KB Home (KBH) 2011 Q4 法說會逐字稿

Good day, everyone. Welcome to the KB Homes 2011 Fourth Quarter and Year End Earnings Conference Call. Today's conference is being recorded and webcast on KB Homes' website at KBhome.com. The recording will be available via telephone replay until midnight Eastern Time on December 28, 2011 by calling 719-457-0820 and using the replay passcode of 432-3387. A replay will also be available through KB Homes website for 30 days.

KB Homes' 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, strategy 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 Homes' actual results could be materially different from those expressed in or implied by the forward-looking statements. Many of these risk factors are identified on KB Homes' 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 of 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 releases link on the right hand side of the page. I'll now turn the conference over to Mr. Jeff Mezger. Please go ahead, sir.

Thank you, Melody, and good morning, everyone. I'd like to thank you all for joining us today to discuss the results of our fourth quarter and fiscal year 2011. With me this morning, as always, are Jeff Kaminski, our Executive Vice President and Chief Financial Officer, and Bill Hollinger, our Senior Vice President and Chief Accounting Officer. As we have shared on our previous calls this year, our objective at KB Home over the past several quarters has been to continue to realign our business consistent with the principles of our KBnxt Built to Order business model and to position ourselves to restore sustained profitability. Our pre-sold model emphasizes choice and value for the consumer. This approach enhances sales revenue and customer satisfaction, while at the same time reaps the benefits of production and cost efficiencies, all of which improve operating margins.

We know through experience that our Built to Order sales generate four to five percentage points of higher margin. Given our stronger backlog position today, we expect Built to Order homes to comprise a growing percentage of our deliveries as 2012 unfolds. Establishing an adequate backlog to support our business model has been very challenging in the difficult housing market of the past few years. That is why we have taken a number of strategic and proactive steps this year to increase our backlog and in particular, our pre-sold backlog. Our fourth quarter net order and backlog comparisons reflect the diligent efforts of our entire team on this objective. Through the combination of new product lines, new communities, and emphasis on our Built to Order process and industry-leading energy efficiency initiatives, we established a sales pace that led us to close the year with the highest year-end backlog we have had since 2008. We are confident this will improve the predictability of our deliveries and increase our margins going forward. And now that we have an adequate level of pre sold backlog to support evenflow production, there are even more potential synergies to be realized through overhead and cost to build efficiencies.

While we were very pleased to report a profit in the fourth quarter of 2011, equally important for us was the success we achieved in reestablishing the right balance of backlog at year-end and setting up improved year-over-year results starting with our first quarter of 2012. Our optimism in achieving better results in 2012 stems in large part from our ability, over the past six months, to generate a markedly improved sales pace over the prior year, despite the ongoing challenges of the market. We reported a 38% year-over-year improvement in net orders in the fourth quarter, keeping up the strong pace of our 40% year-over-year increase in net orders in the third quarter of 2011. As a result of our second half sales performance, we ended the year with positive year-over-year net orders for the full year of 2011, when compared to 2010. Net orders were higher in all four of our operating regions in the fourth quarter, as was also the case in the third quarter of 2011. Net orders in our Central and Southeast regions were up 40% and 39%, respectively. We were especially pleased with the performance of our West Coast region, where net orders were up 48% and where our gross profits are also highest.

Our average selling price for the quarter was $238,400; up both sequentially and year-over-year, as we had guided it would be. This increase reflects the higher priced product we are offering as a result of our strategic shift to opening new communities in more desirable sub-markets. These sub-markets feature higher median incomes and less inventory, allowing us to sell homes at higher price points with increased square footages and higher studio revenues. Moving on to backlog, we ended 2011 with the highest year-end backlog we have had in three years; a compelling 61% increase in units and a 74% increase in dollars representing $459 million of future housing revenues. Like our net orders, our backlog was, once again, higher in all four of our operating regions. We are moving closer to our per community backlog target and in particular, we have increased the percentage of our backlog that is sold and unstarted. This pipeline is a reflection of the value of our business model and is a core prerequisite to realizing the cost efficiencies of evenflow production.

This represents a sharp contrast to our relatively weak backlog position at the end of the fourth quarter of last year and as I mentioned, sets us up very well heading into 2012. Most importantly, our consumer is increasingly recognizing the value inherent in the Built to Order process, which gives them a new home experience with exactly the design and features they want in a build time that averages just over three months. This is a compelling advantage against our fiercest competitor, resale homes. We delivered 1,995 homes in the fourth quarter compared to 1,918 in the fourth quarter of 2010; our first year-over-year delivery increase in 2011. We recognize that this delivery number is in line with analyst estimates, but we had a higher expectation for deliveries entering the quarter. While we saw the difficult underwriting environment continue to hamper our customers' ability to obtain a mortgage, we attribute the shortfall primarily to issues arising from our transition to our new non-exclusive marketing agreement with MetLife Home Loans. As of July 1, MetLife went to work mobilizing teams in our markets to compete for our customers' business. But as MetLife was in the process of gearing up, many of our customers chose to finance their home purchases with a variety of mortgage companies other than MetLife, most of which were not reliable in meeting a closing date.

As a result, our customers and our deliveries in the fourth quarter were adversely impacted by lender-related delays. Many homes that were completed and ready for delivery at year end will now close in the first quarter of 2012. To give you some color on this, in the past, our preferred lender has provided mortgages for as many as 80% of our customers, but in the fourth quarter of 2011, this ratio was less than 40%. MetLife performed well for our customers during the quarter and is achieving sequential month-to-month improvement in the share of our customers' business that it earns. We expect this ongoing trend to result in more predictable closing going forward. As you may know, however, during the fourth quarter, MetLife announced their intention to sell their home loan business. Until there is a decision on MetLife's home loan business and we are able to evaluate its impact, we expect to continue our existing arrangement.

