KB Home (KBH) 2011 Q1 法說會逐字稿

Good day, everyone. Welcome to KB Home's 2011 first-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 April 12, 2011 by calling 719-457-0820 or 888-203-1112 and using the replay passcode of 6020115. 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 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 of its control, KB Home's actual results could be materially different from those expressed in or implied by the forward-looking statements. Many of these risks factors are identified in KB Home's filings with the SEC, which the Company urges you to read with care.

The discussion today may also include references to 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. I will now turn the conference call over to Mr. Jeff Mezger. Please go ahead, sir.

Thank you, James. I would like to thank everyone for joining us today for a review of our results for the first quarter of 2011. 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 this morning with some comments on our results for the first quarter, which were obviously a disappointment for us. I will also provide some color on market trends, while Jeff Kaminski will discuss the details of our financial results. After a few closing comments, we will then open it up for your questions.

As we observed during our year-end call in early January, our favorable financial results for the fourth quarter of 2010 reflected a number of factors that worked in our favor. We reported relatively high deliveries and revenue, our highest gross margins of the year, reduced SG&A expenses and solid leverage on both gross margin and SG&A that resulted in a pretax profit.

In contrast, our results for the first quarter of 2011 reflect the combined impact of factors that worked against us. Entering the year, we guided that our low level of backlog would result in lower revenues and a loss for the first quarter. While we did have an above-average conversion rate of backlog to deliveries in the quarter, the drop in our revenue dramatically impacted both margin and our SG&A ratio, even though our SG&A expenses were down during the quarter.

At the same time, we recognized substantial charges related to the South Edge joint venture prompted by the court decision that we reported in February. Taken together, these negative factors blur much of the underlying progress we have made over the past few years in repositioning our Company. As the year unfolds, we plan to grow our revenue in part as a result of opening more communities and believe that this volume leverage will cause our financial metrics to settle back into balance by the second half of the year.

Due to the financial impact of the events in the quarter, we do not anticipate a net profit for 2011. However, we maintain that our operating strategy has us positioned to achieve profitability at some point later in 2011.

From a macroeconomic perspective, the economy is continuing to improve. We are pleased by the encouraging trends in many sectors. Even so, this recovery has yet to include significant job growth and has not spilled over into housing. The recently reported Case-Shiller home price index and consumer confidence data further underscore the headwinds that housing markets continue to face. These headwinds will not go away and a sustained broad-based housing recovery will not occur until we start to experience material job creation and higher consumer confidence levels.

Having said that, we are seeing evidence of stability in many of the more desirable submarkets, those located close to employment centers that feature supply and demand that is in balance and offer affordability levels that are extremely compelling relative to historical norms. While the recently reported new home and resale data reinforces that a difficult housing environment continues nationally, the positive submarket trends we are seeing reinforce that housing is a very local business. We have been capitalizing on these trends by focusing our investment and community development in these high preference submarkets.

As the stabilization process gains traction over time, we expect to see the housing recovery gradually spread to adjacent submarkets within each metro area and our investment and revenue growth strategy will broaden as the recovery evolves. In the meantime, we will remain selective in our investments, continue to open new communities, work to increase sales and grow our backlog and take additional steps to align our overhead levels with projected revenue.

Turning now to our results, we reported an operating loss for the quarter of $48 million versus $36 million for the first quarter of last year. Excluding the South Edge loan guarantee loss in 2011 and inventory-related charges in both years, we were essentially flat year-over-year despite a 28% reduction in deliveries.

Our pretax results for the first quarter included a large financial impact from charges we booked related to the South Edge joint venture. While we were surprised and disappointed with the court's ruling in February, we are endeavoring to work together with the banks and other builders in the South Edge joint venture in an effort to resolve the current situation and to gain ownership of the rest of this well-located master planned community.

The overall Las Vegas housing market continues to have its challenges. However, our Las Vegas division is actually performing quite well with some of the highest sales rates per community in the Company. Over time, the land-constrained Las Vegas market will recover and thrive once again and we believe that our Inspirada community, including the land that we expect to get out of the South Edge bankruptcy, has tremendous value to our business. Jeff Kaminski will provide further detail regarding the South Edge financial impact.

On the sales front, we normally limit our comments to activity within the quarter. However, given the unusual tax credit influence of last year and investor interest in real-time data relative to the current selling season, we have elected to also share our sales and traffic activity for the month of March.

Today's consumers remain very cautious, whether they have concerns about home prices falling further, their job status, their ability to qualify for a loan or general confidence in the economy. The timeline to make the purchase decision has extended significantly with a typical buyer visiting a community numerous times before signing a purchase contract.

As we reported, net orders in the quarter were down 32% year-over-year to 1302. While we are not pleased with this result, there were encouraging trends that developed as the quarter played out. In all three months of our first quarter, traffic levels per community continued to be higher than the prior year, similar to our experiences in the fourth quarter.

On the sales side, our net orders improved sequentially each month from 276 homes in December to 400 in January and 626 in February. It was in February of last year that the tax credits started to gain traction with the consumer and as a result, we had a 36% shortfall for the month versus the prior year even with the sequential increase over January.

