10-K 1 v22568e10vk.htm FORM 10-K e10vk
Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
þ  Annual Report Pursuant to Section 13 or 15(d) of     
the Securities Exchange Act of 1934
For the Fiscal Year Ended November 30, 2006
or
o  Transition Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the transition period from _ _ to _ _.
Commission File No. 001-09195
KB HOME
(Exact name of registrant as specified in its charter)
     
Delaware
(State or other jurisdiction of
incorporation or organization)
  95-3666267
(I.R.S. Employer
Identification No.)
 
10990 Wilshire Boulevard, Los Angeles, California 90024
(Address of principal executive offices)
Registrant’s telephone number, including area code:  (310) 231-4000
 
Securities Registered Pursuant to Section 12(b) of the Act:
 
     
    Name of each exchange
                      Title of each class   on which registered
 
Common Stock (par value $1.00 per share)
  New York Stock Exchange
Rights to Purchase Series A Participating Cumulative Preferred Stock
  New York Stock Exchange
91/2% Senior Subordinated Notes due 2011
  New York Stock Exchange
Securities Registered Pursuant to Section 12(g) of the Act: None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o  No þ  
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o  No þ 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ   No o  
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  þ    Accelerated filer  o    Non-accelerated filer  o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No þ
 
The aggregate market value of voting stock held by non-affiliates of the registrant on May 31, 2006 was $4,675,498,342, including 12,412,982 shares held by the registrant’s grantor stock ownership trust and excluding 23,183,707 shares held in treasury.
 
The number of shares outstanding of each of the registrant’s classes of common stock on December 31, 2006 was as follows: Common Stock (par value $1.00 per share) 89,374,122 shares, including 12,340,782 shares held by the registrant’s grantor stock ownership trust and excluding 25,274,482 shares held in treasury.
 
Documents Incorporated by Reference
 
Portions of the registrant’s definitive Proxy Statement for the 2007 Annual Meeting of Stockholders (incorporated into Part III).
 
 


 
TABLE OF CONTENTS

PART I
Item 1. BUSINESS
Item 1A. RISK FACTORS
Item 1B. UNRESOLVED STAFF COMMENTS
Item 2. PROPERTIES
Item 3. LEGAL PROCEEDINGS
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
PART II
Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Item 6. SELECTED FINANCIAL DATA
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Item 9A. CONTROLS AND PROCEDURES
Item 9B. OTHER INFORMATION
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
PART IV
Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
SIGNATURES
EX-10.21
EX-10.31
EX-10.32
EX-21
EX-23
EX-31.1
EX-31.2
EX-32.1
EX-32.2


Table of Contents

KB HOME
FORM 10-K
FOR THE YEAR ENDED NOVEMBER 30, 2006
 
TABLE OF CONTENTS
 
             
        Page
 
        No.  
 
Explanatory Note
    1  
 
PART I
Item 1.
  Business     4  
Item 1A.
  Risk Factors     14  
Item 1B.
  Unresolved Staff Comments     19  
Item 2.
  Properties     19  
Item 3.
  Legal Proceedings     19  
Item 4.
  Submission of Matters to a Vote of Security Holders     20  
 
PART II
Item 5.
  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     22  
Item 6.
  Selected Financial Data     23  
Item 7.
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     25  
Item 7A.
  Quantitative and Qualitative Disclosures About Market Risk     42  
Item 8.
  Financial Statements and Supplementary Data     43  
Item 9.
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     91  
Item 9A.
  Controls and Procedures     91  
Item 9B.
  Other Information     92  
 
PART III
Item 10.
  Directors and Executive Officers of the Registrant     92  
Item 12.
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     93  
 
PART IV
Item 15.
  Exhibits and Financial Statement Schedules     94  
Signatures
    98  


Table of Contents

 
EXPLANATORY NOTE
 
We are restating our consolidated financial statements to reflect additional stock-based compensation expense and related income tax effects relating to annual stock option awards granted since 1998. This Form 10-K reflects the restatement of our consolidated financial position as of November 30, 2005 and our consolidated results of operations and cash flows for the years ended November 30, 2005 and 2004. We have also included under Item 6. Selected Financial Data restated financial information as of and for the years ended November 30, 2003 and 2002.
 
Background
 
In light of various media reports that stock options had been backdated at a number of public companies, and in conjunction with a request from the Chairman of the Audit and Compliance Committee of our board of directors, in May 2006 our internal legal department began a preliminary review of our annual stock option grant practices.
 
On July 25, 2006, we commenced a voluntary independent review of our stock option grant practices (the “Stock Option Review”) to determine whether we had used appropriate measurement dates for, among other awards, the twelve annual stock option grants we made from January 1995 to November 2005. The Stock Option Review was directed by a subcommittee of our Audit and Compliance Committee (the “Subcommittee”) — consisting solely of outside directors who have never served on our Management Development and Compensation Committee (the “Compensation Committee”) — with the advice of independent counsel and forensic accountants. The Subcommittee and its advisors conducted 66 interviews, including seven with current and former members of our Compensation Committee, and collected more than 1.2 million documents relating to our stock option grant practices from 64 individuals.
 
On November 12, 2006, we announced that the Subcommittee had substantially completed its investigation and concluded that we had used incorrect measurement dates for financial reporting purposes for the eight annual stock option grants made since 1998. At the same time, we announced the departure of our Chairman and Chief Executive Officer and our head of human resources.
 
On December 8, 2006, we filed a Current Report on Form 8-K announcing that our management, in consultation with the Audit and Compliance Committee and after discussion with our independent registered public accounting firm, had determined that our previously issued consolidated financial statements and any related audit reports for the years ended November 30, 2005, 2004 and 2003, and the interim consolidated financial statements included in our Quarterly Reports on Form 10-Q for the quarters ended February 28, 2006 and May 31, 2006, should no longer be relied upon and would be restated.
 
Findings
 
The evidence developed through the Stock Option Review indicates that our Compensation Committee met in October each year since 1998 to consider and approve annual stock option awards for the next year. At those meetings, our Compensation Committee specifically approved the number of stock options to be granted to our former Chief Executive Officer and other senior management and an unallocated block of stock options to be allocated by our former Chief Executive Officer and our former head of human resources to other employees.
 
In addition to allocating annual stock options among other employees, starting with the annual stock option grant approved by the Compensation Committee in October 1998, our former Chief Executive Officer and former head of human resources also selected the grant date. The Subcommittee discovered evidence confirming or, in some years, suggesting that hindsight was used to secure favorable exercise prices for seven of the eight annual stock option grants since 1998. Grants in 1999, 2000 and 2001 were made at the lowest closing stock price during the grant month. The Subcommittee discovered direct evidence that the 2001 grant was priced with hindsight to secure favorable pricing, and the Subcommittee concluded that the evidence it reviewed suggests that hindsight pricing was used for the 1999 and 2000 grants as well. The Subcommittee also found that there is evidence that hindsight was used for the three annual grants made from 2003 to 2005, but within a floating three-day window as a result of the Securities and Exchange Commission’s (“SEC”) accelerated filing requirements for reports of stock transactions by executive officers.
 
Involvement in, and knowledge of, the hindsight pricing practices by our senior management, based on the evidence developed through the Stock Option Review, was limited to our former Chief Executive Officer and our former head of human resources. The Subcommittee concluded that these hindsight pricing practices did not involve any of our current


1


Table of Contents

senior management, including our new Chief Executive Officer, our principal financial officer or our principal accounting officer, nor were any of those individuals aware of these practices. The Subcommittee further concluded that none of our other accounting or finance employees were involved in, or aware of, the hindsight pricing practices.
 
Stock Option Adjustments and Related Actions
 
As part of its review, the Subcommittee determined whether the correct measurement dates had been used under applicable accounting principles for these options. The “measurement date” means the date on which the option is deemed granted under applicable accounting principles, namely Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB Opinion No. 25”) and related interpretations, and is the first date on which all of the following are known: (a) the individual employee who is entitled to receive the option grant, (b) the number of options that an individual employee is entitled to receive, and (c) the option’s exercise price.
 
Based on the findings of the Subcommittee, we have changed the measurement dates we use to account for the annual stock option grants since 1998 from the grant dates selected by our former Chief Executive Officer and our former head of human resources to the dates our employees were first notified of their grants. These measurement date changes resulted in an understatement of stock-based compensation expense arising from each of our annual stock option grants since 1998, affecting our consolidated financial statements for each year beginning with our year ended November 30, 1999. We have determined that the aggregate understatement of stock-based compensation expense for the seven-year restatement period from 1999 through 2005 is $36.3 million. In connection with the restatement of our consolidated financial statements to reflect the stock-based compensation adjustments associated with the stock option measurement date changes, we recorded an aggregate increase of $4.8 million in our income tax provision for the seven-year restatement period. This amount represents the cumulative income tax impact related to Internal Revenue Code (“IRC”) Section 162(m), partially offset by the income tax impact of the additional stock-based compensation expense. The stock-based compensation expense and related income tax impacts reduced net income by $41.1 million for the years ended November 30, 1999 through 2005. The related tax effects on our consolidated balance sheet included an increase of $72.3 million in accrued expenses and other liabilities, and a decrease of $77.8 million in stockholders’ equity. See Note 2. Restatement of Consolidated Financial Statements in the Notes to Consolidated Financial Statements in this Form 10-K for the impacts on our consolidated financial statements.
 
After considering the application of Section 409A of the IRC to our annual stock option grants, in December 2006 we increased the exercise price of certain annual stock options and will pay the difference to our current employees in the first quarter of our year ended November 30, 2007. This amount is not expected to exceed $7.0 million.
 
Other Adjustments
 
In addition to the adjustments related to the Stock Option Review, the restated consolidated financial statements presented herein include an adjustment to increase the income tax provision and reduce goodwill in 2004 and 2005 in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS No. 109”) to reflect the income tax benefit realized for the excess of tax-deductible goodwill over the reported amount of goodwill. The aggregate impact of this adjustment on 2004 and 2005 was a $7.8 million increase in the income tax provision with a corresponding reduction in goodwill. This adjustment is not related to the Stock Option Review.
 
Restatement
 
We have restated our consolidated financial statements for the years ended November 30, 2005 and 2004 and our quarterly results for the periods reflected in this Form 10-K. Because the impacts of the restatement adjustments extend back to the year ended November 30, 1999, in these restated consolidated financial statements, we have recognized the cumulative stock-based compensation expense and related income tax impact through November 30, 2003 as a net decrease to beginning stockholders’ equity as of December 1, 2003. In addition, for purposes of Item 6. Selected Financial Data for the years ended November 30, 2003 and 2002, the cumulative stock-based compensation expense from December 1, 1998 through November 30, 2001 has been recognized as a decrease to beginning stockholders’ equity as of December 1, 2001 and the 2002 and 2003 impacts associated with such items have been reflected in our consolidated balance sheet and statement of income data set forth in Item 6. Selected Financial Data in this Form 10-K.


2


Table of Contents

The table below reflects the impacts of the restatement adjustments discussed above on our consolidated statements of income for the periods presented below (in thousands):
 
                                         
                            Cumulative
 
                            December 1, 1998
 
                            through
 
    Years Ended November 30,     November 30,
 
Category of Adjustments:
  2005 (a)     2004 (a)     2003 (b)     2002 (b)     2001 (c)  
 
Pretax stock-based compensation expense related to stock option measurement date changes (d)
  $ 5,809     $ 2,366     $ 3,443     $ 6,684     $ 17,977  
                                         
Income tax impact on measurement date changes
    (1,500 )     (500 )     (700 )     (1,200 )     (3,200 )
Income tax impact related to IRC Section 162(m)
    10,300       1,300       100       200        
                                         
Total income tax impact related to stock option measurement date changes
    8,800       800       (600 )     (1,000 )     (3,200 )
Other income tax adjustments (e)
    4,100       3,700                    
                                         
Total income tax adjustments
    12,900       4,500       (600 )     (1,000 )     (3,200 )
                                         
Total net charge to net income
  $ 18,709     $ 6,866     $ 2,843     $ 5,684     $ 14,777  
                                         
 
 
(a) See Note 2. Restatement of Consolidated Financial Statements in the Notes to Consolidated Financial Statements included in this Form 10-K for additional information regarding the adjustments made to our restated consolidated financial statements.
 
(b) The impacts on 2003 and 2002 have been reflected in Item 6. Selected Financial Data in this Form 10-K.
 
(c) The cumulative effect of the stock-based compensation adjustments from December 1, 1998 through November 30, 2001 is reflected as an adjustment to stockholders’ equity in the 2002 period in Item 6. Selected Financial Data. The following is a summary of the pretax and after-tax expense by year (in thousands):
 
                                 
    Pretax
    Income Tax
    Net Charge to
       
Years Ended November 30,
  Adjustments     Adjustments     Net Income        
 
1999
  $ 4,319     $ (800 )   $ 3,519          
2000
    5,773       (1,000 )     4,773          
2001
    7,885       (1,400 )     6,485          
                                 
Cumulative effect
  $ 17,977     $ (3,200 )   $ 14,777          
                                 
 
(d) Stock-based compensation expenses have been recorded as adjustments to the selling, general and administrative expenses line item in our consolidated statements of income for each period.
 
(e) This represents the income tax impact from a goodwill book/tax difference and is not related to the Stock Option Review.
 
The effects of these restatements are reflected in our consolidated financial statements and other supplemental data, including the unaudited quarterly data for 2006 and 2005 and selected financial data included in this Form 10-K. We have not amended and do not intend to amend any of our previously filed annual or quarterly reports.
 
As a result of our failure to file our Quarterly Report on Form 10-Q for the quarter ended August 31, 2006 on a timely basis, we will not be eligible to use our shelf registration statement, or any other registration statement on Form S-3, to offer or sell our securities until we have timely filed all required reports under the Securities Exchange Act of 1934 for the 12 months prior to our use of the registration statement.


3


Table of Contents

 
PART I
 
Item 1. BUSINESS
 
General
 
KB Home, a Fortune 500 company founded in 1957 and listed on the New York Stock Exchange under the ticker symbol “KBH,” is one of America’s largest homebuilders. We also build residences and commercial projects in France through our subsidiary Kaufman & Broad S.A. (“KBSA”), which is publicly traded on the Premier Marché of Euronext Paris under the ticker symbol “KOF.”
 
In 2006, we delivered a total of 39,013 homes. We generated total revenues of $11.00 billion and pretax income of $698.1 million, up 17% and down 46%, respectively, from 2005.
 
In the United States, we offer a variety of residential units designed for first-time, move-up, luxury and active adult buyers, including attached and detached single-family homes, townhomes and condominiums. We offer residential units in development communities, at urban in-fill locations and as part of mixed use projects. We use the terms “home” and “unit” to refer to a single-family residence, whether it is a single-family home or other type of residential property. We use the term “community” to refer to a single development in which homes are constructed as part of an integrated plan.
 
Reflecting the geographic diversity of our business, we have five construction reporting segments — West Coast, Southwest, Central, Southeast and France. Our construction pretax income accounted for 95% of our total pretax income in 2006.
 
We also operate a financial services segment which offers mortgage banking, title, insurance and escrow coordination services to our homebuyers in the United States.
 
We are a Delaware corporation with principal executive offices at 10990 Wilshire Boulevard, Los Angeles, California 90024. The telephone number of our corporate headquarters is (310) 231-4000 and our website address is http://www.kbhome.com. Our Spanish-language website is http://www.kbcasa.com. In addition, location and community information is available at (888) KB-HOMES. The website of KBSA is http://www.ketb.com.
 
Markets
 
Our homebuilding operations in the United States span the country from coast to coast. KBSA’s operations in France cover a significant portion of that country. Because of the geographic reach of our homebuilding business, we have created five operating segments based on the markets in which we construct homes. Within our four U.S. construction segments, we operate in the 15 states and 40 major markets shown below:
 
         
Segment   State(s)   Market(s)
 
West Coast
  California   Bakersfield, Fresno, Los Angeles, Oakland, Riverside, Sacramento, San Diego and Stockton
Southwest
  Arizona   Phoenix and Tucson
    Nevada   Las Vegas and Reno
    New Mexico   Albuquerque
Central
  Colorado   Colorado Springs and Denver
    Illinois   Chicago
    Indiana   Indianapolis
    Louisiana   Baton Rouge and New Orleans
    Texas   Austin, Dallas/Fort Worth, Houston, McAllen and San Antonio
Southeast
  Florida   Daytona Beach, Fort Myers, Jacksonville, Lakeland, Melbourne, Orlando, Port St. Lucie, Sarasota and Tampa
    Georgia   Atlanta
    Maryland   Washington, D.C.
    North Carolina   Charlotte and Raleigh
    South Carolina   Bluffton/Hilton Head, Charleston and Columbia
    Virginia   Washington, D.C.


4


Table of Contents

In France, KBSA’s principal market is metropolitan Paris, where it built 65% of its individual homes and 25% of its condominium units in 2006. KBSA also operates in the Alsace, Aquitaine, Cote d’ Azur, Languedoc-Roussillon, Midi-Pyrenees, Nord, Normandy and Rhone Alps regions, principally in the main cities of Bordeaux, Grenoble, Lille, Lyon, Marseille, Nantes, Nice, Rouen, Strasbourg and Toulouse.
 
Segment Operating Information.  The following table sets forth specific operating information for our construction segments for the years ended November 30, 2006, 2005 and 2004:
 
                         
    Years Ended November 30,  
    2006     2005     2004  
West Coast:
                       
Unit deliveries
    7,213       6,624       5,383  
Percent of total unit deliveries
    18 %     18 %     17 %
Average selling price
  $ 489,500     $ 460,500     $ 411,500  
Total revenues (in millions) (a)
  $ 3,531.3     $ 3,050.5     $ 2,215.2  
Southwest:
                       
Unit deliveries
    7,011       7,357       7,478  
Percent of total unit deliveries
    18 %     20 %     23 %
Average selling price
  $ 306,900     $ 265,600     $ 202,600  
Total revenues (in millions) (a)
  $ 2,183.8     $ 1,964.5     $ 1,518.0  
Central:
                       
Unit deliveries
    9,613       9,866       9,101  
Percent of total unit deliveries
    25 %     27 %     29 %
Average selling price
  $ 159,800     $ 157,600     $ 151,300  
Total revenues (in millions) (a)
  $ 1,553.3     $ 1,559.0     $ 1,385.9  
Southeast:
                       
Unit deliveries
    8,287       7,162       4,975  
Percent of total unit deliveries
    21 %     19 %     16 %
Average selling price
  $ 244,300     $ 215,100     $ 171,700  
Total revenues (in millions) (a)
  $ 2,091.4     $ 1,549.3     $ 855.4  
France:
                       
Unit deliveries
    6,889       6,131       4,709  
Percent of total unit deliveries
    18 %     16 %     15 %
Average selling price (b)
  $ 230,400     $ 206,300     $ 211,500  
Total revenues (in millions) (a) (b)
  $ 1,623.7     $ 1,287.0     $ 1,033.8  
Total:
                       
Unit deliveries
    39,013       37,140       31,646  
Average selling price (b)
  $ 277,600     $ 252,100     $ 219,900  
Total revenues (in millions) (a) (b)
  $ 10,983.5     $ 9,410.3     $ 7,008.3  
 
 
(a)  Total revenues include revenues from residential developments, land sales, and, in France, commercial activities.
 
(b)  Average selling prices and total revenues for our French operations have been translated into U.S. dollars using weighted average exchange rates for each period.
 
Unconsolidated Joint Ventures.  The above tables do not include deliveries from unconsolidated joint ventures. From time to time, we participate in the acquisition, development, construction and sale of residential properties and commercial projects through unconsolidated joint ventures. Unit deliveries from unconsolidated joint ventures accounted for less than 2% of our total unit deliveries in 2006.
 
Strategy
 
We began operating under the principles of our KBnxt operational business model in 1997. The KBnxt operational business model seeks to generate greater operating efficiencies and return on investment through a disciplined, fact-based


5


Table of Contents

and process-driven approach to homebuilding that is founded on a constant and systematic assessment of consumer preferences and market opportunities. The key elements of our KBnxt operational business model include:
 
  •  Gaining a detailed understanding of consumer location and product preferences through regular surveys;
 
  •  In general, managing our working capital and reducing our operating risks by acquiring developed and entitled land at reasonable prices in markets with high growth potential, and by disposing of land and interests in land that no longer meet our strategic or investment goals;
 
  •  Using our knowledge of consumer preferences to design, construct and deliver the products they desire;
 
  •  In general, commencing construction of a home only after a purchase contract has been signed;
 
  •  Building a backlog of sales orders and reducing the time from construction to final delivery of homes to customers;
 
  •  Establishing an even flow of production of high quality homes at the lowest possible cost; and
 
  •  Offering customers low base prices and the opportunity to customize their homes though choice of location, floor plans and interior design options.
 
Implementation Strategy.  Through the continued execution of our KBnxt operational business model, we have concentrated on achieving a leading position in our existing markets, expanding our business into attractive new markets and expanding our product lines in both our existing and new markets. This focus has allowed us to achieve lower costs and improved profitability through economies of scale with respect to acquiring land, purchasing building materials, subcontracting labor and providing options to customers.
 
We will continue to adhere to the disciplines of our KBnxt operational business model in 2007, a year that is likely to present operating challenges similar to those that developed in 2006. We do not expect the difficult conditions currently present in the U.S. housing market, including an oversupply of new and resale home inventories in certain markets, lack of affordability in certain areas and greater competition, to improve significantly, or at all, in 2007. Accordingly, in the short-term, we are focused on aligning the size of our organization with the lower unit volume expected this year and preserving our strong financial condition. We also believe, however, that the general health of the U.S. economy, including historically low interest rates and high employment levels, bodes well for the recovery of the homebuilding industry and our company. Our long-term focus remains the profitable growth of our homebuilding business.
 
