Results of Operations
OVERVIEW
Revenues are generated from our homebuilding operations and our financial
services operations. The following table presents a summary of our consolidated
results of operations for the nine months and three months ended August 31, 2012
and 2011 (in thousands, except per share amounts):
                                         Nine Months Ended August 31,            Three Months Ended August 31,
                                           2012                2011                2012                 2011
Revenues:
Homebuilding                         $     974,055       $       829,816     $      421,555       $      364,532
Financial services                           7,859                 6,178              2,949                2,784
Total                                $     981,914       $       835,994     $      424,504       $      367,316

Pretax income (loss):
Homebuilding                         $     (89,307 )     $      (195,900 )   $      (11,798 )     $      (10,716 )
Financial services                           7,830                 3,321              4,359                1,067
Total pretax loss                          (81,477 )            (192,579 )           (7,439 )             (9,649 )
Income tax benefit (expense)                14,800                  (100 )           10,700                    -
Net income (loss)                    $     (66,677 )     $      (192,679 )   $        3,261       $       (9,649 )
Basic and diluted earnings (loss)
per share                            $        (.86 )     $         (2.50 )   $          .04       $         (.13 )

In the first nine months of 2012, we have seen increasing signs that the overall housing market is moving into a period of recovery from the severe housing downturn that began in mid-2006, and, in a growing number of individual housing markets, gaining a certain degree of sustained momentum. Historically high housing affordability, particularly compared to rising rental costs, reflecting record-low interest rates for residential consumer mortgage loans, is motivating more consumers to buy homes. At the same time, relatively low inventories of homes available for sale in some markets has helped to moderate prior downward pricing trends and, in a few higher-demand areas, has pushed selling prices higher. Conditions are uneven, however, with local economic and employment dynamics strongly influencing the health or weakness of and within individual housing markets, and during the period there has generally been greater sales activity for existing homes than for new homes. Moreover, the homebuilding industry still faces significant challenges from an imbalance in the inventories of homes available for sale in several markets; sales of distressed homes, including lender-owned homes acquired through foreclosures and short sales that are currently or may soon be made available for sale; and various constraints on consumer demand for housing. These constraints include unsteady macroeconomic conditions, tepid job and wage growth, tight residential consumer mortgage lending standards and reduced credit availability for residential consumer mortgage loans. In addition, with the increased home sales and development activity by homebuilders in 2012, labor and some materials costs have risen compared to prior years. Though we are encouraged by the healthier housing market environment and are accelerating our investments and moving forward with operational initiatives designed to expand our business, the strength and breadth of the current recovery will primarily depend on the extent and pace of economic growth in future periods.
In the three months ended August 31, 2012, we continued to generate improvement in several key financial and operating metrics as we remained focused on our primary strategic goals - to achieve and maintain profitability at the scale of prevailing market conditions; to generate cash and strengthen our balance sheet; and to position our business to capitalize on future growth opportunities. We ended the 2012 third quarter with potential future housing revenues in backlog up 33% and the number of homes in backlog up 18% in each case from a year ago. Our net orders in the third quarter of 2012 increased 3% from our strong net order level in the third quarter of 2011, which had increased 40% from the third quarter of 2010. The year-over-year increase in our current quarter net orders occurred even though our number of new home communities open for sales at the end of the current quarter was 13% lower than at the end of the year-earlier quarter. The overall value of our third quarter 2012 net orders increased 16% year over year, reflecting a higher average selling price.
During the quarter, we also saw favorable year-over-year performance in our homes delivered; revenues; housing gross profit