For March, a month in which we also experienced a positive impact from the tax credit last year, we closed the gap in year-over-year net orders significantly, falling short by less than 6% with 763 reported net sales for the month. We generated sequential gains in net sales each week during March and we anticipate sustaining solid sales results as we open up additional communities throughout the second quarter.

We will have a negative year-over-year comp in April, which was the strongest sales month of 2010 and was also the last month of the tax credit. As you may recall, we reported that May's sales results last year post-tax credit were extremely weak and that our third and fourth-quarter results did not materially improve from there. As a result, post-April this year, we expect to sustain positive year-over-year monthly sales comps for the balance of the year, which should be strong enough to lead to a favorable year-over-year comparison in 2011. This should also set us up with a larger backlog and momentum as we enter 2012.

Part of the improvement in March is tied to the performance of our new community openings in the first quarter and highlights that there are pockets of opportunity in every market. Our new communities that have opened are, for the most part, exceeding our pro forma projections. In the select submarkets where these grand openings are occurring, we are experiencing a solid sales pace that relies on traditional demand driven by high affordability, desirable locations and the right product offerings.

Our focus remains on competing profitably with resales, our largest and fiercest competitor. While we cannot always compete with resales on price, we can absolutely compete through offering floor plans that meet the needs of today's homebuyer, a broad choice of features and options in our studios with our built-to-order approach, quality locations and most importantly, we can compete favorably against resales' total cost of home ownership.

A great example of how our products lowered total cost of homeownership as demonstrated in the marketplace is our new KB Home Energy Performance Guide or EPG. As our sustainability initiatives have evolved, we now have the capability, via third-party consultants, to calculate and communicate to the consumer a projection of what their approximate utility costs should be in every community companywide.

The EPG marks the first time we have been able to truly quantify and project the financial benefit of the energy efficiency of a KB Home to the consumer and the advantage versus resales are significant. The EPG was strategically launched in mid-February, just in time for the spring selling season, with a two-day major media tour that generated almost 200 million media impressions.

As a result of this incredible media buzz, the EPG program is not only bringing more traffic to our communities, homebuyers are now choosing KB Home specifically because of the EPG projected savings and peace of mind that it brings as they plan their monthly homeownership costs. It is not uncommon to hear reports from our customers that the savings versus resale exceeds $100 per month. In today's economy where every dollar is important, these savings are meaningful to our buyers.

On our last earnings call, we told you about the KB Home GreenHouse, an idea home created with Martha Stewart, our first net zero energy concept home in Orlando that also featured state-of-the-art water and energy-saving technologies. The home is registered with the Department of Energy having the capability of actually selling power back to the grid. More than 2000 people toured the home during the event, which also helped us to promote our nearby communities.

We received such a positive response that we are now planning to build a net zero energy concept home within a model park in every division in 2011. Not only is it a terrific traffic generator for our communities, it is a great way to showcase KB Home's energy programs and available energy options for the consumer.

A third innovative energy program is our recent announcement that, for the first time, KB Home will be offering solar power systems as standard in 10 new home communities across Southern California. We are leveraging our strategic partnerships and supply chain in order to provide this valuable feature on our homes while keeping them priced affordably and also presenting the consumer the opportunity for a potential federal tax credit.

This is just another example of how we are setting KB Home apart in a competitive marketplace. If this program is positively received by the consumers, we have the capability to quickly expand it to other markets outside of Southern California.

Before I turn the call over to Jeff, I want to provide an update on our KBA mortgage joint venture. During the quarter, we were informally advised by Bank of America that they want to strategically move away from operating under joint venture structures in their business. Recognizing that we still have over nine years remaining on our joint venture contract, we are working with them to see if we can restructure our relationship in a manner that is beneficial to both parties.

As we explore new options, our business will continue to operate as usual. We are working toward a seamless transition for our business and our customers both today and as we move to a new relationship. Now I will turn the call over to Jeff Kaminski.

Thank you. Jeff mentioned in his remarks that there were many factors that came together during the quarter to adversely impact our financial results. However, beneath the surface, there is underlying improvement and momentum in our business and many of our financial metrics reflect this dynamic as well.

Our pretax loss in the first quarter of 2011 was $114.1 million compared to $54.5 million in the prior year. The current year quarter included $77 million of charges relating to the South Edge joint venture and $1.8 million of inventory-related charges. Our pretax loss in the first quarter of 2010 included $13 million of inventory-related charges. Excluding the South Edge impact, as well as the inventory-related charges from both periods, we actually narrowed our pretax loss to $35.8 million, a 13% improvement versus 2010.

We delivered 949 homes in the first quarter, representing a backlog conversion rate of 71%. Those homes had an average selling price of approximately $206,000, generating $195.2 million in housing revenues. This compared to 1326 deliveries in the year-ago quarter at an average selling price of approximately $198,000.

Housing gross margin, excluding impairments, was 13.4% in the first quarter of 2011 versus 18.8% in the prior year and 19.7% in the fourth quarter of 2010. Our lower overall volume of deliveries in the quarter had a significant impact on this number, accounting for 410 basis points of the sequential decrease from the fourth quarter to the first quarter. As compared to Q4 2010, we delivered roughly one-half the number of homes in the first quarter and at the same time maintained field infrastructure necessary to support new community openings and revenue expansion later in the year. This obviously had a large negative impact on margins in the current quarter.