Any expansion into new markets will depend on our assessment of a potential new market’s viability and our ability to develop operations in any new market we decide to enter. The extension of our product line into new product types in specific markets will be driven by our assessment of consumer preferences and fit within our existing business operations. We also will continue to explore appropriate acquisitions as market conditions may result in attractive opportunities.
 
Marketing Strategy.  In 2006, we continued our marketing strategy of building a national brand that stands out from other homebuilders by combining a consistently executed marketing program with nationwide promotions and partnerships. We believe this approach has yielded results. In 2006, a study we conducted in each of our markets across the United States found that KB Home is the best known homebuilding brand in both aided and unaided awareness.
 
Our brand recognition continues to benefit from our high-profile partnership with Martha Stewart. In addition to the opening of the first two Martha Stewart communities in 2006, we partnered with Martha Stewart on Martha’s Ultimate KB Home Giveaway, a month-long national promotion in conjunction with her syndicated daytime TV show, Martha. The promotion gave viewers a chance to win a Martha Stewart home in their choice of our first two Martha Stewart communities located in North Carolina and Georgia.
 
A key marketing focus in 2006 was the creation of new marketing tools to reach out to some of our most essential audiences, including real estate brokers, online home shoppers and our current homeowners. These tools include an emphasis on new broker programs and materials for our local markets, as well as an expanded focus on market-specific online advertising. We launched a new email strategy to more effectively communicate timely messages to our prospective homebuyers. We designed a new web site, http://www.kbhomeowner.com, to provide a post-sale service to our homeowners, including information on services in their new neighborhood and a place to store their most important homeowner information online. The http://www.kbhomeowner.com web site, which we launched in January 2007, is


6


Table of Contents

intended to reinforce our commitment to our customers after they move into their homes and to serve as a vehicle to encourage additional referral business.
 
In 2007, we plan to continue to focus on improving the effectiveness of our marketing programs and the promotion of a single brand across the United States. We also plan to continue to expand our Martha Stewart communities to other areas of the country.
 
Sales Strategy.  To ensure consistency of message and adherence to our KBnxt operational business model, the sales of our homes are carried out by an in-house team of sales representatives. Our sales representatives are trained to provide prospective customers with floor plan and design choices, pricing information and tours of fully furnished and landscaped model homes that are decorated to emphasize the distinctive options we can provide to customers. We also have representatives available in many of our U.S. communities to assist prospective customers with financing questions and to provide information on the homebuying process.
 
To help our homebuyers customize their homes, we operate KB Home Studios in many of our markets. KB Home Studios are large showrooms where our customers may select from thousands of options to conveniently purchase as part of the original construction of their homes. The coordinated efforts of sales representatives, KB Home Studio consultants and other personnel in the customer’s homebuying experience are intended to provide high levels of customer satisfaction and lead to enhanced customer retention and referrals.
 
In France, we introduced the American concept of a master bedroom suite, as well as walk-in closets, built-in kitchen cabinetry and two-car garages. We believe that our value engineering allows us to offer appealing and well-designed homes at competitive prices. Our French operations offer a broad choice of options to customers through new home studios in Paris, Lyon, Marseille and Nice that are similar to our U.S.-based KB Home Studios.
 
Local Expertise
 
We believe that our business requires in-depth knowledge of local markets in order to acquire land in desirable locations and on favorable terms, to engage subcontractors, to plan communities keyed to local demand, to anticipate consumer tastes in specific markets and to assess the local regulatory environments. Accordingly, we operate through local divisions that we establish to take advantage of our local market expertise. We have experienced management teams in each of our divisions. Although we have centralized certain functions, such as marketing, advertising, legal, materials purchasing, product development, architecture and accounting, to benefit from economies of scale, our local management exercises considerable autonomy in identifying land acquisition opportunities, developing product and sales strategies, conducting product operations and controlling costs.
 
Community Development
 
Our new home community development process generally consists of four phases: land acquisition, land development, home construction and sale. Historically, our community development process has ranged from six to 24 months in our West Coast region to a somewhat shorter duration in our other domestic regions. In France, the community development process has historically ranged from 12 to 30 months. The length of the community development process varies based on, among other things, the extent of government approvals required, the overall size of the community, necessary site preparation activities, weather conditions and marketing results.
 
Although they vary significantly, our domestic new home communities typically consist of 50 to 250 lots ranging in size from 2,000 to 20,000 square feet. Depending on the community, we offer from two to five model home design options to customers, with premium lots often containing more square footage, better views or location benefits. In France, our single-family home developments typically consist of 50 to 150 lots, with average lot sizes of 5,500 square feet. Our goal is to own or control enough lots to meet our forecasted production goals over the next three to five years.
 
Based on our assessment of market conditions, we will dispose of land inventory holdings that no longer fit our strategic plans or that no longer meet our internal investment standards. We generally accomplish this through sales of land or interests in land or by forfeiting or abandoning options to purchase land.
 
Land Acquisition and Development.  Prior to our adoption of our KBnxt operational business model in 1997, we typically acquired undeveloped and/or unentitled land on which significantly more than 250 lots could be developed. Since we adopted our KBnxt operational business model, we have focused on obtaining land containing less than 250 lots and have substantially reduced our acquisition of undeveloped and/or unentitled land. Instead, we have focused on


7


Table of Contents

acquiring lots that are entitled and, either physically developed (referred to as “finished lots”) or partially finished. Acquiring finished or partially finished lots enables us to construct and deliver homes shortly after the land is acquired with minimal additional development expenditures. This is a more efficient way to use our working capital and reduces the operating risks associated with having to develop and/or entitle land, such as unforeseen improvement costs and/or changes in market conditions. However, depending on market conditions, we may acquire undeveloped and/or unentitled land. We expect that the overall balance of undeveloped, unentitled, entitled and finished lots in our inventory will vary over time.
 
Consistent with our KBnxt operational business model, we target geographic areas for potential land acquisitions based on the results of periodic surveys of both new and resale homebuyers in particular markets. Local, in-house land acquisition specialists conduct site selection research and analysis in targeted geographic areas to identify desirable land consistent with our marketing strategy. Studies performed by third-party marketing specialists are also utilized. Some of the factors we consider in evaluating land acquisition targets are: consumer preferences; general economic conditions; specific market conditions, with an emphasis on the prices of comparable new and resale homes in the market; expected sales rates; proximity to metropolitan areas and employment centers; population and commercial growth patterns; estimated costs of completing lot development; and environmental matters.
 
We generally structure our land purchases and development activities to minimize, or to defer the timing of, cash and capital expenditures, which enhances returns associated with new land investments. While we use a variety of techniques to accomplish this, as further described below, we typically use agreements that give us an option right to purchase land at a future date at a fixed price for a small or no initial deposit payment. Our decision to exercise a particular option right is based on the results of the due diligence we conduct after entering into an agreement. In some cases our decision to exercise an option may be conditioned on the land seller’s obtaining necessary entitlements, such as zoning rights and environmental approvals, and/or physically developing the land by a pre-determined date to allow us to build homes relatively quickly. Depending on the circumstances, our initial deposit payment for an option right may or may not be fully or substantially refundable to us if we do not purchase the underlying land.
 
In addition to acquiring land under option agreements, we may acquire land under agreements that condition our purchase obligation on our satisfaction with the feasibility of developing and selling homes on the land by a certain future date. Our option and other purchase agreements may also allow us to phase our land purchase and/or lot development obligations over a period of time and/or upon the satisfaction of certain conditions. We may also acquire land with seller financing that is non-recourse to us, or by working in conjunction with third-party land developers.
 
As previously noted, under our KBnxt operational business model, we generally attempt to minimize our land development costs by focusing on acquiring finished or partially finished lots. Where we purchase unentitled and unimproved land, we typically use option agreements as described above and perform during an applicable option period technical, environmental, engineering and entitlement feasibility studies, while we seek to obtain necessary governmental approvals and permits. These activities are sometimes done with a seller’s assistance or at the seller’s cost. The use of option arrangements in this context allows us to conduct these development-related activities while minimizing our overall financial commitments, including interest and other carrying costs, and land inventories. It also improves our ability to accurately estimate development costs, an important element in planning communities and pricing homes, prior to incurring them.
 
Before we commit to any land purchase, our senior corporate management carefully evaluates each acquisition opportunity based on the results of our local specialists’ due diligence and a set of strict financial measures, including, but not limited to, gross margin analyses and specific discounted after tax cash flow internal rate of return requirements. Potential transactions involving significant financial commitments or that are outside the ordinary course of our business are subject to review and approval by our investment committee, which is composed of our senior executive officers. Smaller but still sizeable potential transactions are subject to review and approval by our corporate land committee, which is composed of senior management experienced in land acquisitions. The smallest potential transactions for the release of non-refundable deposits and the expenditure of entitlement costs are subject to review and approval by our divisional land committees, which are composed of senior divisional and regional management, with further development expenditures subject to prior ratification by our corporate land committee. The stringent criteria guiding our land acquisition decisions has resulted in our geographic expansion to areas which generally offer better returns for lower


8


Table of Contents

risk and lower cash and capital investment. In France, we employ similar strategies and policies regarding land acquisition and development.
 
In light of difficult market conditions and a more moderate demand for new homes, we have recently sold some of our land and interests in land, and have abandoned some of our options to acquire land. Consistent with our KBnxt operational business model, we determined that these sold or abandoned properties no longer met our strategic needs or our internal investment standards. If market conditions remain challenging, we may sell more of our land and interests in land, and we may abandon or try to sell more of our options to acquire land.
 
The following table shows the number of lots we owned in various stages of development and under option contracts in our construction segments as of November 30, 2006 and 2005. The table does not include approximately 393 acres and 479 acres optioned in the United States in 2006 and 2005, respectively, which have not yet been approved for subdivision into lots.
 
                                                                 
                      Total Lots
 
    Homes/Lots in
    Land Under
    Lots Under
    Owned or
 
    Production     Development     Option     Under Option  
    2006     2005     2006     2005     2006     2005     2006     2005  
 
West Coast
    10,957       11,439       4,387       6,791       11,762       24,253       27,106       42,483  
Southwest
    9,773       13,489       2,338       2,918       11,101       16,183       23,212       32,590  
Central
    12,799       19,398       6,856       7,740       5,448       17,638       25,103       44,776  
Southeast
    10,576       12,869       6,034       5,616       19,436       42,056       36,046       60,541  
France
    7,877       5,942       2,635       2,027       8,569       2,216       19,081       10,185  
                                                                 
Total
    51,982       63,137       22,250       25,092       56,316       102,346       130,548       190,575  
                                                                 
 
Reflecting our geographic diversity and balanced operations, as of November 30, 2006, 21% of the lots we owned or controlled were located in the West Coast reporting segment, 18% were in the Southwest reporting segment, 19% were in the Central reporting segment, 27% were in the Southeast reporting segment and 15% were in France.
 
Home Construction and Sale.  Following the purchase of land and, if necessary, the completion of the entitlement process, we typically begin marketing homes and constructing model homes. The time required for construction of our homes depends on the weather, time of year, local labor supply, availability of materials and supplies and other factors. The construction of our homes is generally contingent upon customer orders to minimize the costs and risks of standing inventory. However, cancellations of home purchase contracts prior to the delivery of the underlying units may cause us to have standing inventory of completed or partially completed units.
 
We act as the general contractor for the majority of our communities and hire subcontractors for all production activities. The use of subcontractors enables us to reduce our investment in direct labor costs, equipment and facilities. Where practical, we use mass production techniques, and prepackaged, standardized components and materials to streamline the on-site production phase. We have also developed systems for national and regional purchasing of certain building materials, appliances and other items to take advantage of economies of scale and to reduce costs through improved pricing and, where available, participation in national manufacturers’ rebate programs. At all stages of production, our administrative and on-site supervisory personnel coordinate the activities of subcontractors and subject their work to quality and cost controls. As part of our KBnxt operational business model, we have also emphasized even flow production methods to enhance the quality of our homes, minimize production costs and improve the predictability of our revenues and earnings.
 
In our domestic homebuilding operations, we provide customers with a limited home warranty program administered by personnel in each of our divisions. This arrangement is designed to give our customers prompt and efficient post-delivery service. For homes sold in the United States, we generally provide a structural warranty of 10 years, a warranty on electrical, heating, cooling, plumbing and other building systems each varying from two to five years based on geographic market and state law, and a warranty of one year for other components of the home such as appliances.


9


Table of Contents

Backlog
 
Sales of our homes are made pursuant to standard purchase contracts, which generally require a customer deposit at the time of execution. We generally permit customers to cancel their obligations and obtain refunds of all or a portion of their deposit in the event mortgage financing cannot be obtained within a period of time, as specified in the contract. Once mortgage financing approval is obtained, we generally require an additional deposit.
 
“Backlog” consists of homes which are under contract but have not yet been delivered. Ending backlog represents the number of units in backlog from the previous period plus the number of net orders (sales made less cancellations) taken during the current period minus unit deliveries made during the current period. The backlog at any given time will be affected by cancellations. In addition, deliveries of new homes typically increase from the first to the fourth quarter in any year.
 
Our backlog at November 30, 2006, excluding the effects of unconsolidated joint ventures, totaled 17,384 units, down 32% from the 25,722 backlog units at year-end 2005. Our backlog ratio was 53% for the fourth quarter of 2006 and 43% for the fourth quarter of 2005. (Backlog ratio is defined as unit deliveries as a percentage of beginning backlog in the quarter.) Domestically, unit backlog of 10,575 units at November 30, 2006 decreased by 48% compared to 20,240 units at November 30, 2005. Unit backlog of 6,809 in France was 24% higher at November 30, 2006 compared to the 5,482 unit backlog at November 30, 2005.
 
The significant decrease in domestic backlog levels in 2006 resulted from a decrease in net orders due in part to increased home purchase contract cancellations. Our net orders declined 28% to 30,675 in 2006 from 42,405 in 2005. Our average cancellation rate in 2006 was 42%, up from an average of 27% in 2005. During the fourth quarter of 2006, our net orders decreased 38% from the fourth quarter of 2005, reflecting a 50% decline in net orders generated by our U.S. operations to 3,763 from 7,510, partially offset by a 3% increase in net orders in France to 2,296 from 2,237 in the year-earlier quarter. During the fourth quarter of 2006, our cancellation rate rose to 48% from 31% in the year-earlier quarter and improved from 53% in the third quarter of 2006.


10


Table of Contents

The following table sets forth unit deliveries, net orders and ending backlog relating to sales of homes and homes under contract for each quarter during the years ended November 30, 2006 and 2005:
 
                                                         
                                        Unconsolidated
 
    West Coast     Southwest     Central     Southeast     France     Total     Joint Ventures  
Unit deliveries
                                                       
2006
                                                       
First
    1,446       1,552       1,835       1,610       1,462       7,905       76  
Second
    1,579       1,813       2,183       1,827       1,630       9,032       189  
Third
    1,683       1,798       2,489       1,923       1,630       9,523       93  
Fourth
    2,505       1,848       3,106       2,927       2,167       12,553       188  
                                                         
Total
    7,213       7,011       9,613       8,287       6,889       39,013       546  
                                                         
2005
                                                       
First
    1,095       1,572       1,873       1,314       993       6,847       210  
Second
    1,417       2,033       2,117       1,665       1,303       8,535       143  
Third
    1,781       1,943       2,638       1,871       1,579       9,812       75  
Fourth
    2,331       1,809       3,238       2,312       2,256       11,946       81  
                                                         
Total
    6,624       7,357       9,866       7,162       6,131       37,140       509  
                                                         
Net orders
                                                       
2006
                                                       
First
    1,399       1,492       2,295       1,854       1,679       8,719       209  
Second
    1,628       1,239       2,723       1,899       2,419       9,908       66  
Third
    775       806       1,549       1,037       1,822       5,989       59  
Fourth
    772       576       1,156       1,259       2,296       6,059       113  
                                                         
Total
    4,574       4,113       7,723       6,049       8,216       30,675       447  
                                                         
2005
                                                       
First
    1,857       2,140       2,541       1,841       1,522       9,901       55  
Second
    2,025       2,457       3,201       2,523       2,084       12,290       41  
Third
    1,836       1,930       2,860       2,171       1,670       10,467       60  
Fourth
    1,693       1,706       2,151       1,960       2,237       9,747       245  
                                                         
Total
    7,411       8,233       10,753       8,495       7,513       42,405       401  
                                                         
Ending backlog — units (a)
                                                       
2006
                                                       
First
    4,207       5,368       5,405       5,857       5,699       26,536       520  
Second
    4,256       4,794       5,945       5,929       6,488       27,412       397  
Third
    3,348       3,802       5,005       5,043       6,680       23,878       363  
Fourth
    1,615       2,530       3,055       3,375       6,809       17,384       288  
                                                         
2005
                                                       
First
    4,229       5,120       4,726       4,807       4,452       23,334       340  
Second
    4,837       5,544       5,810       5,665       5,233       27,089       238  
Third
    4,892       5,531       6,032       5,965       5,324       27,744       223  
Fourth
    4,254       5,428       4,945       5,613       5,482       25,722       387  
                                                         
Ending backlog — value, in thousands (a)
                                               
2006
                                                       
First
  $ 2,059,191     $ 1,690,266     $ 841,504     $ 1,455,301     $ 1,196,790     $ 7,243,052     $ 119,600  
Second
    2,200,413       1,473,792       947,562       1,499,091       1,537,656       7,658,514       92,898  
Third
    1,726,232       1,129,899       802,950       1,295,886       1,576,480       6,531,447       75,662  
Fourth
    819,795       708,206       487,223       811,533       1,606,924       4,433,681       70,602  
                                                         
2005
                                                       
First
  $ 1,878,556     $ 1,200,915     $ 719,885     $ 997,926     $ 1,006,152     $ 5,803,434     $ 60,370  
Second
    2,150,227       1,428,789       903,725       1,211,460       1,098,930       6,793,131       40,460  
Third
    2,228,977       1,509,186       906,352       1,324,161       1,091,420       7,060,096       38,360  
Fourth
    2,045,476       1,562,698       751,589       1,324,410       1,079,954       6,764,127       80,883  
                                                         
(a)  Ending backlog amounts for 2005 have been adjusted to reflect acquisitions made during that year. Therefore, the ending backlog at November 30, 2004 combined with net order and delivery activity for 2005 will not equal the ending backlog at November 30, 2005.


11


Table of Contents

Land and Raw Materials
 
We currently own or control enough land to meet our forecasted production goals for approximately the next four years, and we believe that we will be able to acquire land on acceptable terms for future communities as needed. In fact, as discussed above, we have recently been selling some of our land and abandoning options to purchase land in order to balance our holdings with the more moderate demand for new homes that we have been experiencing. The principal raw materials used in the construction of our homes are concrete and forest products. (In France, the principal materials used in the construction of our commercial buildings are steel, concrete and glass.) In addition, we use a variety of other construction materials, including sheetrock, plumbing and electrical items in the homebuilding process. We attempt to maintain efficient operations by utilizing standardized materials that are commercially available on competitive terms from a variety of sources. In addition, our centralized or regionalized purchasing of certain building materials, appliances and fixtures allows us to benefit from large quantity purchase discounts and, in some cases, supplier rebates, for our domestic operations. When possible, we make bulk purchases of such products at favorable prices from suppliers and often instruct subcontractors to submit bids based on such prices.
 
Land Sales
 
In the normal course of business, we occasionally sell land which either can be sold at an advantageous price due to market conditions or does not meet our strategic needs or internal investment standards. Such property may consist of land zoned for commercial use which is part of a larger parcel being developed for single-family homes or may be in areas where we may consider our inventory to be excessive. Generally, land sales fluctuate with our decisions to maintain or decrease our land ownership position in certain markets based upon the volume of our holdings, the strength and number of competing developers entering particular markets at given points in time, the availability of land in markets we serve and prevailing market conditions. Such sales have been limited in recent years, but were more significant in 2006 compared to prior periods, as we sold some of our land in light of challenging market conditions and more moderate demand for new homes. Land sale revenues totaled $129.7 million in 2006, $40.3 million in 2005 and $27.9 million in 2004.
 
Customer Financing
 
On-site personnel at our communities in the United States facilitate sales by offering to arrange financing for prospective customers through Countrywide KB Home Loans. Countrywide KB Home Loans is a retail mortgage banking joint venture that we established with Countrywide Financial Corporation (“Countrywide”) in 2005. We believe that the ability of Countrywide KB Home Loans to offer customers a variety of financing options on competitive terms as a part of the sales process is an important factor in completing sales.
 
Countrywide KB Home Loans provides mortgage banking services to our domestic homebuyers. Leveraging the resources of Countrywide, the joint venture operates with decentralized teams of employees located in all of our markets. Through its relationship with Countrywide, the joint venture offers virtually every loan program in the industry, as well as some products not offered by other lenders. This includes fixed and adjustable rate, conventional, privately insured mortgages, Federal Housing Administration (“FHA”)-insured or Veterans Administration (“VA”)-guaranteed mortgages and mortgages funded by revenue bond programs of states and municipalities. In 2006, Countrywide KB Home Loans originated loans for 57% of our domestic home deliveries to customers who obtained mortgage financing.
 
In France, we assist our customers by arranging financing through third-party lenders, primarily major French banks with which our French business has established relationships. In some cases, our French customers qualify for certain government-assisted home financing programs.
 
