MDC Holdings Inc (MDC) 2011 Q3 法說會逐字稿

Good afternoon. We are ready to begin to the MDC Holdings Inc., Q3 2011 earnings call. I will now turn it over to Bob Martin, Vice President of Finance and Business Development. Sir, you may begin your call.

Thank you. Good morning, ladies and gentlemen and welcome to MDC Holdings' 2011 third quarter earnings conference call. On the call with me today I have Larry Mizel, Chairman and Chief Executive 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 that participants limit themselves to 1 question and 1 follow-up question. Please note that 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 the forward-looking statements. These and other factors that could impact the Company's actual performance are set forth in the Company's third quarter 2011 Form 10-Q, which was filed with the SEC earlier this morning. 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 will turn the call over to Mr. Mizel for opening remarks.

Thanks, Bob. Good morning, everyone. We're excited to be able to present those achievements that we started on during the second quarter. We announced a very focused endeavor and here we are in the third quarter, kind of reporting pretty much a wide spectrum of initiatives. As reported during the second quarter, we began to make changes of our business, in light of the weakening economic conditions. During the third quarter, we aggressively accelerated our efforts by reducing overhead, changing key processes, and modifying our capital structure. Our goal is to achieve profitability without the benefit of an improvement in overall market conditions. In the third quarter, we made the decision to reduce our headcount by more than 100 positions across our Organization. As a result of this decision, and previous cost reduction efforts, our general and administrative headcount has decreased by 33% year-over-year, which equates to approximately $20 million of annual savings for the Company. These changes have flattened our management structure in many areas of our organization, eliminating high positions in areas such as information technology, mortgages, division management, national home building operations, national land, national marketing, and human resources.

We have also made changes to our sales leadership and have begun to change certain aspects of our sales process. Our goal is not only to increase absorptions and gross margins, but also to simplify our business model, allowing us to operate more effectively with substantially lower overhead. Over the past 18 months, we have relied on large promotions as a critical component of our sales and marketing strategy. These promotions were successful in producing a sense of urgency for our sales personnel and customers. A side effect, however, was increased volatility in sales absorptions and cancellation rates, which complicates the management of our day-to-day operations. Therefore, we will rely less on these large promotions in the future. Also, we previously announced a shift in our strategy away from production and sale of speculative inventory homes. Spec homes historically have yielded margins significantly below those homes that were started with a buyer under contract. In most of our markets, we have started very few spec homes in recent quarters, resulting in a 45% year-over-year reduction in our supply of spec inventory. This strategy benefited our overall margins in the third quarter. However, at the same time, it also decreased both our pace of home orders and our backlog conversion rate. We continue to believe that the margin benefit from this strategy outweighs the corresponding loss in unit volume.

Because we have moved away from building speculative inventory, our commitment to offering our buyers an opportunity to personalize their homes has been an increasingly important part of our sales process. Therefore, we have spent considerable time evaluating and streamlining our personalization process, including the operating model of our home galleries across the Company. Finally, we have announced that we will retire nearly $500 million of debt by the end of 2011, which will reduce the annualized amount of interest we incur annually by $30 million. Given that we have substantially reduced our land acquisition activities, we believe that this reduction of our debt better aligns our capital structure with our current capital needs. Following the completion of these debt redemptions, we anticipate that our cash and investments will still exceed our total debt and no senior note maturities until the end of 2014. Thank you for your interest and attention. I look forward to providing additional updates on our progress towards meeting our goals of profitability in the coming quarters. For now, let's turn the call back to Bob for more specific financial highlights of our 2011 third quarter.

Thanks, Larry. Turning to the next slide. The chart you see here shows the metrics that typically are the major drivers of our income statement. During the 2011 third quarter, we saw a 2% decline in closings and a 3% decline in average selling price, which drove our home sales revenue down by 5%, from $216.5 million in the third quarter of last year, to $204.9 million this year. In addition, our gross margin percentage declined by 500 basis points year-over-year, from 20.9% in the third quarter of 2010, to 16.8% in the third quarter of 2011. This decrease combined with the decline in home sales revenue resulted in a $10.9 million decrease in our gross margin. It's important to note, however, that on a sequential basis, our gross margin percentage improved and I'll get into more of the details on that in a moment.

Offsetting the decrease in gross margin was a $5.4 million decrease in our SG&A expense, reflecting some of the work we've done over the past few quarters to reduce overhead. Although SG&A as a percentage of home sales revenue came down in the third quarter of 2011 versus a year ago, it still sits at a relatively high level of 25.9%. As you can tell from Larry's comments, this is an area of high focus for our Company and the actions we have taken in the third quarter with regard to headcount and other areas of overhead expense should immediately help us to drive SG&A lower on a gross and percentage of revenue basis. The bigger driver behind the change in our income this quarter is the $18.6 million charge we recognized for our previously announced debt tender offer, which closed in early July. Also, we incurred $7 million of asset impairments and project abandonment charges compared with $3.7 million a year ago. Overall, our pre-tax loss for the third quarter was $34.2 million, compared with a $10.6 million loss during the same period last year.

