KB Home (KBH) 2011 Q2 法說會逐字稿

Good day, everyone, and welcome to the KB Home 2011 second-quarter earnings conference call. Today's conference call is being recorded and webcast on the KB Home website at KBHome.com.

The recording will be available via telephone replay until midnight Eastern Time on July 7, 2011, by calling 719-457-0820 or 888-203-1112 and using the replay pass code of 362-5696. A replay will also be available through the KB Home 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 risk 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 issued earlier today, which is posted on the Investor Relations page of the Company's website under Recent Releases and through the Financial Information News Release link on the right-hand side of the page.

And now I would like to turn the conference over to Mr. Jeff Mezger. Please go ahead, sir.

Thank you, Kelsey, and good morning, everyone. I would like to thank you all for joining us today for a review of our results for the second quarter 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 with some commentary on housing and the economy, and then I will talk about our Q2 results and how we are operating within the broader market. Next I will turn it over to Jeff who will provide a financial overview and, after a few closing comments, we will then open it up to your questions.

The second quarter was a difficult one for us, especially given our low backlog levels coming into the quarter and a prior-year comparison that included the positive impact of last year's federal tax credit. However, these reported results masked the progress we have made and continue to make in our business.

When you look closer at the numbers and take out the one-time charges, financially we were roughly flat year over year despite approximately 500 fewer unit deliveries than a year ago. More importantly, we believe we have reached a turning point in many aspects of our business.

We are growing our community count through opening communities in more desirable and stable areas, improving our gross margins, lowering our cost to operate, and generating sales momentum that should result in positive order comps in the second half. All of these actions are aimed at restoring our profitability and we expect to achieve this goal in the fourth quarter of 2011.

Many of the recent national reports on housing activity reflect today's soft housing environment and illustrate that we have a way to go on the road toward a housing recovery. On the resale front in May sales were down 3.8% from April, the fourth consecutive monthly decline, and inventory levels now stand at a 9.3-month supply. On the new home front May sales were down sequentially 2.1%, while new home inventory is at an all-time record low of 167,000 units.

Just yesterday the S&P Case-Shiller Home Price and Conference Board Consumer Confidence indices reinforced the continued weakness in economic and housing conditions. However, it is important to remember that when it comes to housing the national data presents a picture that often blurs the reality of what is going on at the local level. When you focus on the individual markets and submarkets that make up the larger picture, there is indeed more positive news to be found.

As I have said before and as we continue to see in the second quarter, there are markets in many cities located in desirable areas close to employment centers and good schools that are demonstrating stability. In these locations inventories are at manageable levels with supply and demand in balance and prices that have been steady or even rising for many months. These are the areas in which KB Home is focusing its investment and new community openings, particularly in coastal California and Texas.

There are three distinct market categories with their own price bands that we are now seeing emerge in housing -- distressed sales, traditional resales, and new homes. And KB Home can compete quite effectively in the latter two.

Reported pricing pressures are largely the result of cash foreclosure buyers and investors in the distressed category. We are seeing an increase in traditional buyers who are not interested in a foreclosure and are willing to pay a premium for a well-maintained resale or the benefits of owning a Built to Order energy-efficient KB Home.

In most markets monthly payments to own are lower than rent. Indeed at the same time that home prices and low interest rates are making homeownership more affordable rents are rising.

The increase in rental rates is not because the American dream has lost its appeal. In fact, many public surveys have recently reported on the continued desire of the majority of renters to become home owners in the future, and with an increase in consumer confidence this demand can quickly become unlocked. The housing downturn has been deeper and more protracted than most of us imagined it would be a few years ago and, as a result, many are wary of calling a bottom.

Tighter mortgage lending standards and even a looming reduction on conforming loan limits are serving to further dampen overall housing demand. Most importantly, jobs and consumer confidence have not recovered and both are critical in order to return to a more normalized housing market.

In the meantime, we are staying focused on the desirable submarkets that have demonstrated stability, improving our product offerings to meet the needs of today's homebuyers, and doing what we do best to differentiate our company in the marketplace and capitalize on opportunities.

Turning now to our results, KB Home reported a net loss of $68.5 million in the second quarter or $0.89 per diluted share. Major contributors to the loss included an additional $14.6 million charge related to our South Edge joint venture and $20.6 million of abandonments and impairments.

While we are not happy with these results, as I mentioned, there is meaningful progress behind these numbers. Our deliveries, gross margin, and SG&A percentages all improved sequentially from the first quarter and, based on our current momentum, we expect to see continued sequential improvement in these metrics throughout the second half of the year.

We are also pleased to report that many of the positive trends we discussed on our last call with regard to sales and traffic continued in the second quarter. Net orders of 1998 were down 11% in the second quarter compared to the prior year, a considerable improvement over the 32% year-over-year decline we experienced in the first quarter of 2011. And we anticipate positive quarterly year-over-year order comps for the remainder of 2011.

Moreover, when comparing the sequential increase in net orders, from the first quarter to the second quarter of 2011 we saw an increase of 53% compared to an increase of just 17% in 2010.

On a regional basis, orders in our central region were up 5% year over year and we were pleased to see those strengths in the more stable Texas and Colorado markets. Our West Coast region was down 11%. However, we expect this comp to improve dramatically as our new community openings gain traction over the second half of the year.

Orders in our Southwest and Southeast regions were down 23% and 29%, respectively. The majority of the shortfall in these two regions was related to decreased orders in Arizona and the Carolinas, where we have significantly reduced our market presence.

In the absence of the [extraordinary] tax credit influence on demand that we experienced in the first half of 2010, overall 2011 has shown a more typical pattern of gradual increases in home buying interest and activity through the spring selling season, albeit a pattern at low levels. At the same time, traffic remained strong. In fact, the second quarter of this year was our highest traffic quarter since 2008.

Even though sales remain historically weak and the consumer continues to require a longer timeframe to make the home purchase decision, it is encouraging to see this more normalized pattern emerge. Serious buyers are returning to the market and they are recognizing that affordability has never been better. As we open new communities in more desirable locations, we are seeing a larger share of higher income first time, move up, and active adult buyers reflected in our buyer profile and product mix.