Other factors included the closeout of certain top-performing communities in Q4 and pricing pressure in select markets and to a lesser extent, a shift in regional and product mix. Our selling, general and administrative expenses in the first quarter were $49.6 million versus $72.2 million in the same quarter the prior year and $55.7 million in the fourth quarter of 2010. Reduced revenue levels obviously had a major impact on our SG&A percentage and while this is typical of our first quarter, it did show an improvement versus the prior year as implemented cost-reduction initiatives benefitted this year and the first quarter of 2010 included significant legal expenses, which did not repeat.

On a sequential basis, significant drivers of the variance from the prior quarter included the reduced volumes and higher variable selling expenses in the first quarter of 2011 and the favorable legal recoveries realized in the fourth quarter of last year. We basically maintained our favorable annualized run rate of the underlying fixed SG&A expenses in the first quarter of 2011.

Early in the quarter, we completed a bid process and sold our [ENOVIA] condominium rental community in Southern California at terms we believe were favorable to KB Home. Although this was a valuable asset, it was not core to our business strategy. Cash proceeds from the sale were used to pay off the related secured debt.

As Jeff mentioned, our first-quarter results included significant charges related to the South Edge joint venture. As a result of the February 3, 2011 court decision confirming the involuntary bankruptcy of the joint venture, we have determined that our investment in the JV is no longer recoverable and we recognized a charge of $54 million to write off the remaining amount on our balance sheet.

In addition, we recorded an obligation to cover our estimate of the probable amount that we will pay to the lenders if we cannot offset or defend against the enforcement of the Springing Guaranty. Our obligation relating to the Springing Guaranty is partially offset by an amount equal to the current estimated fair value of the South Edge land.

In connection with recording a probable obligation, we took a charge of approximately $23 million in the quarter. Excluding our estimate of KB Home's share of the probable amount due for related arbitration award, which is separately reserved, this leaves a liability on the balance sheet of $137 million relating to the South Edge joint venture at February 28, 2011. Essentially, the charges taken in the first quarter are due to our reassessment as a result of the court decision in early February of probable amounts that will be paid to the lenders and the underlying legal status of the JV entity.

As of year-end and up through the time of filing the 10-K, we did not consider it probable that the court would enter the order for relief. We were obviously surprised and disappointed by the court's ruling and had to recalibrate our liability estimates based on that event. However, South Edge continues its legal defense in relation to this matter and it has appealed the court's decision.

I want to emphasize that this is a complex situation with a range of potential outcomes that may take many months to finalize. As Jeff said, we are looking at a variety of ways to resolve the issue. We remain committed to eventually taking ownership of our share of the South Edge assets and in the land-constrained Las Vegas market, we believe this will provide great value to KB in the future. Please refer to our Form 10-Q, which will be filed on Monday, for additional disclosures and details relating to this issue.

I would also add that the remainder of our Company's joint venture exposure is quite low as we have been actively working to reduce this over many years. We actually just favorably resolved our Kyle Canyon JV during the quarter and we have no debt associated with any of our remaining eight joint ventures.

Moving on, our backlog at the end of the first quarter decreased 38% on a year-over-year basis to 1689 from 2713 while the projected future revenues in backlog declined 32% to approximately $354 million at the end of February 2011 from approximately $524 million at the same time last year.

We began the year in a trough in terms of backlog and deliveries and our backlog at the end of the first quarter remains low, but our momentum is growing. As sales activity picks up during the year and as we continue to introduce more new home communities, we expect volume and margins to expand in the second half.

Until more of our planned new communities are in line and we see the sales pace that is established during the spring selling season, it is difficult to make predictions. However, our view is that our backlog should be higher year-over-year by the end of Q3.

Our cash position at quarter-end was approximately $857 million, reflecting the normal seasonal cash burn of a low delivery quarter, our first-quarter land acquisition and development spending and a heavier bond interest payment schedule. As we plan our cash management for the rest of the year and evaluate our capital structure, we remain mindful of our potential South Edge obligations and continue to evaluate our financing strategy going forward. Now I will turn the call back over to Jeff Mezger.

Thanks, Jeff. As I have shared, the stabilization process is commencing with select submarkets in many of our cities and based on our previous land investment and new community opening strategy, we are well-positioned to benefit. As we continue to navigate these times, we remain nimble, prudent and strategically opportunistic in our land and lot acquisitions. We spent $140 million on land acquisition and development in the first quarter, a figure, which could, depending on market conditions on the ground, increase in future quarters just as our investments increased in the latter half of 2010.

If markets strengthen, we have the flexibility to spend more, but if markets weaken further, we will hold back on future investment until we feel the timing is right. We grand opened or reopened with new product 33 new communities in the first quarter of 2011, most of which occurred in the month of February, while at the same time closing out 18 communities in the quarter. We have plans to open about 40 more communities in the second quarter for a total of around 70 in the first half of the year, setting up a nice growth trajectory for the latter half of 2011.

As we open more new home communities, we remain committed to our built-to-order model, which historically provides for stronger margins and better visibility in our business, as well as higher customer satisfaction. The sales momentum we have experienced since March was based primarily on build-to-order sales. Our build-to-order homes represent the utmost in quality, value and choice to the consumer and our products and Company continue to be acknowledged.