Moving to home closings on the next slide. We closed 707 homes during the quarter, which is down slightly from the 722 closings we had during the same quarter last year. Typically we would have expected closings to be higher as we started the quarter with backlog that was 28% higher than a year ago. However, the percentage of our backlog that was under construction to start the quarter was much lower than a year ago -- 59% to start the third quarter of 2011, as compared with 78% a year ago. Said another way, the number of units in our backlog that were under construction to start the quarter was actually down slightly versus the prior year, 843 at June 30, 2011, as compared with 865 at June 30, 2010. As a result, our backlog conversion rate was 50% for the third quarter, down significantly from 65% a year ago. While the 50% backlog conversion rate is low when compared with recent quarters, it's actually right in line with our 10 year average for the third quarter. The drop in our conversion rate is a direct result of our change in policy on specs, which has driven our sales volume away from speculative inventory and into dirt start units. We believe the margin we gain by shifting away from speculative inventory more than offsets the decline in our conversion rate.

Home closings decreased in most of our markets with the exception of Florida and Arizona which saw increases of 117% and 15%, respectively. Also, we had 49 closings in Seattle, which was not yet a part of our operating footprint in the third quarter of 2010. The average selling price of our closings decreased 3% year-over-year to roughly $290,000. The increase was driven largely by a change in the mix of homes we close. As I just mentioned, the mix of our closings shifted in favor of Arizona, Florida, and Washington for the third quarter, all of which are among our lower priced markets. We also saw some significant declines year-over-year in the average selling price in 2 of our higher priced markets, California and Virginia. 1 other note. New subdivisions defined as those acquired in 2009 or beyond accounted for 71% of our closings in the 2011 third quarter, a significant increase from 31% a year ago. Moving on to home gross margin.

This slide shows the quarterly trend from the third quarter of 2010 to the third quarter of 2011. As reported, the chart you see in the upper left-hand corner of this slide, our margins were 16.8% in the third quarter of 2011, compared to 20.9% in the third quarter of 2010, and 13.1% in the second quarter of 2011. In the lower left corner of the slide, you can see the trend excluding the impact of interest and cost of sales and warranty adjustments. On this basis, our third quarter margins were 18.9% in the third quarter of 2011, compared with 20.2% in the third quarter of 2010 and 14.9% in the second quarter of 2011. Note that our third quarter margins did include a $2.3 million benefit related to the settlement of a construction defect claim in Colorado as well as a $4.1 million benefit related to unused land budgets in California.

If those 2 benefits were taken out of our third quarter adjusted gross profit margin, we would see about a 300 basis point decline from 18.9% to 15.9%, which is still up by about 100 basis points from where we were in the second quarter but still down significantly year-over-year. That year-over-year decrease in the gross margin was largely a result of accepting lower margins to drive volume, especially on older speculative inventory, consistent with our focus on reducing our speculative inventory count earlier in the year. We've also seen some price deterioration year-over-year in a few markets. Looking at the sequential improvement in margin, after taking out the 2 benefits noted on the slide, we believe that the improvement is attributable to our new strategy on specs. In the third quarter we drove the percentage of our closings from spec homes down to 55%, a significant change from the second quarter when 79% of our closings originated from spec sales.

Moving on to selling expenses. Overall we are down year-over-year. Commissions expense was $7.5 million for the quarter, down from $8.1 million a year ago. The decrease is consistent with our decrease in home sales revenue but is also related to a decrease in the percentage of buyers who are represented by an external broker. Marketing expenses decreased by 11% from $11.2 million in the third quarter of 2010 to $10 million in the third quarter of 2011. The decrease was the result of reduced product advertising costs, most notably, cost for signage. Turning now to G&A. The $35.6 million we incurred in the 2011 third quarter is down from the $39.3 million we incurred a year ago. The primary reason behind the year-over-year improvement was a $7.3 million reduction in compensated relation expense. Most of that decrease is attributable to our significant reduction year-over-year in headcount which I will talk about in more detail in the next slide. Offsetting those savings was a $3 million expense that we incurred to increase our loan loss reserve.

On the next slide I've given you a graph to show you where our headcount has gone since the end of 2009. We reached a peak at the end of the second quarter last year as we added individuals to our team to manage the considerable growth we expected in our community count driven by an increase in our land acquisition activity starting in the second half of 2009. However, after the tax credit ended and the home building market softened, we again started reducing our employee count. Over the past 12 months, we've reduced our headcount by 33% -- 262 positions in total that carried an annual cost of approximately $20 million. The decrease in our overall headcount would have been more significant were it not for our entry into the Seattle market which added about 60 employees to our payroll in the second quarter of 2011.

During the third quarter alone, we reduced our G&A headcount by 104 positions which carried an annual cost of approximately $9 million. At the end of the third quarter, we stand at 943 total employees, including 531 who are in our G&A account. To give you perspective, would you have to go back almost 20 years to 1993 to see the last time our head count was that low. It's important to note that we are looking at our Organization top-to-bottom when evaluating our headcount. In the process we've removed layers of management at a very high level with the goal of reducing the overall complexity of our Organization. Looking at our expenses beyond our reduction in headcount through the end of the third quarter, we've identified about $5 million of additional savings versus our third quarter run rate and we expect that we will start realizing the benefits of those savings by no later than the first quarter of 2012.

Next slide is home orders. In the third quarter we received 595 net home orders, which was a 25% decrease from the same period last year. Looking at individual markets, we saw declines across the board with the exception of Nevada, which was flat year-over-year. These decreases were partially offset by the sales we received from our Seattle market which was not a part of our operations last year. Gross home orders were down by 7% year-over-year and our cancellation rate increased from 30% in the third quarter of 2010 to 44% in the third quarter of 2011. Traffic for the quarter decreased by a little bit more than 10%. We ended the quarter with 1,312 homes in backlog, up 10% from the same time last year. Our average price in backlog of $308,700 at September 30, 2011, is even with $309,800 average price in backlog at September 30, 2010.