Our Built to Order approach, which gives buyers control over the size and structural layout of their floor plan in addition to their homes design features, has allowed for this seamless and fluid shift. We opened over 60 communities in the first half of the year and expect to open an additional 45 to 50 in the second half. These openings are heavily weighted to California and Texas.

As I mentioned, our customers are cautious in today's environment and we are seeing that phenomenon reflected in our grand openings as well. Some of our new communities have been taking longer to achieve our anticipated sales rate once open, but we do see this momentum build over the 90-day time frame post opening.

In the second quarter, over 320 of our reported net sales came from first-quarter grand openings, [and] we expect a favorable trajectory going forward as our recently-opened communities gain traction and we continue to open additional communities in the second half.

Today we announced that we have acquired a sizable land and lot position in San Antonio from a private builder who is leaving the market. It was an ideal transaction for us as we were able to acquire the land position of a major builder in a market that has reasonable land costs and good housing fundamentals without having to acquire a business enterprise and the liabilities that come with it.

This transaction did not require a lot of capital and comprises approximately 1,900 lots, over 600 of which are fully developed in 11 communities. It is a great example of our focused growth strategy in which we can move quickly to be opportunistic and leverage a strong performing management team and our KBnxt business model in a targeted city. In fact, we expect to have our first Open Series model homes completed and merchandised in several communities by the end of August.

This acquisition bolsters our already strong market position in San Antonio and is expected to provide incremental sales in the fourth quarter, an additional 300 to 400 deliveries in fiscal 2012.

In order to continue to fuel our community comp growth we have been interesting in select markets and submarkets that we believe are positioned for positive housing growth, primarily in California and Texas. We have spent a total of approximately $300 million on land and land development in the first half of 2011, roughly 80% of which was in those two states.

We are pleased with the investments we have been making and continue to commit our capital to high-quality assets in performing submarkets where we can begin to convert into revenue in less than 12 months. As we remain diligent in applying our investment hurdles and strategic criteria, we expect our land and land development expenditures for the full year to be approximately the same as 2010 around $560 million.

Turning now to other recent developments, as we mentioned in our earnings release this morning, KB Home has selected MetLife Home Loans as our new preferred lender. MetLife is a strong consumer-friendly company with an outstanding reputation for customer service. We chose to sign a marketing services agreement with MetLife because we are confident that they will provide exceptional mortgage services to our homebuyers, allowing us to focus on what we do best -- building high-quality, energy-efficient, built-to-order homes.

MetLife Home Loans recently ranked number two in overall customer satisfaction and number one in the category of loan officer performance based on an industry study of 14 mortgage originators by JD Power and Associates.

There are companies, including MetLife, who are interested in forming a mortgage banking joint venture with us and we are continuing to explore these options. In the meantime, we do not anticipate that this transition will result in any disruption for our customers or our delivery cycle.

I also wanted to discuss our recent announcement related to the South Edge joint venture. We are pleased to have reached an agreement with the lenders in this matter, which was described in detail in our 8-K filing of June 16. This agreement provides a roadmap for settling our liability and eventually gaining ownership of the land. It also gives us more clarity on timing, which allows us the ability to start planning more aggressively for the future.

Our business in the land-constrained Metro Las Vegas area continues to perform well for us despite the challenges in that market overall, and we believe a highly desirable in Inspirada community has tremendous value for our business in both the near and long term.

Now I will turn the call over to Jeff Kaminski, who will provide more detail on our financials. Jeff?

Thank you. As Jeff mentioned and as we commented during the Q1 call, we knew our financial results in the second quarter would be difficult. If you look at the sequential trends, however, improvement can be seen in many of our financial metrics. We expect this positive momentum to continue into the second half, which speaks to the improvement of our underlying operations and should significantly enhance our financial results.

Our pretax loss in the second quarter of 2011 was $68.8 million compared to a loss of $30.6 million in the prior year. The current year quarter included $14.6 million of charges relating to the South Edge joint venture and $20.6 million of abandonments and impairments taken in the quarter. Excluding the South Edge impact, as well as the inventory-related charges, our pretax results were essentially flat to the prior year in spite of a reduction of over 500 unit deliveries, primarily related to last year's federal tax credit.

KB Home delivered 1,265 homes in the second quarter at an average selling price of $213,400, representing a conversion ratio of 75% of our first-quarter backlog. This compared to 1,782 deliveries in the second quarter of 2010 at an average selling price of $207,900.

We continue to improve our business efficiency setting a company record in the second quarter for our average Built to Order cycle time of just 129 days between signing a contract and closing on the home. Our construction cycle time also hit a new low of 71 days. These compressed timeframe's help us to effectively compete with resales in the market as we remain committed to our Built to Order business model.

Our backlog at the end of the second quarter stood at 2,422 homes, representing potential housing revenues of approximately $502 million. This represents a 43% unit improvement from the 1,689 homes we had in backlog at the end of February 2011. Housing gross margin, excluding impairments and land option abandonments, was 14.9% of housing revenues in the second quarter 2011 compared to 17.7% in the same period of the prior year.

On a sequential basis, our margins improved by 150 basis points as compared to the first quarter. Higher deliveries in Q2 provided a benefit of approximately 250 basis points, which was partially offset by other miscellaneous impacts.

I would note that we have also closed the year-over-year gap on our margin performance significantly from a 5.4 percentage point difference year over year in the first quarter compared to just 2.8 percentage points in the second quarter. For the third and fourth quarters we expect to see continued sequential improvement in our gross margins.

Our selling, general, and administrative expenses in the quarter were $62.5 million versus $83 million in the prior year and $49.6 million in the prior quarter. As a percent of housing revenues, SG&A expenses improved a sequential basis by 2.2 percentage points from the first quarter of 2011 and we expect this trend as well to continue for the remainder of the year.