KB Home's leadership in building energy-efficient homes was recently recognized by the US Environmental; Protection Agency with their highest honor -- the ENERGY STAR Sustained Excellence Award based on our many years of successful collaboration. KB Home was the only builder to receive this prestigious award in 2011.

KB Home was also once again named the number one homebuilder in Fortune Magazine's 2011 list of the World's Most Admired Companies. This is the third time in the past four years that KB Home has achieved the top ranking and our Company also received the highest score in the subcategories of innovation, people management and social responsibility among homebuilders.

This kind of independent recognition from analysts and our peers as to how we are running our business is gratifying for us as a company and confirms for us that we are doing the right things to stand out and succeed in our industry going forward. I would like to thank our talented and hard-working employees for their efforts in making all of these accomplishments possible.

As we look ahead to the remainder of 2011, we like our position from a strategic, geographic and financial point of view. The encouraging sales trends we are beginning to see develop should play out in the second half in the form of improved financial results. The transformation we have undergone over the past few years is also starting to gain traction in our business. We have dramatically reduced our overall costs to operate the business.

We have a product that is attuned to today's buyer and design features and price point. We are operating in 30 of the best long-term growth markets with new communities concentrated in the best submarkets within each of those locations. Our community count growth is underway. We are enhancing our brand awareness through our marketing and PR outreach and we are achieving record levels of customer satisfaction.

Lastly, our current sales pace and trajectories should allow us to generate favorable monthly sales comparisons starting in May, positioning us for a positive year-over-year sales comp and strengthening our backlog as we head into 2012. While the economy is improving, it is unclear whether the broader housing market is bouncing along the bottom, stabilizing or improving. Nonetheless, tangible momentum is building in our business and we look forward to leveraging the talents of our entire team to seize opportunities. And with that, we will open it up to you for your questions.

(Operator Instructions). Stephen East, Ticonderoga Securities.

Thank you. Good morning, guys. If we could focus a little bit on -- go back to Inspirada and could you just sort of give us a rundown of, okay, if you have reserved for everything, this $180 million, $200 million, is that fully reserved with the liability of $137 million? I guess I am just not clear as to where we are on that. And then the focus group arbitration, there was one earlier, is that already reserved for as well? And just sort of what is involved with bringing the land onto the books and did you bring any on this quarter?

Yes, Steve. We can cover that. First of all, as you know, the situation remains very complex. There is a bankruptcy that is out there. There is various constituents involved, so it is a complex situation. Our reserve at year-end was over $100 million relating to the issue. And we increased the reserves during the first quarter because of the trigger in the February 3 court order. After the court order, we considered it probable that our obligation would grow and we made reserve adjustments as a result.

Just to answer more specifically some of your questions, the reserve at the end of the quarter includes about $212 million relating to principal interest and fees due to the lenders. It is offset, as we talked about in the script, by the fair value of the land that we estimated. We have a reserve on the books as a result at the end of the quarter of $137 million.

In respect of the focus arbitration, we do have a separate reserve set up for that. That did not change during the quarter. So that reserve for focus is not included in the $137 million and it was separately set up and preserved during the quarter.

As we said earlier, it is complex. It is described -- this whole issue is described in much more detail in the 10-Q that will be filed on Monday and ask you to please refer to that for additional disclosure information.

Okay, and so from your standpoint, it looks like you don't believe there is anything else out there that would hit your book value. And what would be involved in bringing the land back on the book that, Jeff, you alluded to and did you do any of it this quarter?

No, we did not record any land on the books this quarter. It was more used as an offset to the estimated liability. The involvement there -- we had to work through the bankruptcy process to actually gain ownership of the land. We will work through that either through an agreed reorganization plan or through a repayment under the Springing Guaranty and then dealing with the bankruptcy as a follow-up.

Michael Rehaut, JPMorgan.

Thanks. Good morning, everyone. First question, I was hoping to get -- drill down a little bit more on the gross margins. The detail on the 410 bps EPS from lower volume was helpful. As you look at -- but you -- so -- but on that number and the other numbers, the 410 bps, did that also include kind of incremental, let's say, fixed or overhead, you are saying, in addition to the lower volume because of the new communities? And then if you could also kind of rank the other impacts that you mentioned for the balance of the -- I assume the 410 was a year-over-year decline. So if you can give us a sense of how the others, order of magnitude or how that kind of -- if there is a way to quantify that impact as well?

Okay, let's start with the leverage impact. The leverage impact was more a maintenance of our expenses as opposed to increased expenses during the quarter. As our volumes were down significantly from the fourth quarter to maintain the same percentage level, we would have had to cut several different types of expenses on a pro rata basis, which we elected to not do that and instead keep those resources in place for upcoming launches. And those expenses included things like our land operations in the field, our construction operations, purchasing, customer service, those type functions that don't really fluctuate that tremendously by volume on a quarter-to-quarter basis.

We saw less of an impact on the leverage when you looked year-over-year because we had taken some reductions on those expense types as we moved through 2010, but the difference between the fourth quarter and the first quarter were not there so we maintained it at that level. To rank (multiple speakers)

The 410 -- so the 410 was a sequential number?

That was a sequential number from the fourth quarter. That is correct.

Okay. And then the other items, if you can kind of give us a degree of magnitude in how they impacted the closeout of the higher communities' negative pricing and mix?