To give you a little more color on our third quarter orders, the next slide splits our third quarter gross orders to show the trend for both dirt orders which are sold before construction begins and spec orders which are sold at some stage during the construction process. We were successful in increasing our orders for dirt homes. Both in total and on a per community basis, consistent with our spec inventory strategy. However, these gains were more than offset by a decrease in the number of specs we sold. Given that we started the quarter with only 496 specs available for sale, we didn't have the opportunity to get to the 743 spec sales that we had last year. Keep in mind that to drive the level of spec sales we did last year, we offered significant incentives that hurt our gross margin in subsequent quarters. Our new spec policy is designed to avoid this kind of margin erosion. By limiting the supply of specs we carry, we believe we have a better chance of holding the line on margin.

On the next slide, taking a closer look at cancellation rate, our as-reported cancellation rate that you see in the top left corner which is total cancellations divided by gross orders, that did increase year-over-year to 44%. However, when you look at our cancellations as a percentage of the beginning backlog, the graph at the bottom left, you can see that the rate we experienced in the third quarter was flat year-over-year which tells us that the number of cancellations we received in the third quarter was not unusual given the size of our backlog. The reason our cancellation rate appeared so high when measured against gross orders is that many of the cancellations are coming from a large sales promotion that occurred at the end of the second quarter. So in the end we had somewhat of a mismatch between cancellations and gross sales.

Next, on active subdivisions, this slide gives more detail on our subdivision count. For each period shown here, the light blue bar represents active subdivisions which are projects that have sold at least 5 homes and have at least 5 remaining to sell. The brown bar gives you a sense for the subdivisions we believe will become active soon. They have started construction or sales activity but they do not yet have the 5 sales necessary to reach an active status. And the gray bar shows the number of subdivisions that are currently active but are close to reaching inactive status. You can see that our active subdivision count continued to increase this quarter, up 28% year-over-year and 3% sequentially. However, the number of subdivisions we have coming online is declining, largely due to a decrease in our acquisition activity. The number of subdivisions that are likely to become active soon still exceeds the subdivisions that are close to reaching an inactive status. The spread between the 2 is 8, which means we have an opportunity to grow our active subdivision count in the near term. As we look at our potential to grow community count longer term, we focus on our acquisition activity as shown on the next slide.

For the first time in 5 quarters, our net activity has gone negative, meaning that we relinquished control of more lots through option terminations than we added to our control through the approval of new transactions. As a result, our lot supply decreased from about 12,000 lots owned and optioned to start the quarter to about 11,000 at year end. Year-over-year, our lot supply has decreased which by about the same amount. While we are taking a particularly conservative approach to land acquisition right now, we still are reviewing new potential land transactions almost every week. As continued uncertainty persists in our industry, we will be cautious to select transactions that minimize our need to expose capital to a turbulent marketplace. Given the strength of our balance sheet, however, we have the ability to quickly transact if market conditions change or if we see an attractive opportunity going forward. Our final slide takes a look at our -- at the impact of our recent and upcoming debt repurchases.

Larry has already told you about the magnitude of the debt we are retiring as well as how much our interest incurred will decline going forward. The graph you see here shows how the changes we are making will better align our capital structure with our capital needs. You can see that our senior notes balance has significantly exceeded our inventory balance for each of the past 5 quarters. In this situation, a portion of the interest we incurred is immediately expensed on a routine basis, impacting our bottom line. However, on the graph in the September 30 pro forma scenario that you see here, which is simply based on the execution of the debt redemptions that we have already announced, our debt falls back in line with our current inventory which will allow us to substantially reduce or eliminate the amount of interest that is directly expensed on our income statement. Our $237 million debt tender offer was completed in the third quarter, resulting in an $18.6 million charge. In the fourth quarter, we will complete a total of $263 million in redemptions which will result in a charge for the quarter of $22.8 million. I should also note that we expect that our cash and investments balance should still exceed our debt after the last redemption is finalized and our next debt maturity will not be until December 2014. That concludes my prepared remarks. And at this time we will open the line for any questions you may have.

(Operator Instructions)

Your first question comes from the line of Michael Rehaut from JPMorgan. Your line is now open.

Thanks. Good afternoon, everyone. Good morning, out in Denver, I guess still. First question on the gross orders and net orders sales pace, it seems that at little under 1 on a net basis that that's a rate that's fairly below your peers and I recognize that there might be some timing issues with the change in strategy but is that a number that you can expect to get back to 1.5 or 2 over time as you transition from the spec to the dirt strategy?

Michael, I think you could feel comfortable that we're going through a short timing differential and that we expect to be back to where we were and hopefully do better in the processes and procedures that we have instituted that should be more effective going forward than where we have been. But your analysis is accurate. It is a transitional period. But we expect that to be a very short period.

Okay. Thank you, Larry. And the second question, and I don't know if Larry or Bob, you can answer this, but with the reduction in debt and the reduction in interest incurred, can you just remind us where you are right now on an annualized rate pre-debt buyback in terms of the interest that's been expensed through the P&L and what that would be if it would just simply go down by the $30 million of interest incurred or would it be something a little less than that, if you can just help us out there or would it even be greater than that, given the change in inventory to debt?

I believe year-to-date the interest expense line item on our income statement is about $19 million, and 1 of the impacts of having our debt balance fall below our inventory balance is that we should be able to capitalize most of the interest that we incur. And therefore, under those assumptions, we would expect that interest expense line item that you see on the income statement to essentially disappear. Now, if our inventory levels change and again drop below our debt level, that certainly could change. And we will continue to incur interest through cost of sales.