We continued our consistent cost reduction efforts during the quarter, further consolidating resources amongst our division offices and corporate functions, and, as difficult as they are, continuing our work force reductions. Since year-end there have been approximately 100 net positions eliminated across the Company with about half of the reductions occurring during the second quarter. These actions represent over $8 million of annualized savings in compensation and benefits.

Offsetting the cost improvements were increased marketing and advertising expenses of over $3 million during the second quarter to support our new community openings, as well as higher variable expenses due to the increased order and delivery activity.

Consistent with the terms of our agreement with the South Edge lenders, we took an additional charge of $14.6 million to adjust our accrual estimates relating to this issue to approximately $226 million. We maintained our valuation of the underlying land at approximately $75 million, consistent with what we reported in the first quarter, and resulting in a net obligation of approximately $151 million.

We expect the cash flow relating to this transaction to occur in the fourth quarter of 2011 or potentially early in the first quarter of 2012 coinciding with the emergence of the joint venture from bankruptcy and our recording of the land as an asset on our books. In addition to reducing uncertainty surrounding this issue for KB Home, this settlement is the next important step in moving forward with our monetization and development plans for this valuable asset.

Turning now to liquidity, our cash position at quarter end was approximately $735 million. As we look to the remainder of the year there are two major events that will negatively impact this cash balance -- a $100 million outflow relating to the bond maturity in August and the previously discussed South Edge obligation.

Potential offset to the South Edge-related outflow are monetization strategies that may be implemented once we gain control of the land. A combination of operational factors are also expected to positively impact our liquidity, including higher unit deliveries, improving margins, lower SG&A expenses, and a disciplined land and development investment strategy. Excluding South Edge, we do expect positive operating cash flow for the second half of the year.

In addition, we continue to evaluate the capital markets and may opportunistically access them to further augment liquidity. We remain mindful of our balance sheet and liquidity positions and will take the necessary steps to ensure we have enough liquidity to take advantage of opportunities in the market and support our operating strategy.

Now I will turn the call back over to Jeff Mezger for some final remarks.

Thanks, Jeff. Before I move on to our longer-term outlook, I want to highlight some of our actions and accomplishments in the quarter that relate to the many ways we are differentiating our company and our homes from both resale and new home competition.

The energy efficient features we are building into our homes make them a superior value over other available homes in the market. A great tool that helps to illustrate this point with consumers is our new KB Home Energy Performance Guide, or EPG, which projects typical gas and electric costs for every home we build, similar to an MPG sticker projecting gas mileage on a car. Consumers are responding positively as they are now empowered with vital information about their expected energy costs.

Homebuyers have always calculated and considered the PITI in any home purchase -- the monthly principal, interest, taxes, and insurance costs associated with homeownership. We are now encouraging buyers to consider the PITI plus E for energy costs. Energy costs are another monthly cost that buyers should be aware of before they make the home purchase decision, because it can vary greatly depending on the home they choose and is truly part of the total cost of home ownership.

Our company also continues to receive third-party recognition for its commitment to building high-quality energy-efficient homes. We recently earned 12 ENERGY STAR Leadership in Housing awards from the US Environmental Protection Agency, a company record, for our contributions to energy-efficient construction and environmental protection.

We were also proud to release our fourth-annual sustainability report on Earth Day, April 22, and remain the only national builder to publish such a document. I encourage you to take a look at this report posted on our website in that it truly represents the cutting edge in sustainable production home building.

In addition, during the quarter we reaffirmed our position as the first, and only, national homebuilder to receive National Housing Quality Certification of our operations nationwide by the NAHB Research Center. This means that both our divisions and our subcontractors have been trained and certified in quality assurance systems that set the standard for excellence in our industry, and is a key driver in our high levels of customer satisfaction.

I would like to thank our talented and dedicated employees for making all of these accomplishments possible and for their continued commitment to our customers. This is a commitment that lies at the core of our business strategy and long-term success.

We expect that the overall housing market will remain relatively stable at current levels, at least through the end of this year, with local pockets of stronger performance. The housing recovery will be a slow and steady process, but along the way KB Home remains very well-positioned to capitalize on opportunities.

As we look ahead in our business, we expect that the positive momentum we have achieved in increasing deliveries and improving our operating margins will continue in the second half of 2011. We have in many ways hit an inflection point within our company, a point in which our new community openings are progressing well, our backlog is growing, our costs to operate are coming down, and matters that were once uncertain in outcome, such as South Edge, are now being resolved. We are also pleased to have MetLife available to service the mortgage needs of our customers.

All of our actions are positioning our company for a return to profitability and, assuming continued stability in our markets, we expect to achieve profitability in the fourth quarter of this year. We will continue to plan and strategically invest for our future while maintaining a strong capital structure and ample liquidity. Moreover, we have the team, the business strategy, and the market positioning in place to achieve our profit goal, and we will continue to work diligently to make it happen.

And with that we will open it up to your questions.

(Operator Instructions) Michael Rehaut, JPMorgan.

Thanks. Good morning, everyone. First question, I was hoping you can give a little bit more detail on the order trends during the quarter. Coming out of last quarter you mentioned that March was down only 6%, so we were looking for something a little bit better than down 11% for the overall quarter.

I was hoping just to get a feel or numbers on month-to-month, year-over-year changes, as well as some better clarity in terms of the sales pace that you are seeing in the new communities. I think you mentioned that maybe it's -- initially you are not getting the traction that you had hoped, but things improve as the community continues to operate.

Okay, Mike. Yes, we will start with talking a little bit about the quarter trends.

As we talked about last quarter, March was down about 6% year over year and we started -- we felt that was a pretty strong trend going into the quarter given that the sales -- we liked what we saw in March. And given it was coming off of a tough tax comp in the prior year with the tax credit, we liked the start.

April, as we had anticipated, and I think we actually even talked on the call, was down fairly big compared to last year as we had just an unbelievable month in April. It was the final month of the tax credit. And then May for us bounced back in a big way, offsetting a lot of the percentage decline that we saw in April.

