M.D.C. Holdings, Inc.
Q2 2008 Earnings Call Transcript

Published: 31 Jul 2008

[Operator:]

Ladies and gentlemen, thank you for standing by. I will now be turning the conference over to Mr. Bob Martin. Please go ahead.

[Bob Martin:]

Thank you. Good morning ladies and gentlemen and welcome to MDC Holdings 2008 Second Quarter Earnings Conference Call. Joining me today on the call are Larry Mizel, Chairman and Chief Executive Officer; Gary Reece, Executive Vice President and Chief Financial Officer; Michael Touff, Senior Vice President and General Counsel; Joe Fretz, Secretary and Corporate Counsel; and finally, we are very excited to have Chris Anderson on our call for the first time today. As many of you know, from our previous disclosures, Chris will take over the reigns of our finance organization as Senior Vice President, Chief Financial Officer, and Principal Accounting Officer, effective upon Gary's retirement as an officer of the company, which is scheduled to occur at the end of business tomorrow. At this time, all participants are in a listen-only mode. After finishing our prepared remarks, we will conduct a question-and-answer session, at which time we request that participants limit themselves to one question and one follow-up question. Please note that this conference is being recorded, and will be available for replay. For information on how to access the replay, please visit our website at mdcholdings.com. I will now turn over the call to Joe Fretz for a disclaimer on forward-looking statements. Joe?

[Joe Fretz:]

Before introducing Larry Mizel and Gary Reece, it should be noted that certain statements made during this conference call, including those related to MDC's business, financial condition, results of operations, cash flows, strategies and prospects and responses to questions, may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties and other factors that may cause the company's actual results, performance or achievement to be materially different from the results, performance or achievements expressed or implied by the forward-looking statements. These and other factors that could impact the company's actual performance are set forth in the company's 2007 Form 10-K and 2008 second quarter Form 10-Q. It should also be noted that SEC Regulation G requires that certain information accompany the use of non-GAAP financial measures. Any information required by Regulation G will be posted on our website, mdcholdings.com. I will now introduce Larry Mizel, Chairman of the Board and Chief Executive Officer of MDC Holdings.

[Larry Mizel:]

Good morning. As our nation continued to face a strong economic headwind in the second quarter, we experienced an ongoing sluggish sales pace, which led to a substantial year-over-year decline in net home orders. While the issues in the housing market have received a significant amount of attention from the government, highlighted by the recent approval of Housing Rescue Legislation, we cannot assume that a recovery is eminent. Therefore, in the second quarter, our balance sheet again was a central focus of our company. Our divisions continue to aggressively pursue the sale of lots that no longer meet or restrict underwriting criteria, which not only provide immediate cash proceeds, but also generated a taxable loss that will help us in maximizing with tax refund we expect to receive early next year. These lot sales contributed to an 11% reduction in the number of lots we own, a key accomplishment that allowed us to generate more than $90 million in operating cash flow during the second quarter alone. As a result, we ended the quarter with nearly $1.3 billion in cash on hand, which exceeded our total debt outstanding by more than 20%. Our exposure to performance bonds and letters of credit related to land development activities remains low, with an estimated cost to complete of less than $50 million. Our ongoing effort to conserve cash by right sizing overhead expenditures has yielded significant cost savings for our company. By reducing both operating divisions and employee headcount, we achieved a significant reduction of our total general & administrative expenses for the 2008 second quarter. We will continue to look for opportunities to reduce our expenses for the foreseeable future, especially if the pace of homebuilding activity of our company continues to decline. After making significant progress over the past two years in preparing our balance sheet for better times, our experienced management team can afford to focus on the future, even as others in our industry focus on liquidating their land assets. Our initiatives are designed to address key aspects of our operating platform. We seek to better leverage our overhead and further reduce the cost of construction through our companywide initiative to transform and streamline our processes and business practices. We can provide our buyers with better quality, highly personalized homes through our unique home gallery concept and we can improve the satisfaction of our customers by focusing on every aspect of the home buying process through our customer experience initiative. By making progress in these areas, we can strengthen our operating platform in anticipation of opportunities to invest our substantial capital resources in the future. As many of you know, Gary Reece, our Chief Financial Officer, will retire after fulfilling his reporting duty for this 2008 second quarter. I would like to take this opportunity again, to thank him for his service to our company, which has spanned more than 20 years. And so, for the last time, I would like now to turn this call over Gary, who will describe more specific financial highlights of our 2008 second quarter.