Yes, the closeout of the higher communities was in the neighborhood of a 150 basis point impact. The pricing was about 50 basis points and the rest of the mix impact kind of fills in the balance.

Okay. Second question on just looking at the order decline for the actual quarter. I think Jeff mentioned that the communities that you opened were mostly in February. And if I understand it right, you ended the quarter around 140 -- well, can you give me what the average community was for the quarter?

But my question I guess is really for the fourth quarter you had a decline, average communities down year over year of about 24%. Is it fair to say that the majority of the declines during the quarter were driven by the community count decline versus the absorption? Or how would you think about year-over-year absorption pace?

Let me make a couple comments because we are trying to figure out how to reposition our communication to the investor world on community count. Because we've traditionally counted it based on deliveries of a minimum of 5.25. We have done it that way for 20 years and it has been an ongoing debate both for us and our industry to try to get something that is clear and objective and makes sense.

When your deliveries drop the way ours did, it understates your communities because we didn't have as many deliveries of five or more in a community as we would have in previous quarters. And having said that, I shared what is opening for sale because our community-opening strategy remains totally on track. Our delivery results blur what is actually going on in the specific community count. So Jeff, I don't know if you want to share what kind of numbers we want to --

Yes, sure.

-- set up for the year.

I think, as Jeff said, the delivery decrease predominately was due to absorption as opposed to community count change. We did open 33 new communities in the first quarter. We had 18 closeouts. As Jeff mentioned, we are still on pace with our opening plans as we discussed during previous calls. We still have 40 additional openings scheduled for Q2.

The historical method of calculating it based on deliveries really doesn't make a lot of sense. It is giving us a number that really distorts our view of our store footprint and we have pulled back really from going public with that number at this point just -- and really rethinking the way we are counting communities on that basis.

The reason we started providing more detail into this last quarter was really in relation to the current year strategy where we are opening new planned communities. As we reopen these communities and start delivering homes, it will take several months, in many cases, a two-quarter lag, before you see those in the way we have historically measured community count. But despite that, by the third and fourth quarter, our community count should be reflecting the 25% increases as we previously discussed.

So I think the message here, the underlying message is the quarter volume was mainly absorption-related as opposed to community count change. We are on track with our community count openings and we are optimistic on the success of those openings as we move through the year. We see nice success with most of the openings. In fact, even early on at this point in the year, and we are hitting our pro forma numbers that we underwrote too. So that is sort of the high level on that one.

Ivy Zelman, Zelman & Associates.

Good afternoon, guys. (technical difficulty).

Michael Smith, JMP Securities.

Good morning, guys. I just -- if we could, just dig into the margin question a little bit more. Jeff, could you talk about just seasonally how the margin changed a little bit and specifically, if there is some stuff that you guys generally load into Q1 that isn't there in the other quarters that might make the margins a little bit lower seasonally in Q1?

There is nothing through the accounting or through any kind of loading of expenses or loading of accruals or anything else in Q1 that would make it significantly different than Q4. Like I said, the main driver is really the volume and the leverage on the volume in the first quarter as compared to the prior quarter.

Okay. And can you guys comment on what your margins are in your backlog right now, your gross margin?

We really haven't guided on gross margins, Michael. As we have shared in our strategy, we have a nice trajectory of new communities opening that are in better locations and positioned for better margin. And we know that the higher revenue that comes with the increased openings will leverage our margins and our SG&A later in the year. But until we get deeper into the selling season and see how things totally evolve in the next couple of months, we are really not giving guidance on go-forward margins.

That's fair. Can you guys comment on what kind of spreads you are seeing in sort of new versus old land on the gross margin front?

I don't know that we have really done that. As we have shared, our basis, our lot basis in these new communities is better positioned for higher margins, but we want to see how the sales evolve. At a high level, you would expect the new communities are going to have better margins than your legacy book of business, I will call it. But we haven't guided on that because we want to see what happens. April, May and June are critical selling months for us. Then we will have that answer.

One of the things we have been talking about the last couple of quarters is the mix in deliveries coming from impaired versus unimpaired communities. And we saw sequential improvements in that, in other words more towards new in both the third quarter and the fourth quarter. The difference between the fourth quarter and the first quarter this year has been more consistent. We remain at about one-third of our deliveries coming from impaired, which is about the same number that we ended the fourth quarter. So that was a factor on margins in prior quarters. Because of the flatness in that, it really had very little impact this quarter.

Bob Wetenhall, RBC Capital Markets.

Hi, good morning. I wanted just to get some clarity on your backlog and to confirm, did you say that the number of backlog in the third quarter was likely to be higher year-over-year on an absolute basis?

No, we did Bob. We are going to go through what we call an inflection point where we are confident in our sales comps because they were so weak after April of last year, we are confident that we will have positive sales comps. And we are projecting that we will cross over and have a higher unit backlog by the end of the third quarter.

If that is the case, then are you expecting your conversion rate to -- what kind of conversion levels are you looking for in the next two to three quarters?

That is a great question because part of what we are working through here is a transition back to a fully loaded build-to-order model and in normal times, our conversion rate will be 50% to 60% because a lot of the backlog has yet to be started.