So overall the three months -- March, April, May -- were, I guess, improving. May was actually better than April; April was down from March and down big on a comp basis.

When you swing into June, we are -- right now we are looking to be moderately up versus the prior year. So I think -- I would say overall the seasonal trend has been, more or less, a normal seasonal trend that we are seeing, except that we are seeing I think even a stronger Q2 bounce off Q1 than we have seen historically. I mean we were up over 50% in the quarter versus Q1, which we don't normally see. And we are pleased with that and pleased with some of the indications.

On the new communities --

Mike, I can talk to community count. We shared that -- and on previous calls as well -- the consumer remains cautious. In normal times a grand opening event will pop a month or two months of sales on the opening weekend.

We are seeing the traffic we typically get in an opening weekend -- and it's not unusual to get 300, 400, 500 people to a community. We do a great job of promoting the new product and the new location. But they are not making the purchase decision as quickly as they did previously.

Many of the analysts and investors have been asking us, well, how are the sales in your new communities? It's not like we can flip a switch and we get instant sales. What we are seeing is as people reflect and visit and compare and contrast they are coming back and making the investment decision in their new home 60 days later or 90 days later, not that very next week, because they are exploring all the options and they are nervous.

And so that is why I shared that our Q1 openings generated over 320 sales in Q2. I can't remember what the opening count was in Q1, but it's pretty healthy sales pace once they got open. And that is what we expect to see going forward is our -- we will gain traction in these openings from Q2 where you will see more sales out of those. Then we will continue to open the community count that we shared in our prepared comments.

Thank you, appreciate that. The second question kind of hits on the gross margin side. We saw a little bit of improvement from first quarter and I believe part of the first-quarter disappointment was due to some higher costs that you let in to support the community openings at that point.

And at the same time, you had said that you would expect the back half fiscal 2011 margins to be more in the neighborhood of what we saw for most of 2010. So I was wondering if you could kind of walk through the second-quarter margins, if there were still some incremental costs to support the new community openings. And how -- give an update on how you are thinking about the back half of the year?

Yes, Mike. On the quarter, starting with the quarter, when you compare the second quarter to the first we actually got some benefit on the additional absorptions, and that was really the primary driver, if you recall, from the first quarter. Not so much additional expenses relating to community openings, but more so the down volume quarter that we had and the impact on that. I think we talked about 410 basis points of negative impact in the first quarter.

We called back about 250 basis points this quarter due to that same issue. As we had an improving delivery quarter and saw more volume coming through, we were able to absorb some of those costs that we have on the margin side. So that was helpful.

There was a couple other smaller factors affecting it, a small miscellaneous price in certain markets and a few other net items that offset the absorption. But still right around 15% was pretty close to our expectations and I think we indicated that last quarter. That we had sequentially improved but not [to see] margins returning to [post] 2010 levels until the back half.

As I made a statement in the prepared remarks, we still do expect sequential improvement in the third and then again in the fourth quarter. And I would say by the fourth quarter the running rate, given the new communities that we have up and running and the deliveries that we expect from the new communities, as well as the additional delivery volumes that we are looking at in the second half of the year, should keep us in that range of last year.

Stephen East, Ticonderoga Securities.

Thank you, good morning. First question, Jeff Kaminski, you talked about accessing the capital markets for liquidity, potentially at least evaluating that. Is that on the debt side or are you looking on the equity side as well?

Well, as we said, we are looking at evaluating the capital market situation and making some decisions. Our opportunities are open right now. We are not specific on what side of the market we may access or even whether that transaction gets done.

We are not using this call to announce a transaction, but to announce the indication that we are strongly looking at it. We are obviously well aware of liquidity and carefully managing the business along those lines. So we will explore all options as we move forward.

Okay. And then if you look at your SG&A, last quarter you said, what, 90%/95% of it was fixed, but this quarter it moved up 25% sequentially as revenues moved up close to 40%. So it sounds like there is a lot more variable on it than what we thought.

Could you talk what is going on there regarding that? And then also the impairment charges, not the South Edge but the $20 million, what that was driven by and when that land was purchased. Whether this is some old legacy or some new stuff.

Sure. Starting with the SG&A. We talked -- there was some incremental marketing expenses in the current quarter relating to new community openings, and we have generally classified marketing as more or less a fixed cost.

We did invest some money to support the new openings. As Jeff indicated, pretty happy with the progress from the first-quarter openings where we have now seen a full quarter of sales activity and expect to see more progress from those communities as we go through that year. So there was an investment made there.

We did see on the variable side an uptick of about 70 basis points, really on the commission side. And that is really more come from a mix of our business. In certain regions we carry a slightly higher percent commission rate, more due to the selling prices of the homes and lower commissions in other markets where the prices are higher. So we saw a bit of an impact coming from that side.

Again, the SG&A from an internal point of view, looking at our forecast and where we were expecting it to go, we did expect sequential improvement. We saw that. We did expect to see increased marketing. We made that investment consciously and we saw that.

So again from an internal point of view we were pretty much on.

I guess -- I will go ahead and answer your third question, Stephen, because we like you so much. But on abandonments and impairments I will start with a few comments just talking about our process overall, and then I will give you a little bit of detail on the charges in the quarter and some reasons and drivers behind it.

But I think, as most of you guys know, at KB we have a very disciplined process for evaluating our land parcels and communities. We look at our inventory first. We determine whether we see indicators of potential impairment and whether they exist. Then if they do exist, we identify. We take that identified inventory and we evaluate it for recoverability in accordance with GAAP.

In the case of our company, the process is performed very consistently each and every quarter. It's performed in our national accounting Center in Phoenix. We don't leave it up to division finance or operations management and we really feel the centralized approach provides us a greater level of consistency, definitely a greater level of accuracy and objectivity, as we move through it.

Now as you know, during the current quarter we recorded almost $21 million of abandonments and impairments. That represented charges associated with seven communities. Obviously, the quarter did represent a spike as compared to our recent history, and if you go back party much all the way to the beginning of 2010 it's definitely a bit of an outlier.

