MDC Holdings Inc (MDC) 2009 Q2 法說會逐字稿

Good afternoon. We are ready to begin the MDC Holdings and Company second quarter 2009 earnings call.

I will now turn it over to Robert Martin, Vice President of Finance and Investor Relations. Sir, you may begin.

Thank you. Good morning, ladies and gentlemen. Welcome to MDC Holdings' 2009 second quarter earnings conference call. On the call with me today I have Larry Mizel, Chairman and Chief Executive Officer; and Chris Anderson, Senior Vice President and Chief Financial Officer. At this time, all participants are in a listen only mode. After finishing our prepared remarks we will conduct a question and answer session, at which time we request participants limit themselves to one question and one follow-up question. Please note this conference is being recorded and will be available for replay. For information on how to access the replay, please visit our website at MDCHoldings.com.

Before turning the call over to Larry, it should be noted that certain statements made during this conference call, including those related to MDC's business, financial condition, results of operation, cash flows, strategies and prospects, and responses to questions may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties, and other factors that may cause the company's actual results, performance, or achievements to be materially different from the results, performance, or achievements expressed or implied by forward-looking statements. These and other factors that could impact the company's actual performance are set forth in the companies 2009 second quarter Form 10-Q.

It should also be noted that SEC Regulation G requires that certain information accompany the use of non-GAAP financial measures. Any information required by Regulation G will be posted on our website. And now I'll turn the call over to Mr. Mizel for opening remarks.

Good morning and welcome. During the second quarter, difficult economic conditions persisted as evidenced by a national unemployment rate that now stands at its highest level in more than 25 years. However, the homebuilding industry shows some signs of life. After dropping to historic lows in the first quarter, housing starts, permits and new home sales all rebounded in the second quarter. For our company, quarterly net home orders increased year-over-year for the first time since the third quarter of 2005. Additionally, after booking significant inventory impairments in each of the last 11 quarters, impairments in the second quarter of 2009 were minimal, in large part due to the fact that our WIP and land balances have dropped to their lowest level in more than a decade.

We continued to focus our internal operations during the quarter through our companywide initiative to reevaluate, transform, and streamline our core business practices. A key focus for this initiative currently is the evaluation of our product offerings. We are pleased to report that the smaller, more affordable homes that we introduced earlier this year in many of our markets have been well received by our buyers, with the sales absorption pace exceeding the company's average. We are excited to expand the ability of this new product in a large percentage of our active communities in the future as we look to return to a period of profitability and growth.

We have also reevaluated our strategy on unsold inventory. We continue to believe that finished unsold inventory negatively impacts our operating results, and therefore, we reduced our exposure to this type of inventory by more than 70% in the quarter alone. However, we also believe that the strategic production of unsold homes can be very effective if managed properly. Therefore, we built a limited supply of unsold inventory with the requirement that the construction of these new homes stop at the drywall stage so that the buyers have an opportunity to personalize the homes with upgrades from one of our home galleries or design centers. We believe that this strategy will help us to turn our inventories more quickly while we maintain margins similar to those received for a built to order home.

While our low exposure to land is a positive in this unstable economic environment, we are looking forward to redeploying our capital into new investments. With our cash and investment balance of more than $1.6 billion at the end of the quarter, no borrowings outstanding on our homebuilding line of credit, and no senior debt maturities until 2012, we are well positioned to act on opportunities that arise. We continue to actively pursue and evaluate a number of potential investments, subjecting each to our rigorous and disciplined investment process, and approving only those that we believe will maximize our long term value for shareholders.

I will now turn the call over to Chris Anderson for more specific financial highlights of our 2009 second quarter.

Thank you, Larry and good morning, everyone. First off, as has been our practice for the last few quarters, our 10-Q has already been filed. So there's significant detail available as you take a look at our quarterly results, and we've also prepared slides to aid you in your review. So I'll jump into those now.

As Larry mentioned, for the first time in 15 quarters, we achieved a year-over-year improvement in sales. In the second quarter, we received 977 net home orders, which were a 2% improvement over the same period last year and a 45% increase over the first quarter. The slight net order improvement was driven by significant increases in our Mountain and East segments, offset by a substantial decline in our West segment. The declines we saw in the West were mostly attributable to significant decreases in active subdivisions.

Net orders per active subdivision improved to 1.6 for the second quarter of 2009 compared with 1.1 in the quarter a year ago. Our gross orders were down about 27% for the quarter, but this decline was more than offset by a decrease in cancellations. Our cancellation rate of 20% was much improved from 43% in the second quarter of 2008. If you look at it a little differently though, as a percentage of beginning backlog instead of as a percentage of gross sales, then the rate was actually up slightly from a year ago.

