KB Home (KBH
Fiscal Second Quarter 2008 Earnings Call
June 27, 2008 11:30 am ET
Jeffrey Mezger – President & CEO
Domenico Cecere – Executive VP & CFO
Kelly Masuda – Sr. VP & Treasurer
William Hollinger – Sr. VP & CAO
Dan Oppenheim – Credit Suisse
Dennis McGill – Zelman & Associates
Michael Rehaut - JP Morgan
Jim Wilson - JMP Securities
David Goldberg – UBS Securities
Timothy Jones - Wasserman & Associates
Joel Locker - FBN Securities
Lawrence Taylor – Credit Suisse
Alex Barron - Agency Trading Group
Jay McCanless – FTN Midwest Securities
Good day everyone and welcome to the KB Home second quarter earnings conference call. As a reminder today’s conference is being recorded and webcast in the KB Home’s website at www.kbhome.com. The recording will also be available via telephone replay until midnight on July 6th. You can access the recording by dialing 719-457-0820 or 888-203-1112 and entering the replay pass code of 9916184. KB Home''s discussion today may include certain predictions and other forward-looking statements. These statements may cover market or economic conditions, KB Home''s business and prospects, its future financial and operational performance and/or future actions or strategies and their expected results. They are based on management’s current expectations and projections about future events and business conditions but are not guarantees of future performance.
Due to a number of risks, uncertainties, assumptions and the events outside its control, KB Home''s actual results could differ materially from those expressed in, or implied by the forward-looking statements. Many of these risk factors are identified in the company’s periodic reports and other filings with the SEC, which the company urges you to read with care, and now for opening remarks and introductions I would like to turn the conference over to KB Home President and Chief Executive Officer, Mr. Jeffrey Mezger. Please go ahead Mr. Mezger.
Thanks Calcy (ph). Good morning everyone; thank you for joining us today for a review of our second quarter results. With me this morning are Dom Cecere, our Executive Vice President and Chief Financial Officer, William Hollinger, our Senior VP and Chief Accounting Officer and Kelly Masuda, our Senior VP of Investor Relations and Treasurer. This morning I will cover the state of the housing market, our second quarter results and our outlook and strategies for the remainder of the year. Dom will take you through our second quarter financial results and I will have some brief closing remarks before we open it up for your questions. Let’s start with market conditions. The second quarter remained very challenging for home builders. Inventories of both new and existing homes hovered at a 10 to 11 month supply throughout the period with buyers remaining on the sidelines concerned with the weakening economy and tightening mortgage lending standards. Foreclosure activity continues to rise, compounding the inventory overhang and maintaining pressure on prices. This was borne out by the SMP Case-Schiller composite 20 index which reported that prices in April had dropped 15.3% from a year earlier as well as the conference board’s recent release which indicated that the consumer confidence index fell to 50.4% in June, the lowest level since February, 1992.
Taken as a whole, these operating conditions are some of the most difficult the home building industry has ever experienced. Our financial results for the second quarter reflect this persistently challenging environment and the decisive actions we have taken to address these conditions over the last two years. The market price declines in the quarter and the uncertain timeframe for housing market recovery required additional revaluation of our assets in the quarter. We took pre-tax non-cash charges of $177 million for inventory and joint venture impairments and abandonments and $25 million for goodwill impairment. We also recorded a $99 million deferred tax asset valuation allowance charge for the quarter. Largely due to these charges we reported a net loss for the quarter of $256 million or $3.30 per diluted share. About 90% of our total impairments and abandonments in the second quarter were recorded against assets in California, Arizona, Nevada and Florida; the states hardest hit by foreclosures and falling prices. While we were disappointed with the substantial impairment charges in the quarter they are driven by the difficult market conditions that we and other home builders continue to confront. Generally accepted accounting principals required that we book an additional charge in the second quarter to fully reserve the tax benefits generated from our pre-tax loss. As of May 31, 2008 our valuation allowance on our deferred tax assets exceeded $720 million. From my perspective this represents nearly $10.00 of potential additional book value per share which I believe is one of the highest among our peers and a real opportunity to unlock value in the future.