Employees
 
We employ a trained staff of land acquisition specialists, architects, planners, engineers, construction supervisors, marketing and sales personnel, and finance and accounting personnel, supplemented as necessary by outside consultants, who guide the development of our communities from their conception through the marketing and sale of completed homes.


12


Table of Contents

At December 31, 2006, we had approximately 5,100 full-time employees in our operations. No employees are represented by a collective bargaining agreement.
 
Competition and Other Factors
 
We believe the use of our KBnxt operational business model, particularly the aspects that involve gaining a deeper understanding of customer interests and needs and offering a wide range of choices to homebuyers, provides us with long-term competitive advantages. The housing industry is highly competitive, and we compete with numerous housing producers ranging from regional and national firms to small local builders primarily on the basis of price, location, financing, design, reputation, quality and amenities. In addition, we compete with housing alternatives other than new production homes, including used homes and rental housing. In certain markets and at times when housing demand is high, we also compete with other builders to hire subcontractors.
 
Financing
 
We do not generally finance the development of our domestic communities with project financing. By “project financing” we mean proceeds of loans specifically obtained for, or secured by, particular communities. Instead, financing of our domestic operations has been primarily generated from results of operations, public debt and equity financing, and borrowings under our domestic $1.5 billion unsecured revolving credit facility with various banks (the “$1.5 Billion Credit Facility”).
 
KBSA has financed its business activities from results of operations, public debt and borrowings from its unsecured committed credit lines with a series of banks.
 
Regulation and Environmental Matters
 
It is our policy, as part of our due diligence process for all land acquisitions, to use third-party environmental consultants to investigate for environmental risks and to require disclosure from land sellers of known environmental risks. Despite these precautions, there can be no assurance that we will avoid material liabilities relating to the removal of toxic wastes, site restoration, monitoring or other environmental matters affecting properties currently or previously owned by us. No estimate of such potential liabilities can be made although we may, from time to time, purchase property which requires modest environmental clean-up costs after appropriate due diligence. In such instances, we take steps prior to acquisition to gain assurance as to the precise scope of work required and costs associated with removal, site restoration and/or monitoring, using detailed investigations by environmental consultants. To the extent such contamination or other environmental issues have occurred in the past, we believe we may be able to recover restoration costs from third parties, including, but not limited to, the generators of hazardous waste, land sellers or others in the prior chain of title and/or insurers. Utilizing such policies, we anticipate that it is unlikely that environmental clean-up costs will have a material effect on our future consolidated financial position or results of operations. We have not been notified by any governmental agency of any claim that any of the properties owned or formerly owned by us are identified by the U.S. Environmental Protection Agency (“EPA”) as being a “Superfund” clean-up site requiring clean-up costs, which could have a material effect on our future consolidated financial position or results of operations. Costs associated with the use of environmental consultants are not material to our results of operations.
 
Access to Our Information
 
We file annual, quarterly and special reports, proxy statements and other information with the SEC. Our SEC filings are available to the public over the Internet at the SEC’s website at http://www.sec.gov. The public may also read and copy any document we file at the SEC’s public reference room located at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference room.
 
We encourage the public to read our periodic and special reports. Copies of these filings, as well as any future filings, may be obtained, at no cost, through our website http://www.kbhome.com or by writing to our investor relations department at investorrelations@kbhome.com or at our principal executive offices.


13


Table of Contents

 
Item 1A.  RISK FACTORS  
 
In addition to the risks previously mentioned, the following important factors could adversely impact our business. These factors could cause our actual results to differ materially from the forward-looking and other statements that we make in registration statements, periodic reports and other filings with the SEC, and that we make from time to time in our news releases, annual reports and other written communications, as well as oral forward-looking and other statements made from time to time by our representatives.
 
Our business is cyclical and is significantly affected by changes in general and local economic conditions.
 
Our business can be substantially affected by adverse changes in general economic or business conditions that are outside of our control, including changes in:
 
  •  short- and long-term interest rates;
 
  •  the availability of financing for homebuyers;
 
  •  consumer confidence generally and the confidence of potential homebuyers in particular;
 
  •  federal mortgage financing programs and federal and state regulation of lending practices;
 
  •  federal and state income tax provisions, including provisions for the deduction of mortgage interest payments;
 
  •  housing demand;
 
  •  the supply of available new or existing homes and other housing alternatives, such as apartments and other rental residential property;
 
  •  employment levels and job and personal income growth;
 
  •  the exchange rate of the U.S. dollar and the euro with respect to our French operations; and
 
  •  real estate taxes.
 
Adverse changes in these conditions may affect our business nationally or may be more prevalent or concentrated in particular regional or local areas in which we operate.
 
Weather conditions and natural disasters, such as earthquakes, hurricanes, tornadoes, floods, droughts, fires and other environmental conditions, can also harm our homebuilding business on a local or regional basis. Civil unrest or acts of terrorism can also have an adverse effect on our business.
 
Fluctuating lumber prices and shortages, as well as shortages or price fluctuations in other building materials or commodities, can have an adverse effect on our business. Similarly, labor shortages or unrest among key trades, such as carpenters, roofers, electricians and plumbers, can delay the delivery of our homes and increase our costs.
 
The potential difficulties described above can cause demand and prices for our homes to diminish or cause us to take longer and incur more costs to build our homes. We may not be able to recover these increased costs by raising prices because of market conditions and because the price of each home is usually set several months before the home is delivered, as our customers typically sign their home purchase contracts before construction begins. The potential difficulties described above could cause some homebuyers to cancel or to refuse to honor their home purchase contracts altogether.
 
The homebuilding industry is experiencing a severe downturn that may continue for an indefinite period and adversely affect our business and results of operations compared to prior periods.
 
In 2006, the U.S. homebuilding industry as a whole experienced a significant and sustained decrease in demand for new homes and an oversupply of new and existing homes available for sale. In many markets, a rapid increase in new and existing home prices over the past several years reduced housing affordability and tempered buyer demand. In particular, investors and speculators reduced their purchasing activity and instead stepped up their efforts to sell the residential property they had earlier acquired. These trends, which were more pronounced in markets that had experienced the greatest levels of price appreciation, resulted in overall fewer home sales, greater cancellations of home purchase


14


Table of Contents

agreements by buyers, higher inventories of unsold homes and the increased use by homebuilders, speculators, investors and others of discounts, incentives and price concessions to close home sales compared to the past several years.
 
Reflecting these demand and supply trends, we, like many other homebuilders, experienced a large drop in net new orders, slower price appreciation for new homes sold and a reduction in our margins. We can provide no assurances that the homebuilding market will improve in the near future, and it may weaken further. Continued weakness in the homebuilding market would have an adverse effect on our business and our results of operations as compared to those of earlier periods.
 
The value of the land and housing inventory we own or control may fall significantly and our profits may decrease.
 
The value of the land and housing inventory we currently own or control depends on market conditions, including estimates of future demand for, and the revenues that can be generated from, such inventory. The market value of our land inventory can vary considerably because there is often a significant amount of time between our initial acquisition of land and our ability to make homes on that land available for sale. In the past few years, the value of our inventory has benefited from increases in buyer demand and the rapid appreciation of home prices. However, the recent downturn in the housing market has caused and, if it continues, may in the future cause, the fair market value of certain of our inventory to fall, in some cases well below its estimated fair market value at the time we acquired it. Depending on our assessment of fair market value, we may need to write-down the value of certain of our inventory and take corresponding non-cash charges against our earnings to reflect impaired value. We may also abandon our interests in certain land inventory that no longer meets our internal investment standards, which would also require us to take non-cash charges. On January 16, 2007, we reported that we would record non-cash charges in the fourth quarter of 2006 of $88.3 million related to the abandonment of certain land option contracts and $255.0 million related to inventory and joint venture impairments. If the current downturn in the housing market continues, we may need to take additional charges against our earnings for abandonments or inventory impairments, or both. Any such non-cash charges would have an adverse effect on our reported profits.
 
If new home prices decline, interest rates increase or there is a downturn in the economy, some homebuyers may cancel their home purchases because the required deposits are small and generally refundable.
 
Our backlog numbers reflect the number of homes for which we have entered into a purchase contract with a customer but not yet delivered. Those home purchase contracts typically require only a small deposit, and in many states, the deposit is fully refundable at any time prior to closing. If the prices for new homes decline, competitors increase their use of sales incentives, interest rates increase or there is a downturn in local or regional economies or the national economy, homebuyers may have a financial incentive to terminate their existing home purchase contracts with us in order to negotiate for a lower price or to explore other options. In 2006, we experienced a large increase in the number of cancellations, in part because of these reasons. Additional cancellations could have an adverse effect on our business and our results of operations.
 
Our success depends on the availability of improved lots and undeveloped land that meet our land investment criteria.
 
The availability of finished and partially developed lots and undeveloped land for purchase that meet our internal criteria depends on a number of factors outside our control, including land availability in general, competition with other homebuilders and land buyers for desirable property, inflation in land prices, and zoning, allowable housing density and other regulatory requirements. Should suitable lots or land become less available, the number of homes we may be able to build and sell could be reduced, and the cost of land could be increased, perhaps substantially, which could adversely impact our results of operations.
 
Home prices and sales activity in the particular markets and regions in which we do business affect our results of operations because our business is concentrated in these markets.
 
Home prices and sales activity in some of our key markets have declined from time to time for market-specific reasons, including adverse weather, lack of affordability or economic contraction due to, among other things, the failure or decline of key industries and employers. If home prices or sales activity decline in one or more of the key markets in


15


Table of Contents

which we operate, particularly in Arizona, California, Florida or Nevada, our costs may not decline at all or at the same rate and, as a result, our overall results of operations may be adversely affected.
 
Interest rate increases or changes in federal lending programs could lower demand for our homes.
 
Nearly all of our customers finance the purchase of their homes. In recent years, historically low interest rates and the increased availability of specialized mortgage products, including mortgage products requiring no or low down payments, and interest-only and adjustable rate mortgages, have made homebuying more affordable for a number of customers. Increases in interest rates or decreases in the availability of mortgage financing or of certain mortgage programs may lead to higher down payment requirements or monthly mortgage costs, or both, and could therefore reduce demand for our homes.
 
Increased interest rates can also hinder our ability to realize our backlog because our home purchase contracts provide our customers with a financing contingency. Financing contingencies allow customers to cancel their home purchase contracts in the event they cannot arrange for financing at the interest rates prevailing when they signed their contracts.
 
Because the availability of Fannie Mae, Federal Home Loan Mortgage Corporation, FHA and VA mortgage financing is an important factor in marketing and selling many of our homes, any limitations or restrictions in the availability of such government-backed financing could reduce our home sales.
 
We are subject to substantial legal and regulatory requirements regarding the development of land, the homebuilding process and protection of the environment, which can cause us to suffer delays and incur costs associated with compliance and which can prohibit or restrict homebuilding activity in some regions or areas.
 
Our homebuilding business is heavily regulated and subject to an increasing degree of local, state and federal regulations concerning zoning, resource protection and other environmental impacts, building design, construction and similar matters. These regulations often provide broad discretion to governmental authorities that regulate these matters, which can result in unanticipated delays or increases in the cost of a specified project or a number of projects in particular markets. We may also experience periodic delays in homebuilding projects due to building moratoria in any of the areas in which we operate.
 
We are also subject to a variety of local, state and federal statutes, ordinances, rules and regulations concerning the environment. These laws and regulations may cause delays in construction and delivery of new homes, may cause us to incur substantial compliance and other costs, and can prohibit or severely restrict homebuilding activity in certain environmentally sensitive regions or areas. In addition, environmental laws may impose liability for the costs of removal or remediation of hazardous or toxic substances whether or not the developer or owner of the property knew of, or was responsible for, the presence of those substances. The presence of those substances on our properties may prevent us from selling our homes and we may also be liable, under applicable laws and regulations or lawsuits brought by private parties, for hazardous or toxic substances on properties and lots that we have sold in the past.
 
Further, a significant portion of our business is conducted in California, which is one of the most highly regulated and litigious states in the country. Therefore, our potential exposure to losses and expenses due to new laws, regulations or litigation may be greater than other homebuilders with a less significant California presence.
 
Because of our French business, we are also subject to regulations and restrictions imposed by the government of France concerning investments by non-French companies in businesses in France, as well as to French and European Union laws and regulations similar to those discussed above.
 
The mortgage banking operations of Countrywide KB Home Loans are heavily regulated and subject to the rules and regulations promulgated by a number of governmental and quasi-governmental agencies. There are a number of federal and state statutes and regulations which, among other things, prohibit discrimination, establish underwriting guidelines which include obtaining inspections and appraisals, require credit reports on prospective borrowers and fix maximum loan amounts. A finding that we or Countrywide KB Home Loans materially violated any of the foregoing laws could have an adverse effect on our results of operations.


16


Table of Contents

We are subject to a Consent Order that we entered into with the Federal Trade Commission in 1979. Pursuant to the Consent Order, we provide explicit warranties on the quality of our homes, follow certain guidelines in advertising and provide certain disclosures to prospective purchasers of our homes. A finding that we have significantly violated the Consent Order could result in substantial liabilities or penalties and could limit our ability to sell homes in certain markets.
 
We build homes in highly competitive markets, which could hurt our future operating results.
 
We compete in each of our markets with a number of homebuilding companies for homebuyers, land, financing, building materials, skilled management and labor resources. Our competitors include other large national homebuilders, as well as smaller regional or local builders that, based on long-standing relationships with local labor, materials suppliers or land sellers, can have an advantage in their respective regions or local markets. We also compete with other housing alternatives, such as existing homes and rental housing.
 
These competitive conditions can:
 
  •  make it difficult for us to acquire desirable land which meets our land buying criteria, and to sell our interests in land that no longer meet our investment return criteria on favorable terms;
 
  •  reduce our sales or profit margins;
 
  •  cause us to offer or increase our sales incentives, discounts or price concessions; and
 
  •  reduce new home sales or increase cancellations by homebuyers of their home purchase contracts with us.
 
Any of these competitive conditions can adversely affect our revenues, increase our costs and/or impede the growth of our local or regional homebuilding business.
 
The design and construction of high density, mixed use properties in the United States present unique challenges, and we have limited experience in this business.
 
We have a limited operating history in the United States in designing and constructing high density, mixed use properties, but we have increased our involvement in such projects over the last few years. Among other risks, our success depends on our ability to accurately gauge customer demand for this type of housing. If our high density, mixed use projects underperform, or the KBnxt operational business model does not translate well to these types of projects, our overall results of operations may be adversely affected.
 
Because of the seasonal nature of our business, our quarterly operating results fluctuate.
 
We have experienced seasonal fluctuations in quarterly operating results. We typically do not commence significant construction on a home before a home purchase contract has been signed with a homebuyer. Historically, a significant percentage of our home purchase contracts are entered into in the spring and summer months, and a corresponding significant percentage of our deliveries occur in the fall and winter months. Construction of our homes typically requires approximately four months and weather delays that often occur in late winter and early spring may extend this period. As a result of these combined factors, we historically have experienced uneven quarterly results, with lower revenues and operating income generally during the first and second quarters of the year.
 
Our leverage may place burdens on our ability to comply with the terms of our indebtedness, may restrict our ability to operate and may prevent us from fulfilling our obligations.
 
The amount of our debt could have important consequences. For example, it could:
 
  •  limit our ability to obtain future financing for working capital, capital expenditures, acquisitions, debt service requirements or other requirements;
 
  •  require us to dedicate a substantial portion of our cash flow from operations to the payment of our debt and reduce our ability to use our cash flow for other purposes;
 
  •  impact our flexibility in planning for, or reacting to, changes in our business;


17


Table of Contents

 
  •  place us at a competitive disadvantage because we have more debt than some of our competitors; and
 
  •  make us more vulnerable in the event of a downturn in our business or in general economic conditions.
 
Our ability to meet our debt service and other obligations will depend upon our future performance. Our business is substantially affected by changes in economic cycles. Our revenues and earnings vary with the level of general economic activity and competition in the markets in which we operate. Our business could also be affected by financial, political and other factors, many of which are beyond our control. Changes in prevailing interest rates may also affect our ability to meet our debt service obligations because borrowings under our $1.5 Billion Credit Facility and other bank loans bear interest at floating rates. A higher interest rate on our debt could adversely affect our operating results.
 
Our business may not generate sufficient cash flow from operations and borrowings may not be available to us under our $1.5 Billion Credit Facility and other bank loans in an amount sufficient to pay our debt service obligations or to fund our other liquidity needs. Should this occur, we may need to refinance all or a portion of our debt on or before maturity, which we may not be able to do on favorable terms or at all.
 
The indentures governing our outstanding debt instruments and our $1.5 Billion Credit Facility and other bank loans include financial and other covenants and restrictions, including covenants to report quarterly and annual financial results and restrictions on debt incurrence, sales of assets and cash distributions by us. Should we not comply with these restrictions or covenants, the holders of those debt instruments or the banks, as appropriate, could cause our debt to become due and payable prior to maturity or they could demand that we compensate them for waiving instances of noncompliance.
 
We may have difficulty in continuing to obtain the additional financing required to operate and develop our business.
 
Our construction operations require significant amounts of cash and/or available credit. It is not possible to predict the future terms or availability of additional capital. Moreover, our outstanding domestic public debt, as well as the $1.5 Billion Credit Facility and the credit facilities of our French subsidiary, contain provisions that may restrict the amount and nature of debt we may incur in the future. Our bank credit facilities limit our ability to borrow additional funds by placing a maximum cap on our leverage ratio. Under the most restrictive of these provisions, as of November 30, 2006, we would have been permitted to incur up to $5.24 billion of total consolidated indebtedness, as defined in the bank credit facilities. This maximum amount exceeded our actual total consolidated indebtedness at November 30, 2006 by $2.58 billion. There can be no assurance that we can actually borrow up to this maximum amount at any time, as our ability to borrow additional funds, and to raise additional capital through other means, is also dependent on conditions in the capital markets and our credit worthiness. If conditions in the capital markets change significantly, it could reduce our sales and may hinder our future growth and results of operations.
 
Our future growth may be limited if the economies of the markets in which we currently operate contract, or if we are unable to enter new markets, find appropriate acquisition candidates or adapt our products to meet changes in demand. Our growth may also be limited by the consummation of acquisitions that may not be successfully integrated, or our entry into new markets or our offerings of new products that may not achieve expected benefits.
 
Our future growth and results of operations could be adversely affected if the markets in which we currently operate or the products we currently offer to potential homebuyers, or both, do not continue to support the expansion of our business. Our inability to grow in our existing markets, to expand into new markets and/or adapt our products to meet changes in homebuyer demand would limit our ability to achieve growth objectives and would adversely impact our future operating results. Similarly, if we do consummate acquisitions in the future, we may not be successful in integrating the operations of the acquired businesses, including their product lines, operations and corporate cultures, which would limit our ability to grow and would adversely impact our future operating results.
 
Because we build homes in France, some of our revenues and earnings are subject to foreign currency and economic risks.
 
A portion of our construction operations are located in France. As a result, our financial results are affected by fluctuations in the value of the U.S. dollar as compared to the euro and changes in the French economy to the extent those


18


Table of Contents

changes affect the homebuilding market there. We do not currently use any currency hedging instruments or other strategies to manage currency risks related to fluctuations in the value of the U.S. dollar or the euro.
 
We are involved in an SEC investigation and litigation relating to our past stock option grant practices.
 
As disclosed in the Explanatory Note on page 1 of this Form 10-K, the Subcommittee concluded that we used incorrect measurement dates for financial reporting purposes for the eight annual stock option grants made to our employees since 1998. The Subcommittee discovered evidence confirming or, in some years, suggesting that hindsight was used to secure favorable exercise prices for seven of these eight annual grants. The SEC is conducting an investigation into our stock option grant practices. In addition, shareholder derivative lawsuits have been filed in California state and federal courts relating to our stock option grant practices. It is possible that additional lawsuits may be filed. The investigation and lawsuits have resulted in, and will continue to result in, substantial legal and professional fees, and will continue to occupy our time and attention. An adverse outcome to the investigation or one or more of the lawsuits may have a negative effect on our business and our results of operations.
 
The process of restating our financial statements is subject to uncertainty and evolving requirements.
 
We have worked with our independent registered public accounting firm and the SEC to make our filings comply with applicable accounting and financial reporting guidance for restatements of the kind presented in this Form 10-K. The issues surrounding past stock option grant practices and financial statement restatements are complex, however, and guidance in these areas may continue to evolve. If new guidance imposes additional or different requirements, we may be required to amend this filing or previous filings. The additional cost and time to prepare any such amendment and the public reaction to any such amendment may have an adverse effect on our business.
 
Item 1B.  UNRESOLVED STAFF COMMENTS  
 
None.
 
Item 2.  PROPERTIES  
 
We lease our corporate headquarters in Los Angeles, California. Our homebuilding division offices, except for our San Antonio, Texas office, and our KB Home Studios are located in leased space in the markets where we conduct business. Our homebuilding operations in San Antonio, Texas are principally conducted from premises that we own.
 
We believe that such properties, including the equipment located therein, are suitable and adequate to meet the requirements of our businesses.
 