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

Thanks very much. Was wondering and if we look at the cancellations and the specs, it seems that a lot of the cancellations likely came on homes that weren't yet started, so probably orders that came in at the end of the second quarter when you were having the promotions. Is there something that you're doing in terms of the sale process, the qualifying process? What do you think went wrong with that and what's the change taking place now with the -- you said there's new people running all these different areas?

I think the last comment is a very important one. We have changed out our leadership in the sales organization by a substantial manner and we expect those effects to be immediate. The slowdown during that particular period really was a matter of the change in process and procedures and the procedures will expedite the sales process from the time of contract, from the time of the purchaser making a decision to buy the home to the time of a contract and mortgage transparency, financing transparency will be substantially shorter. Additionally, the complexities of the design centers that play an important role have been substantially simplified and pretty much everything that you see on the slides and the press release, a material amount of them took place in the last quarter in the changes and what you're seeing is the result of these activities that will solidify and streamline and make more efficient our operation and we believe strongly that our velocity and our gross profit margins will increase also.

Okay. And then I guess in terms of the community count going along to some extent with the philosophy there, should we expect basically to see a real slowing of that community count especially apparent as we get into next year, given the comments in terms of -- or given what we're seeing in terms of new communities coming on line but also slowing down the new community opening or acquisitions?

I think what you'll see is -- our goal is -- I have to emphasize goal -- is higher performance of our existing subdivisions and I think that will speak for itself. If you go back in history, we always tried to operate on a 2 or 2.5 year supply of land and because of the slowdown in the market and our land repurchases, we probably are in the range of 3 to 4 year supply. So what we're doing is tightening up our structure in order to increase our velocity in our inventory turns. And as you know, a slight improvement in inventory turns is a substantial contribution to the bottom line and we are focused on that very intensely and as Bob said, the pick-up of selective additional subdivisions will be in line with the current market conditions and absorptions, so we will be more in balance with our previous performances that we've had in prior periods of time versus this current period of time.

Your next question comes from the line of Ivy Zelman from Zelman & Associates. Your line is now open.

Thank you. Good afternoon, everyone. Larry, recognizing that it's difficult to always look back at strategies you've implemented in the past, I guess the first part of the question is how long is this transition do you think going to take to work? And then secondly, with the strategies that you've implemented in the past dating back to '09 and starting drywall as a way or just speccing to drywall or being promotional or now not being promotional, what do you think has gone wrong with the prior strategies that has not worked and understanding that -- is it really the Management that you've now let go, that it was really decisions they made that you allowed them to operate autonomously? Because I remember when you were approving people with basically as long as the salesperson can sign someone up, don't worry about their credit, worry later. So I think there's been a lot of things over the last 4 years that haven't worked, that you've tried, and we're kind of just curious to why you think this time it will work?

Well, Ivy, I think that's a good observation and it's probably like talking to a portfolio manager, why he picked some bad stocks but had a good idea. I'd like to start off with what did work and then I'll talk about what didn't work. What did work is in 2005, I nailed it when we created the liquidity that allows us to have net liquidity over our debt, and that was in 2005. And seeing that that was the peak of the market, we increased our liquidity in a material amount over the ensuing 4 year period and when we got to the back end of 2009, we believed that the market was going to develop some legs on it. And in 2010, we were aggressive in acquiring new subdivisions. I believe that those were the right moves at the right time and as the economy deteriorated and consumer confidence hit an all-time low and the Fed couldn't figure out kind of what to do and that's how we had -- remember, we had '08 and '09 cooking in there and when we went in in '09 and started purchasing, we thought we were picking off a good timing. We were wrong. We started too early. And in '10, the lots that we acquired, since we don't speculate in land, almost everything we own is fully finished, developed, doesn't need any work to it and is ready to roll. So in order to purchase those lots in 2010, the tax credit that the government had created probably more velocity than we gave it credit for, because when the tax credit --

Larry, may I interrupt? Larry, may I interrupt? I think everyone can look back at the history and understand that things didn't go right in the economy, et cetera. But I guess a lot of reasons and excuses of what didn't work and why, but what gives you the confidence now, because last quarter Bob Martin was quoted as saying that you were using aggressive promotions and that it wasn't a margin hit. In fact, you were creating great value for the consumer and there's been -- from our perspective, we're listening -- but we want to know going forward what gives you the confidence, not what happened. We know for the last 4 years things didn't go right and what we want to better understand is why will it go right going forward?

Fair question, Ivy.

Okay.

We said in nice words that we flattened the management lines and the difference between David and I and on the ground is we've eliminated a whole level of Management that we believed was useful and necessary for growth and by us accepting and making the comment last quarter, we were going to be profitable and by us accepting the fact that the economy was not getting better, that there wasn't going to be an increase in velocity in sales, except around the $300,000 annualized unit, we know that we needed to direct the marketing and sales and construction and all those aspects more of on a simplified manner and the people that made this Company great are more directly involved. And because of the size of the Company is now adjusted to market conditions, you should and can rely on the fact that our focus is very intense on the decisions we make. When they're made, they're executed very quickly and I don't ask for anything other than, okay, we've tried X, we've tried Y, and you know what? We're doing what we know best, which is building and selling homes with a proper gross profit and a high quality home and by the way, our execution time frame I'm not asking for years, I'm saying over the next month -- quarter or 2, you will see in absolute numbers the results of the things that we've set forth.

Your next question comes from the line of Nishu Sood from Deutsche Bank. Your line is now open.