[Gary Reece:]

Great. Thank you, Larry. I guess, I better do this, so I can fulfill my reporting duties. By the way, I will run through the second quarter results as quickly as I can to leave enough time for questions. But I would refer you to, for greater clarity into our company's performance this quarter, to our Form 10-Q, which has gone effective this morning, prior to this call. So, that information is out there and available for your review. This quarter, we continued our focus on the balance sheet, with an emphasis on generating cash flow, and again we are successful as we have been for the last year eight consecutive quarters. We have had eight straight quarters of positive operating cash flow, over which time we generated close to $1.4 billion in positive operating cash. During the second quarter, which is typically a seasonally usage of cash, as we build our backlog and our work in process grows. We actually generated in excess of $90 million in operating cash flow. Almost twice the amount, we generated in the second quarter a year ago. Year-to-date, we generated $323 million in cash, which includes $90 million of tax refunds we received in early February and over the last 12 months, we generated $716 million in positive operating cash flow. This cash flow has really been accomplished through a real reduction in inventory. Over the last eight quarters, and here in the first half of 2008, we have increased our focus on selling lots. The slides that you see before you, is an interesting slide that depicts the real story of the impact of our inventory reductions. Obviously, we've been impacted as everyone, has by impairments. But, as you can see from the slide, most of the reductions we've seen, have generated in real cash flow. Two years ago, at this time, we had close to $3.3 billion in inventories including $1.760 billion in land. Today, we stand at just over $1 billion in inventories with only $367 million in land. So, we've really seen a $1.4 billion drop in our land balances over that two year period. That decrease, $545 million you see by the yellow box is really related to impairments, which is a combination of the total impairments we have taken to date of $978 million, less $433 million that we have actually seen come through our cost of sales over that period of time. So, that leaves in excess of $1.7 billion of our decrease in actually generating positive cash flow. During the second quarter, we saw our land sales increase. We sold close to 300 lots, for approximately $12 million in proceeds. Most of these lots were in the west, in Arizona and California. Had a book value of $9 million and we actually generated a tax loss of $24 million. As Larry mentioned, this brought our year-to-date tax loss to $90 million, which should further our efforts to maximize the NOL carryback refund that we expect to get from 2006. As we mentioned in the press release, this number could reach as high as $164 million, which we would hope to receive early next year. We also have identified, of the lots that we have remaining, in excess of 1,600 lots that we are holding for future sale, as we've determined that's the highest and best use, with a book value of $46 million. Again, most of these lots are in our western markets, in our West segment of California, Arizona, Nevada, although, we do have 266 lots in Florida as well that we are holding for sale. The next slide shows the continued decline in our lots controlled, both owned and optioned. Of course, with our option lots, we have limited risk with respect to those lots and it corresponds to a continuing and accelerating decline in our active subdivisions. Our lots controlled, exclusive of WIP, are down 44%, and as Larry mentioned, also, we are down 11% just in the last quarter. The owned lots are down 42%. Our option lots are down 52%, and with respect to the 2,782 lots we have under option, we only have $13 million of risk, $10 million being deposits and $3 million due diligence costs. Our work in process lots are also down. We are down to 2,718 lots, less than 1,000 of those are unsold at this time, and we only have 298 homes that are completed, that have not yet been sold as of the end of the quarter. As we have talked about before, not all lots are created equal. Of the lots that we own, we have about 8,894 lots that we own, close to 90% of those lots are actually finished. We have continued to focus on keeping our exposure on the surety side down. We are now down to $230 million in bonds outstanding. Of course, as we have disclosed, we have less than $50 million of development work that's required to fulfill our obligations under those bonds. Our active communities, as I mentioned in prior calls, have started to come down, and that's really a precursor and a requirement to our ability to continue to reduce our G&A. We started the year with right around 300 active communities. We were down to 260 at the end of the first quarter and here at the end of the second quarter, we are actually down to 227 active communities. The largest declines being in the west, as we have talked before, with California, Nevada, and Arizona being down significantly. Florida is also down quite a bit. The next slide, I think is really reflective of the primary story of our company, and that's the direction our cash has gone relative to the amount of our leverage. What this slide shows, is at the end of the second quarter last year, we had $668 million of cash and cash equivalents, relative to just short of $1.1 billion of outstanding debt. Today, we stand with $1.297 billion in cash and cash equivalents, which is 23% higher than the $1.053 billion of total debt that we have outstanding today. And we do have unrestricted cash and available borrowing capacity of just over $2 million. Turning to our operating performance for the quarter, starting with our orders. We continue to drive sales through a reduced number of active communities, but demand is still limited, and that's obviously evidenced by the significant decline in our net orders. Our orders are down 51% this quarter to 959 net homes, net orders received. Part that of course is due to a 22% decline in active communities. We've seen significant declines in orders in virtually every market, ranging from down 26% in Delaware Valley to close to 100% decline in Chicago here. We have one of the higher cancellation rates in the industry, and I think, there are a number of things that have to do with that. Our tendency to write virtually every contract we can, as much as we can, and not have our salespeople do the underwriting of those buyers. Obviously, we are exposed in markets that were very heated during the strong part of the market and have seen a higher rate of decline. Also the fact is that we do not participate in down payment assistance programs. This is something that also may contribute to the higher [can] rate, as we likely have seen some of our buyers move out of contracts they signed with us, when they run up against difficulties in obtaining financing and go to someone else, where they are able to get the down payment assistance. Of course, we know that that is a program that will no longer be permitted as of October 1st. These lower net orders have contributed to a significant decline in our backlog. Our backlog is down to 1,576 homes. Our average price is also down from $358,000 at the end of the quarter last year to $331,000 this year. The next slide shows our operating results for the quarter. The limited demand for homes, as we have experienced here over recent quarters continues to drive unit volume and prices down, which is translated in continued losses; losses that have been occurring at a faster pace than our ability to reduce G&A or reduce impairments. But, I think the story of this quarter and for the six months really is the fact that we did see reduced losses on a pre-tax basis and an after-tax basis year-over-year. This is due to a significant