And then in turn with those dirt sales, you convert to even flow production and you get the synergy and benefits of the even flow. So my guess would be, as our backlog grows, you will see our conversion rate go down a little bit. We have been running it higher with covering some of the inventory that was a carryover from last year that we are not going to have by the third quarter or fourth quarter of this year.

Having said that, I said in normal times it is 50% or 60%. We have positioned the Company for a much quicker turn from contract to close. So maybe 60% in a fully loaded backlog, which we are not at yet. We still have some inventory to cover and you saw what we did in the first quarter. But once the backlog is fully spread out, it will drop down, probably around 60%.

Fair enough and that is very helpful. If you could just enlighten me a little bit, I am trying to bridge through and understand your commentary about new orders. It sounds like you are excited and can achieve pretty strong favorable comparisons in 3H, in the second half of the year, but can you give us some guidance on the May quarter? Like you expect positive comps in May. It sounds like you don't know yet in April and it was still a tough March. Is that a fair summary of it?

Let me go the other way, Bob. We actually shared March and we were pleased that it is, quote, only a negative 6% comp because, last year, March became the feeding frenzy tied to the tax credit deadline. I also shared on the comments that April we will have a negative comp because April last year was the pinnacle of frenzy and then our sales fell off the map for the rest of the year. So we know we will have a negative comp in April. We also feel very confident we will have a positive comp in May and as April and May unfold, we will see how we end up the year. But the trajectory of our sales is very favorable and we think after April and May, we will be repositioned with a better community count, and a weak comp from last year. So you have got all these things that will be working in our favor once we get past April.

Ivy Zelman, Zelman & Associates.

Hey, guys. Sorry about that (technical difficulty)

Joshua Pollard, Goldman Sachs.

Hey, good morning. My first question is on gross margins. If you look back over the last two years, both '09 and '10, you have seen a range of somewhere around 200 to 250 basis points from high to low on your gross margin. Is there anything about this year between what you have seen from first-quarter margins, what you guys see from your backlog and how your sales experience has gone that would suggest that that range should be wider in 2011?

Yes, Josh. I think it will be wider in 2011 as we were talking about. When our volume levels and our deliveries come back in the second half, we will basically have eliminated much of that negative leverage impact that we saw in the first quarter. So there is 410 basis points coming from that.

And keep in mind too, when we are talking, these swings right now off small top-line numbers, that is $8 million. So we had an $8 million expense penalty, I will call it, in the first quarter for maintaining those expenses. At a $400 million top line, we have basically eliminated a lot of that negative leverage. So I think you will see wider swings this quarter, particularly between the first half and the second half.

So I mean is it unreasonable, when we think about modeling going forward, to have you guys getting back towards your second-half 2010 levels as you get into the second half of 2011?

I don't think that is unreasonable.

Okay, that's helpful. I guess the other question that I had for you guys was centered around your cash balance and ultimately your balance sheet. You are now sitting at 62% -- 60% plus net debt to cap. I recognize that the deferred tax asset is off the balance sheet, but, A, what is the target there? B, can you talk about what, if any, cash impact you guys would expect from the South Edge ruling as you look at where your cash balance would be and how much cash outflow would need to happen? And then could you talk about any other large expected uses of capital for this year? Thank you very much.

Okay, sorry, you asked a lot of questions into one. I guess starting with the South Edge, like we talked about, there is $212 million that we have accrued as an obligation and I think that is fair probably a fair starting point for the cash impact from that issue. You have to add some estimate on the arbitration depending on when that is settled and also consider that there are other strategies other than an outright cash outflow from the Company that we could employ to reduce the cash impact from that. Partnering, financial partners, etc. are other things that we are exploring and looking at. So the timing is a little uncertain. The ultimate resolution is uncertain, but there are some range of options there.

The largest impact on cash is land spend. That is somewhat discretionary as we move through the year. Jeff mentioned we are watching that very carefully. Our underwriting standards have remained very high and consistent and we will meter that up or down depending on our outlook and the strength of the market, strength of the deliveries and on the opportunities that we see as we move through it. So those are the two primary sides.

As far as targeting goes, you are correct in pointing out, the DTA is not on the balance sheet, over $800 million of valuation allowance right now that would significantly move our leverage ratio. So it remains our Company's focus and one of our highest priorities to remain and continue down the path of sustained profitability so that we are able to recapture that DTA and fix a lot of issues right now with our leverage ratio as a result. So we're watching it closely. We are mindful of the obligations that we have and we will continue to maintain and watch the capital structure.

David Goldberg, UBS.

Hello, it's actually Susan on for David. I just wanted to go and ask a little bit about the discussions that you are having with B of A around your mortgage JV. I know that you mentioned that you are exploring some different or new options. Would this kind of include different JVs or could you potentially bring this back into sort of more of an in-house model?

Susan, we could. We haven't contemplated that at this time. As you look back over the years we had the JV with Countrywide and then in turn B of A, it was a very nice partnership and it frees us up to focus on what we do well, which is building homes and taking care of our customer and leaves the mortgages to the mortgage experts. And it worked well on both sides and we like that.

At this time, we continue to talk with B of A. We are in the first few innings of the discussions on where to take it, but there is numerous avenues that we could follow. We just haven't picked one yet because we are continuing to work with B of A.

