Q3 2008 KB Home Earnings Conference Call - Final.(Broadcast transcript)

OPERATOR: Good day everyone and welcome to KB Home's third quarter earnings conference call. As a reminder, the conference is being recorded and webcast on KB Home's website at KBHome.com. The recording will also be available via replay until midnight on October 5th, 2008. You can access this recording by dialing 719-457-0820 or 888-203-1112 and entering the replay pass code of 1423691.

KB Home's discussion today may include certain predictions and other forward-looking statements. These statements may cover market or economic conditions, KB Home's business and prospects, its future financial and operational performance and/or future actions or strategies and their expected results. They are based on management's current expectations and projections about future events and its business condition, but are not guarantees of future performance. Due to a number of risks assumptions, uncertainties and events outside its control, KB Home's actual results could differ materially from those expressed in or implied by the forward-looking statements. Many of these risk factors are identified in the company's periodic reports and other filings with the SEC, which the company urges you to read with care. Now for opening remarks and introductions, it is my pleasure to turn the conference over to KB Home's President and Chief Executive Officer, Mr. Jeffrey Mezger, please go ahead, sir.

JEFFREY MEZGER, PRESIDENT, CEO, KB HOME: Thanks, Kelsey. Good morning and thank you for joining us today for a review of our third quarter results. With me are Dom Cecere, our Executive Vice President and Chief Financial Officer, Bill Hollinger, our Senior Vice President and Chief Accounting Officer and Kelly Masuda, our Senior Vice President of Investor Relations and Treasurer. By now, you have probably had the opportunity to read our earnings release. In a few moments, I will turn the call over to Dom who will go through the numbers in greater detail. Then of course we will open it up for your questions.

But first, I would like to offer my own perspective on the state of the industry, our quarterly results, and how KB Home's strategic decisions are enabling us to manage successfully through these very difficult market conditions and to emerge from the downturn a more nimble company, well-positioned to seize attractive growth opportunities as they arise. The past few weeks have been truly historic and certainly represent the most drastic change in the capital markets that I have seen in my lifetime. While it will be some time before the impact of any comprehensive government intervention will be fully understood, we welcome any steps that help to stabilize the mortgage markets and increase consumer confidence. However, it should be noted that the current proposal provides no direct relief for housing, despite the fact that policy makers recognize that once again, housing will be a cornerstone for the broader economic recovery.

For the time being, difficult market conditions persist. Lending standards are tightening further in the mortgage market, and consumer confidence which remained low prior to the recent news may decrease even further. At 6.1%, unemployment stands at the highest level in five years and inventory of both new and existing homes remains bloated. While resale inventory driven in large part by the spike in foreclosures now stands at 4.26 million, we are encouraged by the uptick in activity in some markets. This increased sales activity, however, is driven by extraordinarily low pricing levels as local markets seek to reach an equilibrium between supply and demand. Markets will eventually stabilize, and when they do, new normals will be set for pricing, demand, and credit terms, against which future housing market performance will be judged. We should not expect a snapback to the pricing and credit dynamics we saw a few years ago, even after the current downturn comes to an end.

We believe success in today's environment calls for an integrated and disciplined approach to balance sheet and profit management, centering on three strategic imperatives. First, maintaining a strong cash position and balance sheet. Second, restoring operational profitability. And third, positioning ourselves to capitalize on a housing market recovery when it occurs. When we first embarked on these imperatives in 2006, our initial objective was to generate cash and reduce inventory levels. At that time, we were among the first builders to recognize the importance of having a strong balance sheet with plenty of cash on hand during a downturn. The benefits of this choice can still be felt today as we enter the third quarter with reduced debt levels and a sizable cash balance of $942 million. We expect to be cash flow positive for both the balance of and full year 2008, with over $1 billion in cash and no cash borrowings outstanding on our unsecured credit facility at year-end. This positions us well to weather the continued downturn and capitalize on investment opportunities when they arise. Although, until the markets stabilize, we will remain conservative with our spending and investment decisions.

Having accomplished our primary objective of a strengthened balance sheet, we are now focusing our efforts on maintaining this position while restoring profitability and we are making progress toward this goal. Our net orders in the third quarter declined 66% to 1,329 homes, driven in large part by three factors. First, we enforced price discipline in the face of some very powerful downward pressures. Because of our cash position, we do not have to sell and build homes at a loss just to generate cash. Second, our community count was down by 38% year-over-year and over 50% from the 2006 peak. We will continue operating with fewer communities until we believe investments in new communities will deliver financial results with acceptable returns. Finally, we accelerated a major product transition strategy, which slowed the sales pace in a number of our communities in the short term. These three factors will exert downward pressure on our net orders in the fourth quarter, as we position ourselves for restoring profitability going forward.

We also continue to realign our business to operate efficiently in this environment. In the third quarter, we consolidated the operations of seven of our divisions. While taking steps like this to become as lean as possible, we are also staying mindful of our strategic growth platform. The markets where we operate today are the same markets where we delivered over 30,000 homes at the housing peak. We expect these markets to lead the housing recovery and we will be ready to mobilize when they do. These division consolidations produced one-time charges that hit in the third quarter. As a result of these moves, and other reductions in our workforce, our employee count is now 66% below the 2006 peak, including an 18% reduction in the current quarter. As much as we have already done, our SG&A is still at unacceptable levels, and cost reductions in this area will continue to remain a top priority.

Perhaps our most significant move in the quarter was accelerating the transformation of our product line. As we sharpened our focus on the first-time buyer, we recognized that many of our product offerings were not aligned with their current needs and affordability levels. Our houses were too big, included too many costly features, and as a result, were too expensive for our core customer. So we began down sizing and down specking our homes. For example, last year in California's Inland Empire region, we quickly moved from building 3400-foot homes that sold for $450,000, to building 2400-foot homes that sell for $300,000. That worked for a time but the market continued to move away from us. Now, we have introduced a new line of homes that start at three bedrooms and 1230 square feet for just over $200,000, a price that is very competitive with today's resales, including foreclosures. The market has responded very favorably. Even in the Inland Empire, arguably one of the most difficult housing markets in the country, we are seeing more than two sales per week in the communities where we have introduced these new plans. I share the detail behind this success story because it typifies our strategic direction company-wide.

We are heavily focused on competing with resale price points in every market. As you know, KB Home does best when we focus on our core market of first time home buyers. These buyers are especially important in these times because they are not burdened with the need to sell a home before making the buying decision. We continue to differentiate the customer experience by offering built to order homes that give buyers the power to choose exactly the features and upgrades they want in their home. And even with the pressure on pricing, the sales and margins at our KB Home Studios, where our buyers can personalize their homes, have held up quite well.

Environmental leadership is also an increasingly important differentiator and we have a stated goal of becoming a leading environmentally friendly national company. During the quarter, we released our first sustainability report, a comprehensive review of our current initiatives and commitments. The report is part of our larger My Home, My Hearth initiative that among other things helps drive costly waste out of our business. As I have noted on earlier calls, the country's long-term economic and demographic outlook remains …