decline in impairments and SG&A. Obviously offset by the impact of reduced home closings, average prices, and home gross margins. Our net losses, while they are lower than last year, were obviously impacted by the fact that beginning in the fourth quarter of last year, we began to recognize valuation allowances against our deferred tax assets, which we did this quarter as well. As reflected on the schedule, our pre-tax loss for the quarter was $102 million, down from $171 million last year on $412 million of revenues versus $717 million last year. As I said, the decline in the loss year-over-year is attributable largely to the fact that our SG&A was down by $53 million versus the quarter last year and our impairment were down $73 million versus the quarter last year. Offsetting that, our closings were down 36% with significant declines in every market except for Chicago, where we were up 69%. Virginia was virtually flat and Colorado was only down 15%. Our average price was down 13% to $296,000, which is the lowest average price we have seen in a number of years, down $43,000 from where it was last year. Again, declines in every market except Colorado, which actually was up slightly, primarily due to the fact that we closed a number of homes in some higher priced communities here in this market during the quarter. Margins were down 240 basis points to 11.7%, pretty much flat, even up slightly from where we were in the first quarter, and I will come back to margins here in a moment. Financial services profits were down slightly, primarily due to lower insurance revenues. Our construction activity, obviously, is lower, and therefore the premiums we collect from our subcontractors, is down. With the mortgage activity down, we also saw lower gains on sales of mortgage loans, but we more than offset that decline. Mortgage company has done a great job in cutting its G&A, and we actually saw a greater decline in G&A than the reduction in mortgage gains during the quarter. On the corporate side, our loss was also slightly larger than it was last year. This is primarily due to the fact that we do charge a supervisory fee to our other segments. That's predicated upon the assets that they had deployed and with the lower level of assets, those fees are lower. We also saw lower interest income during the quarter. Even though our cash balances were significantly higher, we saw much lower interest rates applicable to those investments during the quarter, generating lower interest income. Coming back to margins specifically, this slide will show you the trend in margins. You will see that we have broken this slide into two pieces or at least each bar in two pieces. We report margins based upon the blue bar in this graph, which is net of interest costs that have been capitalized against our inventories. We think it is the appropriate way to report it. However, since interest is a significant differentiating factor between margins now and even a year ago, we have added back the interest component in the green bar so, you can see what margins would have been without the interest. So, as you can see in this slide that margins have moved a little bit, we are actually a fairly close to where we were a year ago, in fact up slightly. Margins for the last several quarters as reported, before the interest add-back are fairly consistent. The interest component is 440 basis points this quarter. That is fairly consistent with where it was in the first quarter but, much higher than the 180 basis points that we saw a year ago. So, this is a phenomenon that is really related to the fact that there is a mismatch between the interest income and expense. We are investing our cash. We are not paying down debt. Our debt levels stayed the same, so our interest costs stay the same on a much lower level of inventory. So, the amount of interest that we attach to each dollar of inventory is much higher. Therefore, it is coming through as interest and cost of sales at a much higher rate. Because, of the fact that our inventory levels are actually pretty much equal to our debt levels now and if they continue to decline, you will actually see some level of interest that we incur being expensed through the P&L as opposed to coming through cost of sales. One element that I would say here is our margins this quarter and, as we reported in the 10-Q, have been impacted by roughly $7 million of costs related to warranty that we determined we no longer needed, because of some favorable experience recently in terms of our warranty payments. So that has been reversed to cost of sales here during this quarter. Our margins, obviously, are impacted by the fact that we have seen a significant amount of impairments of the lots that we own. In fact, during this quarter, of the closings that we had in the quarter, approximately 80% of these closings were on lots that have been impaired at least once. Also the impact of specs, it seems that in many of our markets, our buyers who are willing to sign contracts are looking for bargains. They are looking for homes for quick move-ins. So, a much higher percentage of our closings are actually of spec homes. During this quarter, we reached pretty much a high watermark that we have seen for a long time, where close to 72% of our closings in this quarter were on specs, which tends to see lower levels of margins. Our G&A expenses on the next slide, as you can see, continued to decline. Here in the second quarter, we reached a level of right around $45 million for total G&A. Our marketing expenses are down 31% as well and our commissions are down 40%. So, we continue our efforts to reduce our G&A. I think as our subdivision count continues to come down, we have reduced our operating divisions over the last year from 19 to 12, and with the community count declining, we should be able to see some further leverage on that. Finally, on the final slide here is on impairments, just to give you a little color on that. This shows the history of our impairments since the beginning, starting in the third quarter of 2006. You can see the steady rise through the third quarter of 2007 and then declines. We are up slightly from the first quarter after two sequential declines, but we are down 45% from the impairments that we saw a year ago. The West markets continue to see the majority of the impairments. However, as you can see, the impairments in the West continue to decline. We have less than $10 million in land in California now, and in most of our markets in the West, we have seen the asset levels decline. However, the mountains segments, you can see as marked by the green bar, has come up a bit, as we have seen a greater impact in Utah and Colorado from declines that started a little later in this downturn than they did in most of the other markets. Albeit all in all during the quarter, we impaired 3500 lots and 110 subdivisions, that includes 855 lots and 15 subdivisions that are held for future sale. We impaired 50 million of land, 22 million of work in process, and 13 million of held for sale assets. At this point in time, about 70% of the lots that we own today, including our work-in-process have been impaired at least once. About 70% of the subdivisions that we have today have been impaired at least once, and about 50% of those have been impaired more than once. Then finally, before turning it back to the operator for questions, I would like to welcome Chris Anderson, who will be assuming the financial duties from me as soon as this call ends. Actually, after the end of the day tomorrow. Chris, I have gotten to know him pretty well here over the last few months, and I appreciate the opportunity to participate in finding Chris for this company. He brings a long history of public accounting and corporate finance experience and he is well armed to provide the financial leadership that MDC will need going forward. So, welcome, Chris and I would now like to open the call for questions.