A couple of other items to note on this slide. First, the smaller more affordable homes that Larry talked about earlier are starting to have an impact on our results. They represented just under 10% of our gross home orders during the quarter and we're really just getting started with them. Second, the average price of the net home orders increased 2% year-over-year to roughly $296,000, primarily due to higher mix of homes coming from markets priced higher than our average.

While the slow pace of home orders over the past year led to a year-over-year decline in our backlog, the good news is that our backlog has increased by almost 80% from the beginning of the year, including a 50% jump in the second quarter alone, to our current level of 941 homes. Prior to 2009, we had experienced a sequential decrease in backlog for eight consecutive quarters. So we're pleased with the direction that we're headed. Our average price in backlog is also down from $331,000 at June 30, 2008 to $313,000 at June 30, 2009.

Moving on to inventory this slide shows the trend over the past year for both our land and work in process with sequential declines every quarter for both categories. Overall, our inventory's down by more than 50% over the past 12 months and 11% in just the past quarter. For both land and WIP, our inventories the lowest it's been in more than a decade. Looking at the land side of things, we decreased our lot count by 24% over the past 12 months and by about 6% for the quarter. The decline in the first quarter primarily was the result of transferring lots to our work in process inventory at the start of home construction in the normal course of business.

Land acquisitions and sales were relatively insignificant. We were a net purchaser of lots with about 35 lots sold versus 264 lots acquired. Of the roughly 6,700 lots we have remaining, about 750 are classified as held for sale, meaning that we've determined that the best use for them is to sell them to an outside party. At the end of the quarter, these lots had a book value of approximately $10 million, with California having the largest concentration of these lots.

As we've noted on previous calls, the majority of lots we own are finished, so there's not a lot of development money to be spent on these assets. And we've continued to focus on keeping our exposure on the surety side down. At the end of the second quarter, we had only $134 million in bonds outstanding, which is down 9% since the end of the first quarter. We estimate the cost to complete land development under our outstanding bonds are less than$ 20 million.

We had approximately 1,400 work in process units at the end of the quarter, a decrease of 50% from the same time last year. Sequentially there wasn't much of a decrease during the quarter, because we started a significant number of homes that we expect to close in the last half of the year. Our spec units declined significantly due to a drop in our finished spec count, and I'll give you a little bit more color on this topic in the next slide. In addition, we reduced our model count by almost 10% during the quarter, in the interest of saving our selling costs and through the overall reduction in our subdivision count. Over the past year, our model count is down 54%.

The lots that we have under option only decreased by 13% during the quarter, and year-over-year they're down 29% to roughly 2,000 lots at quarter end. For those lots, we have less than $10 million at risk. In the second quarter, our active subdivisions fell from 175 to 142, with the largest declines in Arizona and California. Over the past year, our active subdivisions are down 37% from 227 at June 30, 2008, with about two-thirds of that decrease coming from Nevada, Arizona, California, and Virginia.

This slide gives you a visual on one of the topics Larry covered earlier. You can see our strategy on unsold inventory at work here. Just in the second quarter, we reduced our finished unsold inventory by 72% to 82 homes at June 30. That's only about a week supply, which is very manageable. We prefer not to let our specs get to the finished stage because they tend to be much less profitable for us than a home that's been personalized for its ultimate buyer.

On the other hand, we think the use of unsold inventory can be a very effective strategy if managed properly. Our experience tells us we can still maintain an attractive margin on an unsold home if we at least give the buyer a chance to personalize the home at one of our home galleries or design centers. So we built a limited supply of unsold homes that fit with this strategy. Construction on these units is typically halted after the drywall is installed until a buyer is identified and upgrade selections are made. On this slide, you can see the combined number of unsold homes in the foundation and frame categories actually increased in the second quarter after decreasing for each of the prior periods shown reflecting implementation of our new strategy. And we expect to invest additional capital in unsold inventory during the second half of the year.

Turning to the next slide, we would be remiss if we didn't include a slide on our cash position. For the sixth consecutive quarter our cash and investment balance exceeded our total debt, in this case by 60%, and on top of that we have just shy of $500 million of available borrowing capacity on our homebuilding line of credit.

The next slide takes a look at our bottom line. This story is much the same as the past few quarters. Both our home closings and average selling price declined year-over-year for the second quarter, but we were able to narrow our losses on a pre-tax basis and an after-tax basis due to a significant decline in impairments and SG&A.

Total revenue for the second quarter fell 52% to $195 million, mostly due to a 49% decrease in home closings. In addition, the average closing price was down 6% to $279,000 in the second quarter. That's down about $17,000 from where it was last year. All of our markets were down except for California, with the biggest drops coming in Nevada, Maryland, Utah, and Arizona. In California, the increase is a function of selling larger homes, not a price appreciation.