margin; selling, general and administrative expenses as a percentage of housing revenues; and operating income. In addition to helping to generate our improved results in the current quarter, we believe that actions we have taken since the beginning of 2012 have further strengthened our business and our ability to capitalize on any future improvements in housing markets. These actions included an operational transition to Nationstar Mortgage LLC ("Nationstar") as our preferred mortgage lender, as further discussed below; sustained investment in inventory by spending approximately $337.0 million in the first nine months of 2012 on land and land development in desirable locations within our served markets; and the extension of our senior debt maturity schedule through the issuance of the $350 Million 8.00% Senior Notes in the first quarter and the issuance of the $350 Million 7.50% Senior Notes in the third quarter to fund the related applicable January 2012 Tender Offers and July 2012 Tender Offers, respectively.
Our total revenues of $424.5 million for the three months ended August 31, 2012 increased 16% from $367.3 million for the three months ended August 31, 2011 primarily due to higher housing revenues. Housing revenues increased 16% to $421.6 million for the third quarter of 2012 from $364.4 million for the year-earlier quarter, reflecting a 7% increase in the number of homes delivered and an 8% increase in the overall average selling price of those homes. We use the term "home" in this discussion and analysis to refer to a single-family residence, whether it is a single-family home or other type of residential property. We delivered 1,720 homes at an overall average selling price of $245,100 in the third quarter of 2012, compared with 1,603 homes delivered at an overall average selling price of $227,400 in the year-earlier quarter. The year-over-year increase in the number of homes delivered in the three months ended August 31, 2012 reflected our relatively higher backlog level at the beginning of the quarter, which was up 22% from the prior year. Within our homebuilding reporting segments, the number of homes delivered in the three months ended August 31, 2012 increased by 3%, 15% and 24% in our West Coast, Central and Southeast homebuilding reporting segments, respectively, and decreased by 20% in our Southwest homebuilding reporting segment, in each case as compared to the year-earlier quarter.
Our overall average selling price of homes delivered for the three months ended August 31, 2012 increased from the year-earlier period primarily due to changes in community and product mix, as we delivered more homes from markets with economic and consumer demand dynamics that supported larger home sizes and higher selling prices. These mix changes, and their associated favorable impact on our results, illustrate among other things the ongoing steps we have taken over the past several quarters to position our operations and to open more of our new home communities for sales in highly desirable, land-constrained submarkets that attract relatively more affluent consumers who are choosing larger floorplans and investing in more interior options at our KB Home Studios. These efforts have also led to our having fewer new home communities open for sales compared to a year ago, reflecting in part our selling out of older communities in relatively weaker locations more quickly than we can open new communities for sales. Nonetheless, we believe our strategic operational shift to stronger, better-performing markets that can produce higher average selling prices is working to help us accomplish our top priority of achieving and maintaining profitability at the scale of prevailing market conditions. We also expect that the number of new home communities open for sales will begin to increase in 2013. Our higher overall average selling price of homes delivered in the 2012 third quarter reflected year-over-year increases of 14%, 13% and 6% in our West Coast, Southwest and Southeast homebuilding reporting segments, respectively. In our Central homebuilding reporting segment, the average selling price of homes delivered for the 2012 third quarter remained essentially even with the year-earlier quarter.
Our total revenues included financial services revenues of $2.9 million for the three months ended August 31, 2012 and $2.8 million for the three months ended August 31, 2011.
We generated net income of $3.3 million, or $.04 per diluted share, for the three months ended August 31, 2012, compared to a net loss of $9.6 million, or $.13 per diluted share, posted for the three months ended August 31, 2011. Our 2012 third quarter net income reflected our recognition of a probable insurance recovery of $16.5 million related to costs we have incurred to make repairs on and to handle claims with respect to previously delivered homes, including homes affected by allegedly defective drywall material. Partly offsetting the favorable impact of the probable insurance recovery in the current quarter were an $8.3 million loss on the early extinguishment of debt associated with the repurchase of certain of our senior notes due 2014 and 2015 pursuant to the applicable July 2012 Tender Offers and $6.4 million of inventory impairment charges. Our 2012 third quarter net income also included an income tax benefit of $10.7 million, which primarily resulted from the resolution of a federal tax audit. The net loss for the three months ended August 31, 2011 included $7.4 million of favorable warranty adjustments that resulted from trends in our overall warranty claims experience on homes previously delivered and $8.3 million of legal expense recoveries, which were partly offset by $1.2 million of inventory impairment and land option contract abandonment charges.
Our homebuilding operations generated operating income of $10.9 million for the three months ended August 31, 2012 and $1.4 million for the three months ended August 31, 2011. The year-over-year change in our homebuilding operating results reflected higher housing gross profits, partly offset by slightly higher selling, general and administrative expenses in the current quarter. Housing gross profits of $73.6 million for the three months ended August 31, 2012 increased by $12.0 million from $61.6 million for the year-earlier period. Our housing gross profit margin improved to 17.5% in the third quarter of 2012 from 16.9% in the

