telephone replay until midnight on October 4 by calling 719-457-0820 or 888-203-1112 and using the replay passcode of 406-0985. A replay will also be available through KB Home's website for 30 days.

KB Home's discussion today may include certain predictions and other forward-looking statements that reflect Management's current expectation 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 differ from those expressed 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. And now I would like to turn the conference over to your host, Mr. Jeffrey Mezger. Please go ahead, Mr. Mezger.

Thanks, Kelsey. Good morning, everyone. Thank you for joining us today for a discussion of our third quarter 2010 results. With me this morning are Jeff Kaminski, our Executive Vice President and Chief Financial Officer, and Bill Hollinger, our Senior Vice President and Chief Accounting Officer.

I will begin by providing an overview of the housing market and some color on our third quarter performance. In addition to discussing the actions we have taken and continue to take, as we move our Company towards sustained profitability, Jeff Kaminski will offer some detail on our third quarter financial results and I will conclude our prepared remarks by sharing our outlook for KB Home as we head into the fourth quarter and 2011. We will then open the call to your questions.

Turning to the broader housing environment, we are all familiar with the monthly housing and economic data that have reflected the general doldrums in the market over the past few months. This morning's Commerce Department report on new home sales in August and yesterday's report from the National Association of Realtors on existing home sales, although marginally improved over the worst month on record in July are both down appreciably versus the prior year serving to further illustrate the historic lows at which the housing market is functioning. The expected pull back in home sales following the expiration of the Federal Home Buyer Tax Credit has for the most part persisted through the Summer and we are looking forward to housing conditions that are void of this extraordinary external influence.

That being said, sales continue to be impacted by the soft economy, sustained unemployment, and lack of consumer confidence. Sales activity that is occurring being driven by today's incredible affordability and extremely low interest rates. New tighter lending standards could serve to further dampen overall demand' although based on our home buyer profiles, we do not expect the new guidelines to have a large impact on our business specifically. Distressed resale inventory is clearing; however the overall supply of homes is slowly growing, in part due to banks putting more REOs on the market for sale. I do feel we are now bumping along the bottom, but do not expect significant improvement in housing dynamics until the economy is on firmer ground.

Despite the challenging macroeconomic conditions facing the homebuilding industry, there are pockets of opportunity in every market, and we continue to make solid progress toward our profitability goal in the third quarter. Our bottom line results approach breakeven levels and extended our track record of year-over-year improvement to nine straight quarters. Operating income from our homebuilding business entered positive territory, for the first time in nearly four years. This reflected an increase in the number of homes delivered, a higher housing gross margin and a sharp reduction in our selling, general and administrative expenses. Ongoing actions to generate increased operating efficiencies and overhead reductions were evident in our financial performance for the quarter.

As a percentage of revenues our housing gross margin excluding inventory related charges increased year-over-year for the eighth consecutive quarter to 18.2% and our SG&A ratio, which has continued to improve since the beginning of the year, declined to 15.8%. We delivered 2320 homes in the third quarter, the second consecutive quarter in which we increased deliveries, over the prior year. This was primarily the result of a higher level of backlog conversion and compressed cycle times, which are tangible benefits of the progress we have made in improving our business execution over the past few years. As we enter the fourth quarter, we clearly have more work to do but we are moving in the right direction on many fronts and are steadily closing in on our goal of restoring sustained profitability at our current scale.

Moving on to sales, the drop off in demand following the tax credit expiration was exacerbated by the protracted weakness in the economy and at the same time, we are operating with a lower community count. Net orders were 1,314, a decrease of 39% over the third quarter of 2009. This negative comparison was compounded by the fact that last year's third quarter orders were extremely strong. While our community count last year was down 37% over 2008, our sales were up 62% as we maximized build to order home sales related to the 2009 home buyer tax credit, and accelerated the rollout of our new Open Series product line.

While current sales remain at difficult levels, we have experienced a sequential improvement in orders, each and every month since the April 2010 tax credit contract deadline. In June, which is historically one of our best selling months of the year, our net orders were down 50% year-over-year. Since then, we have seen a gradual and sustained uptick each month, with July orders off 37% and August 29%. For the first half of September, the year-over-year order gap has continued to narrow. Interestingly, this positive sales movement throughout the Summer unfolded as our traffic levels remain below average, suggesting that more committed buyers are coming back into the market, reloading the demand that was previously pulled forward by the tax credit. This trend is encouraging and hopefully an indicator that we are slowly breaking out of the confusing market environment in which the tax credits have been both a benefit and disruption to new and existing home sales.

Despite these unusual market conditions, we are finding that our well located, well priced communities are continuing to sell at above average rates. For example, we have had a successful infill business in the Bay Area of Northern California for many years, and our sales in that region have held well throughout the downturn. At The Preserve Townhome community in Redwood Shores we have averaged a brisk 2.8 sales per week since opening and have even been able to raise prices. These homes, which currently start at $650,000, boast a one of a kind location in the heart of the Silicon Valley, situated alongside the Bay and just a half mile from the headquarters of Oracle and Electronic Arts.

One of our newest developments in the East Bay is Parkside, which opened at the end of August and garnered 12 sales in the first three weeks. Our Parkside communities, which offer both single family and townhome product are Green Point rated, an energy rating that exceeds ENERGY STAR standards and are ideally located close to schools and transportation, including the Bart Station just one mile away. In Las Vegas, a particularly hard hit market, one of our new open series communities, Abelino Ridge, is a great example of achieving favorable sales rates by getting the location, product, and pricing just right. Since we grand opened Abelino in February 2010, we have sold 63 homes, with 20 sales coming in the third quarter.