Looking at gross margin, overall for the company we were 18% in the second quarter, which was up 630 basis points from last year and up 260 basis points from the first quarter. I'll give you a little bit more detail on that in a moment. We also have a slide later on for impairments as well, but the story is fairly simple. In the second quarter of 2009, impairments were minimal, only about $1.2 million. We decreased our SG&A expense year-over-year by about $26 million, a 33% drop. If you annualize that reduction, that would be about $100 million per year in savings. Financial service profits were up for the quarter, primarily due to a decrease in G&A cost that more than offset a decline in revenue.

On the corporate side, we shifted from an $8 million loss to a $24 million loss in the second quarter. A couple of things drove this decline. First, similar to the past two quarters, we recognized significant interest expense at the corporate level outside of what runs through our cost of sales, because we couldn't capitalize the full amount of interest incurred related to our senior notes. The amount for the current period was about $10 million while minimal interest was expensed in the corporate segment during the second quarter last year. Second, we earned almost $6 million less interest income during the quarter as higher cash balances did not offset much lower rates of return on our investments. And we have interest charges coming through in a couple of different places on our income statement.

So we put a bullet on the bottom to tie it all together. When you add together the homebuilding piece, which runs through cost of sales to the corporate piece, which you can see on our face of our income statement, the total is about $19 million. Then subtract our interest income, which you can also see on the face of our income statement, and you get to a net interest expense figure of about $16 million. Arguably, we could make some changes to our capital structure to bring this net interest number down, but right now we're more interested preserving the financial flexibility we have to pursue opportunistic investments.

Overall, our pre-tax loss for the second quarter was $19 million, down from $102 million during the same period last year, and our net loss for the quarter was $30 million as compared with $101 million in the 2008 second quarter. As you can see, we actually had an income tax charge in the second quarter of about $11 million despite the fact that we had a pre-tax loss. This occurred primarily because we recorded a $10 million 2006 alternative minimum tax liability associated with the 2008 net operating loss carryback. Overall, we recognized an $18 million valuation allowance against our deferred tax assets compared with the $43 million we booked during the same period last year. As of June 30, 2009, our total valuation allowance is $327 million which is a full reserve of our deferred tax assets.

Now looking a little bit closer at our home gross margin, this slide shows our trend since the second quarter of 2008. On both a pre and after interest basis, margins improved in the first quarter both year-over-year and sequentially. Interest continued to have a significant impact at 470 basis points. However, the interest impact was similar for both the second quarter of last year and the first quarter of this year, so it doesn't have a big impact on the change in margins year-over-year or sequentially.

Looking at things before the interest impact, shown as the green bar on the slide, our gross margins are up by 660 basis points from the same quarter last year. There's a twofold explanation for the improvement. First, our warranty adjustment in Q2 of 2009 versus Q2 of last year increased the percentage by about 300 basis points. Second, as we mentioned in prior quarters, the improvement in margins is largely a function of the significant amount of impairments we've taken in the past. So what you see here is a result of our inventories having been appropriately valued to market conditions over the past 11 quarters.

Looking at the sequential trend compared with the first quarter, our pre-interest home gross margin increased by 250 basis points. Again, the improvement was driven by lower basis in land because of prior impairments and the warranty adjustment.

Now if you take out both interest and the warranty adjustment in all periods, the gross margin is 16.8% in the second quarter of 2009, up from 13.4% in the second quarter of 2008, but slightly down from the 18% in the first quarter of 2009. So we're still seeing some volatility, and part of that is the impact of finished unsold homes and model sales that we recognized in the second quarter. About 58% of the closing in Q2 were for finished specs or models, which typically generate a significantly lower margin than dirt sales or homes that can still be personalized. As the percentage of finished unsold homes and models decrease in our mix of closing, we should be able provide you with a better picture of what normalized margins will look like.

Turning now to selling expenses, we've reduced these expenses by nearly 60% year-over-year. The decrease in commissions is really just a function of the decrease we've seen in home sales revenue, but the reduction in marketing expenses is the result of our efforts to reduce the expenses we incur related to model homes. Over the past year, the 54% decline in our model home count has outpaced our 37% decline in active subdivisions as we've reevaluated the number of models we need in each community or move to sell homes in multiple communities using the single set of models. And we continue to closely control the merchandising spend that we put into each of our homes. The amortization of these costs was down by almost 80% in the second quarter compared to the same period a year ago.