We believe that a meaningful improvement in market conditions will require a sustained decrease in inventory levels, price stabilization, reduced foreclosure rates, and the restoration of consumer confidence in making the home buying decision. While it is difficult to predict when these events will occur, what I can tell you with confidence is that we have responded quickly and judiciously to the dramatic reversal in the housing markets and I believe we will emerge from this down cycle a stronger, leaner and better company than ever before. In the remainder of my opening remarks this morning I will give you a picture of where KB Home stands today and where we are headed. Let’s begin with the here and now. For the past two years we have made financial strength and operating flexibility the centerpiece of our strategic response to rapidly declining markets. As a result, KB Home is among the financially strongest and best positioned national home builders operating today. Since early 2006, we have focused relentlessly on strengthening our balance sheet and repositioning our operations to align with market realities. We’ve built up and preserved our cash position, reduced our inventory and community count and consolidated operations in some markets while selectively exiting others. This strategy has generated tangible results. At May 31, 2008 we had a cash balance of over $1.3 billion, more than triple the year-earlier amount. Typically our operations use cash in the first half of our fiscal year. But with a disciplined focus on curtailing expenditures we finished the second quarter with essentially the same cash level we reported at year-end and at the end of the first quarter.
Cash flow from operations was positive for each of the first two quarters of 2008, and we anticipate generating positive cash flows from our operations for the remainder of the year. We have reduced inventory levels by 50% from a year ago to $2.6 billion at May 31, 2008. We entered the second quarter with approximately 56,600 lots owned or controlled down 70% from a peak of 186,000 lots in the first quarter of 2006. We currently have an attractive geographically diverse land portfolio that represents about a three year supply to us. We believe that our short land position is prudent given the current environment. As the market stabilizes we expect to reload our pipeline with lower cost lots at a competitive advantage that should expedite our return to profitability. Our leverage ratio net of cash was 40.2% at quarter-end. This is at the low end of our targeted range of 40% to 50%. Net debt was $856 million at quarter-end, down from $2.4 billion at the 2007 quarter-end, a reduction of 65%. We had approximately $2.4 billion of liquidity at the end of the second quarter with an un-drawn revolver and $1.3 billion of cash. This will enable us to be opportunistic with land acquisitions from distressed builders, developers and banks as they arise. With our lower inventory levels and strong liquid balance sheet we recently decided to reduce debt further. In July we will redeem all $300 million of our outstanding 7 ¾% senior subordinated notes. The economic case for the redemption is compelling. Based on our current cash yields, this should generate almost $16 million of annual savings and a 4.5 month breakeven on the 1.9% redemption premium.
This is another example of a measured action that we are taking to position ourselves to return to profitability. All of these targeted measures have given us ample dry powder for the future. So, let’s look forward. Our central priority now is to restore the profitability of our home building operations. For the immediate future this means selling at the right price, with the right product and the right marketing strategy for each individual market in which we operate. Single-minded pursuit of market share or higher volume has no economic attraction in today’s environment, and given the strength of our financial position we believe that generating profit is more critical to our shareholders than generating additional cash. It also means continuing our focus on cost reduction and operating more efficiently. Our KB Next principals of lean, build-to-order production have never been more important. Finally it means looking to the future and preparing for the recovery. We have the financial strength to capitalize on land and lot purchase opportunities as they arise and we are ready to do so to create an inventory base that can generate future profitable growth. Here’s a brief look at our current key strategies. First we will operate in individual markets at a size that optimizes economic returns and avoid markets where profitability currently appears improbable at any size. As you know, over the past several quarters we have aligned the size of our business with lower levels of demand. Our community count is down 37% from a year ago as a result of our downsizing operations in certain markets as backlog is delivered and completely exiting others.
We are comfortable with our current position in markets across the country and believe they will provide a solid platform for growth in the future. We will continue to assess and reassess our geographic footprint seeking optimal volume levels at which to operate and we will adjust our community counts to maximize financial performance. We are confident that our current platform positions us well for solid growth as each market stabilizes. Next we will use our financial strength to acquire land and lots in good, long-term markets at distressed prices. Opportunities will inevitably arise to reload our pipeline and we will not hesitate to do so when the price and timing are compelling. Even now we are in the market actively analyzing potential land acquisitions. Deal flow is increasing and we are seeing both portfolio and single-asset transactions. However we are being careful and patient in order to seize the right opportunities. Our land acquisition and development will remain limited in the near-term as we continue to rescale our business with reduced sales rates. We are developing smaller phases and restructuring our land development expenditures at each community to match with demand. Currently for 2008 we are budgeting total land acquisition expenditures of approximately $300 million and total development expenditures of approximately $400 million. We will remain conservative in our assumptions and thoroughly evaluate the specifics of each deal. We will also be highly strategic in our choice of submarkets and product types. Next we will develop product types and marketing strategies on an individual region, market and even community level. Our entire team is dedicated to improving our pre-tax results. This may mean implementing a specific set of marketing decisions for individual market conditions. We will continue to balance sales rates and pricing and evaluate the best use for our assets including whether we should modify entitlements or redesign product if the profit potential is greater.