We have developed a contingency plan if the outcome is not advantageous to KB Home or our customers. It remains our strategic intention to reestablish a joint venture on the mortgage side, which can provide additional benefits in terms of predictability of loan closings, synergies, and profits. Our lower than expected delivery volume in the fourth quarter also affected many other aspects of our business, including gross margins, SG&A ratios, profits, and cash. While we are pleased to see the positive results of our sales strategy, we still have challenges; foremost of which in the quarter was our disappointment with our gross margin. We understand that we cannot achieve our goal of sustained profitability without both volume and margin growth. We are continuing to work diligently on improving our gross margins through better execution of our business model. As I mentioned, the margins on our Built to Order homes are historically four to five percentage points higher than on inventory sales.

As further evidence that we have more fully realigned with our presale model, at year-end, we had the lowest unsold inventory number we have had in quite some time, allowing our sales teams to primarily focus on Built to Order sales. With an increased backlog in place, we expect to gain cost efficiencies and overhead and cost to build as we fully realize the benefits of our strategy and evenflow production. We are confident this will lead to better gross and operating margins going forward. Finally, we were pleased that the South Edge joint venture litigation was essentially resolved in the quarter, at terms and conditions we had anticipated. Now that this matter is behind us, we are moving forward with our efforts to optimize the potential of this valuable asset in the highly land-constrained Las Vegas market. The city of Henderson is a very desirable community to live in and was just recognized by Forbes Magazine as the second safest city in America. We are working together with the City of Henderson and others to revise a development plan, which is the next step in the process, and are hopeful we will begin land development on these future phases by the end of 2012. Now, I will turn the call over to Jeff Kaminski, who will offer some detail on our financials in the quarter. Jeff?

Thank you. As Jeff mentioned, we were pleased to post a profit in the fourth quarter of 2011 and we will continue to strive to expand this profitability in the future. The momentum that we discussed during the last two quarterly calls continued into the fourth quarter and we are very well-positioned entering fiscal 2012. KB Home reported net income of $13.9 million in the fourth quarter, or $0.18 per share, compared to net income of $17.4 million, or $0.23 per share, in the same period of the prior year. The 2011 results included gains relating to the wind down of our mortgage banking joint venture and the resolution of South Edge legal matters. For the fourth quarter, our housing gross margin, excluding impairments and land option contract abandonments, was 15.1% of housing revenues. This was essentially flat from the third quarter, excluding the positive impact of $7.4 million of warranty adjustments in that quarter.

We had expected improvement over the 2011 third quarter from an increased mix of deliveries coming from newer communities, the positive impact of volume leverage, and expected partial recovery of prior quarter expenditures relating to Chinese drywall. The mix of deliveries coming from new communities increased by less than we had anticipated in the quarter, in part due to some of the closing delays caused by mortgage issues. As a result, the favorable impact from this shift was not realized. In relation to the drywall expense recovery, while this was not finalized in the fourth quarter, we do expect to see a positive impact on margin from recoveries in 2012. In addition, we continue to prioritize our Built to Order model and, as part of that process, continue to reduce our level of unsold inventory during the quarter, which had a moderately negative impact on margins. However, our spec reduction strategy was successful and we ended the fiscal year with an average of only about one unsold finished inventory unit per community. Selling, general and administrative expenses in the fourth quarter were $75.6 million compared to $55.7 million in the fourth quarter last year and $60.2 million in the third quarter of 2011.

On a sequential basis, the increased costs in the quarter related primarily to a difference in legal reserves and insurance reimbursements. We had an insurance recovery of over $8 million in the third quarter, which we talked about on our last earnings call, and an increase of $4.5 million of noncash legal reserves during the current quarter, accounting for almost $13 million of the quarter-over-quarter variance in SG&A expenses. In addition, higher volume drove an expected increase in variable selling expenses of $6 million, which were partially offset by continued reductions in fixed costs, including salaries, professional services, rent, and insurance. Overall, our SG&A expense ratio of 15.9% reflected our third consecutive quarter of improvement. While we still have more work to do, we believe we are making solid progress in aligning our overhead structure with revenue levels in a challenging market environment. With regard to South Edge -- in late October, the joint venture received court approval for its proposed reorganization plan and the plan was confirmed in November. This action allowed us to resolve and fund our share of South Edge's outstanding liabilities during the fourth quarter, as we had guided on previous calls.

Our final obligations related to the reorganization plan and the settlement of South Edge legal matters were favorable to our prior projections and we recorded a gain of $6.6 million during the quarter. A new joint venture has been established with three of the other builders and as a result, we have recorded a joint venture investment on our books that essentially reflects the value of the underlying land. It is important to note that the new joint venture is for development planning purposes only and will be utilized while the builders conclude their discussions with the city and finalize their strategy for moving forward.

Turning now to our land acquisition development activity, our total investment in 2011 was approximately $478 million. When you consider the additional $75 million of South Edge land that was reflected as a new joint venture investment, our total land spend during the year was in line with expectations and prior guidance of approximately $550 million. Despite our lower than anticipated deliveries and the substantial cash impact of revolving both the South Edge reorganization plan obligations and the related arbitration award during the quarter, we ended the year with a cash balance of $480 million. This balance does not include approximately $20 million of cash received during the first week of December, in connection with the wind down of our mortgage joint venture.