[Operator:]

Okay. Thank you. (Operator Instructions). And our first question will come from Michael Rehaut with JPMorgan. Please go ahead.

[Michael Rehaut:]

Hi, thanks. Good morning, everyone.

[Gary Reece:]

Hi, Mike.

[Michael Rehaut:]

First off, great working with you, Gary, and I look forward to working with Chris going forward. But it's been a pleasure, Gary.

[Gary Reece:]

Thank you, same here, Mike.

[Michael Rehaut:]

Question on, you mentioned that, if I heard it right, 72% of your closings were spec in the quarter and that's, obviously, a big driver to the margin compression, continuing to depress the gross margins. Other builders are obviously trying to move away from that model, pretty hard in the other direction. It seems like I guess that given that your specs are down only about 140 or so, sequentially, that it continues to be a part of your operational strategy. So, I was wondering just what goes behind that decision-making process, given that perhaps you could have some improvement in the gross margins if you did more build-to-order? That's my first question then I have a follow-up.

[Gary Reece:]

Okay, Mike, let me first say that, the rise in spec closings is not a function of a strategy. It's more a function of the market and the conditions that exist in each one of these markets. Our objective continues to be a build-to-order. We much prefer to build a home for a buyer from the beginning. But, the fact of the matter is and it's probably a function of the fact that we have close to a 50% cancellation rate and have for the last several quarters, we sign a contract for a home and start it. We're not starting a lot of spec homes saying that we want to sell specs. But there is a couple of things going on here. We have a number of communities that are in close-out, that it behooves us to get the foundations in the ground and get the houses started, so we can facilitate the close-out of that subdivision. We have a number of communities in that particular condition. So, that might be one reason why we would start some specs. But I would say our objective in our markets generally is to start a house for a buyer. When market conditions start to go the other way, I think that's something this company will do. But it's more a result of the market than it is a result of a strategy that we have such a high spec percentage.

[Michael Rehaut:]

Okay. Thanks Gary. Then my second question relates more to the drop in community count and as you had mentioned, even just before that closing out and building out some of the remaining ones that you have. I was wondering if you could give us a sense of, you're at 227 for the second quarter; what that number could be by the end of the year? And many builders are retrenching and getting out of markets that a couple years ago they would have deemed more core or central that they are willing now to put on ice. I was wondering if there were any markets like that, that might be part of your current thinking?