Item 3.  LEGAL PROCEEDINGS  
 
Derivative Litigation
 
On July 10, 2006, a shareholder derivative action, Wildt v. Karatz, et al., was filed in Los Angeles Superior Court. On August 8, 2006, a virtually identical shareholder derivative lawsuit, Davidson v. Karatz, et al., was also filed in Los Angeles Superior Court. These actions, which ostensibly are brought on our behalf, allege, among other things, that defendants (various of our current and former directors and officers) breached their fiduciary duties to us by, among other things, backdating grants of stock options to various current and former executives in violation of our shareholder-approved stock option plans. Defendants have not yet responded to the complaints. We and the parties have agreed to a stipulation and proposed order that was submitted to the court on January 5, 2007, providing, among other things, that, to preserve the status quo without prejudicing any party’s substantive rights, our former Chairman and Chief Executive Officer shall not exercise any of his outstanding options, at any price, during the period in which the order is in effect, and that the order shall be effective upon entry by the court and expire on March 31, 2007, unless otherwise agreed in writing. The court entered the order on January 22, 2007. In connection with the entry of this order, the plaintiffs agreed to stay their cases while the parallel federal court derivative lawsuits discussed below are pursued. A stipulation and order effectuating the parties’ agreement to stay the state court actions was entered by the court on February 7, 2007.


19


Table of Contents

On August 16, 2006, a shareholder derivative lawsuit, Redfield v. Karatz, et al., was filed in the United States District Court for the Central District of California. On August 31, 2006, a virtually identical shareholder derivative lawsuit, Staehr v. Karatz, et al., was also filed in the United States District Court for the Central District of California. These actions, which ostensibly are brought on our behalf, allege, among other things, that defendants (various of our current and former directors and officers) breached their fiduciary duties to us by, among other things, backdating grants of stock options to various current and former executives in violation of our shareholder-approved stock option plans. Unlike Wildt and Davidson, however, these lawsuits also include substantive claims under the federal securities laws. On November 6, 2006, the court entered an order that, among other things, consolidated these two cases and specified that defendants’ response to the consolidated complaint would be due within 45 days after service of the consolidated complaint. On January 9, 2007, plaintiffs filed their consolidated complaint. Defendants have not yet responded to the complaint, and discovery has not commenced.
 
SEC Investigation
 
In August 2006, we announced that we had received an informal inquiry from the SEC relating to our stock option grant practices. In January 2007, we were informed that the SEC is now conducting a formal investigation of this matter. We have cooperated with the SEC regarding this matter and intend to continue to do so.
 
Storm Water Matter
 
In January 2003, we received a request for information from the EPA pursuant to Section 308 of the Clean Water Act. Several other public homebuilders have received similar requests. The request sought information about storm water pollution control program implementation at certain of our construction sites, and we provided information pursuant to the request. In May 2004, on behalf of the EPA, the U.S. Department of Justice (“DOJ”) tentatively asserted that certain regulatory requirements applicable to storm water discharges had been violated on certain occasions at certain of our construction sites, and civil penalties and injunctive relief might be warranted. The DOJ has also proposed certain steps it would expect us to take in the future relating to compliance with the EPA’s requirements applicable to storm water discharges. We have defenses to the claims that have been asserted and are exploring methods of resolving the matter. While the costs associated with the claims cannot be determined at this time, we believe that such costs are not likely to be material to our consolidated financial position or results of operations.
 
Other Matters
 
We are also involved in litigation and governmental proceedings incidental to our business. These cases are in various procedural stages and, based on reports of counsel, it is our opinion that provisions or reserves made for potential losses are adequate and any liabilities or costs arising out of currently pending litigation will not have a materially adverse effect on our consolidated financial position or results of operations.
 
Item 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
On October 25, 2006, we commenced a solicitation of consents from holders of our $1.65 billion outstanding senior notes. The purpose of the consent solicitation was to obtain from the holders of such notes approval to amend the indenture governing our senior notes to suspend through and including February 23, 2007 the occurrence of certain defaults or Events of Default (as defined in the indenture), and the consequences thereof, caused by our failure to timely deliver consolidated financial statements for our quarter ended August 31, 2006, and certain related matters. We also sought a waiver of all defaults caused by such matters prior to the effective date of the proposed amendment.
 
We received valid and unrevoked consents with respect to $320.1 million principal amount of our 63/8% Senior Notes due 2011 (91.5%), $248.9 million principal amount of our 53/4% Senior Notes due 2014 (99.5%), $153.3 million principal amount of our 57/8% Senior Notes due 2015 (51.1%), $295.0 million of our 61/4% Senior Notes due 2015 (65.6%), and $194.9 million principal amount of our 71/4% Senior Notes due 2018 (65.0%). The proposed amendment to the indenture and the waiver became effective on November 9, 2006.


20


Table of Contents

EXECUTIVE OFFICERS OF THE REGISTRANT
 
The following sets forth certain information regarding our executive officers as of January 31, 2007:  
 
                                     
              Year
    Years
       
              Assumed
    at
  Other Positions and Other
   
          Present Position at
  Present
    KB
  Business Experience within the
   
Name  
Age
    January 31, 2007  
Position
   
Home
  Last Five Years (a)  
From – To
 
Jeffrey T. Mezger
    51    
President and Chief
  Executive Officer
    2006     13  
Executive Vice President and Chief Operating Officer
  1999-2006
                                 
                                 
                           
Domenico Cecere
    57    
Executive Vice President and
    2007      5  
Senior Vice President and Chief Financial Officer
  2002-2006
           
  Chief Financial Officer
             
Consultant, Gryphon Investors
  2001-2002
                                 
                                 
                           
Glen Barnard
    62    
Senior Vice President, KBnxt Group
    2006     8  
Regional General Manager (b)
  2004-2006
                           
Chief Executive Officer, Constellation Real Technologies
  2001-2003
                                 
                                 
                           
Robert Freed
    50    
Senior Vice President, Investment
    2005     12  
Regional General Manager
  2000-2005
           
  Strategy and Regional General
             
President, KB Home North Bay Inc.
  2000-2004
           
  Manager
             
President, KB Home South Bay Inc.
  1997-2003
                                 
                                 
                           
William R. Hollinger
    48    
Senior Vice President and
    2007     19  
Senior Vice President and Controller
  2001-2006
           
  Chief Accounting Officer
                   
                                 
                                 
                           
Kelly Masuda
    39    
Senior Vice President and
Treasurer
    2005     3  
Senior Vice President, Capital Markets and Treasurer
  2005
                           
Vice President, Capital Markets and Treasurer
  2003-2005
                           
Director, Credit Suisse First Boston
  2000-2002
(a)  All positions described were with us, unless otherwise indicated.
 
(b)  Mr. Barnard was a senior executive with us from 1996-2001, and rejoined us in 2004.


21


Table of Contents

 
PART II
 
Item 5.   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
As of December 31, 2006, there were 923 holders of record of our common stock. Our common stock is traded on the New York Stock Exchange under the ticker symbol “KBH.” The following table sets forth, for the periods indicated, the price ranges of our common stock. Stock prices and dividend amounts have been adjusted to reflect the impact of the two-for-one split of our common stock described below.
 
                                 
    2006     2005  
    High     Low     High     Low  
 
First Quarter
  $ 81.99     $ 64.80     $ 63.19     $ 43.89  
Second Quarter
    69.10       50.40       67.55       54.21  
Third Quarter
    52.65       37.89       85.45       66.50  
Fourth Quarter
    52.18       38.66       77.92       60.82  
 
 
We paid quarterly cash dividends of $.25 per common share in 2006 and $.1875 per common share in 2005.
 
On April 7, 2005, our stockholders approved an amendment to our certificate of incorporation increasing the number of authorized shares of our common stock from 100 million to 300 million. Immediately following this action, our board of directors declared a two-for-one split of our common stock in the form of a 100% stock dividend that was paid on April 28, 2005 to stockholders of record at the close of business on April 18, 2005.
 
Certain debt instruments to which we are a party contain restrictions on the payment of cash dividends. Based on the most restrictive of these provisions, $532.2 million of retained earnings was available for payment of cash dividends at November 30, 2006.
 
The description of our equity compensation plans required by Item 201(d) of Regulation S-K is incorporated herein by reference to Part III, Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters of this Form 10-K.
 
We did not repurchase any of our equity securities during the fourth quarter of 2006.


22


Table of Contents

 
Item 6.  SELECTED FINANCIAL DATA
 
The data in this table should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and our Consolidated Financial Statements and Notes thereto included elsewhere in this report. The information presented in this table reflects the restatement of our financial results which is more fully described in the Explanatory Note on Page 1 of this Form 10-K.
 
KB HOME
SELECTED FINANCIAL INFORMATION
(In Thousands, Except Per Share Amounts)
 
                                         
    Years Ended November 30,  
    2006     2005 (a)     2004 (b)     2003 (b)     2002 (b)  
          (as restated)     (as restated)     (as restated)     (as restated)  
 
                                         
Construction:
                                       
Revenues
  $ 10,983,552     $ 9,410,282     $ 7,008,267     $ 5,775,429     $ 4,938,894  
Operating income
    755,717       1,351,187       772,333       559,456       446,233  
Total assets
    8,970,440       7,711,446       5,623,593       3,984,837       3,393,513  
Mortgages and notes payable
    3,125,803       2,463,814       1,975,600       1,253,932       1,167,053  
                                         
Financial services:
                                       
Revenues
  $ 20,240     $ 31,368     $ 44,417     $ 75,125     $ 91,922  
Operating income
    14,317       10,968       8,688       35,777       57,506  
Total assets
    44,024       29,933       210,460       253,113       634,106  
Notes payable
                71,629       132,225       507,574  
                                         
Consolidated:
                                       
Revenues
  $ 11,003,792     $ 9,441,650     $ 7,052,684     $ 5,850,554     $ 5,030,816  
Operating income
    770,034       1,362,155       781,021       595,233       503,739  
Net income
    482,351       823,712       474,036       367,921       308,666  
Total assets
    9,014,464       7,741,379       5,834,053       4,237,950       4,027,619  
Mortgages and notes payable
    3,125,803       2,463,814       2,047,229       1,386,157       1,674,627  
Stockholders’ equity
    2,922,748       2,773,797       2,039,390       1,592,162       1,274,535  
                                         
                     
Basic earnings per share
  $ 6.12     $ 10.06     $ 6.05     $ 4.67     $ 3.72  
Diluted earnings per share
    5.82       9.32       5.62       4.37       3.51  
Cash dividends per common share
    1.00       .75       .50       .15       .15  
                                         
 
 
(a)  See Note 2. Restatement of Consolidated Financial Statements in the Notes to Consolidated Financial Statements in this Form 10-K for a description of the restatement and its effects.


23


Table of Contents

 
(b)  The following table reflects the adjustments related to the restatements for periods not derived from the accompanying audited consolidated financial statements (in thousands, except per share amounts):
 
                                                                         
    2004     2003     2002  
    As previously
                As previously
                As previously
             
    reported     Adjustments     As restated     reported     Adjustments     As restated     reported     Adjustments     As restated  
 
Construction:
                                                                       
Revenues
  $ 7,008,267     $     $ 7,008,267     $ 5,775,429     $     $ 5,775,429     $ 4,938,894     $     $ 4,938,894  
Operating income
    774,699       (2,366 )     772,333       562,899       (3,443 )     559,456       452,917       (6,684 )     446,233  
Total assets
    5,625,496       (1,903 )     5,623,593       3,982,746       2,091       3,984,837       3,391,434       2,079       3,393,513  
Mortgages and notes payable
    1,975,600             1,975,600       1,253,932             1,253,932       1,167,053             1,167,053  
                                                                         
Financial services:
                                                                       
Revenues
  $ 44,417     $     $ 44,417     $ 75,125     $     $ 75,125     $ 91,922     $     $ 91,922  
Operating income
    8,688             8,688       35,777             35,777       57,506             57,506  
Total assets
    210,460             210,460       253,113             253,113       634,106             634,106  
Notes payable
    71,629             71,629       132,225             132,225       507,574             507,574  
                                                                         
Consolidated:
                                                                       
Revenues
  $ 7,052,684     $     $ 7,052,684     $ 5,850,554     $     $ 5,850,554     $ 5,030,816     $     $ 5,030,816  
Operating income
    783,387       (2,366 )     781,021       598,676       (3,443 )     595,233       510,423       (6,684 )     503,739  
Net income
    480,902       (6,866 )     474,036       370,764       (2,843 )     367,921       314,350       (5,684 )     308,666  
Total assets
    5,835,956       (1,903 )     5,834,053       4,235,859       2,091       4,237,950       4,025,540       2,079       4,027,619  
Mortgages and notes payable
    2,047,229             2,047,229       1,386,157             1,386,157       1,674,627             1,674,627  
Stockholders’ equity
    2,039,390             2,039,390       1,592,851       (689 )     1,592,162       1,274,351       184       1,274,535  
                                                                         
Basic earnings per share
  $ 6.14     $ (0.09 )   $ 6.05     $ 4.71     $ (.04 )   $ 4.67     $ 3.79     $ (.07 )   $ 3.72  
Diluted earnings per share
    5.70       (0.08 )     5.62       4.40       (.03 )     4.37       3.58       (.07 )     3.51  
Cash dividends per common share
    0.50             0.50       .15             .15       .15             .15  
                                                                         
 
As a consequence of the stock option adjustments discussed in the Explanatory Note on page 1, we had to reflect additional stock-based compensation expense in the pro forma information required to be disclosed in our footnotes under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). The effect of this change is presented in the following table (in thousands, except per share amounts):
 
                                         
    2005     2004     2003     2002        
    (as restated)     (as restated)     (as restated)     (as restated)        
 
                                                                 
Net income
  $ 823,712     $ 474,036     $ 367,921     $ 308,666          
Add: Stock-based compensation expense included in net income, net of related tax effects
    4,309       1,866       2,743       5,484          
Deduct: Stock-based compensation expense determined using the fair value method, net of related tax effects
    (19,462 )     (14,922 )     (14,710 )     (15,012 )        
                                         
Pro forma net income
  $ 808,559     $ 460,980     $ 355,954     $ 299,138          
                                         
Earnings per share:
                                       
Basic — as restated
  $ 10.06     $ 6.05     $ 4.67     $ 3.72          
                                         
Basic — pro forma
  $ 9.87     $ 5.89     $ 4.52     $ 3.60          
                                         
Diluted — as restated
  $ 9.32     $ 5.62     $ 4.37     $ 3.51          
                                         
Diluted — pro forma
  $ 9.21     $ 5.54     $ 4.29     $ 3.46          
                                         


24


Table of Contents

 
Item 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
 
The information below has been adjusted to reflect the restatement of financial results which is more fully described in the Explanatory Note beginning on page 1 of this Form 10-K and in Note 2. Restatement of Consolidated Financial Statements in the Notes to Consolidated Financial Statements in this Form 10-K.
 
RESULTS OF OPERATIONS
 
Overview.  Revenues are generated from (a) our construction operations in the United States and France, and (b) our domestic financial services operations. The following table presents a summary of our results for the years ended November 30, 2006, 2005 and 2004 (in thousands, except per share amounts):
 
                         
    Years ended November 30,  
    2006     2005     2004  
          (as restated)     (as restated)  
 
Revenues:
                       
Construction
  $ 10,983,552     $ 9,410,282     $ 7,008,267  
Financial services
    20,240       31,368       44,417  
                         
Total revenues
  $ 11,003,792     $ 9,441,650     $ 7,052,684  
                         
Pretax income:
                       
Construction
  $ 664,515     $ 1,279,014     $ 706,648  
Financial services
    33,536       11,198       8,688  
                         
Total pretax income
    698,051       1,290,212       715,336  
Income taxes
    (215,700 )     (466,500 )     (241,300 )
                         
Net income
  $ 482,351     $ 823,712     $ 474,036  
                         
Diluted earnings per share
  $ 5.82     $ 9.32     $ 5.62  
                         
 
In the first half of 2006, we generated favorable financial results due in part to higher average selling prices and our strong backlog level at the beginning of the year. However, conditions in the homebuilding industry became increasingly challenging in the second half of 2006, mainly due to an oversupply of new and resale homes in many of our domestic markets. The same investors and speculators who fueled high demand in recent years began exiting the market and offering their homes for sale. At the same time, the reduced affordability of housing and a lack of urgency on the part of potential homebuyers amid market uncertainty have heightened competition among homebuilders and other sellers, and caused many homebuyers to delay or cancel their purchases. As a result of these conditions, we increased our advertising efforts and the use of price discounts and other incentives to generate sales. Still, like other homebuilders, we experienced an increase in home purchase contract cancellations and a decrease in net new orders in 2006.
 
These market trends, which we do not expect to improve significantly, or at all, in 2007, negatively affected our results of operations compared to 2005. While we experienced growth in our total revenues, our operating income dropped compared to 2005. This lower operating income was primarily due to a decrease in our housing gross margin stemming from the increased use of price discounts and other sales incentives, increased advertising expenditures and a non-cash charge for the impairment of certain land inventory and the abandonment of land option contracts.
 
While we believe that the long-term prospects for both the homebuilding industry and our operations are solid, it will take time for individual markets to work through the current oversupply of housing. Until market conditions improve, we expect to continue to experience high cancellation rates and fewer net orders compared to recent years. The net order decrease we experienced in the latter half of 2006 is also expected to result in a year-over-year decrease in our unit deliveries in the first half of 2007, and potentially longer.
 
Total revenues reached $11.00 billion for the year ended November 30, 2006, increasing 17% from $9.44 billion in 2005, which had increased 34% from $7.05 billion in 2004. Our revenue growth in both 2006 and 2005 was driven by an increase in housing revenues stemming from increased unit deliveries and higher average selling prices. Included in our total revenues were financial services revenues of $20.2 million in 2006, $31.4 million in 2005 and $44.4 million in


25


Table of Contents

2004. The decrease in financial services revenues in 2006 and 2005 primarily reflects the change in the mortgage banking operations of KB Home Mortgage Company (“KBHMC”) in the fourth quarter of 2005 to an unconsolidated joint venture. On September 1, 2005, we completed the sale of substantially all the mortgage banking assets of KBHMC to Countrywide and in a separate transaction established Countrywide KB Home Loans. KB Home and Countrywide each have a 50% ownership interest in Countrywide KB Home Loans, which is accounted for as an unconsolidated joint venture in the financial services reporting segment of our consolidated financial statements.
 
Net income decreased 41% to $482.4 million in 2006 from $823.7 million in 2005 primarily due to a decrease in the operating margin in our construction operations. Our 2006 pretax income included charges of $431.2 million associated with inventory and joint venture impairments, and land option contract write-offs. It also reflects a gain of $27.6 million related to the sale of our ownership interest in a joint venture. In 2005, net income increased 74% from $474.0 million in 2004 largely due to higher unit delivery volume and an expanded operating margin. Diluted earnings per share decreased 38% to $5.82 in 2006 from $9.32 in 2005, which had increased 66% from $5.62 in 2004.
 
Backlog at November 30, 2006 in both units and value decreased from 2005 levels. The value of our backlog decreased 34% to $4.43 billion on 17,384 units, down from $6.76 billion on 25,722 units at November 30, 2005. All of our domestic geographic segments reported lower backlog as of November 30, 2006 compared to November 30, 2005. The decrease in backlog primarily resulted from higher cancellation rates, which contributed to a 38% decrease in fourth quarter net orders for new homes to 6,059 in 2006 from 9,747 in 2005.
 
In April 2005, our board of directors declared a two-for-one split of our common stock in the form of a 100% stock dividend to stockholders of record at the close of business on April 18, 2005. The additional shares were distributed on April 28, 2005. All share and per share amounts have been retroactively adjusted to reflect the stock split.
 
We repurchased six million shares of our common stock in 2006 at an aggregate price of $377.4 million. As of November 30, 2006, we were authorized to repurchase an additional four million shares under our current board-approved share repurchase program. However, in connection with the Stock Option Review, our board of directors suspended the share repurchase program.
 
As a result of the stock option restatement, we recorded additional stock-based compensation expenses in our quarterly consolidated statements of income. There was no impact on our previously reported revenues in any quarter. Additionally, gross margins for our operating segments remain unchanged. We recorded all costs associated with the Stock Option Review and the restatement as a component of selling, general and administrative expenses.


26


Table of Contents

CONSTRUCTION
 
We have grouped our construction activities into five reportable segments, which we refer to as West Coast, Southwest, Central, Southeast and France. As of November 30, 2006, our domestic reportable construction segments consisted of operations located in the following states: West Coast: California; Southwest: Arizona, Nevada and New Mexico; Central: Colorado, Illinois, Indiana, Louisiana and Texas; Southeast: Florida, Georgia, Maryland, North Carolina, South Carolina and Virginia.
 
The following table presents a summary of selected financial and operational data for our construction operations (dollars in thousands, except average selling price):
 
                         
    Years ended November 30,  
    2006     2005     2004  
          (as restated)     (as restated)  
 
Revenues:
                       
Housing
  $ 10,830,793     $ 9,364,803     $ 6,957,548  
Commercial
    23,027       5,202       22,834  
Land
    129,732       40,277       27,885  
                         
Total
    10,983,552       9,410,282       7,008,267  
                         
             
Costs and expenses:
                       
Construction and land costs
                       
Housing
    8,614,688       6,852,541       5,285,619  
Commercial
    18,760       3,077       17,697  
Land
    220,055       32,521       22,540  
                         
Subtotal
    8,853,503       6,888,139       5,325,856  
Selling, general and administrative expenses
    1,374,332       1,170,956       910,078  
                         
             
Total
    10,227,835       8,059,095       6,235,934  
                         
             
Operating income
  $ 755,717     $ 1,351,187     $ 772,333  
                         
             
Unit deliveries
    39,013       37,140       31,646  
             
Average selling price
  $ 277,600     $ 252,100     $ 219,900  
             
Housing gross margin
    20.5%       26.8%       24.0%  
             
Selling, general and administrative expenses as a percent of housing revenues
    12.7%       12.5%       13.1%  
             
Operating income as a percent of construction revenues
    6.9%       14.4%       11.0%  
 
Revenues.  Construction revenues totaled $10.98 billion in 2006, increasing 17% from $9.41 billion in 2005, which had increased 34% from $7.01 billion in 2004. The increases in both 2006 and 2005 resulted primarily from higher housing revenues driven by increased unit delivery volume and a higher average selling price.
 