third quarter of 2011. Our housing gross profits for the 2012 third quarter reflected the above-described insurance recovery, which was partly offset by the current quarter inventory impairment charges. In the year-earlier quarter, our housing gross profits included the above-described favorable warranty adjustments, which were partly offset by inventory impairment and land option contract abandonment charges. Our housing gross profit margin, excluding inventory impairment charges, was 19.0% in the third quarter of 2012, compared to the housing gross profit margin, excluding inventory impairment and land option contract abandonment charges, of 17.2% in the year-earlier quarter. The calculation of this measure of housing gross profit margin is described below under "Non-GAAP Financial Measures."
Although we delivered more homes on a year-over-year basis, generating higher revenues and associated selling expenses, our selling, general and administrative expenses of $62.8 million in the three months ended August 31, 2012 increased only $2.6 million, or 4%, from $60.2 million in the year-earlier period. Additionally, selling, general and administrative expenses for the three months ended August 31, 2011 included the favorable impact of legal expense recoveries of $8.3 million. As a percentage of housing revenues, selling, general and administrative expenses improved to 14.9% for the three months ended August 31, 2012, compared to 16.5% for the year-earlier period, reflecting the impact of higher housing revenues in the current quarter.
Total revenues for the nine months ended August 31, 2012 were $981.9 million, up 17% from $836.0 million for the nine months ended August 31, 2011. Included in our total revenues were financial services revenues of $7.9 million for the first nine months of 2012 and $6.2 million for the year-earlier period. Our net loss for the nine months ended August 31, 2012 totaled $66.7 million, or $.86 per diluted share, including insurance recoveries of $26.5 million related to repair costs on and costs to handle claims with respect to previously delivered homes, including homes affected by allegedly defective drywall material, and favorable warranty adjustments of $11.2 million that reflected trends in our overall warranty claims experience. These items were partly offset by charges of $22.9 million for inventory impairments and $8.8 million recorded as a result of an unfavorable court decision that is being appealed, as discussed in Note 14. Legal Matters in the Notes to Consolidated Financial Statements in this report. The net loss for the nine months ended August 31, 2012 also included an income tax benefit of $14.8 million, reflecting the resolution of federal and state tax audits during the period. In the year-earlier period, our net loss of $192.7 million, or $2.50 per diluted share, included inventory impairment and land option contract abandonment charges of $23.5 million, and a joint venture impairment charge of $53.7 million and a loss on loan guaranty of $37.3 million, both related to South Edge. Partly offsetting these items in the 2011 period were $7.4 million of favorable warranty adjustments that resulted from trends in our overall warranty claims experience on homes previously delivered, and $8.3 million of legal expense recoveries.
We ended the third quarter of 2012 with $466.5 million of cash and cash equivalents and restricted cash; our balance of unrestricted cash was $420.4 million. Our debt balance was $1.73 billion at August 31, 2012, compared to $1.58 billion at November 30, 2011. Our debt balance at August 31, 2012 reflected the issuance of the $350 Million 8.00% Senior Notes and the $350 Million 7.50% Senior Notes in 2012, which was largely offset by the purchase of $340.0 million in aggregate principal amount of certain of our senior notes due 2014 and 2015 pursuant to the applicable January 2012 Tender Offers and the purchase of $244.9 million in aggregate principal amount of certain of our senior notes due 2014 and 2015 pursuant to the applicable July 2012 Tender Offers. Our ratio of debt to total capital was 82.3% at August 31, 2012, compared to 78.2% at November 30, 2011. Our ratio of net debt to total capital (a calculation that is described below under "Non-GAAP Financial Measures") was 77.2% at August 31, 2012, compared to 71.4% at November 30, 2011. Our backlog at August 31, 2012 totaled 3,142 homes, representing potential future housing revenues of $744.7 million, compared to a backlog at August 31, 2011 of 2,657 homes, representing potential future housing revenues of $559.3 million. The number of homes in our backlog increased 18% year over year due to a higher number of homes in our backlog at the beginning of the 2012 third quarter and an increase in our net orders in the quarter. The potential future housing revenues in our backlog at August 31, 2012 rose 33% from the prior year, reflecting the increased number of homes in backlog and the higher average selling price of those homes.
Net orders from our homebuilding operations increased 3% to 1,900 in the third quarter of 2012 from 1,838 in the third quarter of 2011, despite a 13% year-over-year decrease in the number of new home communities we had open for sales at the end of the quarter. Compared to the year-earlier quarter, net orders for the 2012 third quarter increased 13% in both our West Coast and Central homebuilding reporting segments, and 1% in our Southeast homebuilding reporting segment. In the third quarter of 2012, net orders in our Southwest homebuilding reporting segment decreased by 41% from the third quarter of 2011. The lower net orders from our Southwest homebuilding reporting segment reflected a strategic reduction in our investments in certain underperforming locations. This strategic reduction, mainly the significant downsizing of our business in Arizona during 2011 and into 2012, is part of an ongoing repositioning of our operational footprint to better-performing markets, as described above. In addition, our net order results were a product of our focus in 2012 to prioritize gross profit margin improvement over sales pace. Reflecting this focus, the value of the net orders we generated in the third quarter of 2012 increased 16% to $493.3 million from $426.7 million in the year-earlier quarter. Three of our four homebuilding reporting segments generated year-over-year increases in net order value, with our West Coast homebuilding reporting segment up 25% to $252.6 million, our Central homebuilding reporting segment up 20% to $135.9 million, and our Southeast homebuilding reporting segment up 10% to $70.2