One of our best selling communities today is a high density project that exemplifies our core strategy in urban areas. A Warner Center is located in the San Fernando Valley, outside Los Angeles is a 190 unit low rise condo community that grand opened in August and has already garnered 30 sales. Prices average under $400,000, an affordable price point in this attractive location that offers a unique opportunity to live, work, and play in a walkable urban setting.

San Antonio is another bright spot for KB Home. Overall sales are up significantly year-to-date over 2009 with three communities garnering 20 more sales each in the third quarter. In fact, many San Antonio communities have exceeded their sales plans and are implementing price increases. Of course, not all of our communities nationwide are performing at this level, but these examples illustrate that if you offer the right product at the right price and in the right location, there is underlying demand for new homes today. We continue to have confidence in our diverse and well received Open Series product offerings in addition to the tremendous value proposition our homes and communities represent, compared to both resale and new home competition.

We opened or reopened with new Open Series product more than 30 communities during the third quarter; however because we continue to close out older communities at roughly the same pace, our community count was actually down 6% year-over-year in the quarter which is in line with our projections. As some analysts have reported, our sales per community continue to be among the best in the industry. Our challenge and opportunity as we have discussed previously is to open more communities while achieving further reductions in operating costs. Our goal is to balance our overhead and margin with the current size of our business, while at the same time driving future growth.

Land activity continued in the third quarter, although at a somewhat slower pace than the first two quarters of the year. Year-to-date, we have spent close to $400 million on land acquisition and development and currently have plans to invest up to $150 million in our fourth quarter. On a full year basis, these investments represent less than our prior guidance which we believe is appropriate given the slowdown in home sales; however, we continue to balance our caution in today's Markets with our optimism and investments in the long term growth of our business. In the near term, we are targeting finished lots in A locations within sub-markets that are showing signs of stability, primarily in our West Coast and central regions. In the third quarter, approximately 80% of the lots we secured were located in these areas.

The land sale environment is notably less frenzied than six months ago and favorable terms are available in most markets. As always, we're focusing on land that fits well with our open series product lines, achieves our margin and return thresholds, and can quickly be converted into revenue producing communities. We are constantly evaluating our strategic geographic footprint as well, in order to focus our resources where they offer the greatest opportunity for consistent returns. As a result, we recently decided not to invest further in the Charleston market as we work through our remaining communities in that area and instead, concentrate our efforts on the larger markets of Raleigh and Charlotte.

Our build to order business model allows us to be nimble and move with the market. A year ago we announced our intention to reenter the Washington DC metro area, and now have two successful communities delivering homes with three additional communities opening in the next few months. We saw an opportunity as the local market conditions improved and were able to quickly move back into this vibrant area with proven product offerings, taking advantage of the more stable economy and rising demand.

We took additional steps during the quarter to reduce our SG&A expenses, by consolidating our management structure within our Southeast region, including Washington DC, the Carolinas and Jacksonville. We effectively combined the general and administrative functions for these areas to gain greater operating efficiencies while keeping in place the local teams that are necessary to grow the business from a land and sales perspective. This restructuring, which is expected to generate around $5 million in annual savings, is just one example of our ongoing actions to gain further efficiencies and reduce cost Company-wide without compromising on our execution.

In the context of the current housing environment, it is more important than ever to be able to quickly respond and adjust our business to local market conditions. Our ability to flex up or flex down as needed is a cornerstone of our KB Next Build To Order Business Model and I'd like to take a moment now to touch upon some of the things we have done in our business to reduce our risk profile. We're continually honing the principles of our Build To Order business model, the effects of which can be seen of everything on our balance sheet to our land purchases to what kind of products we offer in a particular neighborhood. It is a financial disciplines of this model that dictate our position as a land light pre-sold builder.

The majority of our new land acquisitions have been finished lot deals that can quickly go from land purchase to community opening, or options which give us tremendous flexibility to react to changing conditions on the ground, and because of our decision-making process related to our floor plans, features and locations is strictly data driven, we know that when we open a community for sale, it will be meeting the specific needs of local home buyers. To appeal to our various buyers, we offer a wide array of product offerings across the Company, based on our detailed home buyer surveys. Our award winning and energy efficient homes from the Open Series include multiple configurations of attached, detached and rear loaded home designs that range from 1000 to 4000 square feet and can flex up or down to meet a buyer's needs. Buyers then have numerous design choices to customize their new hopes at the KB Home studio including options to make their homes even more earth friendly.

A common misconception within the investment community is that the Open Series is exclusively designed for first time buyers. While the majority of buyers responding to the Open Series today are first time, when the move up market reemerges, we will be ready to accommodate this shift with the same product lines because of their inherent ability to add additional bedrooms, bathrooms, and living space with ease.

KB Home is also clearly differentiated by our 50/50 joint venture with one of the nation's premier mortgage lenders, Banc of America. We have been reaping the benefits of this unique partnership in our business for many years, but they are particularly apparent today. This structure enhances our ability to provide a seamless home buying experience to our customers by offering a convenient and competitive lending option without us having to be in the business of operating a wholly-owned mortgage Company. This allows us to focus on what we do best while Banc of America does what they do best. In the third quarter of 2010, 83% of our home buyers who required financing used KBA Mortgage for their new home loans. This joint venture has been extremely successful and a risk managed approach to providing mortgage services to our home buyers.