Okay. And so can you give us any sense of timing on this? I mean is it something that you expect to sort of resolve within this fiscal year or any sense of how long this could take?

I would say by third quarter we will have some idea where we are going.

Okay.

In the meantime, we are continuing to operate delivering homes and working within the JV structure today.

Dan Oppenheim, Credit Suisse.

Thanks very much. I was wondering if you could talk a bit more about cancellations. Didn't hear so much about that in terms of your remarks, but clearly a high percentage of the backlog on the last conference call you talked about how there was a spike in the month of November. Clearly, it continued for the quarter. What would you say is causing -- what are you doing now to try to work on that here?

Good question. Actually it is a nice story. We did have some carryover issues in December tied to those things that we referenced on our last call with the papering of loans in the current environment. But the trajectory here on the can side is very similar to the experience on the sales floor. So Jeff, why don't you give them the actual numbers.

Yes, we will give you some detail in the numbers to give you a better feel for it. We are looking and more focused on the percentage of gross sales because of the low backlog numbers. And you are seeing a lot of distortion in the can rate percentage just moving up or down based on end-of-quarter backlog. So as an alternative, we are looking more at the monthly -- we have always looked at it internally this way, the monthly percentage of gross sales. And there has been a nice progression, as Jeff mentioned.

In the fourth quarter, we talked a fair amount about the spike in November and our cans reached almost 43% in the month of November, again, as a percentage of the gross. That was starting at 29% in September, 38% in October, 43% in November. As we started dealing with the issues and started really digging in and putting a focus on it as a company, we have seen a progression downward in the first quarter. December started or more or less continued to trend from November with a slight improvement down to 37%. January came in at about 29% and the February can rate was down around 24%. So we are continuing to work that issue down and seeing some positive result -- as a result of the actions we have taken.

I guess maybe I am confused here, but I guess everyone else in the industry and that is given seasonally of orders, most everyone else has looked at the percentage of backlog rather than the orders. Especially as you get into the seasonal stronger period, those numbers are clearly going to look more favorable. But I guess is that trend still the same as a percent of the backlog?

Say that again. You are asking for the percentage of --

I am just surprised you would look at percentage of orders that way.

In a build-to-order model, I think it is more consistent. We are seeing a lot of cans before we are starting our homes. So although they are ending up in backlog at a point in time, the can rate before start is an issue and is the main issue from our point of view. We see more secure backlog I think than a lot of the peers as a result of that, as a result of the process and we have less issue from that point forward.

And when it is an inflection point on backlog, our backlog at the beginning of this quarter was the lowest it has been in years and we have shared we are going to be growing it through the year. So I don't -- the reason we are back to gross is you can't take the lowest point in the year and say that is a typical can rate and conversely, while the gross is low, it is a better reflection of your contract activity and that number has continued to decline.

Thank you.

Adam Rudiger, Wells Fargo Securities.

Good morning. Last quarter, we heard from a couple of builders talk about tightening in the mortgage underwriting standards. I was wondering how that changed sequentially for you, if at all?

It really didn't change too much. I am sure you heard of FHA news and what they did on their mortgage insurance premium, which, on our average loan within our business is probably $30 worth of payments. So I guess you would say that is an underwriting impact because you have to be able to cover $30 more in payment. The trends we shared in the fourth quarter were more tied to documentation in the paper required for loan approval. FICO scores haven't changed and ratios haven't changed. So I would say that underwriting remains challenging because it has been for quite some time, but I don't think it necessarily got any more difficult in the quarter.

Okay, great. And then secondly, just housekeeping, can you give us your owned and optioned lot count?

Yes, owned and optioned at the end of the quarter was 37,000.

Do you have the breakout?

We had 7000 optioned and the remainder was owned.

Thank you.

Nishu Sood, Deutsche Bank.

Hi, this is Rob Hansen on for Nishu. So you had a 22% month-over-month increase in sales in March and you opened most of your communities in February. So that implies an absorption pace was pretty good as well. So how does this compare to kind of a typical pace from a March-over-February perspective, historical perspective?

The 22% you referenced was from February to March?

Yes, from March over -- yes, March-over-February.

My gut reaction would be it is a little higher than normal.

Okay. Did you have to offer more incentive to get buyers off the fence or was this -- I think you kind of mentioned it was kind of a natural progression, but --

In March, you typically sell more than you do in February. I think ours was helped by the new community opening impact. So it wouldn't be that we have more incentives on our sales. It's that we have more communities open that are in more desirable submarkets and are working okay.

All right. And then if you exclude the JV charges this quarter, would you expect to be profitable for the full year?

Excluding the JV charges for the quarter, we also had other events in the quarter. I don't think we will comment on that one. I think it just depends on the sales and the strength.

Coming back to your other question on the March versus February, I think it is very important, the comment that Jeff made during the scripted portion of this, we had a 36% year-over-year shortfall in the month of February this year versus last year. We closed that gap significantly in March. It was less than 6% in the month of March. So if you look at -- last year wasn't a usual -- wasn't a progression either with the tax credit, but it is a pretty large gap closure in one month.

Jay McCanless, Guggenheim Partners.

Good morning, everyone. Two questions. The first one is a housekeeping. What was your finished and unfinished spec count at the end of the quarter?

Finished and unfinished was about 400 exclusive of the condos.