Thanks. I wanted to ask about the transition from spec sales to dirt sales. It's progressing and it clearly from the numbers that Bob laid out. It took a pretty heavy toll from a volume perspective. Obviously, your gross orders being down year-over-year, despite the substantial increase in the number of communities by your count. The closings was obviously affected because you had less of your backlog under construction. And the reason for shifting to dirt sales was to boost gross margins but we really only saw 100, I think maybe a little more than that, basis point improvement in gross margin. So my question is, is that all we can expect from this shift or are we just in the early stages of seeing the gross margin benefit of that?

You're in the very, very early stages and you could see the benefit of that shift more substantially over the next few quarters.

Okay. And just another related question. Maybe I'll just throw out a popular concern that we hear from investors, that structurally your gross margins are going to be impacted for some time because of the significant amount of land you bought over the last 2 years and concerns that investors have that you overpaid for that land. Now, I was just wondering, I know that you've released some stats in the past, just the percentage of your sales, the lot cost as a percentage of your sales. I was wondering if you could just address that concern head-on?

I would say that we have -- if you look at the entire industry, we have probably 1 of the 2 shortest supplies of land in the entire industry. In fact, I believe it's correct, except for NVR. There's no one that has as conservative land supply as we do. The evaluation question is a good question. We had impairments on the land that we did buy, on some of it, but we have a process that we review it every quarter on a consistently applied method that has been in existence for several years and, therefore, the pricing evaluation that's on our books now is consistent with the methods that we have used for the last period of years and I think that covers both the valuations and the size of the land inventory.

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

Hello, good afternoon. You attributed some of the rise in cancellations to some of the promotions. You said the promotions drove the volatility. And I was wondering if you could elaborate on that? What exactly -- what kinds of promotions were they? And what's the connection? How do promotions actually sort of impact cancellations?

I think what we had was quality, aggressive sales promotions and in a sales promotion environment, sales are made through a more robust environment than maybe a normal transaction where you're looking to get homes that will be financed. You are in an environment that as your sales personnel and the marketing efforts you make and create a lot of enthusiasm, we had the misfortune that the timing of the consumer confidence probably hitting an all-time low during this last quarter with the conclusion of the sales programming, all came together at the same time. Additionally, the mix that took place and what was sold had more of a fall-out because of those circumstances and when all the numbers line up on the wrong side at the same time at the worst time, is what took place. And that is something we do not expect to reoccur.

Okay. And second question, in your Q, it looks like you increased your reserves for potential mortgage putbacks. And I was wondering, is that just sort of noise? Is there a trend here of gross putback attempts going up? What kind of color can you give us on that front?

That we've handled it over the last period of years on a conservative basis and that our reserves and our expenses have maintained it in a manner that it's not a material issue.

Thank you very much.

Operator. Your next question comes from the line of Joel Locker from FBN Securities. Your line is now open.

Hello, guys. Just with your new strategy going forward and not selling as many specs, do you think your backlog conversion rate will drop 15% or so year-over-year like in the third quarter, like going forward in the fourth quarter, first quarter and so on?

Joel, I think the best thing you can do is look at the numbers we've put out there. Every quarter we put out how many homes in our backlog are under construction and if you look at where we are at the end of September 2011, we have 871 homes that are under construction in backlog. That's about 66%.

Right.

Of our backlog. If you look a year ago, that number was 955 homes that were started in backlog. And that was 80% of your backlog. So that should allow you to make the calculation on where our conversion rates going to go.

Thanks. The other one, the other question on just your cancellation rates, obviously you want to control those a little bit going forward and you talked it about already on the call but just was looking at your customer deposits about 1.6% of backlog and industry average is probably close to double that. Was wondering if you were thinking about maybe changing that or increasing that a little bit to keep cancellations lower?

I don't think we have any plans in place to change that. We have been relatively consistent with our strategy on requiring deposits and we'll continue going forward.

Your next question comes from the line of Stephen East from Ticonderoga Securities. Your line is now open.

Thank you. Good afternoon. If we could talk about the gross margin first, just a few things. The first thing, understanding what unused land budget commitments were, the second thing on that, where's your gross margin in your backlog that you have right now? And then the other thing with gross margins I'm trying to reconcile is apples-to-apples you're about 15.9% of I think you said this quarter. Last year, it was about 20.2%. But you have less specs as a percentage of closings this quarter and the new communities are 71% of closings versus 33% last year. I guess trying to bridge, why wouldn't that be -- that 15.9% be significantly closer to the 20.2% we saw last year?

Let's see. I think there's a couple questions in there. First, looking at the year-over-year decline in margin, recall in Q3 of 2010, we were still bringing in closings with respect to the tax credit. They extended it to the end of September. So we still had some margins that reflected what was a positive environment earlier in the year.

Got you.

During that quarter, though, we were starting to sell homes at a significant discounts to get rid of our inventory and those particular orders that occurred in the third quarter of last year started really hitting our margins in fourth quarter and in 2011. I would also say we certainly have seen some deterioration in markets year-over-year, third quarter versus third quarter. There's no doubt about it. And that just means that we've had to accept lower prices in some communities.

Okay. That's helpful.

What were the other questions, Steve? I'm sorry.

What your gross margin was in the backlog. And then you had a benefit this quarter, unused land budget commitments which I'm not familiar with. What is that?