Moving on to G&A expenses, we're down 14% for the second quarter as compared with last year's second quarter. We've done this primarily through significant adjustments to our employee headcount, which is down by approximately 36% from last year. We're certainly conscious that our G&A expenses have increased in relation to our revenues. This has occurred partly because of the speed of the decline in revenues, but is also because we've made a committment to reevaluate, transform, and streamline our core business practices. In addition, we want to be sure to keep a core team in place to help us return to growth as conditions improve. That doesn't mean we're done with our focus on G&A. We'll continue to make hard choices, especially if we see further declines for the industry, but we remain committed to the long term needs of the company.

And on our final slide here, we have an update on impairments for you. This shows the history of our impairments since the beginning, starting in the third quarter of 2006. As I mentioned previously, impairments in the second quarter of 2009 were minimal, but we did book a small amount in our Virginia market, covering just 56 lots and two subdivisions. We anticipate that our impairment levels remain low going forward given our low exposure to land inventory.

Now to emphasize the message you heard from Larry earlier, we're excited to see the opportunities the market has in store for us. But we're going to be disciplined to make sure that we're making the right decisions, keeping in mind our ultimate goal of creating long term value for our shareholders. In the meantime we're pleased with the progress we've made internally to prepare our company for an eventual turnaround. As always, I want to thank our MDC team from across the country for the work they do every day to put our company at the top of the homebuilding industry. I'd also like to thank everyone on the call for their continued support and interest. At this time we'll open the line for any questions you may have.

(Operator Instructions). Your first question comes from the line of Michael Rehaut. Your line is open.

Hi, guys, this is actually Ray Huang on for Mike. Just a question on the gross margins. Given you've likely impaired your land down to an appropriate level and given where your backlog is today, what should we be expecting for margins for the foreseeable future? Stable around this 18% level or are you thinking up or down sequentially?

I think as we said when you back out some of these other adjustments you can see the volatility from last year's Q2 to this year, and even a balance that we had in Q1. So it's a little hard for us to predict exactly what's going to happen going forward. I think the one message that we would reiterate is what we've done with our inventory. And as we've reduced the amount of finished unsold inventory and as we shift to see a higher mix of inventory, unsold inventory that we'll hold at drywall or dirt sales, then that should have a positive effect for us on our mix.

Okay, and then just a follow-up to that question then. Nice job on the completed spec reduction. If you guys could give a breakout of where that was geographically, and going forward for your new strategy, where are you guys targeting the new spec inventory -- is that broadbased or is that targeted in specific geographic locations?

I'm not sure if we provided a breakdown of that finished unit level inventory, Ray, but we're down to 82 at June 30, which is a pretty minimal amount. So when I think about going forward, it's really across-the-board in all of our divisions. We're focused on the unsold inventory that our buyers will be able to personalize and our dirt sales.

Do you guys have a margin differential between those spec homes versus the traditional build to order homes or is there pretty much no differential anymore?

No. We would say we're still seeing a difference. I think I can't remember if I said that or if Larry said that, but we would expect to see a better margin performance in our unsold inventory that's held and has allowed for specialization versus our finished inventory.

Okay, great. Thanks guys.

Thanks.

Your next question comes from the line of Joel Locker. Your line is open.

Hi, guys. Just curious on the land side, I mean what you're seeing -- obviously you haven't seen a lot in the second quarter, but has anything started to open up or at least the bid ask spreads starting to narrow a little bit?

This is Larry. There's a sequential increase of assets that are being marketed, and the spread is still there between the bid ask. But eventually the financial institutions and others are beginning a slow process of putting these assets on the market for sale. And I expect over the next period of time that the adjustment and realization of values will come to the market and we will be able to be very active.

And have you thought about maybe a more creative way of maybe purchasing delinquent notes from the banks on certain land parcels that you find attractive? I mean, you guys got to be getting frustrated by now, based on what you thought might come through the pipeline maybe six or nine months ago.

I would say that we're very disciplined, not frustrated.

You're definitely disciplined. I'm just saying that you would have thought you would have saw some deals that were attractive, or bigger deals that were attractive by now.

Well, we came to view that if we bought it last month, we overpaid. So that gives you an impression of the marketplace for raw land or finished lots. And those that are willing to take it to foreclosure to restructure, those opportunities to continue to be available. And we evaluate whatever is proposed to us and we'll continue to do so with an open mind.

Open mind. And I guess just last tidbit on that is California -- I guess your land supply you're down [1.5 million] of land and development there, and are you just not seeing anything that pencils there? It looks like you guys are almost out of land there.

Well, I was waiting for the governor to get things straight. California has its own unique circumstances and I read that there's 38 million people that live there. So I assume that they will sort it out, and we will sort out the real estate opportunities there as things stabilize.

All right, well, thanks a lot and stay disciplined.

Thanks.

Your next question comes from the line of Nishu Sood, and I'm sorry if I mispronounced your name. Your line is open. Your line is open.

No, that's actually pretty good. Thanks, hi, guys.