The most significant use of cash in the quarter was the $252 million pertaining to the settlement of the South Edge-related liabilities, for which we received a valuable land asset. On a full-year basis, our cash outflows also included nearly $200 million of debt reductions, as well as the $478 million of land acquisition and development investments just discussed. Our intent is to manage the business to a cash neutral position for fiscal 2012 and as such, we are currently anticipating that our total spending on land investment for the year will be in the range of $400 million to $600 million, depending on large part, of course, on what we are seeing on the ground in our markets as the year progresses. We are confident we have adequate liquidity to support our business needs today and to remain opportunistic going forward. Now, I'll turn the call back over to Jeff Mezger for some final remarks.

Thanks, Jeff. The consumer benefits of KB Homes Built to Order business model are clear. No other builder can consistently provide customers with the unique combination of the customized new home experience they desire with the savings and value that our innovative designs and energy efficient features can deliver. We believe this differentiation in the marketplace has been a real driver of the strong sales numbers we have reported over the past six months. Our commitment to this model, which emphasizes quality, value, and choice for the consumer, is reflected in our ongoing sustainability initiatives. We have put great emphasis on sustainability over the past few years, primarily because it brings real and immediate economic benefits to our customers in the form of lower energy bills and thus a lower total cost of ownership. During the quarter, for example, we expanded our popular solar program in Southern California, where solar power systems now come as a standard feature in 28 communities.

At the same time, KB Home began its nationwide rollout of net-zero energy options featured in model homes in Tampa, Austin, and San Antonio. KB Homes' ongoing leadership in the realm of sustainability, best illustrated with our proprietary energy performance guide included in every home we sell, has sent a clear message to buyers that we will continue to be innovative in offering homes that are competitively priced today and will also save them money for years to come; especially compared to a typical resale home. While our primary objective in this area has always been to bring value to our customers, along the way, we continue to be recognized externally for our efforts. During the quarter, we were the first and only national builder to be named WaterSense Partner of the Year by the EPA for our industry-leading water-saving features. We were also honored by the US Green Building Council with the Outstanding Multi-Family Project of the Year Award for our LEED Platinum Certified Primera Terra community in Southern California. As we look ahead, we are optimistic about the encouraging trends we are seeing in the broader marketplace. In the majority of our markets, house payments are now lower than rent and it is this incredible affordability that is driving demand.

As the stabilization process moves forward, we are seeing inventory levels continuing to ease in many of our markets, which is a prerequisite for a housing recovery. However, we are even more encouraged by the momentum we are building at KB Homes. I want to especially thank all of our employees throughout the Company for their efforts in 2011. As we close the books on the year, I would like to highlight some of our major accomplishments, which include -- more fully aligning our business with our Built to Order model; our regional shift in land investment toward the growth markets of coastal California and Texas; community comp growth in more desirable sub-markets; lowering our non-variable overhead expenses by a meaningful amount; resolving the South Edge liability and removing that uncertainty; eliminating all outstanding joint venture debt; achieving nearly $200 million in debt reduction; elevating our already strong brand position as an industry leader in energy efficient homes; maintaining record levels of customer satisfaction; achieving accelerated second half sales growth; and establishing a significant year-end backlog of future revenues.

We also believe our successful land strategy, based on the disciplines of our business model, will continue to provide opportunities for growth. We are committed to maintaining adequate liquidity to support our business needs and remain opportunistic. This will allow us to further expand our competitive positioning in our served markets across the country. While the challenges of the market certainly remain the same, we are in a very different business as we enter 2012. Now that we have established the sales pace and backlog that will allow us to fully reap the benefits of our Built to Order business model, we believe we have laid the foundation for improved financial and operating performance in the new fiscal year. In addition to delivering more homes at higher prices, we expect that operating margins will improve in 2012 on a year-over-year basis, starting in the first quarter, and will be positive for the year as we execute our Built to Order model. Most of all, we look forward to building on our current momentum to position the Company for sustained profitability. With that, we'll now open it up to your questions.

(Operator Instructions) Joshua Pollard, Goldman Sachs.

I wanted to start by clarifying a comment that you just made, Jeff. Did you say you wanted to be operationally -- or that your plan was to be operationally profitable? I'm trying to understand at what line on the Income Statement you might be talking about, if that's the operating income line, if that's the pre-tax line, or if that's the bottom line?

It was the operating income line, operating margin.

Okay. Could you, along those same levels, talk about what you think a normal SG&A level should be? There's been a bunch of moving items in there, you guys talk about a positive impact from drywall. There's a couple of things in there and I'm really just trying to understand what you guys felt like a clean SG&A, as a percent of sales, figures should be for you guys as you look at 2012? Would love to hear what your thoughts are on the impact, as well, on gross margins from the issues on the mortgage side of the business.

Okay. On the SG&A side, Josh, as we shared, we made meaningful reductions. I agree with your comment that some of them aren't clear because of the one-off adjustments that we've been making on those lines during the third quarter and the fourth quarter. We're committed to continue to take actions to lower our fixed costs going forward. In normal times, our SG&A will run around 12% of revenue. We're not in normal times and with our backlog position, we know that we'll get SG&A leverage coming in 2012, so we'll have a nice mix of leverage and cost reduction in the year. I don't know, Jeff, if you want to give any of your thoughts?