While we don't disclose community-level specifics on our inventory valuations and we don't intend to do that going forward, I will say that we took an $18 million charge this quarter relating to an adjustment to fair value, which we recorded after we took back the collateral on a note receivable in the second quarter. The remaining charges on the other six communities were less significant. They are more or less in line with what we have seen over the past five quarters.

So basically, while pricing, cost, margin, etc., while those are always factors driving the impairments, really the elevated level this quarter was more related to a relatively unique event.

Ivy Zelman, Zelman and Associates.

Good morning, guys. Just to clarify, when you talk about your capital market options I think what I would like to understand when you look at them, recognizing that your equity is trading below book value right now, why you would even consider equity, or why don't you eliminate that as part of your options and at least explain to investors why you would have to do equity right now and it's even being considered. Because obviously that it what is weighing on your stock right now.

While we understand that, we also need to run a company and the Board is involved in capital market decisions. So we don't want to get ahead of our Board, number one. Number two, there are a number of options available to us and the markets change as they go.

We are under no urgency or pressure, and we don't feel urgency or pressure, on liquidity at this point in time. Number one the cash flow, especially relating to South Edge, is still two quarters out or nearly two quarters out for us.

We are not constraining our business operations with their liquidity levels at this point and we have some time to evaluate options. And while we don't like certain things about the capital markets right now, as we all know capital markets change rather quickly and we want to be in a position to react to it.

So there is a range of options available from simple debt or equity issuances to other options that are relating to bank lines, etc. So we are evaluating it all right now and we will be more public with it as decisions get made. It could happen over the next six or seven months.

Relating specifically to South Edge, we are also still exploring options on monetization with that situation as well. So until we really have all those pieces of the puzzle pulled together we are going to stay open on it. Ideally we will earn some cash back, and like I said earlier, we do expect the second half to be positive operating cash flow, so that will help us as well in liquidity. That is sort of our position right now.

I guess I just would -- as a follow up, I would expect that if you were looking at your revolver it would be a lot cheaper than selling stock at below book value if you include the DTA.

That is true.

So you can't eliminate that as a choice for -- in appeasing anyone today, but you would admit that as an option it would be on the lower end of the options?

Right. One of the issues we will look at is the offset between dilution and interest expense with no tax shield, so that is a consideration as well. But, yes, at this point we won't get any more detailed other than to say we will keep our options open as we move forward and announce it at the timing that is appropriate.

Bob Wetenhall, RBC Capital Markets.

Hi, this is actually Tom Austin on for Bob Wetenhall. I noticed that your conversions rates actually ticked up in the quarter and I was wondering if you had any expectations for that going forward through the rest of the year. If you thought that would come down as the backup log grows.

Are you talking about backlog conversions?

Correct.

Well, the backlog conversion in the quarter as we talked about with 75%. First quarter we had 71%, fourth quarter last year 88%, third quarter last year 73%. You have to go all the way back to the second quarter of last year to get it below 70%, so we have been doing quite well on the backlog conversion.

Part of that was in relation to the comments I made on our build cycle times where we brought that down significantly, and were able to convert a lot more of our quarter-end backlog the following quarter. There is -- I see that as a real positive for the business. I mean it's something we have focused on. We have driven down those cycle times quite significantly.

For me -- for planning purposes, in that 70%s range I think is a pretty good range for the Company. Maybe slightly higher in the fourth quarter as we really put a push on those to get closings prior to year-end.

When the market returns to normalcy and perhaps when volumes tick up you may see it to go the other way, but right now we think those numbers are pretty much average for us.

Okay, thanks.

Dan Oppenheim, Credit Suisse.

Thanks very much. Was wondering if you could talk about the discipline in terms of investing in land. You were saying before that -- as you talked about that, what do you think about community openings over the course of 2011? How much of that has already been spent?

And if you think about 2012, how are you looking at that in terms of being aggressive on land versus being fairly cautious and seeing how the environment developed there?

Dan, I can answer the first part of that and then Jeff can walk through what has been spent. I think it's the vast majority, if not all of it, for 2011.

But we continue to remain very disciplined in our return hurdles. We underwrite to an IRR first, we don't bank on inflation. The divisions have to support it with current sales rate in that market. So it's a -- I would say it's an opportunistically cautious approach in that if we see an opportunity that is compelling we will go, but there is no urgency to do a lot of acquisitions.

And it has worked well for us. It's like a built-in governor when we are holding our IRRs up in the mid 20s. As we go forward I think you will continue to see us in that mode. As things come to market that are aligned with where we want to be strategically, we have the ability to make the investment.

But it's not like we are investing much heavier than the number of deliveries we are reporting in a quarter. In terms of the unit count build you can see our lot count didn't move much, and that is in part because we are staying pretty diligent on the better-performing submarkets which happen to be land constrained. But it's not like there is lots on every quarter so it's -- we have these built-in governors and we will remain diligent.

Relating to second-half openings, as Jeff mentioned, we currently have planned 45 to 50 additional openings. That includes the deal that we just announced in Texas. I would say the majority of that, if not almost all of it, actually the cash flow is out on that.

We have some development spending in the second half of the year that is included obviously in our land numbers that we always disclose, but we are really looking to invest now for future periods and looking to start bringing revenues in within a 12-month period after investing.

Great. And then I guess as a follow-up, just wondering about the new communities. You talked about them being a bit sluggish starting off, but are you doing anything -- do you need to do anything price wise? Or are you just finding it more hesitation of buyers and that you are not doing anything to adjust the mix in terms of incentives or price but it just takes a little bit longer?

Well, Dan, I wouldn't use the word sluggish. It's just taking a little longer for people to make the decision. We are not aggressively cutting price and doing incentives. The traffic we are generating and the interest we are generating in our new openings is working well, it's just taking a little longer for the consumer to make the decision. So we are letting that play.

I think on average, in the second quarter we averaged under four a week or a month, I am sorry. Under four a month in the communities that were open, which is about our company run rate. It has just taken a month or two to get there.