There has been some concern raised in the investor community regarding put backs in the mortgage industry. To give you some color on how well this venture is run since its inception in 2005, our share of expenses related to loan buybacks or indemnifications has been minimal. The inherent flexibility and risk averse attributes of our build to order business model are more important than ever in the current environment and should give investors additional confidence in our ability to not only withstand today's challenging market conditions but to prosper in the future. Now I'll turn it over to Jeff Kaminski, who will provide a review of our financials during the quarter.

Thank you, Jeff. Starting with the bottom line for the third quarter of 2010, we narrowed our net loss for the ninth consecutive quarter to $1.4 million or $0.02 per diluted share, a substantial improvement over the 2009 third quarter net loss of $66 million or $0.87 per diluted share. These results included one community impairment and four land option contract abandonments, totaling $3.3 million in the quarter compared to $47.7 million in the same period last year. The Company delivered 2,320 homes in Q3 and generated $501 million in total revenues, a 9% increase over the third quarter of 2009. Our backlog at quarter end stood at 2,169 homes, a lower number than we would like due to our excellent conversion of the prior quarter on backlog and lower orders during the quarter.

Our average selling price increased to about $214,000, up over $11,000 compared to the same period last year. This primarily reflected increased deliveries, in some of our higher priced submarkets in California as well as a higher ASP in our central region due to community and product mix, rather than general price increases in our markets overall. In the third quarter of 2010, our housing gross margin was 17.5% versus 11.1% in the prior year reflecting an increase of 640 basis points. Excluding impairments and abandonments from both periods, we were up 3.6 percentage points over 2009 representing our eighth straight quarter of year-over-year improvement in this metric. This trend of margin expansion continues to reflect the delivery of a higher percentage of our value engineered Open Series product which is designed to reduce direct construction costs and increase operating efficiencies, consistent with our KB Next Build To Order Business Model.

An additional positive influence on margin was the increase in percentage of deliveries, generated from new communities during the quarter. In Q3 2010, 47% of our deliveries related to impaired communities, compared to 85% during the same period of 2009 as we continue to transition out of old communities and into new ones. While we are pleased with our progress and margin improvement as we look ahead, pricing pressures and product mix are likely to affect margins in the fourth quarter.

We are also pleased to report that our SG&A expense ratio has continued its downward trajectory. These expenses represented 15.8% of housing revenues in the third quarter, a significant improvement over the 27.5% reported in the first quarter and 22.4% reported in the second quarter of 2010. This result also compared very favorably to the 18.5% ratio achieved in the third quarter of the prior year. Looking at SG&A expenses sequentially versus the second quarter 2010, we realized a 6.6 percentage point improvement. Over half of this decline resulted from actual net expense reductions from the remainder representing the leverage impact of higher buying in the quarter. Variable accounting relating to stock based compensation plans, net of an increase in bad debt reserves, accounted for approximately $6 million of the improvement.

Additional decreases in SG&A were mainly due to efficiency improvements and overall reductions in legal, advertising, and salary expenses. Since the end of the second quarter, we implemented a number of actions to generate further reductions in SG&A and construction operating costs. A few specific examples include the stock appreciation rights conversion announced in August which will reduce a portion of future expense variability caused by stock price movements, the elimination of 100 positions resulting in annualized savings of almost $12 million on a go forward basis, and the consolidation and restructuring of a portion of our Southeast regional business segment that Jeff mentioned earlier, which will contribute an additional $5 million of savings.

It is this same level of cost diligence and discipline that has allowed KB Home to remove approximately $800 million of annual fixed and variable SG&A expenses since the start of the housing downturn in 2006. Our Management team remains committed to continue to align the Company's expense base to current volume levels as we take further actions to ensure our fourth quarter SG&A expense ratio will continue to show sequential improvement. Our strong balance sheet remains an important foundation for our business.

We ended the third quarter with over $1 billion in total cash. Despite our significant land and development investments in 2010, which are expected to total over $500 million, we still intend to finish the year with around the same level of cash which will provide continued financial strength and flexibility as we head into 2011. During the quarter we secured another 3700 lots, bringing our total lots owned or controlled at the end of the third quarter to approximately 41,000. Last quarter marked our first quarter to quarter sequential lot count increase in four years and that trend continued in the third quarter, which bodes well for our plans to open additional communities in 2011.

Turning now to deliveries. We achieved our forecast in unit deliveries, during the third quarter 2010. Looking ahead as we shared on our last call, we knew our fourth quarter deliveries would largely be driven by our sales experience in the third quarter. Due to post tax credit demand during the months of June, July and August that was significantly weaker than expected and given the continued softness in the broader market, we are lowering our expected unit deliveries, for the fourth quarter of 2010 to around 2,200. This assumes a high conversion of our 2169 homes in backlog at quarter end as well as the delivery of a portion of our inventory homes currently under construction.

As our sales results unfolded over the quarter, we recognized that our projected backlog would be low as we entered the fourth quarter. We therefore made the strategic move to proactively start a designated number of specs in strong performing first time buyer communities in order to generate additional revenue in the fourth quarter while simultaneously reloading our pre-sold sales. Even with this strategy, almost 70% of our homes under construction at the end of the third quarter were sold. Over the long term, we remain committed to our build to order model, which historically provides for higher profit margins but we also believe it is important to be flexible in these extraordinary times.

On a final note, in relation to the Company's financial reporting, we were obviously very pleased to announce earlier this month the SEC notified KB Home it has completed its investigation related to the Company's accounting disclosures which began in October 2009 and that the staff does not intend to recommend any enforcement action. This matter has now been concluded in a positive manner for KB Home and we are glad that it is behind us. Now I will turn the call back over to Jeff Mezger for closing remarks.