million.
The value of the net orders we generated in the first nine months of 2012 increased 11% to $1.27 billion from $1.14 billion in the prior-year period. Our cancellation rate as a percentage of gross orders was 29% in the third quarter of 2012, unchanged from the year-earlier quarter. As a percentage of beginning backlog, the third quarter cancellation rate improved to 26% in 2012 from 32% in 2011.

HOMEBUILDING
The following table presents a summary of certain financial and operational data
for our homebuilding operations (dollars in thousands, except average selling
price):

                                        Nine Months Ended August 31,          Three Months Ended August 31,
                                           2012               2011              2012                 2011
Revenues:
Housing                              $    974,055        $   829,663      $      421,555       $      364,457
Land                                            -                153                   -                   75
Total                                     974,055            829,816             421,555              364,532
Costs and expenses:
Construction and land costs
Housing                                   824,935            723,886             347,908              302,834
Land                                            -                199                   -                   74
Total                                     824,935            724,085             347,908              302,908
Selling, general and administrative
expenses                                  184,938            172,310              62,780               60,185
Loss on loan guaranty                           -             37,330                   -                    -
Total                                   1,009,873            933,725             410,688              363,093
Operating income (loss)              $    (35,818 )      $  (103,909 )    $       10,867       $        1,439

Homes delivered                             4,160              3,817               1,720                1,603
Average selling price                $    234,100        $   217,400      $      245,100       $      227,400
Housing gross profit margin as a
percentage of housing revenues               15.3  %            12.7  %             17.5 %               16.9 %

Selling, general and administrative
expenses as a percentage of housing
revenues                                     19.0  %            20.8  %             14.9 %               16.5 %