I think Jeff summed it up. On the SG&A side, we have focused on a number of areas and we're going to see improvement coming off a number of initiatives that we had this year. First and foremost, probably the easiest way to forecast next year is to look at some of the full-year impacts that we'll see coming off the 2011 initiatives. We'll continue to put focus on cost reductions and we do have several additional areas that we're focused on and will continue to focus on as we go throughout the year. And then, finally, we do expect to see a leverage impact on SG&A in 2012 based on our backlog that we're entering the year and expected higher deliveries in '12 than we saw in '11. We think the combination should give us a somewhat meaningful improvement in the SG&A percentage as we move forward.

Excellent. One last follow-up if I could. You guys have, for the last two quarters, been talking about growing or building momentum in the overall business. I'd love to understand what you guys think is driving that. You did call out in your prepared comments the rent-to-price ratios and how much more favorable it is in many cities to own. But that hasn't changed dramatically in the last six months and you've had a significant amount of negative commentary out of Washington, et cetera. I'm wondering what you think is driving the most recent momentum we've seen, not just for yourselves but also in metrics like housing starts and existing home sales.

Josh, you threw a lot in there at the end. As you probably saw this morning, the resale numbers all just got adjusted, so I don't even know that you can have a quality conversation on what's going on with resales right now. What we do know in the communities that we're opening that we've shared our strategy on, they're located in more desirable sub-markets where there's not as much resale activity for inventory. There's definitely not as much foreclosure activity in those areas and there's no new home competition, so it's a nice combination. Where we've opened these up we've seen solid sales results. So I think in part, our selling effort -- frankly, the most part is that we're a little bit different Company today in our positioning with where our communities are.

(Operator Instructions) Bob Wetenhall, RBC Capital.

Nice job and it seems like you got a very strong backlog going into next year. I was hoping if you could just give us a little view on what you're expecting from conversion rates next year?

As I shared on the last call, Bob, in normal times our conversion rate will be 65% or so and it's pretty easy to calculate how to get there. We like to have enough unstarted backlog to continue to feed evenflow and then it takes you three months to build the home, so in balance, it will be a five month backlog in that community. We're not there yet. We're getting closer, but we're still not there. On the last call, we guided 70% or 75% roughly for Q4 and we were within range of that. I think we'll be a little above 65% in our first quarter deliveries and you'll see the number migrate down to around 65% as the year unfolds.

Got it. Got it. And just touching on gross margin, it seems like you're doing really well with average selling prices going up on a sequential basis and year-over-year. Do you think that's going to be something that's sustainable that will help drive better gross margins? On the other side of the gross margin question, can you just provide any color on incentives you're providing?

Let me make a couple of comments, Bob, then I can hand it over to Jeff to get you more specific details. Our price is going up because of the products we're offering in better, more desirable sub-markets. Along with that, our average home size is also going up. We're in locations where there's much higher median household income and they can afford more, so we have a higher price point sub-market. We're offering a full array of floor plans, the buyer is selecting larger plans on average and then they're spending more money in the studio, so you have a consumer with a lot more buying power in these more desirable sub-markets, so it's been a nice mix. I went through all that because we are not getting pure price in today's market and we're not assuming any price for next year. We think it'll be basically where it is today and that's okay because we know through execution, we can lift our margins without having to raise price.

That's the general strategy. I don't know sitting here where the ASP will go in '12 because it depends on where the buyer's selections go in the floor plan array, whether it's the smaller homes or the larger homes. But on average, we don't expect prices to go down. But I'd say it's going to be fairly static with where it is right now year-over-year. Jeff, you got some more color you want to add?

Sure. As Jeff mentioned in his prepared comments, improving our margin is a very important part of our strategy moving forward and we're placing significant focus on this area. You mentioned specifically the incentives, we remain relatively steady on the incentive side. We would obviously, as a business, like to continue to reduce those and we'll place focus on that area, but there hasn't been any unusual movements either way on incentives up to this point.

Adam Rudiger, Wells Fargo Securities.

I was wondering if you could talk about your projected working capital needs? If you just take into account the $400 million to $600 million in land spend and then the likely seasonal build up in inventory, what you think you'll need and potentially where you see your cash bottoming out at intra-year?

Yes, we're going to stay away from actual specific cash forecasts on a quarterly basis. We talked about it again during the prepared remarks that we'd have a cash neutral and forecasted cash neutral 2012. Obviously, working capital moves up and down depending on [whip] and your backlog and the percentage of under construction inventory that you have. We are going to manage our land spend as we go through the year and really manage it to current conditions. You should expect, in a weaker housing environment, as you might expect, a lower land spend closer to the bottom end of our range and in a more robust environment particularly as the Spring selling season is strong, slightly higher land spend, which would be funded, of course, by higher deliveries in the back half of the year. We do see seasonal trends, you've seen it in prior years in our business. We'll keep an eye on that and we believe we have adequate cash to take us through those ups and downs during the year 2012 and I think importantly, coming out of the year at a neutral cash level.

Adam, let me add a little more color, too, on the quote the inventory build up. When you have a backlog and you're rolling through more consistently with deliveries and starts that are close to imbalance, you don't use up as much cash as you do when you build a lot of houses and then they all deliver in one month at the end of a quarter, two quarters down the road. But we think we'll have a better flow of cash in and out of the whip and what will move our cash number up and down is how aggressive or conservative we are on land spend and that's why we committed to cash neutral for the year.

That makes sense. On that backlog number, and you mentioned in your earlier prepared remarks some efficiencies on evenflow production, can you comment on any kind of -- quantify or talk about that a little bit more? Is there a specific level of or general level of backlog where you think those efficiencies really kick in versus where they're a drag?