Thanks, Jeff. I'd like to take a moment to mention KB Home's outstanding results in the JD Power & Associates New Home Customer Satisfaction Study announced this month, in which we ranked second among all builders nationally and achieved the highest average customer satisfaction score in our Company's history. In addition, KB Home's Arizona division was ranked number one for customer satisfaction in the Tucson market and the Carolina division was number one for new home quality in the Charlotte market, while our Central Florida division was recognized as number one in both categories for the Orlando market. Throughout this downturn, our JD Power results have shown constant improvement year after year, demonstrating the customer centric focus of our business model and our committment to the long term success of KB Home. I'd like to thank our entire team for their incredible efforts and ongoing dedication to quality and customer service.

We also continued to advance our industry leading My Home, My Earth environmental initiatives. In addition to being the first national builder to build exclusively ENERGY STAR qualified homes, we are also the first to build new communities to the EPA's new Water Sense specifications, which save up to 10,000-gallons of water annually per home. The homeowner benefits of an Energy Star home are even more dramatic. In Southern California, we recently surveyed 50 Open Series homeowners to quantify their utility cost savings in their new Energy Star homes. The total gas and electric bill for these homeowners over a 12 month period averaged about $1100 or $90 per month. These buyers were able to own their own brand new home while enjoying utility bills that are often lower than the typical apartment. It's a great illustration of how our product is differentiated in a way that is extremely meaningful to our customers, especially when compared to resale and other new homes.

In closing, let me summarize the major themes we have shared about the market and our Company today as well as our outlook as we head into 2011. While we have seen improvement in our net orders, over the past few months, sales remain soft and the weak economy continues to be a major impediment to any housing recovery. Having said that, when you take a step back and look at the market through the eyes of our consumer, there's actually some very good news. Not the least of which is the fact that today's housing market is one of the most affordable that we have seen in 40 years.

For many would-be buyers, the lack of consumer confidence and general sense of uncertainty in the larger economy has been enough to keep them on the sidelines despite historically favorable conditions, but home buyers who are highly motivated by a relocation, a new baby, an empty nest or simply by affordability in the American dream, they are enjoying historically low interest rates, affordable prices, and energy efficient new home designs that are less expensive to operate.

Now is a great time to buy a new home and we are working very hard to get that message across to potential buyers, especially to renters who are often paying the same or more in rent than they would to own a home of their own. In fact, although our product is flexible enough to meet the needs of a wide spectrum of buyers, a full 73% of our homes delivered in the third quarter were sold to first time buyers with the balance evenly split between move up buyers and empty nesters who were downsizing. We're taking every opportunity from an SG&A perspective to generate further cost savings in our business, tighten our footprint, streamline our organizational structure, and improve our overall operating efficiency. At the same time, we are continuing to strengthen our position as a leading builder in our markets especially as many smaller and medium size builders are unable to compete in today's difficult financing and sales environment.

Our consistently improving financial results demonstrate how KB Home's integrated strategy will successfully compete in today's market has been working and we continue to look for areas in which we can make additional progress. We're also investing in our future growth, with over $500 million in land and land development investments in 2010, we continue to expect a meaningful community count increase in 2011, which should position us to grow our top line and hasten our return to sustained profitability. Our current strategic vision calls for the opening of over 100 communities next year, contributing to an average community count that we expect to be 25% higher than this year. As always, we will remain prudent, disciplined and nimble in our approach, with a robust use of land options and a constant sensitivity to current market conditions.

While we are expanding our community count to create revenue growth opportunities, we are committed to running a profitable homebuilding Company at whatever scale the market will sustain. Combined with the reduced competitive landscape, the upside profit potential for KB Home is tremendous and the value inherent in KBH shares becomes more and more apparent.

The stabilization process continues and the housing market will undoubtedly recover. What no one can control is exactly when this will happen. What we can control is how we operate as a Company in the meantime. In addition to improving our efficiency and execution, the team at KB Home has remained consistent in our focus on providing the utmost in value and choice with flexible, affordable, and energy efficient homes designed for today's consumer. And with that, Jeff, Bill, and I will now take your questions.

Thank you so much, Mr. Mezger. (Operator Instructions). We'll go first to Michael Rehaut with JPMorgan.

This is actually Jason Marcus in for Mike.

Hi.

Given some of the softness that we've been hearing about in the land market, can you talk a little bit about what you've been able to do regarding renegotiating land deals and if you've done that and its been successful or not?

Sure, Jason. It's a great question, as I referenced in my prepared remarks, we do a lot of business in rolling options where you'll put up a deposit and build your models and take lots as you sell them and it lowers your risk profile. What it also allows you to do is move a little better with the market so as prices in any given sub market may get lowered from where the deal was originally under written, we have had a lot of success in going back to sellers, sharing with them market data, showing them what we're doing to sell homes and if you can't get your return at the market prices at that time, a lot of sellers have been willing to work with us and partner to drop the basis in the lot as well.

Okay, thanks and the next question is with the conclusion of the SEC investigation I was just wondering what your legal costs had been quarterly and what do you expect them to be going forward?

Yes, we haven't really disclosed the total costs relating to that one particular issue and don't feel it's appropriate to do so. We did see a benefit in the quarter on the legal side and we'll continue to keep an eye on that expense line as well as all of the other expense lines on the SG&A side but we don't see the appropriateness at that in this point.

Next, we'll hear from Stephen East from Ticonderoga.