What happens is we have to estimate what money we're going to spend to develop our land and even if your lot is finished there are still costs that you have to put into the land. We do have to estimate that up front so that we can appropriately reflect it in our cost of sales. Now, in California in particular, there is quite a bit of risk with respect to land development. You have to put up a lot of bonding for the work that you do in California and therefore there's a higher risk that the municipalities are going to come back to you and require you to potentially do additional work that you don't originally anticipate. So our land budgets in California tend to be a little bit higher. Now, we have actually performed a lot better than that. We have done a great job in getting some of the old land deals finished and have not had to incur some of those extra costs in California. And because of that, we did not incur as much money as we thought for those budgets so we had to take that unused amount which had previously been expensed on our income statement through cost of sales and put it back through cost of sales. It gets really a little bit confusing on how that works but at the end of the day we made an estimate to start. It ended up being a little bit too high because of solid execution, we did better than we thought and it was a benefit that we recognized in the third quarter when we had closed those deals out.

Your next question comes from the line of Adam Rudiger from Wells Fargo Securities. Your line is now open.

Hello. Thank you. I wanted to get back to 1 of the first questions asked at about the resumption or acceleration of order pace and why this is only temporary right now. And I'm confused or I don't understand how that's going to happen, if you have some peers out there that in some cases are already more profitable and they're willing to build specs and are willing to promote and move to the market and how you think you can compete in that environment with those kind of competitors?

Well, we've always competed with all the competitors out there and we believe that our change in management team will have a substantial effect on that process. And our own internal processes, we believe that -- you know, as they say, the proof is in the pudding. We'll look back on it here in over the next few quarters to see if we're not accurate. But what we saw this last quarter was something unusual with all the unintended circumstances converging at the same time. And so competing with all of our -- all the other major builders is what we've done for decades and we're fully competent and capable of doing it in an aggressive manner and we're focused more on the gross profits and the velocity and I think this focus that we have will inure to the profitability of the Company.

Can you tell us though what -- I mean, it's not clear to me what this new Management's going to do from a sales perspective and you also mentioned streamlining some of the upgrade process and some of the new processes. Can you qualify what some of those processes are and what these changes are going to be? Because again, I know you said you mentioned you've been competing with these guys for a long time but if you just look at your orders this quarter, I recognize there are some 1-time events but they really underperformed some of your peers and so I just don't understand what you're going to do that's going to enable you to get that order pace back up, again, if your competitors are all willing to cut prices?

You know, everyone has had the ability to cut prices over the last 4 years and you have a deterioration in value of the homes and that's something that we always face and so do each of the builders. The stability in values in some of the markets we're in are actually improving a little bit and I think that what we've seen with the government's operation twist will be added value. The specific activities of what we're doing day-to-day and procedurally and in the field, I'm not going to discuss at this time.

Your next question comes from the line of Ken Zener from KeyBanc Capital Markets. Your line is now open.

Hello, everyone. This is Rodney Nacier on for Ken. I'm looking at the just your closings, your spec closings as a percent of your deliveries. And I know it was at 55% this quarter and that's down from 65% last quarter and 79% in the second quarter. But if I'm just trying to tie that back to the change in strategy that's going to be happening over the next few quarters, I mean are we looking for ratio to go down to zero or will there be some level of spec still left in the business model?

Because of cancellations you'll always have some specs and there will be some circumstances in select markets where it makes sense to start specs but I would expect that 55% number to go down. On the last call, we talked about a number closer to 30%.

Okay. Thank you. And just as I'm looking at the SG&A, you've identified about $5 million in additional savings that you're targeting for 2012. I know you have in the corporate expense line some ERP and things of that nature as well. Would that be something that's at this point closer to finishing in 2012 as well? Any updates there?

Yes, we only have w divisions left to be implemented for ERP and those will occur in 2012. 1 of them is Colorado. So that is close to home and doesn't require as much travel expense. The consulting expenses should go down a little bit as well. So in short, the answer is yes, some of it is ERP expenses.

Would that be the bulk? Because it was $15 million this quarter in corporate G&A versus about $18.5 million last year. So it seems like there's still a good portion that would continue beyond the ERP program?

I'm sorry, I'm not sure what you're referring to, $15 million of --

Of G&A.

Oh, $15 million of total G&A but not just --? We don't have $15 million of G&A related to ERP. I want to make sure that's clear.

I understand that but it's--.

It's not the bulk. What we're assuming in the $5 million, just to put a nail in it, the bulk of it is not just ERP.

Okay.

Your next question comes from the line of Mike Widner from Stifel Nicolaus. Your line is now open.

Most of my questions have been answered, guys, but I guess I want to come back to one that a couple people have mentioned and we're all I think sort of wrestling with. You know, the continued change in strategy -- I guess 1 thing I haven't heard you guys talk about yet is this is what our customers want or any compelling rationale that suggests this is why this is appropriate for this market, either the target buyer has changed, what the buyer wants has changed, we're moving away from spec because buyers want more custom. I mean, whatever the compelling rational is that has to do with the customer has seemed to be completely absent from the discussion and instead we're hearing a well, you know, we're trying a bunch of things. We've tried some things and we're going to keep trying things until we find something that works. And the latter is just much less compelling from sort of a strategic point of view. So I'm wondering if you can address that and is there any sort of customer-centric view at hand here? Or is it just we've got a bunch of new managers and they're going to try some new things?

I would say that between the end of the second quarter of this year throughout the next period in time that in many of the markets or most of the markets we'll also have some product change that is less expensive and more affordable to build and we can probably have a shorter construction period to reflect the efficiencies that are taking place in the design of the product and this isn't 1 group of good ideas after another group of good ideas, as you know, there's always a risk in trying to be a little early in what you do and when you make a mistake, it's like holding a position. We don't just hold it and live with it. We find that we've gone in different directions, very focused over the last couple years and we will continue to adjust our positions until we find an appropriate sweet spot in the execution of it. This is what we do and we believe that we're now focused in a way that will be transparent and properly rewarded with good execution.