Hard to quantify, Adam, because we haven't had the benefits for years, frankly. When you have a backlog that sets up evenflow and you start the same number of houses each day or each week in a market, you can go to the contractors and work with them and negotiate a better price because they're able to better manage their overhead and their materials without the spikes that our industry has been creating as we've navigated through this thing. In the good old days, we saw a couple of points of margin due to the synergies and efficiencies on cost to build and better leveraging your overhead. Right now, we're not getting that. We do know we'll see an improvement as the year unfolds and it's to be told. But there is meaningful benefit to our margin, either from a higher percentage of build-to-order sales delivering through or hopefully, down the road this year, synergies and efficiencies on the evenflow side.

Michael Rehaut, JPMorgan.

First question, I was hoping you could give us a sense of what community count was for the quarter? What that translates to on comparing it sequentially and year-over-year? Given the land spend range, I would assume that there would be some modest growth in '12 expected; if you could share any of that with us?

Sure. Yes, community count in the fourth quarter -- we ended the quarter at 234 communities, which is about the same, just up one community from the end of the third quarter; actually had a fair amount of activity going into that. We had 29 new community openings in the fourth quarter and 28 close outs. But at the end of the day, we were up just one community, so basically flat quarter-over-quarter. Year-over-year, if you average it out and you look at the averages by quarter, again about 233.5 this year in the fourth quarter and about 210 last year in the fourth quarter, so we're up about 11% year-over-year in community count. When we look going forward, basically, we're looking at opening about 25 new communities in the first half and the relative growth on that will be highly dependent, obviously, on the number of close outs, which is difficult to predict based on deliveries. We'll continue some new openings into the first half of the year and then monitor conditions as we go out into the second half.

Okay, appreciate that. A second question, I just want to kind of circle back to SG&A and gross margins. What I'm getting at is how to think about 2012 for both line items? You have SG&A that, I believe if you strip out the benefit in the third quarter and the legal reserve increase in the fourth quarter, you're still looking at about a 19% SG&A rate for 2012, actually slightly above -- I'm sorry that 2011, the 19%. You've also mentioned some improvements that you're doing that you did throughout the year. I'm just trying to get a sense of how to think, all else equal, obviously, there's a leverage for revenue growth but, that aside, if there's a core reduction in SG&A that we should take into account?

Similarly on the gross profit margin, you've been calling for an improvement in the back half of the year, really hasn't fully materialized and you pointed to some factors in the fourth quarter that kind of pushed out that improvement. Just trying to get a sense of how we should think about 2012. What type of improvement we should be looking for, given that it's fallen short in the last two or three quarters? Should we be thinking in terms of a 50, 100, 200? What's the type of degree of magnitude that we should be expecting?

Mike, let me make a couple of strategic comments and then I'll again hand it to Jeff for some specifics. If you look at 2011, and a lot of it ties back to your community count question, we really had a tale of two companies. We had a first half with no backlog entering the year and a lot of expense tied to all the communities that we opened. In the second half, you had stronger sales and community counts that are now in place and opening, which set us up for a 2012 with momentum. That's why in part we guided, we know our operating margin will be higher year-over-year sequentially through '12 and we guided to positive operating margins for the year. It's a different world when you have sales momentum and you can pull levers that manage to a pace versus try to get models open and chase a pace.

Now that the models are open with the number Jeff gave you, you don't have this need to push through a lot of model openings, because they're there. We can now manage far better to a business that's more in balance and that's why we're confident that we're going to have a better result as we go into '12, because we're far better positioned whether it's the backlog, the product types, or the overhead structure and alignment with revenue. You want to give them any specific numbers, Jeff?

Yes, sure. I think what we're focused on, Mike, is over operating margin. We think that's the most important component for the business. We do expect to see pretty significant improvement in operating margins in the neighborhood of 500 basis points for the year, coming of course, the combination from both SG&A reductions, the leverage impact of SG&A, as well as margin improvement. That's pretty much where we're pegging it at right now and where our forward plans are leading us. A lot of clarity will come to that number as we get through really the first quarter and into the Spring selling season and we're able to see better and have better visibility into the back half of the year. But at this point, we're pretty confident with that operating plan and that operating forecast.

Dennis McGill, Zelman & Associates.

I just wanted come back to the fourth quarter margins because realizing there's a lot going on and how that will impact 2012. If we go back to your expectations, Jeff, you had implied that margin could be up sequentially from the third quarter level, which included the warranty reserve. I think on our numbers, at least, that's about 250 basis points or so; the actual came in 250 basis points or so lower than that. You mentioned some different things being mix, the loss of leverage on the top line, and the drywall reversal. Can you kind of break those things down so we can understand what's temporary and what's potentially going to be pushed out into next year?

Sure. We have, like I mentioned, there were several fairly significant impacts in the quarter versus our expectations. I think it is important to note we didn't have a decline in operating margin quarter-over-quarter. We were more or less flat.

Gross profit.

In gross profit margin, sorry, quarter-over-quarter, we were more or less flat. The impact of each, if you look at starting with the spec deliveries and the impact coming from that, that was less than 100 basis points impact on the gross margin. The most significant one was in our expectation relating to the drywall recovery. We have a fairly significant recovery that we're expecting and in fact, we do plan to receive that and capture that in 2012. It was deferred for a number of reasons, not the least of which that we were not happy with the point in time and the negotiations at the end of the year and feel there's much more in it for us.