With little pricing power in today’s markets we will be particularly vigilant in maintaining a competitive value proposition. In most of our markets we believe our prices are already at or below the resale median for that market, and while existing home prices are likely to fall further in 2008 we have anticipated this and have taken steps to ensure that our selling prices remain competitive and our value proposition continues to be compelling to consumers. We will also remain focused on lowering our direct costs.
We have already made substantial in reducing square footage and simplifying our floor plans to meet buyer demand. We have also offset pricing pressures to some degree with strategic cost reductions including value engineering our home designs and renegotiating labor and supply contracts. We continue to focus on featuring design elements that blend low cost with high value putting the custom home experience within reach of our home buyers. We will continue to pursue further cost reductions and improve efficiency by streamlining our core business processes with the goal of improving gross margins. We will also remain relentless in removing unnecessary overhead costs. Our selling, general and administrative expenses decreased by $75 million or 38% in the second quarter of 2008 from the year earlier quarter. While a portion of these expenses are variable, the sizable overhead reductions we have achieved have been outpaced by the rapid and dramatic decrease in our revenues. As margins are likely to remain compressed due to pricing pressure, we will continue to bring overhead in line with our reduced revenues. We expect to see further improvements on this front over the next several quarters due to our ongoing initiatives. One analyst report recently pointed out that we have the highest revenues per employee among our peers, a testament to our discipline and business model. Based on the latest available data for 2007 our revenue per employee was $2.2 million while the next highest of our peers was $1.8 million and the average was $1.3 million. If we maintain our financial discipline and concentrate on the markets and product types we know best and we will, I am confident that KB Home will continue to successfully manage through this downturn. But the larger picture is even more compelling because looking a little further down the road, I believe the prospects for our industry and our company, are excellent. The fundamentals of our business remain strong especially for builders like KB Home that focus on first time home buyers. I believe no one understands this market segment better than we do. No one anticipates buyer trends more accurately; no one innovates more effectively in product design and marketing strategies.
Recently Fortune Magazine featured KB Home in its pages making essentially the same point. After the magazine named us the number one home builder on its list of most admired companies of 2008, it’s editor-at-large Shawn Tully took an in depth look at our company in its June 9th issue. The story highlighted our renewed focus on the needs of first time home buyers and our diligent efforts to ensure we are offering the right homes at the right price for today’s market. He referred to our obsession with making homes affordable while still offering features that sharply distinguish KB Home from the competition. In answering his own question why will housing come back? Tully concludes that it will be, and I quote, “for a reason as solid as floor joists, the entry level buyer for the first time in years is finding that owning a new house is suddenly just as cheap as renting.” And I totally agree. Home prices have come down in many areas of the country for nearly two years while rents have increased closing the affordability gap between renting and owning a home. At KB Home we are effectively demonstrating this increased affordability to our first time buyers by featuring potential low monthly payments in our marketing and advertising outreach. These monthly payments allow renters to make a direct comparison to what they are paying in rent today often discovering that home ownership is within their reach.
So we are encouraged that the precursors of a housing market recovery are in place and we believe that KB Home is uniquely positioned to respond. The great uncertainty of course, is when that recovery will begin. Whatever the future brings we remain focused on running our business prudently at whatever volume market conditions support. We will pursue our goal of restoring profitability while maintaining our strong financial position. By adhering to our proven KB Next operating business model and leveraging our strengths we are poised to emerge from the downturn as one of the strongest national players in the home building industry.
Now I’ll turn the call over to Dom for his financial review.
Thanks Jeff. Net orders of 4,200 new homes in the second quarter were down 42% on a year-over-year basis due primarily to a 37% decrease in our community accounts and a softening demand in a number of our served markets. We had 215 active selling communities in the second quarter of 2008 compared to 342 in the second quarter of 2007. Community count was lower in each of our four regions with decreases ranging from 24% to 45%. We anticipate operating with lower year-over-year community counts for the remainder of the year consistent with our renewed focus on restoring profitability. Second quarter net orders were nearly triple the 1,449 we posted in the first quarter of 2008 partly due to our improved cancellation rate. The order cancellation rate in the second quarter of 2008 improved to 27% of gross orders from 53% in the first quarter of 2008, 58% in the fourth quarter of 2007 and 34% in the year-earlier quarter. Cancellation rates have been volatile over the past couple of years but have recently returned to more normal levels. This metric may indicate some stability in returning to the market. We entered the second quarter with 4,843 sold homes in backlog and converted 2,810 or 58% of beginning backlog to revenue in the quarter. This compares to a conversion ratio of 43% in the second quarter of 2007. The higher conversion rate and lower cancellation rate suggests the quality of our backlog is improving. Our backlog does remain geographically diverse with the largest portion on a value basis in our West Coast and Southeast regions.