Okay. So I guess what I'm still hearing is in that discussion, I mean it still feels a little bit like you get your senior management team in a room, you come up with some ideas and you're sort of groping around in the dark. Whereas I think what we hear out of a lot of other companies, both in this sector and otherwise, is look, we tried something, it didn't work. We went out and talked to our customers. We understand what our customers want, how the world has changed, how they want different products and what exactly they want in the development cycle, in the delivery cycle, et cetera. We're still just not hearing that from you. It just sounds like, well we tried some stuff, it didn't work and we're going to try some new stuff and we think maybe it will work. Is that the accurate characterization? Because it sounds like that's what you're saying.

I think what we're saying is that our management structure has been streamlined. We will have more efficient executions and all those comments that you've made of what builders do, builders do that every day as you get feedback from your line people on the sales and all of us continue to change. This is not a business of hey, let's try a good idea and see how it works. This is a business of trying to focus on being opportunistic in light of an ever-changing market and an environment. We were in markets that were fabulous. They were the ones that were impaired the most. The great places to live, whether it's Arizona, Nevada, Colorado, California, we had major operations. We've adjusted to the changing markets in each of those places and the adjustments we've made I think will be transparent in the very near future. That's the business we're in and we know the business well. We didn't just start 10 years ago. We've been at it for decades. And we've tried to be intuitive as we were to pull back. We've tried to be intuitive to go forward. 1 of the things perhaps we had a latitude to do is with having no leverage in the sense of having a high debt ratio, we've been able to try a few things that maybe others haven't been able to, and the success of it has not been satisfactory. We've acknowledged that we are making changes and we're working at it diligently and as I said earlier, the results will be transparent as they occur.

Your next question comes from the line of Stephen Kim from Barclays Capital. Your line is now open.

Thanks very much, guys. Larry, it wasn't that long ago where we had a conversation where I believe you were talking about the importance of having a more centralized operation or the value of a more centralized operation, where a lot of builders sort of talk about how the business is intensely local and it's really, they leave it up to the entrepreneurship of the divisional managers that you felt that there was going to be a trend towards increased centralization. And I was curious as to whether any of the actions that you've taken today and that you've announced would be still consistent with that view or if your view around that is being adjusted in some material way.

I would say it would be more consistent with that view in more of even an intense execution thereof and that was by us flattening the management levels. That means the execution is more direct and the hands-on view is more efficient.

Okay. Great. So in other words, like eliminating some of the layers to transmit the decision making from the top into the field, more directly.

Stephen, you said it better than I could. I want you to underline what you said because what you said is maybe what I've been trying to say and couldn't say it quite as clearly as you did.

I guess my next question relates to just your headcount reduction. Can you give us an idea of how much in terms of either individuals, how many individuals or how much of the overall savings you expect to glean are coming from Denver versus the rest of your operation?

By Denver you mean the --?

Yes, the corporate office.

Enterprise. I would say the more recent reductions centered a little bit more around the home office, whereas reductions previously, maybe early in the second quarter or in the fourth quarter of 2010 were more heavily weighted towards our field operations.

Okay. And put some numbers around that, I mean would you say the most recent announcement maybe are we talking 60% is more corporate office? Are we talking like 80%?

You know, I don't think I have the split out here exactly in those terms. We think of it more on a kind of an overall department basis, across our disciplines.

Okay. That's fine. Thanks, guys.

Thanks to you.

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

Thanks, guys. Larry, I was wondering well, first of all, you obviously have taken some concrete steps toward profitability, both by cutting your debt levels as well as cutting headcount. And you mentioned that that is your primary goal. So I'm trying to get a sense as to when do you expect, given everything you know, when do you expect we're going to start to see profitability at the EPS level? Is it within a year? 2 years? 2 quarters? That would be I guess my first question. And tied to that, I'm kind of wondering, do you expect you're going to continue to buy back more debt or you're just going to wait until it expires? And then on the SG&A, you have the highest SG&A ratio of your peers. Do you think it's going to trend back towards where your peers are at?

I'll start backwards. I expect our SG&A to come in line with whatever our gross revenues are in order to achieve our goal of being profitable as soon as possible. I would be extremely disappointed if we were looking forward in years versus a shorter period of time. Assuming the economy doesn't deteriorate any further, assuming consumer confidence doesn't further deteriorate, assuming Europe doesn't blow up and a few other things, I believe the activities and the actions that we have already taken will result in a substantial reduction of G&A and the profitability will be a predicated strictly on market conditions, which we are hopeful will remain consistent as I have previously stated, our goal is to be profitable at this level of sales in the housing market and you should judge us sooner versus later. But I won't make any predictions of when that is or that would be stepping outside of an area that we don't do. But we have done the things that have been outlined here that are a material reduction of G&A and those items will go through the expense line over the next couple quarters and be effective then.

Okay. Then my other question has to do with your land position. When I look at the value of your land versus the amount of land you have acquired in the last few years since you started growing land position again, it seems like the dollars have gone up way more than the actual number of lots. Is that a function of the fact that there's more competition for the land and the land is more expensive as time has gone by or is that more a function that you guys kind of impaired the land to very low levels compared to what market levels are at now?

I can't give it to you on the dime, but you know, the Mid-Atlantic and the California markets are more expensive than the Arizona, Nevada, and Utah markets. So it might be a function of mix of dollars versus unit counts. But the actual numbers I think if you look in the Q, I know they're in the K, the allocation of lots and dollars are fully disclosed in our documents. It's in the Q, too.