Michael Smith, JMP Securities.

Hey, guys. Most of my questions have been answered, but real quick just to follow up on what you just said, Jeff. You said the Company run rate is a little under four months and that is after a little bit of a lag time where the new communities are hitting. Is that right and do I -- should I interpret that as meaning that your new communities are selling about at what the average is for the whole company?

Well, and we are not happy at the 3.5, 4 a month, Mike, but that is pretty much what we are running around the system, maybe a little higher. We are hopeful that we will get the run rates up a little more as the community seasons and you get people living within the subdivision and you gain more momentum. That is what typically happens.

My message is it's not like we are opening these communities and getting instant sales. The sales are coming and they are performing to expectation, there is just this little lag between opening the model and when you get to your run rate.

But I sorry, what I am trying to figure out -- I guess let me be more explicit -- is can you put a number or even qualitatively kind of tell us what the difference is between your newer and older communities on sales pace? I mean is there a big difference there or not?

There is not a big difference. I think we are seeing on average the new communities doing slightly better than some of the more legacy. But there is such a mix in both regions and where we are opening, as well as what you get in the total community count. Where it you have a community, for example, going into close-off phase that is having the pace impacted by that.

Moving into phase two you have an option communities that we may be looking to come out of the option where you have a slightly lower pace. So it's really difficult to drill out generalities around that question.

The other thing, Mike, that I would offer is many of these communities that we are opening are not real large lot counts because they are in land-constrained areas. An example would be the opening that we had in Playa Vista out here in LA back in May, end of May. When it's a 52-unit condo that you cannot replace and you wish you had 1,000 of them you are not going to push your sales pace. You are going to push your price.

So we are -- part of our discipline here is to continue to balance the sales rate to the optimal price and margin without running as hot, because you can't replace these.

Ken Zener, KeyBanc.

Can you walk us through a modest recovery relative to your balance sheet equity and capital? If cash is going to fall $300 million-ish in the year-end, that is the $100 million debt, maybe $200 million for the JV if I am correct, when the recovery occurs, by our estimates -- you can correct me obviously -- I figure you will need $150 million in working capital for each incremental 1,000 units.

So do you think you are basically going to be going to the capital markets for your working capital needs or is it your view over the next two to three quarters that there will be large land purchases that will motivate you, even when your cash is in that $300 million to $400 million range?

Ken, I will have Jeff speak to it. I can tell you that we don't track capital to capital needed per unit, because it depends on whether it's a rolling option lot that you close in 10 weeks in Houston or a major cash purchase in California that may take nine or 10 months to get to the revenue. So it depends on mix, and we don't look at it that way.

I can tell you that we are going to ensure that we have the firepower to be opportunistic. The reason that we have shared the general comments we have is to let the investor world know that we are cognizant of our balance sheet and some of these cash demand that we are going to have.

But in part, even on the South Edge situation, everybody has assumed we are just writing a check. And that is the way we underwrote the thing, but we have options there. So there is a lot of decisions that go in to your cash burn and your cash need. It would start with getting our arms around what we are actually going to do at South Edge, and then from there we will evaluate it and move on.

I don't know if you got any other color?

Yes, I mean, the only other comments I would make, in your estimate -- I am not sure if you are including or not including, or the amount you are including four second half positive cash flow which we do anticipate that will offset some of the negatives that you mentioned. On recovery, when we look at recovery and normalization in the markets, one of the things that happens once the housing market stabilizes and starts getting back on its feet, I believe capital access for companies like KB will be much more open and available and our options will be much wider.

So planning out into that market recovery period we have a level of confidence on both internally generated cash, availability of revolvers, etc., in the marketplace, as well as just a whole different capital market situation. So to us it's a different animal at that point in time.

Okay, I appreciate that. And I guess on a sequential basis, looking at gross margin I think you guys did a great job at least explaining the gross margin issues or the fixed costs in gross margin last quarter.

When you look at it it appears to me that most of the decline or increase in gross margins occurred because of the fixed cost absorption, which means the direct, whether that is land or your vertical, actually went down. So could you comment on that if it's wood, land, labor?

And when you talk about rising gross margins into the back half it also appears, the way we look at it, that that is driven simply by the absorption of that fixed cost. Do you actually see -- the fixed cost and gross margin that is -- do you see your direct labor, land costs or margins also increasing? Thank you.

Yes, just addressing the cost issue first. I would say the costs are relatively stable in the quarter and you are correct in saying the majority of the margin improvement came from the leverage side. The costs were relatively stable and the pricing was relatively stable. So the improvement coming from the incremental builder [rates] was welcomed obviously and I think expected to continue into the second half.

I think a couple of the other drivers on the margin side in the second half, one certainly will be new community openings. We will start deliveries in a more significant manner coming from those communities starting in Q3 and Q4. And we have obviously higher margin projections coming out of the new communities and that mix will help us, as well as regional mix within the business.

Michael Kim, CRT Capital Group.

Thanks for taking my question. I just have a quick question on construction costs. What are your direct construction costs right now and how has that changed over the past few years, and any metrics on a per square-foot basis would be helpful?

Yes, we really don't disclose square-foot construction costs.

Okay, great. And I guess all of -- just on South Edge, are there any potential uses of cash that could exceed what has been accrued for, maybe thinking about a potential [DIP] facility, assumption of JV interest, your pro rata share of accrued interest, etc. and maybe the timing of executing your monetization strategy post [a merger]?

The overall -- the accrual right now includes -- it is an all-in accrual. I mean there is not a separate accrual on accrued interest or a separate risk on accrued interest or anything like that. The settlement agreement right now running through November with a possible extension into December is more or less an all-inclusive agreement.

We did range the potential in the 8-K and obviously for the quarter reporting, we had to pick up the most probable point within that range, which we have done with our $226 million accrual on the gross obligation. So there is always a range in these things, but it is not from a factor that is outside what we are currently contemplating.