We, as opposed to taking the tradeoff of booking a number into the fourth quarter, we decided to maximize that recovery and be a little more patient in order to fight for a stronger recovery out into 2012. It's probably the most significant piece of margin improvement anticipated in the quarter and that is as high as 200 basis points. In addition to those two, the leverage impact, slightly lower, again, less than 100 basis point impact on that side coming off that and I think that pretty much covers it. That's basically the wrap up on that one.

Okay. If we were to exclude a lot of those items, which that's very helpful to isolate those, if you exclude some of those and some of the warranty adjustments, things that would be considered non-core within the year, your expectation into next year is really sort of that baseline plus or minus what happens with the pricing environment?

Again, Dennis, we aren't giving guidance because there's a lot of moving parts still on where the year unfolds. We know that we can improve our gross profits just through delivering a higher percentage of pre-sold homes and that's one of our primary objectives as we go into next year. But we're delivering pre-sold homes today, so you have to get down to what percentage was inventory and what percentage was pre-sold and how much can you lift your margin through that. If you look at the receivable that we would get on our warranty, you can say it's one-time, but the costs were actually incurred and hit our margin at some point prior to that. It's the offset to the negative that we took earlier in the year, so while it's one-time, it is balancing something that we took, in part, earlier in '11 or prior years.

We think that there's margin opportunity. We're committed to it, whether it's more strategic pricing and what I keep getting back to, when you have a backlog that can deliver at a pace now, there's a lot of leverage you can move, whether it's price on this plan that's selling better than others or whether it's the cost side and efficiency you can get there. There's a lot of levers we can now pull that we haven't been able to over the past few years and we think that over time you'll see the margin continue to improve.

David Goldberg, UBS.

My first question, I was hoping we could take a step back here and talk about the capture rate at MetLife. 40% I think, Jeff, was the number that you mentioned in the prepared remarks and it seemed like a very, very low level. I'm wondering if you could give us an idea, one, what it was that drove such a low capture rate? I think that was even lower than you guys -- where you guys were when you originally went to the JV structure five years ago. What drove such a low capture rate and was that a risk that you guys had identified when you were in the due diligence process of choosing a new partner, that you could see a substantial drop off in capture rates from where you had been?

David, there are a couple comments I can share. But first off, when we sold our business to Countrywide many years ago, it took about 18 months to get up to the normalized capture rate. There's an integration period and at the time, we had a lot of backlog, the business was running well, the markets were good, and they were very good at process and even with all of those favorable elements, it still took 18 months to get to normalized retention. But if you look at what we went through this year, our JV partner announced their intention to get out of the JV, and we did in the month of June. On July 1, we literally had to start over.

MetLife's been a great business partner, but it took time for them to establish teams in every city, get them trained, get the synergies of working with our sales teams and sales management. And there was this 90-day window in the third quarter where they were getting traction on their teams and taking care of our customer. But the customers, hey, if you can't handle me -- and there were cities where MetLife literally told us, don't send us the buyers yet, we're not ready. I say that because Met has one of the highest customer satisfaction levels in the industry and they were sensitive to not taking on business that they could not handle. There was a quality concern and we took our time and a lot of the deliveries in the fourth quarter were sold during this window of transition and through the quarter, MetLife performed well. Their capture rate went up sequentially and is continuing to go up and we expect that the hit we took is now behind us. There's still some of it that we're working through, but as we go forward we think we have far better predictability.

We knew that there were some moving parts in our fourth quarter relative to these outside lenders, but it absolutely illustrated for me all the noise that you hear in the media about what buyers get put through to get qualified for a loan. When you're dealing with lenders that aren't your partner and it's just one loan of 100 for them, they don't have the priority and urgency unfortunately that we have. We had a lot of closings with last minute surprises, literally in some cases at the closing table, where customers were told they needed this document, or weren't approved, or just a lot of things that, when you have your own preferred lender, you don't have to deal with. We were surprised. It was worse than we anticipated, but now it's behind us and we think that we've got a far better predictability going forward.

Got it. Second question, this is a little bit more theoretical, but in the prepared remarks, Jeff, you mentioned the cost of ownership being below the cost of renting in a lot of your markets at this point. I'm wondering, as the product migrates up a little bit and you guys find land in communities where there's not a lot of land available and not a lot of inventory, especially as you move up maybe a little more, a move-up buyer versus a pure entry level or whatever. Is the decision as much a question of existing home versus new home, i.e., I'm going to buy a home but what kind of home am I going to buy? Or is it more, am I going to stay a renter or be a homeowner?

I'm just interested because we do put a lot of stock in this. The cost of ownership is less than the cost of rental, but it would seem to me that for a certain stage of life, you're already past being a renter, you're already ready to own a home at this point. Or maybe you've been a renter and you've had some life change experience that would make you more prone towards ownership. Now the question is, am I going to buy a distressed home, a non-distressed home, or a new home and I'm just trying to get an idea about how you think about your buyer profile that way?

I hate to answer this way, David, but I think it's all the above. What we're seeing is with our new communities opening in more desirable sub-markets, you have higher income levels and we're selling expensive larger homes to first-time buyers in some cases. It's a consumer that, over the frenzy of five years ago, elected not to be an owner. They have good incomes, maybe a dual income, they want to live in that area, and they're making the plunge because of the incredible affordability that's out there today, and they make the decision to be a homeowner. A lot of consumers are surprised, frankly, at how low home payments are compared to rent, so there's an education process for others.