[Gary Reece:]

Mike, we can't really tell you where the subdivision count is going, other than you can see the direction, and the decline was much greater in the second quarter. I can't tell you if it picks up or slows down. But, we obviously are in a situation where we have not purchased really any material number of lots. So, we do have some communities that will be opening up in markets like Colorado, not enough to offset what will be coming off though. We aren't adding the new communities, and so therefore, I think it's reasonable to assume that the direction continues down here until we start buying lots. Of course you'll see visibility to that in the Q when our lots under option start to pick up, and they have not yet done that. So, we continue to work through what we have. As far as putting things on ice, I think that we look at this on a subdivision basis, and we're evaluating it. You can't just walk away. We like the markets that we're in. I think we continue to downsize where it makes sense and we've done that in markets like Chicago and Delaware Valley. And some of those markets that we have entered later than others, Tampa is another one. We don't have a lot going on in Tampa right now, and if there's anything that might go on ice, it's Tampa. That's really where most of the lots that we're holding for sale are. But in terms of the other markets, we have a presence. We believe we're in the process of right-sizing that presence in connection with the level of activity that exists there. To the extent that it declines further, we have other ways of managing it. We can manage the subdivisions we have open there from other locations perhaps. There is a lot of things that we can do. But, we like the markets that we're in right now, Mike.

[Operator:]

Okay. And our next question will come from Alex Barron with Agency Trading Group. Please go ahead.

[Alex Barron:]

Yeah, thanks. And again Gary, it was a pleasure to work with you. So, wish you the best.

[Gary Reece:]

Thanks Alex.

[Alex Barron:]

I guess I wanted to ask you, as it pertains to how you guys do the impairments. I had a couple of questions on that. One is what was the benefit from previous impairments to this quarter's margins? Two, generally after you guys do an impairment analysis, what does the gross margin generally reset back to, after an impairment and maybe you could just give me a range?

[Gary Reece:]

Hey Alex. This quarter, coming through home cost of sales, we saw approximately $64 million, and through land cost of sales about $27 million. Last year we had $19 million come through of home cost of sales, and nothing coming through land cost of sales. I'll answer your other one, so it didn't count against you. The margins that we see, you understand how it works, it is a discounted cash flow analysis. And because we have such a short supply in each subdivision, and from a margin standpoint that works to keep your margins lower, than perhaps if you had a longer-term subdivision, because you are in and out of it quicker, you are cash flowing it faster. And if you're looking at, on average, a 15% discount rate, if you're looking at a subdivision that's half built out, you might see a margin that's low double digits. If you are in a subdivision that is perhaps sold out and we're waiting to close houses, you might actually see something in the high single digits.

[Alex Barron:]

That's helpful. I guess my other question was, obviously your SG&A has kept trending lower, and that's good. I'm just trying to understand, is there something else you guys are doing, besides lowering headcount that explains that it moved down?

[Gary Reece:]

Obviously, headcount is the largest component of our G&A. We are hitting it on in every category, though, from dealing with our lawyers, to dealing with our accountants, to dealing with our office space. Our insurance carriers, every major component of our expense is under review and we'll continue to monitor it. But the headcount component is by far the largest. This particular quarter, there's a lot of noise in our G&A. You'll see it described in our 10-Q. We had some severance costs. We had some legal settlements that went our way, that had a positive effect. But we had some restructuring costs and abandonment costs that went the other way. So, there's a lot of noise there, but you can see, we continue to work on pushing it down as much as possible.

[Operator:]

Our next question will come from Chris Hussey with Goldman Sachs.

[Chris Hussey:]

Thank you, guys. Can you hear me okay?

[Gary Reece:]

Hi Chris, we can.

[Chris Hussey:]

Yeah, talking on the cell phone. We'll miss you, Gary. Good luck in your new endeavors.

[Gary Reece:]

Thank you.

[Chris Hussey:]

The questions I have are really around size. You are cutting down to less than 1,000 homes now a quarter. How big do you think you can be, coming out of here? Are you guys going to be a 4,000 home a year company? Or do you think this is just due to your aggressive strategy of not looking to do anything that might lose cash at this trough in the market?

[Larry Mizel:]

Chris, this is Larry. I'll answer it for you. We will drive down our G&A direct and indirect as aggressively as we can. And before the market softened, we were 15,000 closings going to 20,000. You should assume that we are in the business, and we will be positioned uniquely within the industry, and we will be prepared to do business when there is profitable business to be done.