Hi.

I wanted to follow-up actually on the question on the land purchases. I think that it's safe to characterize that some of your peers are going more, shifting more towards the green light perspective on certain types of deals, small deals, finished lots in good locations -- whereas you guys might be characterized as still being more at an amber light. Now the simple answer to that is obviously that the numbers in your pro formas are still a lot lower than what the sellers are asking. But there's also what you're seeing out there in the market and as a result of that what you're plugging into your model. So Larry, I just wanted to get a general sense of if there's any indicators or what fundamental shift are you waiting for before you're going to shift more to a green light perspective?

First of all, we have a bright green light on anything that's priced in line with our assumptions. So we're not at amber. We're at a bright green. I think an element that is becoming pretty transparent is that the banks have major nonperforming loans. And I read something recently, it was over $60 billion in the first quarter but their REO was only $11 billion, which shows that the foreclosure pipeline remains full and the banks have yet to dispose of these distressed assets. This is a --

Construction loan.

This is an ADC loans. And this is just an observation that I think probably tells all of us that the government is just figuring out how to deal with the banks. If you have a financial institution that they're going to close, if you realize the losses that are embedded in your balance sheet and you're out of business, you keep hoping something good is going to happen. And we continue to see a larger flow of proposed transactions and we hope to continue to transact. It is very important that reality be in the forefront, and reality is that the price point and the values on a prospective basis of product that's selling is at a substantially lower level than what it has been in the past. And you have to put that into your calculations of what you expect out of these assets that you're looking at.

Got it. So what I'm hearing you say then essentially, if I could paraphrase, is that the supply -- the increase in supply will bring the asks down as opposed to some set of fundamental conditions, let's say on pricing or orders which is likely to bring your bid up. So the former is more likely than the latter?

I think you're right on the money.

Okay, great. And second question if I could, another area I think, well, some of the other builders have been letting go of their lines of credit, and so I just wanted to get your thoughts on that. Your liquidity position is arguably among the strongest in the industry, so how are you looking at the line and the need to keep it through its expiration?

Well, I think we continue to evaluate all of the financial nuances and we are aware of the various views involved with that and we'll evaluate it as deemed appropriate.

Okay. Thanks a lot.

Thanks.

Your next question comes from the line of Joshua Pollard. Your line is open.

Hi, good morning or good afternoon to you guys. Another question on land, the topic du jour -- you seeing banks willing to take land option deals -- in other words, offer you guys options? The thought process is banks have the land improperly marked and you've discussed that earlier. But they can take the capital hit to quickly transfer ownership of the land on their books, so they instead try to earn their way out. And so as opposed to quickly transferring ownership, they just wait it out by optioning the land out to home builders. Are you starting to see some of that come to the market or are you still only seeing cash deals from banks?

I think that we see both a bank that is financially strong and the assets are properly valued. It's easier for them to achieve more money by doing an option transaction, because you'd get a higher return. Those institutions -- you might think it in reverse that the stronger ones would be inclined to drive for cash. It deals with the accounting.

If the banks have truly scrubbed their balance sheet and marked these assets, it's to an advantage to sell it for cash. But it's also to advantage to actually receive more total dollars by having a more of a rolling option program. So it really deals with the individual financial institution, depending on where they are in the process of marking it to the net realizable value or present value proceeds versus an ultimate dollars recovered. And as you look at investments, an IRR has one calculation, but total dollars received is another. And I think really, it's specific by financial institutions.

Additionally, some of the larger financial institutions have a multitude of assets that they have to develop a strategy on what they're going to do. And the government is getting close to giving clarity of a theme of what they want them to do. But you have a public profile of regulators and then you have regulators on the ground that are actually doing the work, you might call it like the career people. And the career people are being proper and conservative and dealing with how the banks should market. And sometimes the public profile is trying to make it a softer image, but the reality is the banks are working on it and those that have strength and discipline and capital are dealing with it more quickly.

So the simple answer is not simple. It's really -- not only is it asset specific, but it's financial institution specific, and that's what gives both the opportunity and the problem for the bank and the developer and it goes in both directions.

I guess you're softly referring to the PPIP in your comments. Is there any update there since they made the announcement of which financial institutions could participate? Or are you still having conversations with the FDIC and with those financial institutions? And I have a follow-up.

They only announced it in the last week or two and I think it's very very premature. Discipline in this business isn't days or weeks. It's months and sometimes it's years. And there's a story that you can buy in 10 minutes that which you can't sell in a lifetime, it's worth remembering.

Those are actually precious words. Additionally, quick question for Chris. A couple of different financing options out there for you guys with so much cash. Wouldn't expect you to use $1 billion on land in the next couple of months, repurchases of debt, significant investments with money managers to some of your payers, and even if you guys are feeling really good, share repurchases. Could you rank the attractiveness of some of those options?