When I say it's affordability that's driving it, you need consumer confidence and job growth to sustain it. You have the people that are comfortable with their economic situation, they recognize the incredible values today and they make that decision. But we need a higher level of confidence to get back to the traditional move upstream or first time buyer out of the rental. I believe our buyer profile, Jeff, I don't know if you have the numbers over there, our buyer profile didn't change much, it's still 65% first time buyer, but it's a high income first time buyer. That's what's different for us now.

Alex Barron, Housing Research Center.

I wanted to ask you, as far as your market footprint, are you guys still comfortable with every market or is there any markets that you are thinking of entering or any markets you're thinking of exiting at the moment?

Alex, we're comfortable with our footprint today and every city has to stand on its own. The cities we're in are primarily sunbelt. They're cities that are projected over the long-term to have favorable population growth and economic growth and they're cities that are compatible for a volume builder. We chose them with intent and we like where we're positioned today. We are not hung on staying in a city just to say we're in the city. Over time, it has to prove that we can get our returns and profitability in that city or we may elect not to stay there. But at this time, we're focused on growing our backlog and running the business.

Okay, and related to that, what are you seeing on the land side? Are you still finding attractive land deals at [Pencil] for your expected returns or are you finding that that's more difficult? Then just an extra side question, can you tell us what percent of your sales are to FHA buyers?

Jeff has, he can share that statistic with you, Alex. But in our strategy of going to more desirable sub-markets, typically they're more land constrained. It's not like you can walk down the street and identify parcels and turn them into revenue in six or 12 months. There's an inherent constraint and your success is tied to how good your land teams are on the ground. Whether it's Texas or California, where we spent about 75% of our money in 2011, we had good land teams on the ground. The fact that we spent $478 million on land [ac] and development tells you that we're finding deals, but it's not everywhere. We're having to work hard (inaudible) and it's tied to how good our teams are. Having said that, we are finding deals at Pencil and we're continuing to invest in our growth.

Yes, regarding the FHA percentages, historically, we've run in the mid-50%s to low 60%s in recent history. The one caveat I'll put on that is we have less visibility to that number, of course, now after the conclusion of our JV at the end of June. Those numbers are from the beginning part of this year and through 2010, but I'd say they remain fairly stable and I would estimate they're still in about that same range.

Okay, thanks.

Dan Oppenheim, Credit Suisse.

Was wondering in terms of the West Coast exposure, talked about Coastal California, how much of your business would you like that to become? Then next, relatedly, talk about land; being tough to find land and the entitlement process and such taking longer there. How do you think about that given where the cash position and the ability to take on a lot more land?

Dan, if we could find 100 communities in the Bay Area tomorrow we'd buy them all and figure it out because they perform well. There's this built in constraint in that it's not readily available, so we'll continue to push the envelope there. A great reflection of our success has been if you look at the year-end backlog in California, it's primarily Coastal California is up significantly year-over-year. We've been able to grow and we'd love to grow more, but there's a constraint because there's not that much land available.

Are you saying you'd look for capital then if you could find the land now?

We've shared on our comments that we have adequate cash to run the business and we will allocate it to where the best returns are. I shared on the call that California typically has our highest gross profit, so we like the returns there. It's where we've been spending the money and of the $478 million last year, a big chunk of it was California.

Okay. Relatedly, wondering in terms of that, I imagine that more of that's going to end up being attached homes and such. What are you comfortable with the risk in terms of just increasing exposure to that area?

Our product strategy primarily stops at townhomes, or we've done three podium products that are delivering this year, but not a lot in the queue, so it's not higher density stuff. It's typically small lot, high density detached or a townhome community that you can navigate through just like detached homes, so it's not going to higher densities. We're staying on our primary business model.

Mike Widner, Stifel Nicolaus.

Just following up on that topic, one of the things we continue to struggle with when understanding the progression of you guys and the vision is, you call yourself a merchant builder, which implies to some degree land light. You're California-heavy, so you're buying expensive lots and you're buying finished lots, by and large, so, again, even more expensive than raw land. All of that requires a lot of interest and a lot of interest-carrying costs. I sit here looking at you guys carrying five years or so of land and just scratching my head and saying how do I reconcile that merchant builder with somebody with that much land and that much carrying cost on the land and how do I make it work?

I'd have to say that our business model, while we're a merchant builder, it's morphed a little bit due to the market conditions that we're in. We're doing well picking off these semi in-fill locations in Coastal California that are 60, 70, 80 lot positions. They're not big positions and they're not taking years to bring to market once you tie up the land, so you tie up the land and they're not all finished lots, by the way. We are doing some development deals in California because of the seasoned tenure of our teams and the confidence we have in them in hitting their budgets on the cost to develop and the timelines. But these are not long term plays. You go in, you open the community and you get your cash out in a year or two. There's this rollover of this in-fill product and then you have to balance it where you can as in the desirable sub-markets that allow you to be more of a volume builder.

I hear that, kind of have heard that before. If I just tie this back to the operating metrics that you talk about, it sounds like between some additional cost cutting rolling through and some kind of hoped-for gross margin expansion, you're hoping to get back to something on the marginally operating profitable level next year. Yet we sit here and look and you guys are still expensing 45% of your interest. I don't know how that's going to look next year, but it's going to be somewhere in the realm of if it's anything like this year, $0.60 to $0.70 of interest expense flowing through outside of the operating profitability line. Again, it just makes me wonder, as I look at the book value having got cut in half in the past two years, look at how the stock has performed this year and you guys saying everything's going to plan. There just seem to be some conflicts here that I'd like to give you the opportunity to tell us where we're wrong, tell us where the market's missing?