[Chris Hussey:]

All right. Fair answer. And, along those lines, then on your land acquisition strategy, you mentioned you haven't been buying land. But I know you guys have been talking about an [asset-like] strategy in the future. Any progress, any thoughts, anything you've been doing with any financial intermediaries, who you could team up with on that strategy going forward? Have you seen anything enticing? Are there any good markets out there that are starting to get your interest?

[Larry Mizel:]

We have visited with, I would say, at least a substantial amount of those distressed debt buyers and broadly defined looking for strategic and opportunistic relationships for them and for us. I believe that we are an attractive candidate to do transactions with, because we don't have any sideshows and we can provide a substantial degree of expertise in liquidity. The difference of the bid and the ask on the assets that are available, we do not believe are attractive yet. As I'm sure everyone is aware, there is large loan packages in the market. There's large foreclosures taking place, there's substantial bankruptcies that have been in play. All of these assets will be circulated around, until they find a risk-adjusted level that is worth transacting on. And when that takes place, we expect to be very active.

[Operator:]

Okay. And our next question will from Carl Reichardt with Wachovia Securities. Please go ahead.

[Carl Reichardt:]

Good morning guys, how are you? Gary, again we'll miss you, as well and welcome Chris. Just one, on the community count Gary, do you have an idea of how many you would consider to be close to close out? You can define however you want to, maybe 10 lots or less, or 20 lots or less. We're starting to get that information from a few others. I am curious if you have it?

[Gary Reece:]

Carl, it's not something that we have available right now. I understand it's something that would give you some visibility as to where that community count is going. Just for your information, when we give you an active community count, the way we measure an active community is, it's a community that has at least five homes left to sell. We have a whole bunch of communities that we've sold everything and we're in the process of building and closing them out. Some might consider that to be active. We do not include that in our active subdivision count. If we were to include those, our subdivision count would probably be substantially higher than that, maybe 50% or 60% higher than what we're showing. But we only include in our active communities those communities that have at least five homes left to sell.

[Carl Reichardt:]

Okay. Right, and I appreciate that definition. Second, for Larry, last time I asked about the top secret transformation and streamlining of processes programs, let me ask it again. Is the work that you are doing to attempt to long-term improve your processes and practices going to have a meaningful impact on either the price points that you choose to sell or the markets in which you choose to operate geographically?

[Larry Mizel:]

I think the principal results of the endeavors that we're undertaking as to how to improve the enterprise on doing a better job and a transformation from many of the old traditional ways that homebuilders did business into more contemporary ways of how it could be done and should be done, and it's not site specific, but it's operational specific.

[Operator:]

Thank you. And our next question will come from Nishu Sood with Deutsche Bank. Please go ahead.

[Nishu Sood:]

Thanks and good morning everyone.

[Gary Reece:]

Good morning.

[Nishu Sood:]

First question I wanted to ask, great disclosures as always. One of the things you're talking about was that 70% of your lots that you owned have been impaired at least once. Wanted to dig down into the 30% that have not been impaired, just pretty impressive that they have avoided the accountant's hatchet. So, wanted to understand a little bit more as to what might have driven that, perhaps the age of those 30%, the location? Is it just a triggering issue, the undiscounted versus discounted triggering. Just wondering if you can help us understand what differentiates those lots?

[Gary Reece:]

I would say that the differentiation is probably more location, relative to the steepness of the decline in the market. As we look at markets like Nevada and California, for example, every subdivision is impaired. Arizona, most of them have been impaired. But when you get to markets like the mid Atlantic, Maryland and Virginia for example, it's been a little different. Perhaps the decline has not been quite as steep as it was out west. The margins were higher to start with, and in those particular markets, Maryland, Virginia, in particular, maybe half of our subdivisions have been impaired. Same thing in Colorado and Utah, where we didn't see the large spikes that we did out west. And so therefore, they didn't have as far to fall. So, much lower experience there. Utah, perhaps being one that is later to the party at this point, and as a result, it has hasn't experienced as much in the way of impairments as some of the other markets.

[Nishu Sood:]

Great, thanks. That's very helpful. And a follow-up question I wanted to ask. Of the impairments that you've taken to date, obviously, in terms of the inventory categories, you've impaired your land assets and your work-in-progress. What portion of that would you say, if any has been of vertical construction costs, which of course would imply zero recovery of any land investment, either at the raw or the developed? And just also, in relation to that type of situation, how do you manage that on an ongoing pricing basis? I mean, do you mark down your prices enough in a community where a situation like that is happening, so that you get no recovery on the land, or do you just kind of hold your pricing and say, well, we'll sit with no orders?