It is in the Q. And I guess the general response would be it's all of the above that you mentioned. There's a variety of different factors that has driven up our land per unit over the last, say, year or 2 years. But everything you mentioned probably applies to a certain degree.

Operator. Your next question comes from the line of [Mike Rich] from Ivory Capital. Your line is now open.

Hello, just had a quick question on some of the expense reductions that you've talked about. The $20 million of annualized savings, how much have you realized in Q3 and how much do you expect to realize in Q4?

The $20 million refers to year-over-year how much our salaries and compensation expense is down year-over-year, so at 9/30/2011 versus 9/30/2010. So when you look at Q4 2011 versus Q4 of 2010, you should expect that $20 million divide by 4, a $5 million benefit.

Okay. And then the $5 million of additional savings, that has not yet been implemented?

Correct.

Okay. And similar question for the annualized interest reduction, the $30 million that you had talked about, is that a Q4 number annualized or a Q3 number?

The interest, it's an interest incurred number.

Okay.

So we incurred roughly $30 million of interest for that $500 million of debt that we have retired or will retire. So that is different than our interest expense for a variety of different reasons. But as I mentioned earlier, when you look at year-to-date what our interest expense line item on our income statement was, it was about $19 million. And you would expect going forward after we complete these debt repurchases, that that interest expense line item will decrease or go away all together on our income statement. And of course, that is dependent on where our inventory levels go. In any case, we will always incur, continue to show some interest through cost of sales. We always have an interest cost in that line item.

Okay. Got it. So just to make sure I understand, the $20 million of interest or the G&A savings, if I look at your SG&A which I'm just adding up everything from marketing expenses down to other operating expenses, was $55.5 million in the quarter you just reported. A year ago it was $59.4 million. So that's decrease of about $4 million and if you annualize that, that's what you're talking about in terms of the $20 million annualized benefit?

No. We're talking about a point-in-time number. So our total payroll as of September 30, 2011 was down $20 million as compared with a year ago, meaning going forward when you look at our G&A year-over-year, you would expect a $5 million reduction per quarter based upon the overhead reductions that we've implemented over the past year.

Okay.

And I'd certainly be happy to discuss it with you in more detail off line if we didn't get that quite clear for you.

Yes, I'm just trying to understand what the run rate G&A is for -- SG&A is on a quarterly basis. Is it, you just reported about $55 million. Do you expect it to be $50 million on a run rate?

Well, let's take it from Q3 for a moment. The G&A expense in Q3 was $35.6 million. I had said earlier that we had about $9 million worth of savings from the headcount that we took out just in the third quarter. That's $9 million of annualized savings. Because those people came out during various periods in the quarter, effectively the expense that was in the third quarter for those people was about $5 million annualized. Divide that by 4, there was about $1.25 million in the third quarter for those individuals that we took out in the third quarter. So you could take that away from your third quarter balance, $1.25 million. And then in addition, when you think about the $5 million of annualized expense we've identified, that would be additional savings beyond that $1.25 million I just mentioned.

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

Hello. Good afternoon. Thanks for taking my questions. My first question is on breakeven levels with this new strategy, what do you think the annual or quarterly run rate of closings should be to get to breakeven?

You know, Jay, we've given you a lot of the tools to calculate that. We're not going to put out a number because it's really dependent upon any number of different factors. So keeping in mind where our margins have gone sequentially, I had mentioned that we think there's about 100 basis point improvement once you've -- once you factored in the benefits that were present in the third quarter and keeping in mind what we've already mentioned to you that we've done in G&A, I think those are the things you can use to calculate what the run rate will be.

Okay. My second question, with I guess a more conservative view of the world coming from you guys, how do you justify keeping $1 per share dividend out there which is multiples higher on a per share basis than any of your competitors, rather than using that money to either pay down debt or to invest in new land to help spur that profit growth? Can you discuss that dividend policy?

We've maintained the dividend policy predicated on a belief that having the excess liquidity, that there's several things to have shareholders participate in that liquidity. You can buy back stock. You can have a special dividend. You can maintain the dividend. You can buy additional assets to put into your trade and business and we believe that this has been the proper use of the capital and as you can appreciate, we always review it every single quarter to make sure that the business judgment that we are using in measuring the various options are done properly, being fully informed of the conditions and opportunities I previously discussed.

Your next question comes from the line of Stephen East from Ticonderoga Securities. Your line is now open.

Thanks. Just to follow up. 1, trying to get the gross margin in the backlog and then 2, you talked about changing the home galleries. I guess if you can explain what your structure was before with the home galleries, where it is now and what type of cost savings will come out of that restructuring of that business because that's a tough one to justify during this type of environment. So I was wanting to understand the positive movement you're making there.

There's some things about that, Steve, that we're not going to talk about at this moment for competitive reasons and we're still getting to the finishing touches of what we're going to do with the home galleries. I think you can assume that we are working to reduce our overhead with respect to the home galleries and we are working to reduce the complexity that the home galleries add to our overall business. And that should also show itself in terms of overhead savings. So while we're not ready to quite share the quantitative impact at this time, that's really the mindset that we have going into it.

Okay and the gross margin?

The gross margin in backlog, we didn't give a specific number but we did say that it was up slightly at the end of the third quarter versus where we started the quarter.

Okay. Thanks.

There are no further questions at this time.

Thanks for joining us on the call today and we look forward to speaking with you on our next call following the announcement of our fourth quarter results.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.