Okay, again, you throw a lot in there. But we've spent time talking about Coastal California, but we also have a very nice business in many other states. A good example of that is in Texas, where while can talk about high-priced California product, we did a very nice addition in the second half of last year where we acquired the Fieldstone assets in San Antonio in July and opened nine communities before the end of the year, and it's going to be a very favorable impact on our business in 2012. I think if you look at where we're at with our backlog and the momentum we now have and you couple it with the confidence we shared on where our business is going, you can see the road map. Maybe it's not clear to you, but we have a lot of things going for us that we have not had in years, and it starts with the backlog and the community position. I don't know if you want to give him any more color, Jeff.

When you start talking about book value, the number one detriment of book value was the one-off relating to the South Edge situation, so it's separate from the operations and separate from the operating strategy moving forward. As Jeff said, we're pleased with some of the progress we've made, we know we have some work to do, particularly on the margin line. We're going to put a lot of focus on that. The SG&A, we have very high level of confidence in improvements next year, especially on a ratio basis, with more volume leverage coming, as well as full year impacts from the cost reductions that we already had behind us and additional opportunity going forward. I think the combination of those factors is a reason for our confidence going forward and that's what we're looking at as far as the base operations.

Stephen Kim, Barclays Capital.

It's John Coyle filling in for Stephen today. Just regarding the commentary around average selling price growing next year, is this commentary specific to Southern California or is it more widespread?

It's Company-wide. You can't say everywhere, because we have a lot of communities. But if you look across our regions, this strategy of going to more desirable sub-markets is in play everywhere. Our ASP is lifting in all the regions or we have the expectation it will, because of the type of product we're bringing to market.

Got it. As far as the margin impact specifically to the average selling price increase, can you give a bit more color on that?

It starts with a typical margin when we're underwriting the deal. The offset to the higher price point is the land typically costs more, too, so playing at the higher price point doesn't automatically translate to a higher percentage profit. It's how you execute through the community and whether you can leverage that buyer to grow the margin.

Stephen East, Ticonderoga Securities.

Jeff, you've talked a lot about getting land in California and how hard it is in the Coastal areas and that it's valuable. I see your absorption rates ramping up pretty strongly, but your gross margin really hasn't followed along the same path. Would it behoove you all to slowdown the sales pace in the California markets and drive your gross margin higher on that? And just your thoughts between that market on the gross margin approach and say Texas and your other markets?

Our mantra, Stephen, is to optimize every asset. We have a strategy in play that sets an absorption rate and a margin that gives you the best return. We are mindful of communities that are in sub-markets that you can't replace and those will run slower and we'll push margin there. If you're in an area that's desirable, but a lot of lots ahead of it you'll run it a little faster and work more on the returns and the cash side, as opposed to maximize margin. Every asset has its own strategy and I think -- we're not getting into the details, but I think we're doing what you're suggesting in a lot of the irreplaceable communities.

Okay, all right. I appreciate that. Then just two other questions on the gross margin -- one, given some of the gives and takes that you talked about in this quarter and what you expect in '12 -- one, what's the gross margin embedded in the backlog now? And then two, I know the energy efficiency has played really well in California. Another builder that's trying to do it in Texas is struggling getting the consumer to pay for it. Are you seeing a similar phenomenon in Texas?

Stephen, I'll talk to energy efficiency and Jeff can share his thoughts on the gross profit. We're absolutely seeing buyer response to the energy efficiency programs we've put out there. I can't speak to this other builder, but we've been focused, as I said in my shared comments -- or my prepared comments -- we've been focused on driving energy efficiencies and value to the consumer without raising the prices materially. We are seeing a consumer that will not pay for it unless there's an economic tradeoff over a couple of year period. Where we're offering these net-zero option packages, it's going to give us a real insight into the consumers' thinking going forward, because they will have a menu of things to pick from and can go all the way down to no utility bills if they fully option it up. We'll know where the consumer's going to migrate to, but in the meantime, much of what we've done has had no impact on price and then there are things that have moved price a little bit.

If you look at our solar program in SoCal where we were able to leverage our scale and a relationship that, frankly, was created out of our concept home in Orlando last year, where a solar company saw the benefit of linking up with a volume builder. We got the solar panels at a great price. There's an incremental increase to the consumer, but it's more than offset by the utility savings and it's working very well. You're not seeing our prices go up $30,000, $40,000 in order to cover some exotic things that we've put in the home as standard. We're very tied to affordability still. Any other thoughts on the product?

On the backlog side, on the backlog question, the VC in backlog right now, our variable contribution, is about the same as what we experienced in the fourth quarter. But I think it's very important to understand, with our backlog, both the value of the backlog, as well as the contribution margin within the backlog, neither of those include anything coming out of our studio process or generally. As our consumers are going into the studio making selections, you see lifts typically in both of those numbers as they complete that process. That's one of the reasons why if you look at, for our Company, ASP and backlog, we almost always surpass that in the following quarter because of that phenomenon.

If you get back to Jeff's comment on the inventory we cleared out to get absolute focus on our Build to Order approach, that inventory wasn't in backlog at the start of the fourth quarter and it did negatively impact, to a slight degree, our margin. We've also been able to eliminate some of that negative influence as the quarter unfolds.

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

Thanks, Melody. Thanks, everyone, for joining us today. We want to wish all of you a very happy holiday season and we look forward to sharing our progress and success with you as we head into the new year. Have a great day.

That does conclude today's conference. We thank you all for joining.