Good morning guys. Congratulations.

Thank you.

Jeff, your pricing strategy seemed to, it looks like to me that you're willing to forego some orders to get a better price in the market and or maybe you've got some mix shift going on. Could you explain to us what your strategy is and what we should expect moving forward?

Sure. As Jeff shared in his comments, our price was up and it was primarily mix shift. We're not seeing a lot of upward pricing movement in the majority of our markets. I shared a couple of anecdotes but it's community specific. Relative to our pricing and pace strategy as we always share, every community has a unique situation and you'll move price and try to monitor relative to a strategic sales pace.

Our overall strategy is to restore profitability. In order to do that you need solid margins and with what we've been able to do in our gross margins it's set up the opportunity to be profitable. While I say that, there's also a revenue that you need in order to cover the overhead structure of the organization, so our primary goal right now is to hold margins and on a community specific basis we may need to get more aggressive as the quarter unfolds. If the markets don't improve or the sales pace doesn't hit our plants, but first priority is margin.

Okay, and then I thought the SG&A break out was great. That was really helpful for us, and something, when you talk about the Southeast combining the back office, everything except for really what's on the ground there, interfacing with the customer, is that something that can be replicated across all of your divisions? Why just the Southeast, and if it could be replicated, what type of potential cost savings would be sitting out there?

Well, we shared that example, Stephen, because it was a realtime event on action we took in the quarter. I've been sharing these type of actions over the last couple of years. I call it my hang around the rim strategy where the markets have, the activity levels have reduced so much you can't afford a fully loaded division so you'll keep your strategic management in place on land and sales and through technology you can combine the back office, so today, we have 12 divisions managing 30 markets, so we've done quite a bit of this over the years.

Arizona for instance we have one division managing Phoenix and Tucson. At the peak in California I think we had nine or 10 divisions. Today we have two, covering a large geography but again with technology, you can do that. We're never done chipping away at what can we do to lower our overhead so we'll continue to push this strategy. I think we've done most of them but I can't say we're absolutely done on this one item.

The next question will come from Ivy Zelman with Zelman & Associates.

Good morning, Jeff. It's actually Alan on for Ivy. Jeff, I was hoping you can just revisit some of the SG&A guidance that you gave last quarter. I think you said last quarter you were targeting $18.5 million for the year and obviously the sequential improvement was really strong but it looks like you guys need some additional improvement in the fourth quarter and I know you mentioned maybe deliveries are going to be a little bit weaker than you originally are expecting so can you give us an updated guidance on that?

Yes, we could talk about that a bit. As you know, we were very happy with the performance in the quarter, as we expected last quarter, we saw some nice decreases almost across-the-board in SG&A; however due to the downward revision in our expected fourth quarter delivery, we believe that although the fourth quarter SG&A percentage will continue a sequential decline off the 15.8%. We think the full year will be closer to 19% now at this point, but basically only related to the delivery shortfall, not anything related on the expense side.

But you would expect another sequential improvement even if revenues maybe are a little bit lower or kind of right around where they are today?

Yes.

Great, and just to follow-up on that, I think Jeff you made a comment maybe that you would expect to see some margin pressure if demand remains as weak and I no one of your competitors said that they've seen about a 100 to 200 basis point increase on incentives thus far in the fourth quarter. I was hoping that you might be able to frame what you're seeing on the pricing side and maybe gross margin expectations for Q4.

Yes, there's the gross margin side, I mean there's factors on both sides of that positive and negative. On the positive side, the increase in the open series percentage while we have reaped many of those benefits it's still continuing. We're still seeing increases in our percent mix there so that will help us. The cost control and the decrease in material cost pressure that we're putting out into our divisions into our vendor base should also help us on that to offset any potential pricing and then finally, we are seeing a higher percentage of deliveries coming from recent lot purchases versus from previously impaired land and all those factors have been positive on margin.

On the cautionary side, we're seeing a couple things. One is mix and we're seeing a slightly different mix coming through forecasts for the fourth quarter which could potentially negatively impact margin as well as potential pricing as we mentioned our BTO, build to order sales typically carry a slightly higher margin than spec sales. We will be having some more sales on an inventory in the fourth quarter so those two mix factors combined with the positive factors we think we might see a risk of maybe 100-200 basis points.

We'll now move on to Buck Horne with Raymond James.

Hi, thanks. Great. I was wondering just to go back to the SG&A again, if you could give us a little color maybe with the recent changes in cost cuts you've made, do you have an idea for what the current kind of quarterly run rate for the fixed component of SG&A might be?

Are you talking in dollar terms or percentage?

Yes, if you can give dollar terms that would be helpful or some context.

Yes, typically, you can look at 40% or so being variable, if that helps you.

For this quarter it's about 40% was variable?

Yes.

Okay, and just also wondering, are you seeing problems with appraisers out there recently? Are you starting to see that appraisal issues are coming back again with home prices starting to decline after the tax credit or are the additional foreclosures hitting the market becoming a problem with appraisers?

Buck, a good question. We just finished reviews with every division as we prepare for our final business plans going into 2011. Part of that review was a market uptake by Citi. As you know strategically, we like to be competitive with resales and resales are influenced by various levels of REOs dependent on which market you look at. The majority of the markets, pricing held through the Summer. We did not see a lot of pricing declines in the markets that we operate in.