[Gary Reece:]

I would say that very few of our impairments actually fall into that category. Nishu, we've talked about the thought process that we follow as we look at the impairments. We aren't going down a pathway and we're stuck with that approach. If we're headed down a path where it appears that we will not be able to recover our land costs, then why build the houses? Those are the lots that we're shifting to, held for sale. We're always looking for the highest and best use of the asset. And we believe that for the company, we can achieve the highest value by selling the lots, we sell the lots. So, that's one of the primary reasons why we have the lots identified as held for sale. So, it's not to say that you don't have a subdivision here or there, where you're closing out a few houses that you don't take the impairments you have to take to move that house. But, I'd say for the most part, we don't go into the negative category.

[Operator:]

Thank you. And our next question comes from [Gabby Kim with Wellington Management]. Please go ahead.

[Gabby Kim:]

Hey guys. So how is Colorado holding up?

[Gary Reece:]

Well, it's a beautiful day and we've had 19 straight days of 90-degree temperatures. You've seen I'm sure from some of the reports that are out that there seems to be a little bit of life. We've had a couple months in a row, where Case-Schiller has shown improvement in pricing. And so, these are all market data. It's still hard. It's a dogfight. We're seeing competition leave the market in droves, which is good for us because we are becoming more and more of a large player here as that occurs. So, we have some great subdivisions here, Gabe, and some locations that are just opening and some that are about to open. And so, we feel very good about our position in this market. But we're not seeing any large bounce, but there certainly is some rumblings in some of the data that things may be reaching a bottom.

[Gabby Kim:]

Okay, and then, just the valuation allowances, I always forget this. Where do you include that in your income statement?

[Gary Reece:]

It is actually a component of the tax provision. It is the reason why you essentially see no tax benefit associated with $100 million loss.

[Gabby Kim:]

Okay, Perfect. Thank you.

[Gary Reece:]

Sure.

[Operator:]

Okay, and our next question will come from Ivy Zelman, Zelman & Associates. Please go ahead.

[Ivy Zelman:]

Good morning. Gary, like everyone else, we're going to miss you. It's been a pleasure working with you all these years. Again, have the opportunity to meet and work with Chris, but we look forward to working with you. I'm surprised, Gary, to hear you talk about signs of a bottoming considering how ugly and absorption is getting worse out there in July and post, what was already a very scary June. Realizing we may be hearing about it. I guess my question is, do you really believe it because it certainly doesn't feel like it as it relates to new construction. So, first one put it to you. And then secondly, maybe your last tough Ivy question. Secondly, as it relates to your spec inventory and your cancellation rate, if I recall, you were actually only at one time asking for $1 down. I think if I recall you were starting constructions on homes that were with very, effectively zero equity down or a deposit; would that not be part of the problem and why your can rate is above everyone else's and why you have more spec than everyone else's because you were asking so little from the consumer?

[Gary Reece:]

Ivy, thanks for that.

[Ivy Zelman:]

I'm going to miss you, though, Gary, I really am.

[Gary Reece:]

Ivy, first of all, let me say that for the market, I agree with you, things don't feel like it's a bottom in Denver for us. It's just some of the data that's out there, even some of your own reports have identified Denver as a place that maybe things aren't declining as quickly. But for us on the ground, it's a dogfight every day, and here in July, it's even worse. July and August, it's a tough time to measure the temperature of the market. So, I would not raise my hand here as my last official statement to Ivy Zelman before I leave and say that…

[Ivy Zelman:]

I just wanted to make sure you weren't drinking the coolant, Gary. That's all.

[Gary Reece:]

I am not, believe me. I am not calling the bottom. But we're just hopeful that this is one of the markets that starts to show some signs earlier than others. Whether it happens this year or next, the fact of the matter is, we are becoming one of the last men standing in this market, and so, we stand to benefit as a result of this.

[Ivy Zelman:]

Gary, I also thought you were talking about the overall market, not just Denver. So, to clarify.

[Gary Reece:]

No. Just Denver.

[Ivy Zelman:]

Okay. Got it.

[Gary Reece:]

Nice try, Ivy.

[Gary Reece:]

Obviously, when you take $1 down or very little down; that is something that you're basically building a house as a spec, and we manage it that way. But, that concept has really gone the way of the dodo bird. That's not something that we're doing now. It's not what's giving rise to the specs that we're seeing now. I think, Ivy, it could have something to do with, again, where we're operating, and the markets that we're in. There is a lot of turnover, and the buyers seem to be looking for bargains. As I mentioned in my comments, we have less than 300 houses that are finished, which is the lowest level it's been in many, many years. We have less than 1,000 in place, right now, or 955 to be exact, and a lot of those are in the earlier stages of construction. So, it's really the specs or a function of the cans, and the cans are a function of being in some of these more volatile markets, and competing against other builders that are offering this down payment assistance, which we do not. So, that has made it a much more competitive environment for us.