We evaluate everything at all times, I'd say that's accurate. In fact, I talk to Larry every morning at about 6:00. And we've looked at all those, and one thing we've done is we've looked out and said what do we look like over the next five years, under several different scenarios of land acquisition, option, what does our capital structure need to look like under a few different scenarios. And what that's said to us is we need to, we want to preserve that flexibility because the opportunities as Larry talked about on land -- things are changing and they continue to change.

I would say we're focused on not the short-term, but we're focused on what we're going to look like over -- as Chris said, over the next five years. And we believe it on a prospective long term basis it's a great opportunity for us. And we want to maximize that, and that's what we're doing day-to-day.

Thanks guys.

Your next question comes from the line of Dan Oppenheim. Your line is open.

Thanks very much. I was wondering -- as we think about the margins and such, there's significant warranty reserve reduction this quarter and also some in the first quarter. Should we expect more of that coming through the remainder of this year, or do you think that's generally out of the way at this point?

Well, we always will make that assessment in the quarter and we're going to book things on what we see at that time, so we took all of our known inputs and that's what created that reduction. The positive trend, Dan, is that our payment experience has been trending down.

Right.

So will it continue to trend down? I have not made the future projections. We're just going to take that look and apply our accounting on a consistent basis.

Okay, and then thinking about SG&A, the comments were that you'd look at the long term needs of the company. And I guess thinking about the count in land, if it's difficult for land to meet the hurdle rates and such, and so you won't likely have the land coming to you in 2010, or land available for building then -- should we assume that is SG&A is likely to remain at elevated levels as a percent of revenue then at least through next year?

I mean, I wouldn't say that it's going to be down at 15%, but it's a whole business model. And so we're focused not just on the SG&A dollars or percent. We're focused on the top line, on what do we need to do from a product, pricing, and location for growing our top line. And given the changes even in our markets with competition, we think that that's one lever that we're exercising pretty hard. And you saw some of that in our order numbers for this quarter. So we're working that. We'll work the margin pieces, and we'll continue to work efficiencies in our G&A spending.

Okay, thanks very much.

The next question comes from the line of Josh Levin. Your line is open.

Hi, good afternoon guys.

Hi, Josh.

I wanted to ask, what was the rationale to changing your spec strategy now? Was there something that happened about the timing that you decided to build more specs?

I think we focus clearly on both new product and a strategy that (inaudible) the higher gross profit margin. And this is an opportunity for us to create more velocity gross profits, and therefore, the higher specs that you saw at year-end last year were really almost old inventory and old models. So it's like most retail businesses. Got to get rid of last year's merchandise and bring in new models, new product, some cases new people, new process, new procedures, and where we believe we are building a model that we can achieve a similar gross profit margins by going to drywall hold where the consumer can come in and pick all of the finishes and they will be selected at the design center instead of at the sales site. And this is a much more profitable structure for us, since we have design centers in all of our markets.

Okay, second question, if the home buyer tax credit expires as scheduled in November, do you think it would impact demand for homes?

I assume it will have some impact, but our management approach is not relying on the tax credit being there or not being there. We take whatever consumer comes in the door and whatever the circumstances are, that's what we're going to deal with as we always have.

Thank you very much.

Thank you.

Your next question comes from the line of Carl Reichardt. Your line is open.

Hi guys how are you?

Hi, Carl.

I had a pragmatic question I guess about the spec and taking it to drywall stage. So if I'm a customer, do I have the option of walling in a loft or converting it down to a bedroom if I drywalled it in? And of course all my [permanent] electrics behind the walls -- are those options obviously not available to me, and aren't those pretty good margin options?

The margin options that I think as you do your fieldwork and I know you do, you'll see that options that are usually done at the construction site are really backed into the gross profit margin in the basic house. And therefore, we're focusing on those items that will upsell the product through the design center gross profits, which are usually at least double what the base home is. And there might be a few items that one couldn't do, but on the other hand our new product is designed with maximum design flexibility. And therefore, a few items that one could select, we might not be able to do. But the overwhelming majority of the consumers find that the product that we're developing really fits their needs completely.

And you said, Larry, just to clarify, you said the margins on what you sell through the design center are double what you'd get on the core box. Will you have a rough idea and is this changing of what percentage of the selling price of your homes consist of design center chosen options?

I didn't hear Larry say that they were double, but --

I thought I did. Maybe I was just imagining it.

Okay. We would expect that as we're successful with our product that that would take up a bigger piece of our revenue on that home.