Housing revenues totaled $10.83 billion in 2006, $9.36 billion in 2005 and $6.96 billion in 2004. In 2006, housing revenues increased 16% from the previous year due to 5% growth in unit delivery volume and 10% growth in the average selling price. In 2005, housing revenues rose 35% from 2004 results due to a 17% increase in unit delivery volume and a 15% increase in the average selling price.
 
Our housing deliveries increased 5% to 39,013 units in 2006 from 37,140 units in 2005, reflecting growth in U.S. and French deliveries of 4% and 12%, respectively. The growth in our domestic unit deliveries reflected year-over-year increases of 9% and 16% in the West Coast and Southeast segments, respectively, partially offset by decreases of 5% and 3% in unit deliveries from the Southwest and Central segments, respectively.


27


Table of Contents

In 2005, our housing deliveries increased 17% to 37,140 units from 31,646 units delivered in 2004. The increase in our domestic deliveries in 2005 reflected year-over-year increases of 23%, 8% and 44% from our West Coast, Central and Southeast segments, respectively, partially offset by a slight decrease in unit deliveries from our Southwest segment. French deliveries increased 30% in 2005 versus 2004.
 
Our average new home price rose 10% in 2006, to $277,600 from $252,100 in 2005, primarily due to the delivery in 2006 of homes purchased in the latter half of 2005, when market conditions were more favorable than at present. Increases in the average selling price were most notable in the West Coast, Southwest, Southeast and France segments, with a slight increase in the Central segment.
 
The 2005 average new home price had increased 15% from $219,900 in 2004, reflecting generally favorable market conditions, with increases in all of our domestic segments, partly offset by a decrease in the France segment. The higher average selling price in all of our domestic segments in 2005 resulted from a number of market specific factors that pushed demand higher for our homes, premium lots and optional amenities.
 
Revenues from commercial development activities, all of which are located in metropolitan Paris, totaled $23.0 million in 2006, $5.2 million in 2005, and $22.8 million in 2004.
 
Land sale revenues totaled $129.7 million in 2006, $40.3 million in 2005 and $27.9 million in 2004. Generally, land sale revenues fluctuate with our decisions to maintain or decrease our land ownership position in certain markets based upon the volume of our holdings, the strength and number of competing developers entering particular markets at given points in time, the availability of land in markets we serve and prevailing market conditions. Land sales were more significant in 2006 compared to prior periods, as we sold some of our land in light of challenging market conditions and more moderate demand for new homes.
 
Operating Income.  Operating income decreased to $755.7 million in 2006, down 44% from $1.35 billion in 2005. As a percentage of construction revenues, operating income decreased to 6.9% in 2006 from 14.4% in 2005, mainly due to a lower housing gross margin. Housing gross profits in 2006 decreased 12%, or $296.2 million, to $2.22 billion from $2.51 billion in 2005. As a percentage of related revenues, the housing gross margin was 20.5% in 2006, down from 26.8% in the prior year, primarily due to greater use of price concessions and incentives to meet competitive conditions and aggregate charges of $309.5 million associated with inventory impairments and the abandonment of land purchase options we no longer plan to exercise. Operating income increased 75% to $1.35 billion in 2005 from $772.3 million in 2004. As a percentage of revenues, operating income rose to 14.4% in 2005 from 11.0% in 2004. Housing gross profits in 2005 increased 50%, or $840.3 million, to $2.51 billion from $1.67 billion in 2004. As a percentage of related revenues, the housing gross margin rose to 26.8% in 2005, up from 24.0% in 2004, primarily due to a higher average selling price. Commercial activities in France generated profits of $4.3 million in 2006, compared to $2.1 million in 2005 and $5.1 million in 2004. Our land sales generated losses of $90.3 million in 2006, including impairment charges of $63.1 million relating to future land sales. In 2005 and 2004, land sales generated profits of $7.8 million and $5.3 million, respectively.
 
We evaluate our land and housing inventory for recoverability in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”) on a quarterly basis, and more frequently if impairment indicators exist. During 2006, we recognized a non-cash charge of $228.7 million for the impairment of inventory. The inventory is located in markets where conditions have become challenging, mainly as a result of the excess supply in the face of more moderate demand for new homes. These market dynamics caused a decline in the fair value of certain inventory positions and prompted changes in our strategy concerning projects that no longer meet our internal investment standards. In 2005 and 2004, we recorded non-cash charges of $26.7 million and $4.7 million, respectively, related to inventory impairments.
 
From time to time, we will write off costs, including earnest money deposits and pre-acquisition costs, associated with land purchase option contracts which we do not intend to exercise. During 2006, 2005 and 2004, we wrote off $143.9 million, $16.2 million and $32.2 million, respectively, as a result of land option contract abandonments.
 
The inventory impairment charges and land option contract write-offs are included in construction and land costs in our consolidated statements of income.


28


Table of Contents

 
Selling, general and administrative expenses totaled $1.37 billion in 2006 compared with $1.17 billion in 2005 and $910.1 million in 2004. As a percentage of housing revenues, to which these expenses are most closely correlated, selling, general and administrative expenses were 12.7% in 2006, 12.5% in 2005 and 13.1% in 2004.
 
Interest Income and Expense.  Interest income, which is generated from short-term investments, and mortgages and notes receivable, amounted to $6.1 million in 2006, $4.2 million in 2005 and $3.9 million in 2004. Generally, increases and decreases in interest income are attributable to changes in the interest-bearing average balances of short-term investments, and mortgages and notes receivable, as well as fluctuations in interest rates.
 
Interest expense results principally from borrowings to finance land purchases, housing inventory and other operating and capital needs. In 2006, interest expense, net of amounts capitalized, decreased slightly to $18.7 million from $18.9 million in 2005. Gross interest incurred in 2006 was $80.8 million higher than that incurred in 2005, mainly due to higher debt levels in 2006. The percentage of interest capitalized in 2006 and 2005 was 93% and 90%, respectively.
 
In 2005, interest expense, net of amounts capitalized, increased to $18.9 million from $18.1 million in 2004. Gross interest incurred in 2005 was $42.4 million higher than that incurred in 2004, reflecting higher debt levels in 2005. The percentage of interest capitalized in 2005 increased from the 87% capitalized in 2004 due to a higher proportion of land under development compared to 2004.
 
Minority Interests.  Operating income was reduced by minority interests of $68.3 million in 2006, $77.8 million in 2005 and $69.0 million in 2004. Minority interests were comprised solely of the minority ownership portion of income from consolidated subsidiaries and joint ventures related to residential and commercial activities. The decrease in minority interests in 2006 primarily related to decreased activity from a consolidated joint venture in California, partially offset by higher earnings from KBSA. The increase in minority interests in 2005 reflected increased activity from a consolidated joint venture in California, as well as higher earnings from KBSA.
 
We maintain a controlling interest in KBSA and therefore consolidate these operations in our financial statements. As of November 30, 2006 and 2005, we maintained a 49% equity interest in our French subsidiary and 68% of the voting rights associated with its stock. KBSA continues to be consolidated in our financial statements.
 
Equity in Pretax Income (Loss) of Unconsolidated Joint Ventures.  Our unconsolidated joint ventures operate in certain markets in the United States and France where our consolidated construction operations are located. These unconsolidated joint ventures posted combined revenues of $288.2 million in 2006, $326.8 million in 2005 and $248.1 million in 2004. The decrease in revenues from unconsolidated joint ventures in 2006 was due to a change in product mix. The increase in joint venture revenues in 2005 from 2004 primarily reflected additional activity in our West Coast, Southwest and France segments. The joint venture revenues in 2006 and 2005 were generated from both residential and commercial activities; in 2004 all unconsolidated joint venture revenues were generated from residential activities. Residential activities performed by our unconsolidated joint ventures generally include buying, developing and selling land. In some cases our residential unconsolidated joint ventures also construct and deliver homes. Residential unit deliveries from unconsolidated joint ventures totaled 546 in 2006, 509 in 2005 and 931 in 2004. Commercial activities performed by our unconsolidated joint ventures generally include the development of commercial office buildings. Unconsolidated joint ventures generated combined pretax losses of $31.8 million in 2006, and combined pretax income of $45.5 million in 2005 and $31.9 million in 2004. Our equity in pretax losses of unconsolidated joint ventures of $10.3 million in 2006 included our share of pretax results from unconsolidated joint ventures, a charge of $58.6 million to recognize impairment of certain joint venture investments and a gain of $27.6 million related to the sale of our ownership interest in a joint venture. In 2005 and 2004, our share of pretax income from unconsolidated joint ventures totaled $20.3 million and $17.6 million, respectively.


29


Table of Contents

CONSTRUCTION SEGMENTS
 
The following table sets forth financial information related to our construction reporting segments for the years indicated (in thousands):
 
                         
    Years Ended November 30,  
    2006     2005     2004  
          (as restated)     (as restated)  
 
West Coast:                        
Revenues   $ 3,531,279     $ 3,050,486     $ 2,215,258  
Operating costs and expenses     (3,178,973 )     (2,383,112 )     (1,756,876 )
Other, net     7,558       13,929       (6,035 )
                         
Pretax income   $ 359,864     $ 681,303     $ 452,347  
                         
Southwest:                        
Revenues   $ 2,183,830     $ 1,964,483     $ 1,517,981  
Operating costs and expenses     (1,809,930 )     (1,452,272 )     (1,251,552 )
Other, net     (8,802 )     1,635       4,254  
                         
Pretax income   $ 365,098     $ 513,846     $ 270,683  
                         
Central:                        
Revenues   $ 1,553,309     $ 1,559,067     $ 1,385,890  
Operating costs and expenses     (1,591,982 )     (1,512,831 )     (1,322,358 )
Other, net     (16,076 )     (18,084 )     (15,539 )
                         
Pretax income (loss)   $ (54,749 )   $ 28,152     $ 47,993  
                         
Southeast:                        
Revenues   $ 2,091,425     $ 1,549,277     $ 855,367  
Operating costs and expenses     (2,036,000 )     (1,392,825 )     (858,665 )
Other, net     (16,492 )     (3,944 )     (3,778 )
                         
Pretax income (loss)   $ 38,933     $ 152,508     $ (7,076 )
                         
France:                        
Revenues   $ 1,623,709     $ 1,286,969     $ 1,033,771  
Operating costs and expenses     (1,438,588 )     (1,148,492 )     (933,683 )
Other, net     (76,331 )     (67,035 )     (47,494 )
                         
Pretax income   $ 108,790     $ 71,442     $ 52,594  
                         
 
The following table presents information concerning our housing revenues and unit deliveries by construction reporting segment:
 
                                         
          Percent
          Percent
       
          of
          of
       
          Total
          Total
    Average
 
    Housing
    Housing
    Unit
    Unit
    Selling
 
Years Ended November 30,
  Revenues     Revenues     Deliveries     Deliveries     Price  
    (in thousands)                          
 
2006                                        
West Coast
  $ 3,530,679       32 %     7,213       18 %   $ 489,500  
Southwest
    2,151,908       20       7,011       18       306,900  
Central
    1,536,075       14       9,613       25       159,800  
Southeast
    2,024,574       19       8,287       21       244,300  
France
    1,587,557       15       6,889       18       230,400  
                                         
Total
  $ 10,830,793        100 %     39,013        100 %   $ 277,600  
                                         


30


Table of Contents

                                         
          Percent
          Percent
       
          of
          of
       
          Total
          Total
    Average
 
    Housing
    Housing
    Unit
    Unit
    Selling
 
Years Ended November 30,
  Revenues     Revenues     Deliveries     Deliveries     Price  
    (in thousands)                          
 
2005
                                       
West Coast
  $ 3,050,486       33 %     6,624       18 %   $ 460,500  
Southwest
    1,954,196       21       7,357       20       265,600  
Central
    1,554,863       17       9,866       27       157,600  
Southeast
    1,540,226       16       7,162       19       215,100  
France
    1,265,032       13       6,131       16       206,300  
                                         
Total
  $ 9,364,803       100 %     37,140       100 %   $ 252,100  
                                         
2004
                                       
West Coast
  $ 2,215,258       32 %     5,383       17 %   $ 411,500  
Southwest
    1,515,189       22       7,478       23       202,600  
Central
    1,376,723       20       9,101       29       151,300  
Southeast
    854,199       12       4,975       16       171,700  
France
    996,179       14       4,709       15       211,500  
                                         
Total
  $ 6,957,548       100 %     31,646       100 %   $ 219,900  
                                         
 
West Coast — Housing revenues increased 16% to $3.53 billion from $3.05 billion in 2005 due to a 9% increase in unit deliveries and a 6% increase in the average selling price. West Coast unit deliveries increased to 7,213 units in 2006 from 6,624 units in 2005 while the average selling price rose to $489,500 in 2006 from $460,500 in 2005. Pretax income decreased to $359.9 million in 2006 from $681.3 million in 2005. As a percentage of total revenues, pretax income decreased to 10.2% from 22.3% in 2005. This decrease was principally due to $213.1 million of inventory and joint venture impairment charges and land option contract write-offs in 2006, and a lower housing gross margin stemming from greater use of price concessions and incentives as a result of increased competition in the markets within this segment.
 
In 2005, West Coast housing revenues rose 38%, from $2.22 billion in 2004, due to a 23% increase in unit deliveries and a 12% increase in the average selling price. West Coast deliveries increased to 6,624 units in 2005 from 5,383 units in 2004 while the average selling price increased to $460,500 in 2005 from $411,500 in 2004. Pretax income increased to $681.3 million in 2005 from $452.3 million in 2004. As a percentage of total revenues, pretax income increased to 22.3% from 20.4% in 2004. This increase primarily reflected significantly higher prices and very favorable market conditions.
 
Southwest — In 2006, housing revenues rose 10% to $2.15 billion, from $1.95 billion in 2005, due to a 16% increase in the average selling price, partly offset by a 5% decrease in unit deliveries. The average selling price increased to $306,900 in 2006 from $265,600 in 2005. Southwest operations delivered 7,011 units in 2006, down from 7,357 units in 2005. Pretax income decreased to $365.1 million, or 16.7% of total revenues, in 2006 from $513.8 million, or 26.2% of total revenues, in 2005. The decrease was primarily due to a lower housing gross margin stemming from moderating market conditions, greater competition, and the increased use of price concessions and sales incentives.
 
In 2005, Southwest housing revenues increased 29% to $1.95 billion from $1.51 billion in 2004, due to a 31% increase in the average selling price, partly offset by a slight decrease in unit deliveries. Southwest operations delivered 7,357 units in 2005, down slightly from 7,478 units in 2004. The average selling price increased to $265,600 in 2005 from $202,600 in 2004. Pretax income increased to $513.8 million in 2005 from $270.7 million in 2004. As a percentage of total revenues, pretax income increased to 26.2% from 17.8% in 2004, primarily driven by rising prices in a very strong market environment.
 
Central — Housing revenues of $1.54 billion were essentially flat with 2005, reflecting a year-over-year decrease of 3% in unit deliveries offset by a slight increase in the average selling price. In the Central segment, deliveries decreased to 9,613 units in 2006 from 9,866 in 2005. The average selling price increased to $159,800 in 2006 from $157,600 in 2005. Central operations generated a pretax loss of $54.7 million in 2006, down from pretax income of $28.2 million in

31


Table of Contents

2005 primarily due to $48.8 million of inventory impairments and land option contract write-offs in 2006 and a slightly lower housing gross margin.
 
In 2005, Central housing revenues increased 13% from $1.38 billion in 2004, reflecting an 8% increase in unit deliveries and a 4% increase in the average selling price. Deliveries from Central operations increased to 9,866 units in 2005 from 9,101 units in 2004 while the average selling price increased to $157,600 in 2005 from $151,300 in 2004. Pretax income decreased to $28.2 million in 2005 from $48.0 million in 2004. As a percentage of total revenues, pretax income decreased to 1.8% from 3.5% in 2004. This decrease primarily reflected softening in certain submarkets in the segment.
 
Southeast — Housing revenues increased 31% to $2.02 billion in 2006 from $1.54 billion in 2005 due to increases of 16% in unit deliveries and 14% in the average selling price. Southeast deliveries increased to 8,287 units in 2006 from 7,162 units in 2005. The average selling price rose to $244,300 in 2006 from $215,100 in 2005. Pretax income decreased to $38.9 million in 2006 from $152.5 million in 2005. As a percentage of total revenues, pretax income decreased to 1.9% from 9.8% in 2005 principally due to $129.9 million of inventory and joint venture impairment charges and land option contract write-offs in 2006.
 
In 2005, Southeast housing revenues rose 80% to $1.54 billion from $854.2 million in 2004 as a result of a 44% increase in unit deliveries and a 25% increase in the average selling price. Southeast deliveries increased to 7,162 in 2005 from 4,975 units in 2004, while the average selling price increased to $215,100 in 2005 from $171,700 in 2004. Pretax income increased to $152.5 million in 2005 from a loss of $7.1 million in 2004 as a result of significantly higher unit volume and average selling prices, and a positive operating environment.
 
France — Housing revenues rose 25% to $1.59 billion in 2006 from $1.27 billion in 2005, reflecting a 12% increase in both unit delivery volume and the average selling price. French deliveries increased to 6,889 units in 2006 from 6,131 in 2005. The average selling price in France increased to $230,400 in 2006 from $206,300 in 2005 primarily due to a change in product mix and foreign currency exchange rates. Pretax income increased to $108.8 million in 2006 from $71.4 million in 2005. As a percentage of total revenues, pretax income increased to 6.7% in 2006 from 5.6% in 2005.
 
In 2005, French housing revenues rose 27% to $1.27 billion from $996.2 million in 2004. This growth was driven by a 30% increase in unit delivery volume, partially offset by a slight decrease in the average selling price. French deliveries increased to 6,131 units in 2005 from 4,709 units in 2004. The average selling price in France decreased to $206,300 in 2005 from $211,500 in 2004. Pretax income from this segment increased to $71.4 million in 2005 from $52.6 million in 2004. Pretax income as a percentage of total revenues increased to 5.6% in 2005 from 5.1% in 2004.
 
FINANCIAL SERVICES SEGMENT
 
Our financial services segment provides mortgage banking, title, insurance and escrow coordination services to our domestic homebuyers. On September 1, 2005, we completed the sale of substantially all the mortgage banking assets of KBHMC to Countrywide and in a separate transaction established Countrywide KB Home Loans, a joint venture with Countrywide. Countrywide KB Home Loans began making loans to our U.S. homebuyers on September 1, 2005 and essentially replaced the mortgage banking operations of KBHMC, our wholly owned financial services subsidiary which had provided mortgage banking services to our homebuyers in the past. KB Home and Countrywide each have a 50% ownership interest in the joint venture with Countrywide providing management oversight of the joint venture’s operations. Countrywide KB Home Loans is accounted for as an unconsolidated joint venture in the financial services reporting segment of our consolidated financial statements.


32


Table of Contents

The following table presents a summary of selected financial and operational data for our financial services segment (dollars in thousands):
 
                         
    Years Ended November 30,  
    2006     2005     2004  
 
Revenues
  $   20,240     $ 31,368     $ 44,417  
Expenses
    (5,923 )     (20,400 )     (35,729 )
Equity in pretax income of unconsolidated joint venture
    19,219       230        
                         
Pretax income
  $ 33,536     $ 11,198     $ 8,688  
                         
             
Total originations (a):
                       
Loans
            12,109       18,087  
Principal
          $ 2,206,788     $ 3,038,835  
Retention rate
            48 %     59 %
Loans sold to third parties (a):
                       
Loans
            9,295       18,599  
Principal
          $ 1,523,235     $ 3,110,500  
 
  (a)  Information for 2005 is through August 31, 2005 since KBHMC did not directly originate loans subsequent to the sale of substantially all of its mortgage banking assets on September 1, 2005.
 
Revenues.  Our financial services operations generated revenues primarily from the following sources: interest income; title services; insurance commissions; escrow coordination fees; and sales of mortgage loans and servicing rights. Financial services revenues included interest income of $.2 million, $8.2 million and $11.5 million in 2006, 2005 and 2004, respectively, which was earned primarily from first mortgages and mortgage-backed securities held for long-term investment as collateral. Interest income decreased in 2006 and 2005 mainly due to the wind-down of the mortgage banking operations of KBHMC. Financial services revenues also included revenues from title services, insurance commissions and escrow coordination fees of $20.0 million in 2006, $17.3 million in 2005, and $13.0 million in 2004. The increases in revenues related to these services are in direct correlation with the higher unit delivery volume of our domestic homebuilding operations. Financial services revenues included mortgage and servicing rights income of $5.9 million and $19.9 million in 2005 and 2004, respectively. The decrease in 2005 was primarily due to the wind-down of KBHMC’s mortgage banking operations. Due to the sale of KBHMC’S mortgage banking operations in the fourth quarter of 2005, no mortgages and servicing rights income was generated in 2006.
 