As far as the DIP facility goes, I think there was a little bit of confusion on that and there was a couple of press reports that came out right after that agreement went public. And we did again disclose in the 8-K that we have a $21 million escrow deposit that is effectively providing some cash for the estate to administer the bankruptcy, but it is in escrow on our final settlement. So there is I think maybe a little confusion on that issue, which might be what you are referring to.

Understood. And the timing of executing a potential monetization strategy, is that --?

Well, we would like to -- obviously, we would like to get that as close as possible to the outflow and as Jeff said, I mean we are looking at different options and we are planning. We may or may not have -- and may or may not pursue a strategy along those lines. But at this point, the closer we could get it the better.

David Goldberg, UBS. Hearing no response, we will move on to Jay McCanless, Guggenheim.

Good morning. First question, what was your spec count at the end of the quarter?

The spec count at the end of the quarter remained pretty consistent with the last couple quarters, right around 500 and that includes finished and under construction.

Okay. And then on the capital raising that you discussed earlier, if you did decide to do an equity offering, is there a functional way that you can protect the entire value of the DTA and not have to run into I think it's the IRS Section 382 rules where you would potentially lose some of the value of the DTA? Is there a functional way to do that or are you putting it -- or a portion of it at risk if you all do an equity issuance?

Number one, that is a very valuable answer for our Company, the DTA and we would not take any strategies to put that at risk. We have plenty of room on the equity side if we chose to go down that path. And again, this is speculation and a what if answer. If we did choose to go down that path, we would have plenty of room without putting any of that at risk.

Okay, great. Thank you.

Josh Levin, Citi.

Good day, everybody. You talked about the possibility of a near-term monetization for the South Edge land. You said you might want ideally maybe match it up with the cash flow out. You are carrying that land at $75 million. So if we are trying to think about potential cash flow in from monetizing that land at the near term, is $75 million in, is that sort of a reasonable -- are we in the right ballpark?

Yes, I mean, you are thinking of it the right way. I mean when you talk about some monetization coming off the South Edge situation, you compare it more to the land value than to the obligation.

Okay. And you said you expected to return to profitability in the fourth quarter. Can you sort of share what assumptions you are making about really to get to that prediction or that forecast?

Improvements in all financial metrics. I mean increased deliveries, increased margin and lower SG&A are the primary drivers. You would also notice that our capitalized interest is up a bit this quarter as we have grown our inventory and our active inventory. So I think a combination of all of the factors gives us some confidence in talking about the fourth quarter.

Adam Rudiger, Wells Fargo Securities.

I don't want to beat a dead horse here, but I wanted to go back to the gross margin if I could. I am a little bit confused, because you said that costs have basically remained flat and you have attributed a lot of the decline to volume. But if I look at, for example, your first quarter of last year when you had almost a 19% gross margin you actually had lower home sales revenue than you had this quarter.

So I am just curious to know really what has changed versus last year and what is really driving that. Because last year you were humming along pretty well at a 18%, 19% gross margin and then first two quarters of this year it has really plummeted. So if you could just shed any light on that that would be helpful.

Sure. Yes, on a year-over-year basis we talked a lot about quarter to quarter in the prepared remarks. In the press release we did compare the year over year.

We did see some competitor pricing pressure on a year-over-year basis. And if you think about the first two quarters of last year with the tax credit incentive out in the marketplace, pricing held up very well and in some cases was actually up. So that moved backwards as we went through 2010.

We didn't really see much decline Q1 to Q2 sequentially, but if you start looking at it year over year you have a different dynamic. We also had mixed shift that impacted the margin on a year-over-year basis as well. So those two things are more significant factors in the 2011 versus 2010 comparison as opposed to the sequential.

Can you elaborate on what the mix shift was?

Really for us it's a mix between -- not only between regions but between communities. We will have higher performing communities with higher margins and, as those close out -- we closed out a lot of those communities in the fourth quarter. We talked about that during the first-quarter call. You have a shift in relative community profitability and what you have in your sales mix and delivery mix.

Mike Widner, Stifel Nicolaus.

Hey, guys. Thanks for taking the questions. I don't want to be to the South Edge horse to death either, but just wondering if you could talk a little bit about the assumptions there. So the land is presumably at a $75 million valuation is what you are assuming. As I understand it you are assuming you bring on about 650 additional acres there.

Just wondering if you could talk about how that implied valuation compares to what you are already carrying land in the active Inspirada community. If that is sort of an apples-to-apples comparison, if the carrying values are the same.

Then second if you could talk about the profitability of that. You mentioned the sales pace was solid but you haven't really mentioned anything about the profitability there.

In our valuation model on the South Edge land we did a valuation model very consistent with how we value other parcels in our portfolio. And the margins contained within that evaluation model are very solid compared to the Company average. So on a go-forward basis we think we have that about right.

On the land valuation itself, they are not really comparable to carrying values versus the land itself [actually because] most of the land in front of us at South Edge is to be developed land. The land that we have in the portfolio obviously is -- we were buying finished lots from the joint venture as part of KB Home. So they are not comparable directly between the two.

Certainly not directly comparable, but you have plenty of experience there over the past number of years in what the actual development costs are. And so I wouldn't think that it would be terribly difficult to do a conversion between raw land and existing land just by using your historic cost experience in developing that land.

Right, I apologize, I don't have those numbers in front of me on the current carrying value of the lots there at South Edge, but we did analyze the land including a number of factors on the settlement valuation. You were right in what you were saying; it's around 600 acres that we have out there in front of us and we did a very comprehensive valuation model on that land.

Nishu Sood, Deutsche Bank.

Thanks. Yes, just wanted to get some clarity on the statement you were making earlier about operational cash flow being positive in the second half of the year. Just to be clear, that is after the $560 million you have budgeted for land spend for the year, is that correct?

Yes, that is correct. We include land spend as part of the operational cash flow. I did specifically exclude the South Edge out of that number.

Of course, of course. And the restricted cash, how did the covenants develop as the years go on, supposing that things begin to get a little bit better? So does that kind of ease as well as things go along here?

I am not sure what you mean by covenants.