What we did see was a little uptick in inventory, so that could suggest future pricing pressure if sales stay at this level and inventory keeps going up, so as I shared in my comments, the good news is as these REOs hit the market they are clearing, so you have a churn going on that's held price stability, albeit at low levels, and with that price stability, we've seen less pressure on appraisals than we were seeing a year or two ago when these markets were declining much more rapidly. So there's always the one off story of an appraisal issue at any given community but it's not the pressure it was when prices were dropping much further. Or much faster I'm sorry.

We'll move on to Jim Wilson with JMP Securities.

Thanks, good morning. Two questions regarding your lots and your community count. I might have missed it if you mentioned it but the current community count, how did it compare in Q3 compared to a year ago or earlier in the year?

Yes, Jim, this is Jeff. The third quarter was at about 138, the way we count it and I think all you guys are familiar with our methodology on that. Last year same quarter was 147.

And as you look at the 25% targeted increase amid combination of where you've been buying and when you talk about 25% higher community count, where do you expect that to be most of that addition to come from? Where do you expect to be meaningfully bigger on a regional basis?

Well, the last two quarters, Jim, we've shared that the majority of our investment has been in California, Las Vegas and the central region.

Our next question will come from Joshua Pollard with Goldman Sachs.

Hi, thanks for taking my question. The first is at some point, could you let us know what your spec count and homes under construction are and my other question SKU talk about the costs associated with opening this many mu communities and one given year?

Yes, Josh. Talking about the cost. We're positioned right now for a division where we have sort of a fixed cost base where we believe we could flex up pretty significantly without adding a lot of fixed costs out of the division or at the corporate level quite frankly. So what we will be seeing for the most part on the community openings, obviously we'll be seeing a little bit of marketing expense that's variable on the community openings, you'll be seeing things like construction supervision and sales, but outside of that we don't expect to see a huge run up in fixed.

In fact that's the goal of the Company is to hold that down to achieve the greatest operating leverage possible from the openings. So that sort of answers the question on the cost side. On the unit side, at the end of the year, we had a substantial portion of our units in production that were actually sold units.

End of the quarter.

At the end of the quarter excuse me, that we had 2600 units in production, of that about 1750 of those were sold representing about 67% of the inventory. The remaining units are basically started out of the backlog. We need to close about 450 of those units in order to meet our guidance that we just put out for the fourth quarter.

He asked about how many are standing?

There's about 850 standing units.

It's not that big. It's not finished.

Counting the condos?

It's completed in the unsold.

Yes, finished units are about 400. We need to do 450.

Right. But he asked about how many finished.

Sorry.

Josh, the other color I can give you if you think about it I shared in my comments that we opened or reopened 30 communities this quarter and next year, the 100 would all be new, so there's not reopens in that. We've been able to open 30 in the quarter while lowering our SG&A, so our strategy is to expand our footprint and our community count platform but to keep a rein on the overhead so we're going to create more growth opportunities but if the sales stay soft, we can stay lien and continue to make money at the current volume levels or that's our goal.

So Jeff let me ask you this as a quick follow-up. Is it a hundred gross that you want to open up? I don't think it is. I'm assuming it's 100 gross, not 100 net and could you just talk about how many--

That is 25% growth over the average this year.

Yes, so you're talking roughly 25 to 40, so my other question is if you look at your comments on July being better than June, August better than July and September starting off better, if my memory serves me right, the business begins to slow in the mid Summer last year because of the expiration of the first version of the tax credit. Could you talk a little bit about the absolute level of sales in June, July, August and what you're seeing so far in September? Thank you guys.

Sure. Well, Josh, again it's a great question. As we looked back at it and again I shared in my comments, last year in the third quarter we had a very strong sales result and it was because in our business model where you're primarily pre-sold, we had to sell them by August to deliver them by November for the tax credit deadline, so I believe in the third quarter last year among the builder group, we had the highest positive sales comp because of the sales in July and August and then our sales dropped in Q4 because we were done selling for that tax credit deadline so it really illustrates the pace that these tax credits have created extraordinary influence in our normal flow of business.

Our next question will come from Carl Reichardt with Wells Fargo.

Jeff, just to get back on the community count for next year, as you guys know the way you define communities what you report is a little lumpier and has a lot of sequential increase during the course of the year. What's the timing through the balance of the year on how you're opening stores? In particular do you expect to have a larger bulk open for spring selling season or is it trailed through the year?

It will be a trajectory that will be more weighted to the second half, Carl.

Okay, thanks and then Jeff Kaminski, I know when you were at Federal Mogul you were running supply chain, if I recall correctly and when we talked earlier I was curious about your candid assessment on the one or two areas of the supply chain where you guys think you might have the best opportunity to become more efficient or squeeze costs out relative to the way that it traditionally runs.

Yes, there's a couple statements I guess on the supply chain and homebuilding. The way that KB Models worked and the way the Company has it set up I think they are relatively firn rent given the divisional structure. There is a national purchasing organization that sits over in the coordinating role and coordinates on a regular basis with the division purchasing personnel, and there are national contracts written across many of the commodity areas and commodity groups which is best practices in the area. There's probably more opportunity we could put into the indirect side in the Company and we're looking at that and focused on that as we go forward as well as continuing what's been done up to this point.

There's a lot of value engineering gone into the product which is always a key component on the purchasing side as well which allows you to really gain efficiencies both for vendors and for yourself as a Company and increase profits throughout the supply chain. Those are always win-win and something that I've looked at in the past to do and something that KB Home has done rather well. We reenergized that effort recently as we've looked at a lot of our home model and design and try to put more value engineering into the product that I do believe will reap gains as we go forward so overall my assessment is pretty good job done historically but like always, opportunities to do more and I think right mind set across the Company to accomplish that.