Expenses.  Financial services expenses in 2006, 2005 and 2004 were comprised of interest expense, general and administrative expenses, and other income and expense items. Interest expense decreased to a nominal amount in 2006 from $5.2 million in 2005, which had increased from $4.5 million in 2004. General and administrative expenses totaled $5.9 million, $22.0 million and $31.2 million in 2006, 2005 and 2004, respectively. The decreases in general and administrative expenses in 2006 and 2005 were primarily due to the wind-down of KBHMC’s mortgage banking operations in the fourth quarter of 2005 and the change in the mortgage banking operations of KBHMC to an unconsolidated joint venture structure. In 2005, financial services expenses included other items aggregating to income of $6.8 million. These other items included a $26.6 million gain recorded in connection with the sale of assets to Countrywide. The gain represented the cash received over the sum of the book value of the assets sold and certain nominal costs associated with the disposal. In addition, financial services expenses in 2005 included $19.8 million of expenses accrued for various regulatory and other contingencies.
 
Equity in pretax income of unconsolidated joint venture.  The equity in pretax income of unconsolidated joint venture of $19.2 million in 2006 and $.2 million in 2005 relates to our 50% interest in the Countrywide KB Home Loans joint venture, which commenced operations on September 1, 2005.
 
INCOME TAXES
 
Income tax expense totaled $215.7 million in 2006, $466.5 million in 2005 and $241.3 in 2004. These amounts represent effective income tax rates of approximately 31% for 2006, 36% for 2005 and 34% for 2004. The decrease in our effective tax rate in 2006 from 2005 was primarily due to the release of excess state tax accruals, the tax benefits from the


33


Table of Contents

manufacturing deduction created by the American Jobs Creation Act of 2004, and a reduction in the disallowance of stock-based compensation deductions and related expenses, partially offset by a reduction in available fuel tax credits and a 25% phase-out of these tax credits. The increase in the effective tax rate in 2005 from 2004 was primarily due to substantially higher pretax income, growth in markets with higher state tax rates, a decrease in the available tax credits and the effect of non-deductible stock-based compensation adjustments.
 
During 2006, 2005 and 2004, we made investments that resulted in benefits in the form of synthetic fuel tax credits. During 2005, a small portion of these tax credits were forfeited as part of an IRS settlement. Additionally, these tax credits are subject to a phase-out provision that gradually reduces the tax credits if the annual average price of domestic crude oil increases to a stated phase-out range. Our 2007 effective income tax rate, currently expected to be approximately 34%, may increase if oil prices rise above current levels and cause tax credits to be reduced. Based on current estimates of the annual average price of domestic crude oil, no phase-out of tax credits is reflected in the 2007 effective income tax rate.
 
LIQUIDITY AND CAPITAL RESOURCES
 
We assess our liquidity in terms of our ability to generate cash to fund our operating and investing activities. Historically, we have funded our construction and financial services activities with internally generated cash flows and external sources of debt and equity financing. We also borrow under our $1.5 Billion Credit Facility, and KBSA borrows under various lines of credit. At November 30, 2006, we had cash and cash equivalents of $654.6 million, compared to $154.0 million at November 30, 2005 and $234.2 million at November 30, 2004. Operating, investing and financing activities provided net cash of $500.6 million in 2006 and $96.1 million in 2004. These activities used net cash of $80.2 million in 2005.
 
Operating Activities.  Operating activities provided net cash of $715.7 million in 2006 and used net cash of $52.9 million and $78.9 million in 2005 and 2004, respectively. Our sources of operating cash in 2006 included earnings of $482.4 million, an increase in accounts payable, accrued expenses and other liabilities of $452.8 million, and various noncash items deducted from net income. Our sources of operating cash in 2006 were partially offset by an increase in inventories of $482.0 million (excluding $235.2 million of inventories acquired through seller financing and a decrease of $18.1 million in inventories of consolidated variable interest entities (“VIEs”)), an increase in receivables of $78.9 million and other operating uses of $4.4 million.
 
In 2005, our uses of operating cash included net investments in inventories of $1.70 billion (excluding $204.2 million of inventories acquired through seller financing and $120.7 million of inventories of consolidated VIEs) and other operating uses of $21.4 million. The cash used was partially offset by earnings of $823.7 million, an increase in accounts payable, accrued expenses and other liabilities of $618.2 million, a decrease in receivables of $77.7 million, and various noncash items deducted from net income.
 
In 2004, our uses of operating cash included net investments in inventories of $989.2 million (excluding the effect of acquisitions, $53.2 million of inventories acquired through seller financing and $85.5 million of inventories of consolidated VIEs) and a slight increase in receivables. The cash used was partially offset by earnings of $474.0 million, an increase in accounts payable, accrued expenses and other liabilities of $328.2 million, other operating sources of $24.2 million and various noncash items deducted from net income.
 
Investing Activities.  Investing activities used net cash of $201.4 million in 2006, $98.0 million in 2005 and $267.8 million in 2004. In 2006, $237.8 million was used for investments in unconsolidated joint ventures and $22.1 million was used for net purchases of property and equipment. The cash used was partially offset by proceeds of $57.8 million from the sale of our investment in an unconsolidated joint venture and $.7 million from other investing activities.
 
In 2005, $117.6 million was used for investments in unconsolidated joint ventures and $24.0 million was used for net purchases of property and equipment. The cash used was partially offset by proceeds of $42.4 million from the sale of substantially all of the mortgage banking assets of KBHMC and $1.2 million provided from other investing activities.
 
In 2004, $128.7 million was used for investments in unconsolidated joint ventures, $121.6 million, net of cash acquired, was used for acquisitions and $23.2 million was used for net purchases of property and equipment. Partially offsetting these uses was $5.7 million from other investing activities.


34


Table of Contents

Financing Activities.  Financing activities used net cash of $13.7 million in 2006 and provided net cash of $70.7 million and $442.8 million in 2005 and 2004, respectively. In 2006, uses of cash included $394.1 million used for repurchases of common stock, net payments of $294.8 million on short-term borrowings, dividend payments of $78.3 million, payments of $24.9 million to minority interests, and payments of $.5 million on collateralized mortgage obligations. Partially offsetting the cash used were proceeds from an unsecured $400.0 million term loan (the “$400 Million Term Loan”), $298.5 million in total proceeds from the issuance of $300.0 million of 71/4% senior notes due 2018 (the “$300 Million 71/4% Senior Notes”), $65.0 million from the issuance of common stock under employee stock plans and $15.4 million of excess tax benefit associated with the exercise of stock options. On December 8, 2005, our board of directors increased the annual cash dividend on our common stock to $1.00 per share from $.75 per share.
 
In 2005, financing activities provided $747.6 million in total proceeds from the issuance of $300 million of 57/8% senior notes due 2015 (the “$300 Million 57/8% Senior Notes”) and $450.0 million of 61/4% senior notes due 2015 (the “$450 Million Senior Notes”), and $101.8 million from the issuance of common stock under employee stock plans. Partially offsetting the cash provided were $513.8 million of net payments on short-term borrowings, $134.7 million used for repurchases of common stock, payments of $68.2 million to minority interests, $61.6 million for cash dividend payments, and $.4 million for payments on collateralized mortgage obligations. On December 2, 2004, our board of directors increased the annual cash dividend on our common stock to $.75 per share from $.50 per share.
 
In 2004, financing activities provided $596.2 million from the issuance of $250.0 million of 53/4% senior notes due 2014 (the “$250 Million Senior Notes”) and $350.0 million of 63/8% senior notes due 2011 (the “$350 Million Senior Notes”), $122.9 million in net proceeds from borrowings and $42.2 million from the issuance of common stock under employee stock plans. Partially offsetting the cash provided were $175.0 million used for the redemption of 73/4% senior subordinated notes which matured on October 15, 2004, $66.1 million used for repurchases of common stock, $39.2 million of cash dividend payments, $32.4 million of payments to minority interests and $5.8 million of payments on collateralized mortgage obligations. On December 5, 2003, our board of directors increased the annual cash dividend on our common stock to $.50 per share from $.15 per share.
 
At November 30, 2006, $450.0 million of capacity remained available under our universal shelf registration statement filed with the SEC on November 12, 2004 (the “2004 Shelf Registration”). As a result of our failure to file our Quarterly Report on Form 10-Q for the quarter ended August 31, 2006 on a timely basis, we cannot use the 2004 Shelf Registration, or any other registration statement on Form S-3, to offer or sell securities until we have timely filed all required reports under the Securities Exchange Act of 1934 for the 12 months prior to our use of the registration statement.
 
Capital Resources.  Our financial leverage, as measured by the ratio of debt to total capital, was 52% at the end of 2006 and 47% at the end of 2005.
 
External sources of financing for our construction activities include our $1.5 Billion Credit Facility, other domestic and foreign bank lines, third-party secured financings, and the public debt and equity markets. Substantial unused lines of credit remain available for our future use, if required, principally through our $1.5 Billion Credit Facility. Interest on the $1.5 Billion Credit Facility is payable monthly at the London Interbank Offered Rate plus an applicable spread on amounts borrowed. At November 30, 2006, we had $1.04 billion available for our future use under the $1.5 Billion Credit Facility, net of $464.2 million of outstanding letters of credit. In addition, KBSA had lines of credit with various banks which totaled $442.3 million at November 30, 2006 and have various committed expiration dates through September 2008. Under these unsecured financing agreements, $437.2 million was available to KBSA at November 30, 2006.
 
Depending upon available terms and our negotiating leverage related to specific market conditions, we also finance certain land acquisitions with purchase-money financing from land sellers or with other forms of financing from third parties. At November 30, 2006, we had outstanding seller-financed notes payable of $130.7 million secured primarily by the underlying property which had a carrying value of $243.5 million.
 
We continue to benefit in all of our operations from the strength of our capital position, which has allowed us to maintain overall profitability during difficult economic times, finance domestic and international expansion, re-engineer product lines and diversify into new markets. As a result of our geographic diversification, the disciplines of our KBnxt operational business model and our strong capital position, we believe we have adequate resources and sufficient credit facilities to satisfy our current and reasonably anticipated future requirements for funds needed to acquire capital assets


35


Table of Contents

and land, construct homes, fund our financial services operations, and meet the other anticipated needs of our business, both on a short- and long-term basis.
 
OFF-BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
 
We conduct a portion of our land acquisition, development and other residential and commercial construction activities through participation in unconsolidated joint ventures in which we hold less than a controlling interest. These unconsolidated joint ventures operate in certain markets in the United States and France where our consolidated construction operations are located. Through unconsolidated joint ventures, we reduce and share our risk and also reduce the amount invested in land, while increasing our access to potential future homesites. The use of unconsolidated joint ventures also, in some instances, enables us to acquire land which we might not otherwise obtain or have access to on as favorable terms, without the participation of a strategic partner. Our partners in these unconsolidated joint ventures are unrelated homebuilders, land developers and other real estate entities, or other commercial enterprises. While we view our participation in unconsolidated joint ventures as beneficial to our homebuilding activities, we do not view them as essential to those activities.
 
We and/or our joint venture partners sometimes obtain certain options or enter into other arrangements under which we can purchase portions of the land held by an unconsolidated joint venture. Land option prices are generally negotiated prices that approximate fair value. We do not include in our income from unconsolidated joint ventures our pro rata share of unconsolidated joint venture earnings resulting from land sales to our homebuilding divisions. We defer recognition of our share of such unconsolidated joint venture earnings until a home sale is closed and title passes to a homebuyer, at which time we account for those earnings as a reduction of the cost of purchasing the land from the unconsolidated joint ventures.
 
Our investment in unconsolidated joint ventures totaled $397.7 million at November 30, 2006 and $275.4 million at November 30, 2005. These unconsolidated joint ventures had total assets of $2.5 billion and $2.13 billion and outstanding secured construction debt of approximately $1.46 billion and $1.30 billion at November 30, 2006 and 2005, respectively. In certain instances, we provide varying levels of guarantees on debt of unconsolidated joint ventures. When we or our subsidiaries provide a guarantee, the unconsolidated joint venture generally receives more favorable terms from lenders than would otherwise be available to it. At November 30, 2006, we had payment guarantees related to the third-party debt of three of our unconsolidated joint ventures. One of our unconsolidated joint ventures had aggregate third-party debt of $481.6 million at November 30, 2006, of which each of the joint venture partners guaranteed its pro rata share. Our share of the payment guarantee, which is triggered only in the event of bankruptcy of the joint venture, was 49% or $233.6 million. The remaining two unconsolidated joint ventures had total third-party debt of $14.3 million at November 30, 2006, of which each of the joint venture partners guaranteed its pro rata share. Our share of this guarantee was 50% or $7.2 million. Our pro rata share of limited maintenance guarantees of unconsolidated entity debt totaled $147.3 million at November 30, 2006. The limited maintenance guarantees apply only if the value of the collateral (generally land and improvements) is less than a specific percentage of the loan balance. If we are required to make a payment under a limited maintenance guarantee to bring the value of the collateral above the specified percentage of the loan balance, the payment would constitute a capital contribution and/or loan to the affected unconsolidated joint venture and increase our share of any funds the unconsolidated joint venture distributes.
 
In the ordinary course of business, we enter into land option contracts in order to procure land for the construction of homes. The use of such option agreements allows us to reduce the risks associated with land ownership and development, reduce our financial commitments, including interest and other carrying costs, and minimize land inventories. Under such land option contracts, we will fund a specified option deposit or earnest money deposit in consideration for the right to purchase land in the future, usually at a predetermined price. Under the requirements of FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (“FASB Interpretation No. 46(R)”), certain of our land option contracts may create a variable interest for us, with the land seller being identified as a VIE.
 
In compliance with FASB Interpretation No. 46(R), we analyzed our land option contracts and other contractual arrangements and have consolidated the fair value of certain VIEs from which we are purchasing land under option contracts. The consolidation of these VIEs, where we were determined to be the primary beneficiary, added $215.4 million and $233.6 million to inventories and accrued expenses and other liabilities in our consolidated balance sheets at November 30, 2006 and 2005, respectively. Our cash deposits related to these land option contracts totaled $41.9 million at November 30, 2006 and $15.0 million at November 30, 2005. Creditors, if any, of these VIEs have no


36


Table of Contents

recourse against us. As of November 30, 2006, excluding consolidated VIEs, we had cash deposits totaling $90.8 million that were associated with land option contracts having an aggregate purchase price of $2.24 billion.
 
The following table summarizes our future cash requirements under contractual obligations as of November 30, 2006 (in thousands):
 
                                         
    Payments due by Period  
                      After
       
    2007     2008-2009     2010-2011     2011     Total  
 
Contractual obligations:
                                       
Long-term debt
  $ 98,363     $ 414,188     $ 1,312,627     $ 1,295,431     $ 3,120,609  
Operating lease obligations
    34,786       59,952       30,829       15,020       140,587  
                                         
Total contractual obligations
  $ 133,149     $ 474,140     $ 1,343,456     $ 1,310,451     $ 3,261,196  
                                         
 
We are often required to obtain bonds and letters of credit in support of our obligations to various municipalities and other government agencies with respect to subdivision improvements, including roads, sewers and water, among other things. As of November 30, 2006, we had outstanding approximately $1.24 billion and $464.2 million of performance bonds and letters of credit, respectively. We do not believe that any currently outstanding bonds or letters of credit will be called. The expiration dates of letters of credit coincide with the expected completion dates of the related projects. If the obligations related to a project are ongoing, annual extensions of the letters of credit are typically granted on a year-to-year basis. Performance bonds do not have stated expiration dates, rather, we are released from the bonds as the contractual performance is completed.
 
CRITICAL ACCOUNTING POLICIES
 
Construction Revenue Recognition.  As discussed in Note 1. Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements in this Form 10-K, revenues from housing and other real estate sales are recognized when sales are closed and title passes to the buyer. Sales are closed when all of the following conditions are met: a sale is consummated, a significant down payment is received, the earnings process is complete and the collection of any remaining receivables is reasonably assured. In France, revenues from development and construction of single-family detached homes, condominiums and commercial buildings, under long-term contracts with individual investors who own the land, are recognized using the percentage-of-completion method, which is generally based on costs incurred as a percentage of estimated total costs of individual projects. The percentage-of-completion method is applied because we meet applicable requirements under Statement of Financial Accounting Standards No. 66, “Accounting for Sales of Real Estate” (“SFAS No. 66”). Actual revenues and costs to complete in the future, related to long-term contracts, could differ from our current estimates. If estimates of revenues and costs to complete in the future differ from actual amounts, our revenues, related cumulative profits and costs of sales may be revised in the period that estimates change.
 
Inventories and Cost of Sales.  As discussed in Note 1. Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements in this Form 10-K, inventories are stated at cost, unless the carrying amount of the parcel or subdivision is determined not to be recoverable, in which case the impaired inventories are written down to fair value in accordance with SFAS No. 144. Fair value is determined based on estimated cash flows discounted for inherent risks associated with the long-lived assets, or other valuation techniques. Due to uncertainties in the estimation process, it is possible that actual results could differ from those estimates. Our inventories typically do not consist of completed projects.
 
We rely on certain estimates to determine construction and land costs and resulting gross margins associated with revenues recognized. Our construction and land costs are comprised of direct and allocated costs, including estimated future costs for warranties and amenities. Land, land improvements and other common costs are allocated on a relative fair value basis to units within a parcel or subdivision. Land and land development costs generally include related interest and real estate taxes.
 
In determining a portion of the construction and land costs for each period, we rely on project budgets that are based on a variety of assumptions, including assumptions about construction schedules and future costs to be incurred. It is possible that actual results could differ from budgeted amounts for various reasons, including construction delays, labor or materials shortages, increases in costs that have not yet been committed, changes in governmental requirements,


37


Table of Contents

unforeseen environmental hazard discoveries or other unanticipated issues encountered during construction that fall outside the scope of contracts obtained. While the actual results for a particular construction project are accurately reported over time, variances between the budgeted and actual costs of a project could result in the understatement or overstatement of construction and land costs and construction gross margins in a specific reporting period. To reduce the potential for such distortion, we have set forth procedures that collectively comprise a “critical accounting policy.” These procedures, which we have applied on a consistent basis, include updating, assessing and revising project budgets on a monthly basis, obtaining commitments from subcontractors and vendors for future costs to be incurred, reviewing the adequacy of warranty accruals and historical warranty claims experience, and utilizing the most recent information available to estimate construction and land costs to be charged to expense. The variances between budgeted and actual amounts identified by us have historically not had a material impact on our results of operations. We believe that our policies provide for reasonably dependable estimates to be used in the calculation and reporting of construction and land costs.
 
Variable Interest Entities.  As discussed in Note 7. Consolidation of Variable Interest Entities in the Notes to Consolidated Financial Statements in this Form 10-K, in the ordinary course of business we enter into land option contracts in order to procure land for the construction of homes. We evaluate such land option contracts in accordance with FASB Interpretation No. 46(R). Under the requirements of FASB Interpretation No. 46(R), certain of our land option contracts may create a variable interest for us, with the land seller being identified as a VIE. Pursuant to FASB Interpretation No. 46(R), an enterprise that absorbs a majority of the VIE’s expected losses or receives a majority of the VIE’s expected residual returns, or both, is considered to be the primary beneficiary of the VIE and must consolidate the entity. For land option contracts with land sellers meeting the definition of a VIE, we analyze the contracts to determine which party is the primary beneficiary of the VIE. Such analyses require the use of assumptions, including assigning probabilities to various estimated cash flow possibilities relative to the entity’s expected profits and losses and the cash flows associated with changes in the fair value of the land under contract. Generally, we do not have any ownership interests in the entities with which we contract to purchase land and we typically do not have the ability to compel these entities to provide assistance in our review. In many instances, these entities provide us little, if any, financial information. To the extent additional information arises or market conditions change, it is possible that our conclusion regarding the consolidation of certain VIEs could change. While such a change would not materially impact our results of operations, it could have a material effect on our consolidated financial position.
 
Warranty Costs.  As discussed in Note 12. Commitments and Contingencies in the Notes to Consolidated Financial Statements in this Form 10-K, we provide a limited warranty on all of our homes. The specific terms and conditions of warranties vary depending upon the market in which we do business. For homes sold in the United States, we generally provide a structural warranty of 10 years, a warranty on electrical, heating, cooling and plumbing and other building systems each varying from two to five years based on geographic market and state law, and a warranty of one year for other components of the home such as appliances. We estimate the costs that may be incurred under each limited warranty and record a liability in the amount of such costs at the time the revenue associated with the sale of each home is recognized. Factors that affect our warranty liability include the number of homes delivered, historical and anticipated rates of warranty claims, and cost per claim. We periodically assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary. While we believe the warranty accrual reflected in the consolidated balance sheets to be adequate, actual warranty costs in the future could differ from our current estimates.
 
Stock-Based Compensation.  As discussed in Note 1. Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements in this Form 10-K, effective December 1, 2005, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (“SFAS No. 123(R)”), using the modified prospective transition method. Under that transition method, compensation expense recognized in 2006 includes: (a) compensation expense for all share-based payments granted prior to, but not yet vested as of December 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation expense for all share-based payments granted subsequent to December 1, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Determining the fair value of share-based awards at the grant date requires judgment to identify the appropriate valuation model and estimate the assumptions, including the expected term of the stock options, expected stock-price volatility and dividend yield, to be used in the calculation. Judgment is also required in estimating the percentage of share-based awards that are expected to be forfeited. We estimated the fair value of stock options granted using the Black-Scholes option-pricing model with assumptions based primarily on historical data. If actual results differ significantly from these estimates, stock-based


38


Table of Contents

compensation expense and our results of operations could be materially impacted. Prior to December 1, 2005, we accounted for stock option grants under the recognition and measurement provisions of APB Opinion No. 25 and related interpretations.
 