In the past, in prior years, when we probably had more consistency, we believe it added at least 200 basis points to the gross profit margin of the product. The design center, because design center items which is wall covers, floor covering, cabinets, and other products that we're now providing, have a different markup than the basic home. And this is the business model that we believe, because we're able to deliver a new home personalized in 30 to 45 days from drywall hold, which would be about the same that you could do on a finish tone. And also, it competes very aggressively with someone who needs the dirt start. We're still in a market that people that own homes want to sell their homes, get paid, or sell their homes and know where they are before they buy the new one, and they want quicker deliveries. And we are able to provide that by doing this.

Your next question comes from the line of Alex Barron. Your line is open.

Thank you. I wanted to ask you guys -- I guess we've talked a little bit about the SG&A. But focusing in, not looking at the commissions and the marketing which obviously has come down, the other two line items which I guess are more corporate, are you guys basically at the point where you'd be cutting into bone if you keep cutting further? Or is there more opportunities where we could see more of these dollars come down so that you guys can start I guess achieving a level of profitability at the operating margin pretty soon?

Well, if you look at just numbers overall and what's happened to our company year-over-year, at the peak they were over 4,000 people. A significant reduction happened all the way up until about 1,600 people last year at this time. And even since last year at this time, there was a reduction of about 600 people, so we're continuing to look at how do we do things more efficiently, how do we leverage people better, what activities do we need to focus on, what things really drive value and what don't. And we'll continue to do that forever. So we're looking at all pieces of it.

Okay. My other question, slightly different subject. I guess I saw you started picking up a few option deals in a few markets. Wondering what I guess IRR or gross margin you guys are building into those deals. And then I also noticed in your land position or in your backlog it seems Chicago went to zero backlog. So are you guys exiting that market or you're just mothballing it for now?

Well, we actually exited Chicago, and have been really just getting rid of or selling the last of our homes there. And the other pieces, those are normal course of business for us. We're in building homes, and in some cases when the right location at the right price is there, then we're going to pick up that option or pick up the land.

The next question comes from the line of Eric Landry. Your line is open.

Hi, thanks. Larry, I enjoyed that 10 minute comment.

On which part?

Both. I guess I'm just a little concerned that you guys have been proactive throughout more so than any other builder, yet the amount of activity I am picking up at most of these land auction, whatnot, may mute that benefit. And in other words you guys have worked so hard and are in what I would call the catbird seat. But the fact that there's so much capital out there right now, it may not be as good a situation as I had originally thought. Any comments on that?

You bet. The nice thing with others with capital, they create opportunity because those that pick up some of these parcels of land -- usually the second phone call is to use like guess what, we bought this, what do you think? And we look forward, working with our competitors, the speculators, the land bankers, whoever is out there buying assets or has them, we have an open door. And I think over the next period of time, it will turn out to work very well for us, because we are a user of product and -- we are a user and we have the resources.

And in 2005 we were the first ones to go to reduced assets. We didn't do a lot of things over the last five years. And I believe our track record and our vision is really clear whether it takes a quarter or two quarters or a year or two years, we know exactly where we are, where we're going and we look forward to working with everybody that ends up with these lots. Because ultimately, someone has to build a house on it to create a liquidity event and there's room for everyone.

Okay, thanks. Last question, Larry, would you hazard to maybe size the opportunity here relative to say 1991 or 1990?

Boy, I wish my memory was that good. It's different this time. Every cycle -- we've done this for about 40 years and every cycle has its own nuances and I think that during different cycles, sometimes real estate was in trouble. Sometimes it was residential. Then it was commercial, and then the energy business that was in and out of trouble. This time it seems like many of the industries are in trouble, different segments of the economy has been in trouble.

But if you look at the worldwide situation, there's been so much in trillions of dollars throughout the world thrown at this issue, residential housing was the first segment of the economy maybe in many parts of the world that got in trouble. I do not believe housing will lead the economies of the world out of the current recession, but I do believe in the United States that basic housing, single family detached, owner occupied affordable will have a lot of opportunities over the next period of time. And that's what we're really good at and that's what we're going to focus on, but it does take time and discipline and we have both.

Your next question comes from the line of Jim Wilson. Your line is open.

Oh, thanks. Good morning guys.

Hi, Jim.

I think all I really have left to ask is really about the gross margins, and Chris, if you could give any more color on difference by geography or levels of improvement or any relative change? Just trying to figure it out if there's any varying pattern you're seeing and how profitable or less profitable some parts of some regions of the country are for you?

Jim, in our Q, you actually can see the breakdown of our margins by the major groups -- West, East, Mountain, and Other. And when you look at that, you actually think through that and analyze it, what you see is the significant impact of impairments on those results. So the West was the most heavily impaired, and in our most recent Q, they actually -- out of our regions have the highest gross margin.