Moving on to David Goldberg with UBS.

Thanks, good morning. First question I want to get back to this whole REO question but I wanted to ask a question that is a little bit different. What I'm trying to understand guys is the new land that you're buying is it geographically located in different areas from where you're seeing this new push of REOs coming to the market or is it all kind of in the same area and so it's really not like you're buying land in locations that are less impacted?

Good question, David. I think you and I have talked about this. When you look at a given market, the closer you are to the job clusters, the better the market is held and the better pricing is held and demand is stronger, so the further out from the job clusters you go, the higher the REO levels are today and as I shared in my comments we're focused on A locations and an A location is typically the closest you can get to where people work, and as prices have adjusted in these markets, people can now live much closer to work than they had been able to frankly for a decade, and they're taking advantage of that, so with the demand going up in the inner ring, it would drive more foreclosure activity the further out you get, so my summary would be I think where we're investing the markets are more stable and part of that is that there's less REO activity close in than there is out at the end of the ring.

Great. That's what I figured. The follow-up question I had, I want to talk about the specs that you started and the kind of strategy maybe to start a little more to fuel some fourth quarter closing. You guys talked about a couple quarters ago and I think last quarter too about doing more drywall spec building and so you still leave optionality and you still leave some upside from the design center in doing the drywall specs and I just want to understand when you say you're starting specs were the specs getting sold, is there still the opportunity for some optionality, are people adding options into the house, and is that contributing to margins for those houses that are maybe closer to the build to order model? Thank you.

David, we shared our tax credit strategy even before the sales deadline back in April, I think we shared it on our March call and the vast majority of that inventory we started was sold before, in most cases before the 2x4s went in the air so the buyers still had the choice other than any structural flex options they would typically select, and we did not stop anything at sheet rock because of the demand at that time, and the success we had. The inventory that we started now was limited our strong selling first time buyer communities and the inventory we started was the best selling plans, inclusive of the high frequency option, so we didn't just throw a product in the ground and it was a limited strategy. Again, we had this extraordinary influence in April that we had to bridge. Now we've had the extraordinary influence through the Summer that we have to bridge so it's merely a bridging strategy while we reload the pre-sold pipeline and get back to our ordinary course of business.

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

Thanks very much. Was wondering if you can talk just a bit more about what you've been doing in terms of the specs and the focus on margins here and that if you talked about the number of completed homes, spec homes at say it's two per community on average, we're slightly more than that so I guess if it's still in selected communities then it's certainly a higher number in those communities where you're building those. Are you building these in the, are the communities selling well enough that they should be having these specs, just how do you think about that? You say it's a bridge or do you think this is something that continues for you into 2011?

Dan, we fumbled a bit on the finished inventory, because I was speaking different than Jeff, but just to clarify at the end of the quarter, we had about 413 finished and unsold. What's unique about that number is that it's overstated relative to ordinary times because of the condo community I mentioned in Warner Center where you have to finish the whole building, and you're selling as it nears completion so there's over 100 of this number are sitting in Warner Center, so as a Company, the finished inventory is still relatively lean, especially compared to most of the industry.

We targeted specs in the pre-sold markets where it's first time buyer product that's selling well where we think we can continue to reload the pre-sold pipeline and cover this inventory along the way. Over and over again, it's no different today than it was six or seven years ago. Our margins on our pre-sold homes are much higher than the inventory so we do not want to get to that as a core business. Even if a community is selling six or eight a month and you're building as fast as you can, we would not go start specs just to have a bigger universe because you compromise your margin.

Right. And do you think this is something you keep going through if your focus on margin it's something you will continue in 2011 assuming market conditions are similar to those they are today?

It will be a community specific strategy. Some of the inventory we threw out was also in communities we've targeted to close out so we can lower our overhead so that's part of it as well, and I'm hopeful we're still early in the quarter and I'm hopeful that we're successful in this bridge where we cover the inventory and reload the pipeline and one of the things that we haven't really specifically addressed on this call, I touched on and Jeff did in our comments that we really enhanced our execution. Our cycle time in the third quarter from contract to close, so this is right to sale, get a mortgage, go to the studio, start and close the home, was 135 days, so it's basically 3.5 months. That's how well we're operating today and I'm hopeful we can reload the unstarted backlog and go.

Moving on to Megan McGrath with Barclays Capital.

Thanks. I just wanted to follow-up on your comments in your opening remarks about the tightening credit and the new guidelines. I assume you're talking about the FHA guide liens but if you could give us a little bit more detail on the work that you've done to figure out which of your buyers might be affected by that and if you could remind us the percent of your sales that were FHA, that would be great.

Megan, I can share an eye level and Jeff Kaminski give you the actual statistic. FHA has come out and announced that FICO scores below 580 effective October 1 are going to require 10% down. As we went back and analyzed our deliveries in 2009 it was something like 1% of our buyers were below 580 so not meaningful, not material. Our average FICO is much higher. They've also changed around the mortgage insurance premium where you pay a little less up front but there's more in the payment which so in theory your payment is up a little higher but again as we look at our consumer it wasn't meaningful enough to change their ability to qualify.

Yes, and on the percentage, Megan, the FHA during the third quarter is about 64%.

Great. And do you know of the change in the seller concessions as well, do you have an idea of what your percentage concession was historically?