[Operator:]

Thank you. And our next question will come from Jim Wilson with JMP Securities. Please go ahead.

[Jim Wilson:]

Thanks. Good morning, Gary. Good luck in the future, and it has been definitely a pleasure working with you.

[Gary Reece:]

Thanks, Jim.

[Jim Wilson:]

I really just have one question, and I guess, it's maybe multifaceted. But as you're looking at opportunities, and Larry, I know you said basically that the bid announced for what you're looking for still isn't there to take on much in the way of new incremental lot positions. But, to me can you describe what you are looking for may be in return parameters or gross margins? And also maybe describe if or how that varies by market as you look at potential land deals?

[Larry Mizel:]

Jim, I would say that what you're looking for, probably, we're not in a position to discuss.

[Jim Wilson:]

Okay. So, no minimums or anything that you can really describe?

[Larry Mizel:]

You should assume that we're looking on a risk adjusted basis for robust returns. Otherwise, why we would not expose capital at this point of the cycle.

[Jim Wilson:]

Okay. Well then, fair enough. Then second question may be I would just tie in is, where might you say that are deals starting to look, maybe, close enough to start to entice you even though you haven't pulled the trigger, yet?

[Larry Mizel:]

Alright, I think that you have to look at the public information and the markets that probably have had the most aggressive implosions. There will be a inflection point at some time, and there is extensive problems taking place in many of the active markets. And those problems will ultimately create opportunities, it's a matter of timing. And as the banking regulators continue to impose discipline in the markets both in the securities and in the direct loans that banks have made. You're going to see more opportunities available created by realization of what values really are, and as people look at the interpretation of 157, especially, in the banks on their tier capital requirements, I believe that you will see more opportunities than the market currently appreciates.

[Operator:]

Thank you. And we have a question from Jay McCanless with FTN Midwest. Please go ahead.

[Jay McCanless:]

Hi, good morning. I missed the first part of the call, and wanted to make sure I get these numbers right. The specs that you had on hand, completed specs were 298 this quarter; is that correct?

[Gary Reece:]

That's correct.

[Jay McCanless:]

Okay. And then also, I believe you said that spec sales were roughly 72% of the closings in this quarter. And my question is, how does that relate to other quarters? And what is a normal percentage of specs in your closing amount?

[Gary Reece:]

It's hard to call anything normal these days, but a year ago that number was probably closer to 50%. It's not what we would prefer, by the way. We would like to have a significant majority of our closings from dirt starts. But that's not the nature of this market.

[Jay McCanless:]

Okay. And how does the 298 compare to the second quarter last year?

[Gary Reece:]

423 last year, same time.

[Jay McCanless:]

423? Okay. Great, thank you.

[Operator:]

And we have a follow-up question from Alex Barron with Agency Trading Group. Please go ahead.

[Alex Barron:]

Yes, thanks. I guess this question is for Larry. Larry, I was just wondering if you could give us your take on the latest legislation, what you thought of this $7500 credit? And then I had another one if I could.

[Larry Mizel:]

Alex, I guess the first evaluation of the $7500 credit deals with the interpretation of what it means. And I think everyone is trying to make sure that what Congress wrote, what the tax interpretation of it, and how it applies needed to be sorted out a little bit. I would say it's a net positive, and the opportunity to the consumer is unique. After all, there is the best pricing there has been in years for product. The builders are aggressive in marketing their products. And with the tax credit, I think, it will be very helpful. And hopefully, the interpretation of what it says will be robust enough to utilize it in a broader spectrum. Do you have another quest another question, Alex?

[Alex Barron:]

Wondering, you guys made some comments regarding your exposure to completion activities, performance bonds, LOCs, et cetera. Can you just generally talk about what the risk is that perhaps other builders have or why you guys thought it was important to bring this up?

[Larry Mizel:]

We provide public information of our outstanding bonds, and since we have less than $50 million of actual exposure, it's merely providing information for those of you that do your analytics to reaffirm what we believe is the uniqueness and the strengths of our balance sheet.

[Gary Reece:]

Alex, the information is; generally most of the builders are disclosing their exposure on bonds and letters of credit. I have seen some of our peers start to disclose what we did as well as to what their obligations are. But, other than that, we don't have any information on the peers.

[Alex Barron:]

Okay. Thanks again. Take care.

[Operator:]

Okay. And there are no further questions at this time.

[Bob Martin:]

We would like to thank you again for joining our call today. We look forward to having the opportunity to speak with you in a few months, following the announcement of our 2008 third quarter result.

[Operator:]

Thank you. And ladies and gentlemen that does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.