So you actually get into some unusual comparisons, and so one of the things we've done is we've looked at -- I've looked recently at all of our subdivisions, and I want to see what the contribution margin is on homes in those subdivisions ex land. And looking at that because you get into some interesting compares when you try and include all of these prior period impairments from five, eight, 10 quarters ago. But we've got the breakdown in the Q for you and we've got the description about which ones -- what the percentages are. But you can see that the West has a significant margin in this quarter of 26.5%, the Mountain has 8.5%, East is 14.5%, and really Jacksonville, Florida is 10.8%.

Okay, great. All right, that's helpful. Thanks.

Okay.

Your next question comes from the line of Jay McCanless. Your line is open.

Hi, my question has been answered, thank you.

(Operator Instructions). Your next question comes from the line of Ivy Zelman, your line is open.

Good afternoon, guys. I thought I was in the dog house, Larry. I didn't think you were going to let me on for a minute there. But thanks for having me. And I think what I'd like to ask and talk about is the fact that your company today has gotten lean and mean and I think we looked at your closing. I mean you're back to the number of lots you own with back to like 1983 levels. It's clear that you guys are ready for action. My question pertains to action. If you were to see a significant rebound in demand for housing, what do you think the realistic rampup could be in terms of growing units, in terms of your capacity and staffing and relationships you have with respect to getting the utilization rate up to a level that would be achievable? Can you grow at 20% if demand was growing at 20%? If demand grew at 50%, would you be unable to grow at that pace with demand?

I think, Ivy, we're structured to grow as quick as the demand. Remember the movie Field of Dreams? We are dressed, ready to go, and we are in a position to take whatever growth comes in the marketplace and excited and looking forward to it.

You don't think there's a human capital constraint, that you'd find yourself in a position where you didn't have tenured experienced professionals because you've had to unfortunately reduce headcount? That it might mitigate your ability to keep pace given the small position you were relatively in today compared to others? I think they have an advantage because of their human capital they've maintained or just their staffing has not been reduced as strongly as yours. You do not see that as a competitive disadvantage?

No. I'd say that we have the best management team at all levels that we've had since we've been in business. And the business model of what we're looking at in the future has an expectation of substantial growth as the market allows. But the human capital will not be an issue. We are well prepared to react quickly.

Okay. When you look at your sales today and you think about the number of units you're selling and the G&A per unit, and you're realizing the selling component will be somewhat likely variable with your volumes in terms of the cost for those units -- if you were to think today you've reduced G&A pretty substantially per unit, is there more to go? Is it another 5%? You can only grow profitability so much for cost cutting before you really rely in on volume. Where would you say you're in that position today in terms of the magnitude left to go? And then assuming that there is a point of no return, where you're going to have to get volume to grow the bottom line?

Well, one of the elements that is mixed into what we have in G&A is expenditures and time and effort for the future -- that if you were only dealing with the present and you wanted to be lean and mean, we've gone from 4,300 people down to a little over 1,000. And if we were looking for short-term pleasure, I'm sure we could have a substantial reduction of G&A -- and I'm speaking to G&A non-related to the variable of the sales. But we have publicly said for I'm sure at least a year or longer that we are rebuilding and structuring our company for the future. And there's a price you pay, which is being expensed on a current basis as appropriate for being prepared for the future. And that's a business judgment that we've made. And I feel highly confident that in the future, we will look back and you'll say, Larry, it was painful that you spent that money when things were not as robust as they are now, but it looks as though it worked out well for you. And that's the business risk and the judgment that we have undertaken.

Your next question comes from the line of Adam Rudiger. Your line is open.

Hi. I wanted to ask you about the Illinois exit? And if you could talk about some of your thought process in the exit and what were some of the decisions and the factors you considered to help make that decision?

Because we're done in Illinois. We should really have shut down last year. We publicly announced over a year ago that we were exiting. We didn't see that this was a market that we needed to be in over the next few years. In this industry sometimes you come and go into markets, and we thought it was the appropriate time to exit Illinois. And it turned out to be accurate.

So I think you have what, 140 or so lots there still, the plan is to just sell those?

Yes.

Not build on them, just land held for sale?

Yes. 141, I think.

Okay. If my memory, it's obviously not very good since I didn't remember -- but can you talk about maybe what at the time or what were the decisions or your thought processes that go into deciding to stay in a market or not?

Well, there's market conditions, and the market conditions in Illinois, we didn't see that it fit into our strategic shorter term strategy. And therefore, we reduced and closed the division. And it's been in this mode for over a year.

There are no further questions at this time. Mr. Martin, I'll turn the call back over to you.

Thank you. We appreciate you joining us on the call and we look forward to seeing everyone after our third quarter earnings release.

This concludes today's conference call. You may now disconnect.