We incurred a net loss of $256 million or $3.30 per diluted share in the second quarter largely due to pre-tax non-cash charges of a $177 million inventory and joint venture impairment and abandonments and $25 million for goodwill impairment. We also recorded a $99 million charge for deferred tax asset valuation allowance. In the second quarter of 2007 our net loss totaled $149 million or $1.93 per diluted share including a pre-tax non-cash charge of $308 million for impairment and abandonment charges partially offset by an after-tax income of $25 million or $0.33 per diluted share from our French discontinued operations. Excluding the impairment and abandonment charges and the valuation allowance we would have reported a net loss of $32 million or $0.41 per diluted share in the second quarter of 2008 and net income of $37 million or $0.47 per diluted share in the second quarter of 2007. We delivered 2,810 homes in the second quarter of 2008, down 41% from the earlier quarter mainly due to our reduced community counts. Each of our regions delivered fewer homes compared to the earlier quarter with decreases ranging from 30% to 50%.
With our emphasis on improving margins and gaining profitability we will continue to review and adjust our community counts as necessary to maximize our performance in each region. Consistent with the rate of broader market price declines our average selling price for the second quarter decreased 17% to $226,600 from $271,600 in the second quarter of 2007. The lower average sales price was the exact result of the efforts we have taken over the last several quarters to address affordability. Floor plans were simplified, the average square footage was lowered by 10% and pricing was adjusted to remain competitive in the market. We expect increasing supply and weakening demand to exert additional downward pressure on the housing market through the remainder of this year. We are calibrating our pricing and sales rate to strike an appropriate balance that would lead to improved financial performance. However our [bias] is to hold pricing as much as possible to maximize future results. We will also be reducing production costs, be reevaluating spec levels, refining and value engineering our home designs and renegotiating supplier contracts to achieve better terms. Our housing gross margin in the second quarter of 2008 fell to a negative 17.5% from a negative 3.9% in the second quarter of 2007. Excluding inventory impairment and abandonment charges the housing gross margin was 8.7% in the second quarter compared to 9.0% in the first quarter, 10.1% in the fourth quarter of 2007 and 14.9% in the second quarter of 2007. We anticipate that our margins will remain compressed in the second half of the year. Having said that, our goal is to mitigate pressure on margins with cost savings.
Selling, general and administrative expenses in the second quarter decreased $75 million or 38% from a year ago. This is a significant reduction in gross SG&A dollars but our revenues have fallen even faster. SG&A as a percent of housing revenues was 18.7% up from 14.9% in the earlier quarter. We expect this percentage to remain above 2007 levels for the remainder of the year. It will take some time for overhead to fully align with our lower revenue levels. This area will be a constant focus for us as we work hard to close the gap.
Our home building pre-tax loss of $258 million for the second quarter of 2008 included a $156 million of inventory and joint venture impairment charges, $21 million of option abandonment charges related to about 800 lots under option contract we have chosen not to pursue, and a $25 million goodwill impairment charge. During the quarter we impaired approximately 40 projects. Around 90% of the second quarter impairments and abandonments occurred in California, Arizona, Nevada and Florida. The impairments were mainly driven by price reductions in markets as housing inventory increased in the face of rising foreclosures and softening demand. Overall our inventory in joint venture related charges of a $177 million in the current quarter were 43% lower than the $308 million of similar charges in the earlier quarter. The lower charge may indicate that fewer impairments will be needed in future periods, unless market prices drop dramatically. The financial services business contributed pre-tax income of $3 million in the second quarter of 2008. Our Countrywide KB Home Loans mortgage joint venture continues to perform well. Within the joint venture retention rate for the second quarter of 2008 was 80% compared to 70% a year ago. The average FICO score of the joint venture mortgage customers in the quarter was 696, slightly lower than 706 a year ago. Buyers also continued to use more fixed rate product; just 4% of the quarter chose an adjustable rate mortgage.