Just the -- I imagine that the restrictions on the cash are from the debt side or --

No, the restrictions -- that is basically collateral on either land LCs or on surety bonds. That is the bulk of it.

David Goldberg, UBS.

Thanks, guys. Sorry about that before. I want to ask a question, if I can, about the purchase in San Antonio.

And Jeff, it seems to me -- you talked in the opening commentary about the different markets that are developing between new homes, non-distressed existing homes, and distressed existing homes. And it seems to me the key to kind of keeping some pricing on the new home market relative to the rest of the broader housing market is being able to identify and find these lots and better areas people want to live where there is less foreclosure inventory and everything, right?

So what I am trying to get an idea of is, in this San Antonio deal, how many other builders were bidding for this company's assets? What do you think you paid for the land relative to the replacement costs? And how difficult, just more generally, is it to find land in these areas where there is not huge bidding wars going on right now?

Good questions, Dave, and as I said in the prepared comments, we really like this acquisition. It complements very nicely with our business in San Antonio.

These three markets that I touched on, if you go back a couple of years ago, a lot of the foreclosure sales were more weighted to owner-occupied buyers. We had to come up with ways to compete with foreclosures, not just what we call traditional resales.

What we are now seeing emerge is the desire to own the foreclosure as an owner-occupied has waned and we don't have to get our pricing down competitive with this, what I call the foreclosure churn, because we don't care if we cater to the investor. In fact, we don't want to. So let them keep cleaning out the inventory on the foreclosure side.

We have been able to position our product where it's competitively priced with the traditional resales and typically a great opportunity versus the other new homebuilders. So that there is this niche that has developed where you can hover above the foreclosure churn and do just fine.

In the case of the acquisition in San Antonio, I don't know what the percentage would be of replacement value. I do believe we got a discount to that. I know that there were other builders that looked at it. I don't know how many. I don't think it was a full frenzied public auction approach; they talked to a few that they knew could perform.

In our case, with the franchise we have in San Antonio where we are extremely efficient and build at very solid cost per foot because of the network we have with the contractors and the product series, the Open Series, we were able to underwrite this. It's a great combination of solid lot position, instant revenue almost because it will hit early in 2012, but it's a nice deal for us.

I don't think there is a lot of them out there, but it's an example of when one falls in front of you you can move.

Got it, thank you. And then just one quick follow-up here.

Obviously with the FHA -- FHA-approved lenders have the ability to overlay obviously more restrictive covenants than what is mandated by HUD. And I think we all know they have been doing that for a while, maybe 640, 650 FICO scores now. I am wondering if you can talk about -- with your experience in the market, are you seeing that any kind of movement from FHA-approved lenders to do stuff at lower FICOs, maybe closer to the 580 that the Fed is mandating now?

I think the underwriting standards are still much more difficult than they were in 2006 or 2005, and those really haven't changed. I do think there was a pendulum swing where the banks last fall were nervous and were -- the pendulum swung to really tightening down on the documentation and the papering, far more than we had seen in some time.

I think we have seen a slight easing from how rigorous it became. It's still very rigorous, so it's a relative thing, and I think you will see that stay around for a while. But we have learned how to operate within those confinements.

It's just -- my concern would be whether they tighten the underwriting further on FHA or Fannie or Friday, and that is up to the government. But where it's at today it's difficult, but you can navigate within it.

Buck Horne, Raymond James.

All right, thank you. I just wanted to maybe go back to the high level again here, Jeff. You made several statements recently just indicating that you think the biggest reason buyers are still on the sidelines is a lack of confidence or uncertainty in the economy.

And I am just wondering if you could kind of articulate more specifically what you are seeing that tells you that confidence is really the key issue as opposed to some of these other more tangible factors, like inability to sell their existing house or these new, more stringent mortgage underwriting rules or a lack of adequate down payment, or some other factor like that.

Sure. While inability to sell a home is an issue, we are still 65% first time so it's not the biggest part of our business. I do think until prices firm up more and go in the other direction that you will have this built-in cap on those people that may be underwater on their mortgage.

But what we are seeing is a lack of urgency to do anything.

I have shared on a couple of presentations or panels that I participated on, we did a survey in Vegas of people who had been to our models, had the down payment in the bank, and were prequal'd to purchase a home and didn't own at this time. And 35% of them were waiting for the next tax credit, so there is no urgency there, and 30% of them were waiting for prices to come down further. So 65% of them had absolutely no urgency to make a home buying decision at this time.

It's offset by people that are confident in their jobs or their personal situation and see the credible opportunities that are out there on the affordability side. So I think if you can get a little consumer confidence back -- and the numbers yesterday went down, so it's a concern. If you get consumer confidence back it's typically tied to the employment environment out there, and between jobs and consumer confidence you will see demand come back.

Okay. And have you guys made any decisions on disclosing active community counts or how you want to define that going forward or can we expect any supplemental data on that front?

Yes, I think what we are doing -- we will continue the practice that we have been giving you guys which is the pluses and the expectations for the remainder of the year. Like Jeff talked about, the 45 to 50 range is a pretty good number for us in the second half. There is enough sources out there, I think, from whatever website counts and everything else that some of you guys publish where at this point in time we are going to continue with our current practice.

It's very unpredictable on the closeouts and that is the part that as we forecast going forward trying to forecast close outs of communities is one issue. The second one is just trying to get back and having consistent history. But certainly the methodology where we looked at it and it was tied to volume is an issue that you probably won't see us continuing with.

Mr. Mezger, that concludes our Q&A session. I will turn things back to you for closing or additional remarks.

All right. Thanks, Kelsey. Thank you very much everyone for your participation on today's call.

While the recovery may not always be smooth or predictable, we believe KB Home is on the right path to leverage our leadership position in our markets, harness the talent of our team and steadily improve our financial results going forward.

Thank you again. Everyone have a great day and also have a great Fourth of July weekend. Hope to talk to you all soon.

Thank you. And again, ladies and gentlemen, that does conclude our conference for today. We thank you all for your participation.