Goodwill.  As disclosed in Note 1. Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements in this Form 10-K, we had goodwill in the amount of $233.8 million at November 30, 2006 and $234.8 million at November 30, 2005. In accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), we performed impairment tests of goodwill as of November 30, 2006 and 2005, and identified no impairment. However, the process of evaluating goodwill for impairment involves the determination of the fair value of our reporting units. Inherent in such fair value determinations are certain judgments and estimates, including the interpretation of current economic indicators and market valuations, and assumptions about our strategic plans with regard to our operations. To the extent additional information arises, market conditions change or our strategies change, it is possible that our conclusion regarding goodwill impairment could change and result in a material effect on our consolidated financial position or results of operations.
 
RECENT ACCOUNTING PRONOUNCEMENTS
 
In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”), which replaces Accounting Principles Board Opinion No. 20, “Accounting Changes” (“APB Opinion No. 20”) and Statement of Financial Accounting Standards No. 3, “Reporting Accounting Changes in Interim Financial Statements” (“SFAS No. 3”), and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 is not expected to have a material impact on our consolidated financial position or results of operations.
 
In June 2005, the Emerging Issues Task Force (“EITF”) released Issue No. 04-5 “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights” (“EITF 04-5”). EITF 04-5 provides guidance in determining whether a general partner controls a limited partnership and therefore should consolidate the limited partnership. EITF 04-5 states that the general partner in a limited partnership is presumed to control that limited partnership and that the presumption may be overcome if the limited partners have either (a) the substantive ability to dissolve or liquidate the limited partnership or otherwise remove the general partner without cause, or (b) substantive participating rights. The effective date for applying the guidance in EITF 04-5 was (a) June 29, 2005 for all new limited partnerships and existing limited partnerships for which the partnership agreement was modified after that date, and (b) no later than the beginning of the first reporting period in fiscal years beginning after December 15, 2005 for all other limited partnerships. Implementation of EITF 04-5 did not have a material impact on our consolidated financial position or results of operations for the year ended November 30, 2006.
 
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement 109” (“FASB Interpretation No. 48”). FASB Interpretation No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FASB Interpretation No. 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the potential impact of adopting FASB Interpretation No. 48 on our consolidated financial position and results of operations.
 
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS No. 158”). SFAS No. 158 requires companies to (a) recognize the funded status of a benefit plan (measured as the difference between the fair value of plan assets and the benefit obligation) in its statement of financial position, (b) recognize as a component of other comprehensive income, net of tax, the actuarial gains and losses and the prior service costs and credits that arise during the period, (c) measure defined benefit plan assets as of the date of a company’s statement of financial position, and (d) disclose in the notes to the financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed


39


Table of Contents

recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. SFAS No. 158 is effective for companies with publicly traded securities as of the end of the fiscal year ending after December 15, 2006. We do not expect that the adoption of SFAS No. 158 will have a material effect on our consolidated financial position or results of operations.
 
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 provides guidance for using fair value to measure assets and liabilities, defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and for interim periods within those years. We are currently evaluating the potential impact of adopting SFAS No. 157 on our consolidated financial position and results of operations.
 
In September 2006, the SEC Staff issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB No. 108”), which addresses how the effects of prior year uncorrected financial statement misstatements should be considered in current year financial statements. SAB No. 108 requires registrants to quantify misstatements using both balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relative quantitative and qualitative factors. The requirements of SAB No. 108 are effective for annual financial statements covering the first fiscal year ending after November 15, 2006. Our adoption of SAB No. 108 in 2006 did not have a material impact on our consolidated financial position or results of operations.
 
In November 2006, the EITF ratified EITF Issue No. 06-8, “Applicability of the Assessment of a Buyer’s Continuing Investment under SFAS No. 66 for Sales of Condominiums” (“EITF 06-8”). EITF 06-8 states that adequacy of the buyer’s investment under SFAS No. 66 should be assessed in determining whether to recognize profit under the percentage-of-completion method on the sale of individual units in a condominium project. EITF 06-8 could require that additional deposits be collected by developers of condominium projects that wish to recognize profit during the construction period under the percentage-of-completion method. EITF 06-8 is effective for fiscal years beginning after March 15, 2007. We are currently evaluating the potential impact of adopting EITF 06-8 on our consolidated financial position and results of operations.
 
OUTLOOK
 
As a result of the increasingly challenging operating environment that developed in 2006, we entered 2007 with a substantial decrease in backlog compared to year-earlier levels. At year-end 2006, our backlog of orders for new homes was 17,384 units, representing a projected revenue value of $4.43 billion, down 32% and 34%, respectively, from backlog units and value at year-end 2005. This substantial decrease reflects lower backlog levels in each of our domestic regions and stems largely from declining orders for new homes and higher cancellation rates during the second half of 2006. Based on lower backlog levels at the start of 2007 and our current traffic and net order experience, we anticipate our unit deliveries and revenues in 2007 will be substantially lower than in 2006. Traffic levels to our communities and net orders in the first two months of 2007 are approximately 10% below those in the corresponding year-earlier period, while cancellation rates are essentially flat.
 
While it is too early in our prime selling season (February through June) to extrapolate our experience in the first two months of 2007 to the remainder of the year, we do not expect current difficult market conditions in U.S. housing markets to improve significantly, or at all, in 2007. These conditions, which include an oversupply of new and resale home inventories in certain markets, lack of affordability in some areas and greater competition, have encouraged many homebuilders and other sellers of residential real estate to aggressively employ discounts, incentives and price concessions to close home sales. We have also used these tactics to meet competition in certain markets. Until the supply of unsold homes is reduced and affordability improves, we expect the current pressure on pricing to continue. Because the markets in which we operate have experienced varying degrees of difficulty, we expect them to improve at different rates with some markets recovering faster than others.
 
We believe the general health of the U.S. economy, including still historically low interest rates and high employment levels, bodes well for the eventual recovery of the homebuilding industry and our long-term future financial performance. However, in the near-term, economic data suggest that U.S. consumer demand for residential housing at current prices remains soft. The U.S. Census Bureau recently reported that single-family housing starts in December


40


Table of Contents

2006 were approximately 25% lower than in December 2005, while the median sales price for new homes fell approximately 2% in December 2006 from the year-earlier period. Meanwhile, as speculative investors exit the market and consumers delay or cancel home purchases, an oversupply of unsold inventory continues to produce supply/demand imbalances. We believe it will take time for individual housing markets to work through excess supply and that conditions will not improve until late-2007 or 2008 at the earliest.
 
In light of the present operating environment and our current backlog and net order trends, we anticipate that our unit deliveries, revenues, gross margins, net income and earnings per share in 2007 will be substantially below 2006 results. If current net order or selling price trends worsen, or if economic factors, including inflation, interest rates, consumer confidence or employment, deteriorate, our 2007 performance will likely worsen as well. Entering the new year, we remain focused on the disciplines of our KBnxt operational business model to manage through this downturn. Specifically, we are continuing to align our organization with anticipated lower unit sales volumes in 2007, and we are actively seeking opportunities to improve our cost structure and maximize performance. Longer term, we believe that our disciplined operating approach and strong financial position will allow us to capitalize on improvements in the U.S. housing market as they occur.
 
Although we expect our 2007 operating results to fall below those of recent peak years, we believe our overall inventory and debt will decline from 2006 levels, as we intend to be selective in land purchases during the year while generating positive cash flow from our operations similar to levels achieved in the latter half of 2006. We believe this will improve our leverage and liquidity and put us in a strong position to make opportunistic investments in inventory as individual markets rebound, and repurchase our common stock when favorable buying opportunities arise.
 
FORWARD-LOOKING STATEMENTS
 
Investors are cautioned that certain statements contained in this document, as well as some statements by us in periodic press releases and other public disclosures and some oral statements by us to securities analysts and stockholders during presentations, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”). Statements which are predictive in nature, which depend upon or refer to future events or conditions, or which include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” “hopes,” and similar expressions constitute forward-looking statements. In addition, any statements concerning future financial or operating performance (including future revenues, unit deliveries, selling prices, expenses, expense ratios, margins, earnings or earnings per share, or growth or growth rates), future market conditions, future interest rates, and other economic conditions, ongoing business strategies or prospects, future dividends and changes in dividend levels, the value of backlog (including amounts that we expect to realize upon delivery of units included in backlog and the timing of those deliveries), potential entry into new markets and the impact of such entry, potential future acquisitions and the impact of completed acquisitions, future share repurchases and possible future actions, which may be provided by us, are also forward-looking statements as defined by the Act. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties, and assumptions about our operations, economic and market factors, and the homebuilding industry, among other things. These statements are not guarantees of future performance, and we have no specific policy or intention to update these statements.
 
Actual events and results may differ materially from those expressed or forecasted in the forward-looking statements made by us due to a number of factors. The most important risk factors that could cause our actual performance and future events and actions to differ materially from such forward-looking statements include, but are not limited to: general economic and business conditions; material prices and availability; labor costs and availability; changes in interest rates; our debt level; declines in consumer confidence; increases in competition; changes in currency exchange rates (insofar as they affect our operations in France); weather conditions, significant natural disasters and other environmental factors; government regulations; the availability and cost of land in desirable areas; violations of our policies; the consequences of our past stock option grant practices and the restatement of certain of our financial statements; government investigations and shareholder lawsuits regarding our past stock option grant practices; other legal or regulatory proceedings or claims; conditions in the capital, credit and homebuilding markets; and the other risks discussed above in Item 1A. “Risk Factors.”


41


Table of Contents

 
Item 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
We primarily enter into debt obligations to support general corporate purposes, including acquisitions, and the operations of our subsidiaries. We are subject to interest rate risk on our senior and senior subordinated notes. For fixed rate debt, changes in interest rates generally affect the fair market value of the debt instrument, but not our earnings or cash flows. Under our current policies, we do not use interest rate derivative instruments to manage our exposure to interest rate changes.
 
The following table sets forth as of November 30, 2006, our long-term debt obligations, principal cash flows by scheduled maturity, weighted average interest rates and estimated fair market value (in thousands):
 
                                                                 
                                              Fair Value at
 
    Years Ended November 30,           November 30,
 
       2007           2008           2009           2010           2011        Thereafter     Total     2006  
 
Long-term debt (a)
                                                               
Fixed Rate
  $     $     $ 398,672     $ 297,569     $ 598,213     $ 1,295,431     $ 2,589,885       $2,557,643  
Weighted Average Interest Rate
    %     %     8.7 %     7.8 %     7.7 %     6.3 %                
(a) Includes senior subordinated and senior notes.
 
A portion of our construction operations are located in France and sales there are denominated in euros. As a result, our financial results could be affected by fluctuations in the value of the U.S. dollar relative to the euro. For example, for the year ended November 30, 2006, the result of a 10% uniform strengthening in the value of the dollar relative to the euro would have resulted in a decrease in revenues of $162.4 million and a decrease in pretax income of $16.0 million. Comparatively, a 10% uniform strengthening in the value of the dollar relative to the euro in 2005 would have produced a decrease in revenues of $128.7 million and a decrease in pretax income of $10.6 million.


42


Table of Contents

 
Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
KB HOME
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
     
   
Page
 
Consolidated Statements of Income for the Years Ended November 30, 2006, 2005 (as restated) and 2004 (as restated)
  44
Consolidated Balance Sheets as of November 30, 2006 and 2005 (as restated)
  45
Consolidated Statements of Stockholders’ Equity for the Years Ended November 30, 2006, 2005 (as restated) and 2004 (as restated)
  46
Consolidated Statements of Cash Flows for the Years Ended November 30, 2006, 2005 (as restated) and 2004 (as restated)
  47
Notes to Consolidated Financial Statements (as restated)
  48-88
Reports of Independent Registered Public Accounting Firm
  89-90
 
 
Separate combined financial statements of our unconsolidated joint venture activities have been omitted because, if considered in the aggregate, they would not constitute a significant subsidiary as defined by Rule 3-09 of Regulation S-X.


43


Table of Contents

KB HOME
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, Except Per Share Amounts)
 
                         
    Years Ended November 30,  
    2006     2005     2004  
          (as restated)     (as restated)  
 
Total revenues
  $ 11,003,792     $ 9,441,650     $ 7,052,684  
                         
Construction:
                       
Revenues
  $ 10,983,552     $ 9,410,282     $ 7,008,267  
Construction and land costs
    (8,853,503 )     (6,888,139 )     (5,325,856 )
Selling, general and administrative expenses
    (1,374,332 )     (1,170,956 )     (910,078 )
                         
Operating income
    755,717       1,351,187       772,333  
Interest income
    6,146       4,210       3,918  
Interest expense, net of amounts capitalized
    (18,723 )     (18,872 )     (18,154 )
Minority interests
    (68,300 )     (77,827 )     (69,049 )
Equity in pretax income (loss) of unconsolidated joint ventures
    (10,325 )     20,316       17,600  
                         
Construction pretax income
    664,515       1,279,014       706,648  
                         
Financial services:
                       
Revenues
    20,240       31,368       44,417  
Expenses
    (5,923 )     (20,400 )     (35,729 )
Equity in pretax income of unconsolidated joint venture
    19,219       230        
                         
Financial services pretax income
    33,536       11,198       8,688  
                         
Total pretax income
    698,051       1,290,212       715,336  
Income taxes
    (215,700 )     (466,500 )     (241,300 )
                         
Net income
  $ 482,351     $ 823,712     $ 474,036  
                         
Basic earnings per share
  $ 6.12     $ 10.06     $ 6.05  
                         
Diluted earnings per share
  $ 5.82     $ 9.32     $ 5.62  
                         
 
See accompanying notes.


44


Table of Contents

KB HOME
CONSOLIDATED BALANCE SHEETS
(In Thousands, Except Shares)
 
                 
    November 30,  
    2006     2005  
          (as restated)  
 
Assets
               
Construction:
               
Cash and cash equivalents
  $ 639,211     $ 144,783  
Trade and other receivables
    659,512       580,931  
Inventories
    6,454,763       6,128,342  
Investments in unconsolidated joint ventures
    397,731       275,378  
Deferred income taxes
    393,948       223,091  
Goodwill
    233,815       234,771  
Other assets
    191,460       124,150  
                 
      8,970,440       7,711,446  
Financial services
    44,024       29,933  
                 
Total assets
  $ 9,014,464     $ 7,741,379  
                 
                 
                 
         
Liabilities and Stockholders’ Equity
               
Construction:
               
Accounts payable
  $ 1,071,265     $ 892,727  
Accrued expenses and other liabilities
    1,680,014       1,410,959  
Mortgages and notes payable
    3,125,803       2,463,814  
                 
      5,877,082       4,767,500  
                 
Financial services
    26,276       55,131  
Minority interests
    188,358       144,951  
Stockholders’ equity:
               
Preferred stock — $1.00 par value; authorized, 10,000,000 shares; none issued
           
Common stock — $1.00 par value; authorized, 290,000,000 and 300,000,000 shares at November 30, 2006 and 2005, respectively; 114,648,604 and 113,905,123 shares issued at November 30, 2006 and 2005, respectively
    114,649       113,905  
Paid-in capital
    825,958       742,978  
Retained earnings
    2,975,465       2,571,372  
Accumulated other comprehensive income
    63,197       28,704  
Deferred compensation
          (13,605 )
Grantor stock ownership trust, at cost: 12,345,182 and 12,999,980 shares at November 30, 2006 and 2005, respectively
    (134,150 )     (141,266 )
Treasury stock, at cost: 25,274,482 and 19,020,516 shares at November 30, 2006 and 2005, respectively
    (922,371 )     (528,291 )
                 
Total stockholders’ equity
    2,922,748       2,773,797  
                 
Total liabilities and stockholders’ equity
  $ 9,014,464     $ 7,741,379  
                 
 
See accompanying notes.


45


Table of Contents

 
KB HOME
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In Thousands)
 
                                                                                         
    Years Ended November 30,  
    Number of Shares                       Accumulated
                         
          Grantor
                            Other
          Grantor
             
          Stock
                            Comprehensive
          Stock
          Total
 
    Common
    Ownership
    Treasury
    Common
    Paid-in
    Retained
    Income
    Deferred
    Ownership
    Treasury
    Stockholders’
 
    Stock     Trust     Stock     Stock     Capital     Earnings     (Loss)     Compensation     Trust     Stock     Equity  
 
Balance at November 30, 2003, as previously reported
    108,154       (15,214 )     (14,896 )   $ 108,154     $ 538,241     $ 1,408,265     $ 38,488     $ (7,512 )   $ (165,332 )   $ (327,453 )   $ 1,592,851  
Cumulative effect of restatement
                            22,615       (23,304 )                             (689 )
                                                                                         
Balance at November 30, 2003, as restated
    108,154       (15,214 )     (14,896 )     108,154       560,856       1,384,961       38,488       (7,512 )     (165,332 )     (327,453 )     1,592,162  
                                                                                         
Comprehensive income:
                                                                                       
Net income, as restated
                                  474,036                               474,036  
Foreign currency translation
                                        21,480                         21,480  
                                                                                         
Total comprehensive income, as restated
                                                                495,516  
Dividends on common stock 
                                  (39,163 )                             (39,163 )
Exercise of employee stock options, as restated
    2,119                   2,119       36,235       (1,060 )                             37,294  
Restricted stock amortization
                                              1,466                   1,466  
Stock-based compensation, as restated
                            2,366                                     2,366  
Grantor stock ownership trust
          459                   10,876                         4,998             15,874  
Treasury stock
                (2,000 )                                         (66,125 )     (66,125 )
                                                                                         
Balance at November 30, 2004, as restated
    110,273       (14,755 )     (16,896 )     110,273       610,333       1,818,774       59,968       (6,046 )     (160,334 )     (393,578 )     2,039,390  
                                                                                         
Comprehensive income:
                                                                                       
Net income, as restated
                                  823,712                               823,712  
Foreign currency translation
                                        (31,264 )                       (31,264 )
                                                                                         
Total comprehensive income, as restated
                                                                792,448  
Dividends on common stock 
                                  (61,577 )                             (61,577 )
Exercise of employee stock options, as restated
    3,632       950             3,632       91,072       (1,301 )                 10,323             103,726  
Restricted stock awards
          149                   7,940                   (9,555 )     1,615              
Restricted stock amortization
                                              1,996                   1,996  
Stock-based compensation, as restated
                            5,809                                     5,809  
Grantor stock ownership trust
          656                   27,824                         7,130             34,954  
Treasury stock
                (2,125 )                                         (134,713 )     (134,713 )
French share transfer
                                  (8,236 )                             (8,236 )
                                                                                         
Balance at November 30, 2005, as restated
    113,905       (13,000 )     (19,021 )     113,905       742,978       2,571,372       28,704       (13,605 )     (141,266 )     (528,291 )     2,773,797  
                                                                                         
Comprehensive income:
                                                                                       
Net income
                                  482,351                               482,351  
Foreign currency translation
                                        34,493                         34,493  
                                                                                         
Total comprehensive income
                                                                516,844  
Dividends on common stock 
                                  (78,258 )                             (78,258 )
Exercise of employee stock options
    744                   744       34,723                                     35,467  
Restricted stock awards
          537                   32,726                         5,839             38,565  
Restricted stock amortization
                            4,649                                     4,649  
Stock-based compensation
                            19,358                                     19,358  
Grantor stock ownership trust
          118                   5,129                         1,277             6,406  
Treasury stock
                (6,253 )                                         (394,080 )     (394,080 )
Reclass due to SFAS No. 123(R) implementation
                            (13,605 )                 13,605                    
                                                                                         
Balance at November 30, 2006
    114,649       (12,345 )     (25,274 )   $ 114,649     $ 825,958     $ 2,975,465     $ 63,197     $     $ (134,150 )   $ (922,371 )   $ 2,922,748  
                                                                                         
 
See accompanying notes.