And then my other question, I just wanted to find out -- historically I don't believe you all have given out much on incentive levels, but if you could comment on what they were in first quarter of '11 relative to say the fourth quarter and then maybe first quarter of last year, what you all were having to give for incentives.

I don't know how much you have covered our business model, but we are really more priced to the consumer focus. So we are not a heavy incentive company. I don't know what the actual number is, but it has to be tenths of a percent movement. It's not --

Yes, it's not significant.

It wasn't a big number.

Okay. So that was not a significant factor in the year-over-year decline in the gross margin?

No.

Okay, thank you.

Buck Horne, Raymond James.

Hi, thanks. You kind of covered this a couple of times. I just want to see if you can help me quantify it a little bit better. So you are down 36 in February in terms of orders and then you were down six in March. I was wondering can you quantify for us what the year-over-year percentage change in the community count was in March versus February, then what it was in March? Were you up 10 in February and then it went to up 20% in community count in March?

Yes, we are really more focused on what we are opening this year and where we are going. If you look at the progression during last year, we started the year at a higher number and declined as we went through the year and picked it back up in the fourth quarter a little bit.

Compare it back to the first quarter of last year, I'd say we are relatively the same in actual communities out there. Again, trying to differentiate between a five delivery per community where it counts and what is actually physically on the ground, I think you're asking more what is physically on the ground because we pretty much -- we loaded the pipeline to get us back about even with last year.

But we shared what we opened and closed in Q1.

Yes, I think it would help the communication certainly if you would reconsider the definition of what is an active community.

We are going through that. We talked about it a couple times. We are going through that as a company. There are pros and cons from doing it, having a very rigidly defined definition helps you with consistency. The Company has been very consistent for a number of years. On the other side of it, the con of it is when you are having quarter-to-quarter delivery volume impact that we have seen, it makes the number a little less meaningful I think to people.

Last one. Can you just characterize the nature of the pricing pressure that you are starting to see and kind of which markets are you starting to -- where is that starting to show up the most right now?

As I mentioned in my comments, it is an extremely local business. So even within any of the cities we are in, you will have different pressures in one submarket than you would across town. If you go to a more broad-based point of view, the pressures would be in the places that you have heard about like a Phoenix or Orlando, parts of Central Florida. Houston and Texas, we've seen more price pressure than we have in Austin and San Antonio.

But when we look at it and view resale as our biggest competitor, you can look at the resale pricing and tell how our markets are moving around and the caution there is you have to look at the submarket that the communities are in and what is happening to resales there.

We mentioned price pressure because it is an element, but it is not a broad-based prices are going down across the system kind of a thing. It was much less of an impact on our margin than the leverage side.

Mike Widner, Stifel Nicolaus.

Hey, thanks, guys, for taking the question. Most of my questions have been answered, but just wondering if you could comment a little more on geographies and where you might see greater strength, especially in more recent trends both from a volume standpoint, as well as competitive pressures on a pricing standpoint.

Well, clearly the closer you are to the coast in California, the better the markets are and there is parts of coastal California, for instance, Santa Clara County up in the Bay area or Orange and San Diego down in SoCal, that are performing very well. In fact, prices are going up as the months go by, not huge, but 1000 this month and 2000 next month. The further inland you get, the softer it is and the more inventory there is. So we think there will be pricing pressure that is sustained out 40, 50 miles out compared to what you see on the coast.

DC continues to perform well as job growth and prices are up for the second year in a row. Texas overall is holding, didn't boom, hasn't busted. There is parts of Texas that are seeing some pressure, more so in DFW and Houston than in Austin and San Antonio. Colorado is holding its own. I shared our Vegas results. We're doing well in Vegas because of the price points that we are offering product at. Not that the market is healthy.

Carolina is about flat, maybe a little more pressure in Charlotte than in Raleigh, but it is a mixed bag out there and that is why there is a submarket in every city that is firming up, but it is offset by many that are still difficult the further you get from the job centers.

Thanks. And if I could just -- one follow up on the South Edge, clearly, there is still some unknowns out there. Just wondering if you could talk about kind of the exact state of where that discussion is with JPMorgan. Specifically, I mean is it kind of in arbitration at this point? Is it still an individual negotiation between you and JP representing the creditors or is it -- just how is that all evolving and when can we expect any sort of next step toward finality in that?

Okay, yes. I think to start with, we are still in litigation on the various pieces of this. The South Edge entity has appealed the bankruptcy decision, so that is still in litigation. There is a number of other outstanding cases surrounding it. So our comments are somewhat limited on this. But like I said earlier, I mean there is a couple different paths this could go down. We have not been presented with a guarantee payment request at this point. There are discussions happening. To talk much beyond that is probably not terribly appropriate right now, but it is and continues and remains to be a very complex situation.

That will conclude our question-and-answer session. I will turn the conference over to Mr. Jeff Mezger for any additional closing comments.

Thank you. Before we sign off, I want to reiterate KB Home's solid position when it comes to our strategy, customer-focused product offerings, well-balanced geographic footprint and tenured management team. We look forward to improving our results and are prepared to take KB Home to the next level of performance as the housing markets continue to improve. Thank you again and have a great day.

This does conclude today's conference call. Thank you for your participation and have a nice day.