Well, as you know, Megan, in our business model we don't focus heavily on incentives. We want to give the buyer the best price and the best value. I think year-to-date our incentives are 1.5 points or 1.75 points, something like that so it's not a big part of our business. The FHA had announced they were contemplating reducing seller concessions from 6% to 3%. I think they deferred that decision. I don't think that's been announced yet.

Deutsche Bank's Nishu Sood has the next question.

Thanks. I wanted to ask a question about impairments. Obviously, you had a very small impairment number. The general fear out in the investor community is that with a falling price environment, impairments might tick up again. I just wanted to get your thoughts on that, some color, whether you think that's a possibility perhaps with the threshold is for what type of price declines might trigger impairments and how material those would be then.

Yes, I mean, as you know, we do a pretty thorough job on the impairment side and the accounting and we watch it very closely on a monthly basis and do a very thorough review every quarter. The analysis performed is really community by community. It goes into that much detail so it is hard to paint a brush across the universe. You know a couple things to think about with our new communities generating higher margin levels than the previously impaired communities, with the newer land purchases, the more we work into that I'd say the lower the risk goes on impairment for the Company which is certainly the case.

It's always a risk as the market falls enough you're always going to be bumping up against that and one of the ways I like to look at it is at previous times of impairment you sort of lower the water level to the top of the rocks in some cases and if it continues to lower you may be at risk of taking more his impairments but we don't see certainly the last two quarters our impairment side has been very reasonable and under control. We took no impairments in the second quarter and a very minimal amount in the third and just one community and at this point in time, we're very secure in that approach and given or lack of a catastrophic decline in pricing we don't think it's a huge issue for us.

Okay, and just in terms of those new communities that are coming on, obviously land prices were increasing from let's say early 2009 through early 2010. Is that part of the story as to the margin pressure in the latter half of the year or is it strictly due to pricing pressure and mix, or is that part of the mix story as well?

Nishu, it's absolutely not due to us compromising margin by paying more for the lots. We again as I said in my prepared comments, we're very strategic and data driven on where we'll acquire lots and land, and it has to hit our threshold on both the margin and the return when we underwrite it and we also don't bake in any inflation or any pricing assumptions when we underwrite, so part of our margin trajectory is theres more new communities opening up and it's becoming a bigger mix, so it's definitely not due to compromised underwriting.

Moving on to Kenneth Zener with KeyBanc.

Afternoon. Given the comments around the back half weighting for your increase in community growth, can you kind of discuss I assume this is plan A is the world kind of stays steady from here and you open up those communities but what are your alternative strategies given the back half weighting to opening up communities, if the environment in fact slows down. Have you already committed the capital? You own all of the communities or are they really finished communities that you could hold off further incremental investment?

Well again, Ken as I shared in the comments, what we're tying up today is either small, quick hit finish lot deals that you move quickly on or rolling options where you have flexibility and can get out, so there's not a lot of additional cash required other than to build models and pay for the marketing to get them open. We're trying to get to a point where even at today's scale and revenue, we can hit breakeven or generate a profit and then the community count growth would be leverage and upside to your business, so if it bumps along where it is today, we'll stay nimble and keep aligning our overhead to do whatever revenue the market will give us.

Right. I guess the nuance that I'm looking for is given that it's a low capital, high turn approach that you're taking, it sounds as though you're not assured or you don't need to go ahead and open up those communities given that it's back half weighted. Is that correct? Am I misinterpreting what you're saying?

The way the community is tied to delivery, so in our typical cycle, we'll open communities in the first quarter or early second quarter and then your first deliveries are third and fourth quarter, so that's what influences the number, but on average for the year, we still feel we'll be up 25% year-over-year. And that's communities where models are under construction. Today we may even be open for reservations by now but on average, it's weighted more to the back half of the year.

Ladies and gentlemen, unfortunately we only have time for one more question which will come from Jade Rahmani with Keefe, Bruyette & Woods.

Yes, hi, this is Jade Rahmani from Keefe, Bruyette & Woods, I was wondering if you could provide any color on the mix shift that you referred to that you expect to see in the fourth quarter and then secondly any indication on the average order pricing since the calculated average does bounce around a lot. Thanks.

Yes, okay, starting with the mix, I mean we obviously have a forward forecast going out in the quarter. There's a number of things affecting margin and one is product mix and the second community and divisional mix that we're seeing so it's really just a factor of where we're currently forecasting the deliveries coming from in Q4 versus Q3 so nothing terribly dramatic about it or indicative of the future trend or anything else. It does just bounce around a bit up and down quarter to quarter. Second part of your question again, sorry?

Was on order pricing since if you calculate it based on backlog and this quarter's unit orders, it bounces around a lot. Can you indicate where current order pricing is running?

Yes, that's a good question obviously on the backlog side. The way we calculate the backlog is actually quite straightforward. We look at the average selling price in the quarter. We apply it against the mix and the backlog and then forecast out that total backlog dollars that's disclosed in our press release and financials, et cetera. What actually happens then is the actual pricing associated with those models comes through, the consumer hits the studios and pricing gets reflected as a result so right now if you look at the average in the backlog I think it comes out to $209,900, we're actually forecasting a higher ASP slightly than the third quarter actual so we think we'll be north of the $214,000 in the fourth quarter.

Okay, great. That's very helpful. Thanks a lot.

Mr. Mezger, I'll go ahead and turn the conference back to you, sir.

Thank you. Thanks once again, everyone, for joining us this morning. Although the path is not always as smooth as we would like it to be, we are successfully navigating the uncertain terrain of today's housing environment, are confident we're moving in the right direction for our Company and remain very optimistic about where we are headed in the future. Thanks again, everyone and 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.