46


Table of Contents

KB HOME
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
 
                         
    Years Ended November 30,  
    2006     2005     2004  
          (as restated)     (as restated)  
Cash flows from operating activities:
                       
Net income
  $ 482,351     $ 823,712     $ 474,036  
Adjustments to reconcile net income to net cash provided (used) by operating activities:
                       
Equity in pretax income of unconsolidated joint ventures
    (8,894 )     (20,546 )     (17,600 )
Distributions of earnings from unconsolidated joint ventures
    25,505       15,996       11,105  
Gain on sale of investment in unconsolidated joint venture
    (27,612 )            
Gain on sale of mortgage banking assets
          (26,647 )      
Minority interests
    68,300       77,827       69,049  
Amortization of discounts and issuance costs
    3,946       2,919       2,015  
Depreciation and amortization
    20,221       20,528       21,848  
Provision for deferred income taxes
    (170,857 )     (3,661 )     (51,443 )
Excess tax benefit associated with exercise of stock options
    (15,384 )            
Stock option income tax benefits
          36,930       10,999  
Stock-based compensation expense
    19,358       5,809       2,366  
Inventory impairments and land option cost write-offs
    431,239       42,922       36,873  
Change in assets and liabilities, net of effects from acquisitions:
                       
Receivables
    (78,927 )     77,670       (1,332 )
Inventories
    (481,980 )     (1,703,151 )     (989,219 )
Accounts payable, accrued expenses and other liabilities
    452,840       618,178       328,219  
Other, net
    (4,374 )     (21,401 )     24,162  
                         
Net cash provided (used) by operating activities
    715,732       (52,915 )     (78,922 )
                         
Cash flows from investing activities:
                       
Acquisitions, net of cash acquired
                (121,546 )
Proceeds from sale of investment in unconsolidated joint venture
    57,767              
Proceeds from sale of mortgage banking assets
          42,396        
Investments in unconsolidated joint ventures
    (237,786 )     (117,633 )     (128,734 )
Net sales of mortgages held for long-term investment
    204       806       (237 )
Payments received on first mortgages and mortgage-backed securities
    568       454       5,911  
Purchases of property and equipment, net
    (22,115 )     (23,997 )     (23,170 )
                         
Net cash used by investing activities
    (201,362 )     (97,974 )     (267,776 )
                         
Cash flows from financing activities:
                       
Net proceeds from (payments on) credit agreements and other short-term borrowings
    (93,321 )     (365,258 )     178,887  
Proceeds from term loan
    400,000              
Proceeds from issuance of senior notes
    298,458       747,591       596,169  
Redemption of senior notes
                (175,000 )
Payments on collateralized mortgage obligations
    (589 )     (429 )     (5,830 )
Payments on mortgages, land contracts and other loans
    (201,485 )     (148,528 )     (55,942 )
Issuance of common stock under employee stock plans
    65,052       101,749       42,168  
Payments to minority interests
    (24,893 )     (68,152 )     (32,389 )
Excess tax benefit associated with exercise of stock options
    15,384              
Payments of cash dividends
    (78,258 )     (61,577 )     (39,163 )
Repurchases of common stock
    (394,080 )     (134,713 )     (66,125 )
                         
Net cash provided (used) by financing activities
    (13,732 )     70,683       442,775  
                         
Net increase (decrease) in cash and cash equivalents
    500,638       (80,206 )     96,077  
Cash and cash equivalents at beginning of year
    153,990       234,196       138,119  
                         
Cash and cash equivalents at end of year
  $ 654,628     $ 153,990     $ 234,196  
                         
Summary of cash and cash equivalents:
                       
Construction
  $ 639,211     $ 144,783     $ 190,660  
Financial services
    15,417       9,207       43,536  
                         
Total cash and cash equivalents
  $ 654,628     $ 153,990     $ 234,196  
                         
Supplemental disclosures of cash flow information:
                       
Interest paid, net of amounts capitalized
  $     $ 9,720     $ 6,990  
Income taxes paid
    363,952       320,018       191,710  
                         
Supplemental disclosures of noncash activities:
                       
Cost of inventories acquired through seller financing
  $ 235,209     $ 204,185     $ 53,168  
Inventory of consolidated variable interest entities
    (18,130 )     120,674       85,488  
                         
See accompanying notes.


47


Table of Contents

 
KB HOME
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
Note 1.   Summary of Significant Accounting Policies
 
Operations.  KB Home (the “Company”) is a builder of single-family homes with operations in the United States and France. Domestically, the Company operates in Arizona, California, Colorado, Florida, Georgia, Illinois, Indiana, Louisiana, Maryland, Nevada, New Mexico, North Carolina, South Carolina, Texas and Virginia. In France, the Company operates through KBSA, a publicly traded subsidiary, which also develops commercial and high density residential projects, such as condominium complexes. The Company also offers mortgage services through Countrywide KB Home Loans, a joint venture with Countrywide. Countrywide KB Home Loans, which is accounted for as an unconsolidated joint venture within the Company’s financial services reporting segment, began offering loans to the Company’s domestic homebuyers on September 1, 2005. Through its financial services subsidiary, KBHMC, the Company provides title, insurance and escrow coordination services to its domestic homebuyers. The Company previously offered mortgage banking services directly through KBHMC until September 1, 2005 when substantially all of KBHMC’s mortgage banking assets were sold to Countrywide.
 
Basis of Presentation.  The consolidated financial statements include the accounts of the Company and all significant subsidiaries and joint ventures in which a controlling interest is held. All intercompany transactions have been eliminated. Investments in unconsolidated joint ventures in which the Company has less than a controlling interest are accounted for using the equity method.
 
Use of Estimates.  The consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles and, as such, include amounts based on informed estimates and judgments of management. Actual results could differ from these estimates.
 
Cash and Cash Equivalents.  The Company considers all highly liquid debt instruments and other short-term investments, purchased with a maturity of three months or less, to be cash equivalents. As of November 30, 2006 and 2005, the Company’s cash equivalents totaled $392.9 million and $20.4 million, respectively.
 
Goodwill.  The Company has recorded goodwill in connection with various acquisitions in prior years. All of the Company’s goodwill relates to its construction segments. Goodwill represents the excess of the purchase price over the fair value of net assets acquired. The Company tests goodwill for impairment using the two-step process prescribed in SFAS No. 142. The first step is used to identify potential impairment, while the second step measures the amount of impairment, if any. The impairment tests of goodwill performed by the Company as of November 30, 2006 and 2005 indicated no impairment.
 
The changes in the carrying amount of goodwill are as follows (in thousands):
 
                 
    2006     2005  
          (as restated)  
 
Balance at beginning of year
  $ 234,771     $ 245,598  
Goodwill acquired
           
Foreign currency translation and other
    (956 )     (10,827 )
                 
Balance at end of year
  $ 233,815     $ 234,771  
                 
 
Property and Equipment and Depreciation.  Property and equipment are recorded at cost and are depreciated over their estimated useful lives using the straight-line method. Repair and maintenance costs are charged to earnings as incurred. Property and equipment are included in other assets and totaled $62.7 million, net of accumulated depreciation of $64.1 million, at November 30, 2006 and $61.4 million, net of accumulated depreciation of $52.8 million, at November 30, 2005. Total depreciation expense for the years ended November 30, 2006, 2005 and 2004 was $20.2 million, $20.5 million, and $21.8 million, respectively.
 
Foreign Currency Translation.  Results of operations for KBSA are translated to U.S. dollars using the average exchange rates during the period. Assets and liabilities are translated using the exchange rates in effect at the balance sheet date. Resulting translation adjustments are recorded in stockholders’ equity as foreign currency translation adjustments.


48


Table of Contents

Construction Operations.  Revenues from housing and other real estate sales are recognized when sales are closed and title passes to the buyer. Sales are closed when all of the following conditions are met: a sale is consummated, a significant down payment is received, the earnings process is complete and the collection of any remaining receivables is reasonably assured. In France, revenues from development and construction of single-family detached homes, condominiums and commercial buildings, under long-term contracts with individual investors who own the land, are recognized using the percentage-of-completion method, which is generally based on costs incurred as a percentage of estimated total costs of individual projects. Revenues recognized in excess of amounts collected are classified as receivables. Amounts received from buyers in excess of revenues recognized, if any, are classified as other liabilities.
 
Construction and land costs are comprised of direct and allocated costs, including estimated future costs for warranties and amenities. Land, land improvements and other common costs are allocated on a relative fair value basis to units within a parcel or subdivision. Land and land development costs generally include related interest and real estate taxes.
 
Inventories are stated at cost unless the carrying amount of the parcel or subdivision is determined not to be recoverable, in which case the impaired inventories are written down to fair value in accordance with SFAS No. 144. SFAS No. 144 requires that long-lived assets be tested for recoverability whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. Recoverability of assets is measured by comparing the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. These evaluations for impairment are significantly impacted by estimates of revenues, costs and expenses, and other factors. If long-lived assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Fair value is determined based on estimated cash flows discounted for inherent risks associated with the long-lived assets, or other valuation techniques.
 
Financial Services Operations.  Revenues are generated primarily from the following sources: interest income; title services; insurance commissions; and escrow coordination fees. Interest income is accrued as earned. Title services revenue and escrow coordination fees are recognized at the time the home is closed; insurance commissions are recognized when policies are issued.
 
Prior to September 1, 2005, the Company also directly generated revenues from loan originations and sales of mortgage loans and servicing rights. Since September 1, 2005, these mortgage banking activities have been performed by Countrywide KB Home Loans, an unconsolidated joint venture.
 
First mortgages and mortgage-backed securities consist of securities held for long-term investment and are valued at amortized cost. First mortgages held under commitments of sale not designated as hedged items are valued at the lower of cost or market. Market is principally based on public market quotations or outstanding commitments obtained from investors to purchase first mortgages receivable. There are no first mortgages held under commitments of sale that are designated as hedged items.
 
Stock Split.  In April 2005, the Company’s board of directors declared a two-for-one split of the Company’s common stock in the form of a 100% stock dividend to stockholders of record at the close of business on April 18, 2005. The additional shares were distributed on April 28, 2005. All share and per share amounts have been retroactively adjusted to reflect the stock split.
 
Stock-Based Compensation.  Effective December 1, 2005, the Company adopted the fair value recognition provisions of SFAS No. 123(R), which requires that companies measure and recognize compensation expense at an amount equal to the fair value of share-based payments granted under compensation arrangements. Prior to December 1, 2005, the Company accounted for its stock option grants under the recognition and measurement provisions of APB Opinion No. 25 and related interpretations, as permitted by SFAS No. 123.
 
The Company adopted SFAS No. 123(R) using the modified prospective transition method. Under that transition method, the provisions of SFAS No. 123(R) apply to all awards granted or modified after the date of adoption. In addition, compensation expense must be recognized for any unvested stock option awards outstanding as of the date of adoption on a straight-line basis over the remaining vesting period. The fair value of each stock option was estimated on the date of grant using the Black-Scholes option-pricing model. In addition, SFAS No. 123(R) requires the tax benefit resulting from tax deductions in excess of the compensation expense recognized for those options to be reported in the statement of cash flows as an operating cash outflow and a financing cash inflow rather than as an operating cash inflow as previously reported.


49


Table of Contents

SFAS No. 123(R) requires disclosure of pro forma financial information for periods prior to adoption. The following table sets forth the effect on net income and earnings per share as if the fair value recognition provisions of SFAS No. 123(R) had been applied to all outstanding and unvested awards in the years ended November 30, 2005 and 2004 (in thousands, except per share amounts):
 
                         
    Years Ended November 30,        
    2005     2004        
 
Net income, as restated
  $ 823,712     $ 474,036          
Add: Stock-based compensation expense included in restated net income, net of related tax effects
    4,309       1,866          
Deduct: Stock-based compensation expense determined using the fair value method, net of related tax effects
    (19,462 )     (14,922 )        
                         
Pro forma net income, as restated
  $ 808,559     $ 460,980          
                         
Earnings per share:
                       
Basic — as restated
  $ 10.06     $ 6.05          
Basic — pro forma, as restated
    9.87       5.89          
Diluted — as restated
    9.32       5.62          
Diluted — pro forma, as restated
    9.21       5.54          
                         
 
Advertising Costs.  The Company expenses advertising costs as incurred. For the years ended November 30, 2006, 2005 and 2004, the Company incurred advertising costs of $133.9 million, $94.4 million and $75.6 million, respectively.
 
Insurance.  The Company has, and requires the majority of its subcontractors to have, general liability insurance (including construction defect coverage) and workers compensation insurance. These insurance policies protect the Company against a portion of its risk of loss from claims, subject to certain self-insured retentions, deductibles and other coverage limits. The Company records expenses and liabilities for self-insured and deductible amounts, based on an analysis of its historical claims, which includes an estimate of claims incurred but not yet reported. The Company self-insures a portion of its overall risk, partially through a captive insurance subsidiary.
 
Income Taxes.  Income taxes are provided for at rates applicable in the countries in which the income is earned. Provision is made currently for U.S. federal income taxes on earnings of KBSA that are not expected to be reinvested indefinitely.
 
Other Comprehensive Income.  The accumulated balances of other comprehensive income in the balance sheets as of November 30, 2006 and 2005 are comprised solely of cumulative foreign currency translation adjustments of $63.2 million and $28.7 million, respectively.
 
Earnings Per Share.  Basic earnings per share is calculated by dividing net income by the average number of common shares outstanding for the period. Diluted earnings per share is calculated by dividing net income by the average number of shares outstanding including all potentially dilutive shares issuable under outstanding stock options. The following table presents a reconciliation of average shares outstanding (in thousands):
 
                         
    Years Ended November 30,  
    2006     2005     2004  
 
Basic average shares outstanding
    78,829       81,888       78,316  
Net effect of stock options assumed to be exercised
    4,027       6,537       6,040  
                         
Diluted average shares outstanding
    82,856       88,425       84,356  
                         
 
Recent Accounting Pronouncements.  In May 2005, the FASB issued SFAS No. 154, which replaces APB Opinion No. 20 and SFAS No. 3, and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 is not expected to have a material impact on the Company’s consolidated financial position or results of operations.


50


Table of Contents

In June 2005, the EITF released EITF 04-5, which provides guidance in determining whether a general partner controls a limited partnership and therefore should consolidate the limited partnership. EITF 04-5 states that the general partner in a limited partnership is presumed to control that limited partnership and that the presumption may be overcome if the limited partners have either (a) the substantive ability to dissolve or liquidate the limited partnership or otherwise remove the general partner without cause, or (b) substantive participating rights. The effective date for applying the guidance in EITF 04-5 was (a) June 29, 2005 for all new limited partnerships and existing limited partnerships for which the partnership agreement was modified after that date, and (b) no later than the beginning of the first reporting period in fiscal years beginning after December 15, 2005 for all other limited partnerships. Implementation of EITF 04-5 did not have a material impact on the Company’s consolidated financial position or results of operations for the year ended November 30, 2006.
 
In July 2006, the FASB issued FASB Interpretation No. 48, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FASB Interpretation No. 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the potential impact of adopting FASB Interpretation No. 48 on its consolidated financial position and results of operations.
 
In September 2006, the FASB issued SFAS No. 158, which requires companies to (a) recognize the funded status of a benefit plan (measured as the difference between the fair value of plan assets and the benefit obligation) in its statement of financial position, (b) recognize as a component of other comprehensive income, net of tax, the actuarial gains and losses and the prior service costs and credits that arise during the period, (c) measure defined benefit plan assets as of the date of a company’s statement of financial position, and (d) disclose in the notes to the financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. SFAS No. 158 is effective for companies with publicly traded securities as of the end of the fiscal year ending after December 15, 2006. The Company does not expect that the adoption of SFAS No. 158 will have a material effect on its consolidated financial position or results of operations.
 
In September 2006, the FASB issued SFAS No. 157, which provides guidance for using fair value to measure assets and liabilities, defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and for interim periods within those years. The Company is currently evaluating the potential impact of adopting SFAS No. 157 on its consolidated financial position and results of operations.
 
In September 2006, the SEC Staff issued SAB No. 108, which addresses how the effects of prior year uncorrected financial statement misstatements should be considered in current year financial statements. SAB No. 108 requires registrants to quantify misstatements using both balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relative quantitative and qualitative factors. The requirements of SAB No. 108 are effective for annual financial statements covering the first fiscal year ending after November 15, 2006. The Company’s adoption of SAB No. 108 in 2006 did not have a material impact on its consolidated financial position or results of operations.
 
In November 2006, the EITF ratified EITF 06-8, which states that adequacy of the buyer’s investment under SFAS No. 66 should be assessed in determining whether to recognize profit under the percentage-of-completion method on the sale of individual units in a condominium project. EITF 06-8 could require that additional deposits be collected by developers of condominium projects that wish to recognize profit during the construction period under the percent-age-of-completion method. EITF 06-8 is effective for fiscal years beginning after March 15, 2007. The Company is currently evaluating the potential impact of adopting EITF 06-8 on its consolidated financial position and results of operations.
 
Reclassifications.  Certain amounts in the consolidated financial statements of prior years have been reclassified to conform to the 2006 presentation.
 
Note 2.   Restatement of Consolidated Financial Statements
 
The Company has restated its consolidated financial statements to reflect additional stock-based compensation expense and related income tax effects relating to annual stock option awards granted since 1998. This Form 10-K reflects


51


Table of Contents

the restatement of the Company’s consolidated financial statements as of November 30, 2005 and for the years ended November 30, 2005 and 2004.
 
Background
 
In light of various media reports that stock options had been backdated at a number of public companies, and in conjunction with a request from the Chairman of the Audit and Compliance Committee of the Company’s board of directors, in May 2006 the Company’s internal legal department began a preliminary review of the Company’s annual stock option grant practices.
 
On July 25, 2006, the Company commenced the Stock Option Review to determine whether it had used appropriate measurement dates for, among other awards, the twelve annual stock option grants it made from January 1995 to November 2005. The Stock Option Review was directed by the Subcommittee — consisting solely of outside directors who have never served on the Company’s Compensation Committee — with the advice of independent counsel and forensic accountants. The Subcommittee and its advisors conducted 66 interviews, including seven with current and former members of the Company’s Compensation Committee, and collected more than 1.2 million documents relating to the Company’s stock option grant practices from 64 individuals.
 
On November 12, 2006, the Company announced that the Subcommittee had substantially completed its investigation and concluded that the Company had used incorrect measurement dates for financial reporting purposes for the eight annual stock option grants made since 1998. At the same time, the Company announced the departure of its Chairman and Chief Executive Officer and its head of human resources.
 
On December 8, 2006, the Company filed a Current Report on Form 8-K announcing that its management, in consultation with the Audit and Compliance Committee and after discussion with its independent registered public accounting firm, had determined that its previously issued consolidated financial statements and any related audit reports for the years ended November 30, 2005, 2004 and 2003, and the interim consolidated financial statements included in the Company’s Quarterly Reports on Form 10-Q for the quarters ended February 28, 2006 and May 31, 2006, should no longer be relied upon and would be restated.
 
Findings
 
The evidence developed through the Stock Option Review indicates that the Company’s Compensation Committee met in October each year since 1998 to consider and approve annual stock option awards for the next year. At those meetings, the Compensation Committee specifically approved the number of stock options to be granted to the Company’s former Chief Executive Officer and other senior management and an unallocated block of stock options to be allocated by its former Chief Executive Officer and former head of human resources to the other employees.
 
In addition to allocating annual stock options among other employees, starting with the annual stock option grant approved by the Compensation Committee in October 1998, the Company’s former Chief Executive Officer and former head of human resources also selected the grant date. The Subcommittee discovered evidence confirming or, in some years, suggesting that hindsight was used to secure favorable exercise prices for seven of the eight annual stock option grants since 1998. Grants in 1999, 2000 and 2001 were made at the lowest closing stock price during the grant month. The Subcommittee discovered direct evidence that the 2001 grant was priced with hindsight to secure favorable pricing, and the Subcommittee concluded that the evidence it reviewed suggests that hindsight pricing was used for the 1999 and 2000 grants as well. The Subcommittee also found that there is evidence that hindsight was used for the three annual grants made from 2003 to 2005, but within a floating three-day window as a result of the SEC’s accelerated filing requirements for reports of stock transactions by executive officers.
 
Involvement in, and knowledge of, the hindsight pricing practices by the Company’s senior management, based on the evidence developed through the Stock Option Review, was limited to its former Chief Executive Officer and former head of human resources. The Subcommittee concluded that these hindsight pricing practices did not involve any of the Company’s current senior management, including its new Chief Executive Officer, its principal financial officer or its principal accounting officer, nor were any of those individuals aware of these practices. The Subcommittee further concluded that none of the Company’s other accounting or finance employees were involved in, or aware of, the hindsight pricing practices.


52


Table of Contents

Stock Option Adjustments and Related Actions
 
As part of its review, the Subcommittee determined whether the correct measurement dates had been used under applicable accounting principles for these options. The “measurement date” means the date on which the option is deemed granted under applicable accounting principles, namely APB Opinion No. 25, and related interpretations, and is the first date on which all of the following are known: (a) the individual employee who is entitled to receive the option grant, (b) the number of options that an individual employee is entitled to receive, and (c) the option’s exercise price.
 
Based on the findings of the Subcommittee, the Company has changed the measurement dates it uses to account for the annual stock option grants since 1998 from the grant dates selected by its former Chief Executive Officer and former head of human resources to the dates its employees were first notified of their grants. These measurement date changes resulted in an understatement of stock-based compensation expense arising from each of the Company’s annual stock option grants since 1998, affecting the Company’s consolidated financial statements for each year beginning with its year ended November 30, 1999. The Company has determined that the aggregate understatement of stock-based compensation expense for the seven-year restatement period from 1999 through 2005 is $36.3 million. In connection with the restatement of its consolidated financial statements to reflect the stock-based compensation adjustments associated with the stock option measurement date changes, the Company recorded an aggregate increase of $4.8 million in its income tax provision for the seven-year restatement period. This amount represents the cumulative income tax impact related to IRC Section 162(m), partially offset by the income tax impact of the additional stock-based compensation expense. The stock-based compensation expense and related income tax impacts reduced net income by $41.1 million for the years ended November 30, 1999 through 2005. The related tax effects on the Company’s consolidated balance sheet included an increase of $72.3 million in accrued expenses and other liabilities, and a decrease of $77.8 million in stockholder’s equity.
 
After considering the application of Section 409A of the IRC to its annual stock option grants, in December 2006 the Company increased the exercise price of certain annual stock options and will pay the difference to its current employees in the first quarter of the year ended November 30, 2007. This amount is not expected to exceed $7.0 million.
 
Other Adjustments
 
In addition to the adjustments related to the Stock Option Review, the restated consolidated financial statements presented herein include an adjustment to increase the income tax provision and reduce goodwill in 2004 and 2005 in accordance with SFAS No. 109 to reflect the income tax benefit realized for the excess of tax-deductible goodwill over the reported amount of goodwill. The aggregate impact of this adjustment on 2004 and 2005 was a $7.8 million increase in the income tax provision with a corresponding reduction in goodwill. This adjustment is not related to the Stock Option Review.
 
Restatement
 
The Company has restated its consolidated financial statements for the years ended November 30, 2005 an