Operating income (loss) as a
percentage of homebuilding revenues (3.7 )% (12.5 )% 2.6 % .4 %

We have grouped our homebuilding activities into four reporting segments, which we identify in this report as West Coast, Southwest, Central and Southeast. As of August 31, 2012, our homebuilding reporting segments consisted of ongoing operations located in the following states: West Coast - California; Southwest - Arizona, Nevada and New Mexico; Central - Colorado and Texas; and Southeast - Florida, Maryland, North Carolina and Virginia. The following tables present homes delivered, net orders and cancellation rates (based on gross orders) by homebuilding reporting segment for the three months and nine months ended August 31, 2012 and 2011, and our ending backlog at August 31, 2012 and 2011:

                               Three Months Ended August 31,
                Homes Delivered        Net Orders        Cancellation Rates
Segment          2012        2011     2012     2011       2012          2011
West Coast       541          524      658      581        23 %           27 %
Southwest        186          232      154      259        16             20
Central          700          611      765      677        35             34
Southeast        293          236      323      321        27             30
Total          1,720        1,603    1,900    1,838        29 %           29 %



                               Nine Months Ended August 31,
                Homes Delivered        Net Orders        Cancellation Rates
Segment          2012        2011     2012     2011       2012          2011
West Coast     1,180        1,101    1,547    1,527        26 %           22 %
Southwest        513          573      523      735        19             19
Central        1,723        1,449    2,212    1,963        34             33
Southeast        744          694      864      913        30             28
Total          4,160        3,817    5,146    5,138        29 %           27 %



                               August 31,
                                         Backlog - Value
                Backlog - Homes          (In Thousands)
Segment          2012        2011       2012         2011
West Coast       830          629    $ 327,528    $ 211,360
Southwest        213          301       40,727       51,262
Central        1,507        1,207      251,900      199,503
Southeast        592          520      124,589       97,205
Total          3,142        2,657    $ 744,744    $ 559,330

Revenues. Homebuilding revenues totaled $421.6 million for the three months ended August 31, 2012, increasing 16% from $364.5 million for the corresponding period of 2011 primarily due to increased revenues from housing operations. Housing revenues of $421.6 million for the three months ended August 31, 2012 improved from $364.4 million in the year-earlier period, due to a 7% increase in homes delivered and an 8% increase in the average selling price. We delivered 1,720 homes in the third quarter of 2012, up from 1,603 homes delivered in the year-earlier quarter. The increase in homes delivered was largely due to the relatively higher backlog level at the beginning of the 2012 third quarter, which was up 22% on a year-over-year basis. Within our homebuilding reporting segments, the number of homes delivered in the current quarter increased by 3%, 15% and 24% in our West Coast, Central and Southeast homebuilding reporting segments, respectively, and decreased by 20% in our Southwest homebuilding reporting segment, in each case as compared to the year-earlier quarter. Our overall average selling price of $245,100 for the quarter ended August 31, 2012 rose $17,700 from $227,400 for the year-earlier quarter. The third quarter of 2012 marked the ninth consecutive quarter that our average selling price of homes delivered has increased on a year-over-year basis. Compared to the year-earlier quarter, average selling prices increased 14% in our West Coast homebuilding reporting segment, 13% in our Southwest homebuilding reporting segment and 6% in our Southeast homebuilding reporting segment in the three months ended August 31, 2012. In our Central homebuilding reporting segment, the average selling price for the third quarter of 2012 was essentially even with the corresponding quarter of 2011. The increase in our overall average selling price was primarily due to changes in community and product mix, as discussed above under "Overview."
Homebuilding revenues of $974.1 million for the nine months ended August 31, 2012 increased by $144.3 million, or 17%, from $829.8 million for the year-earlier period, reflecting higher housing revenues. Housing revenues for the nine months ended August 31, 2012 rose to $974.1 million, up 17% from $829.7 million for the year-earlier period, due to a 9% increase in the number of

homes delivered and an 8% increase in the average selling price. We delivered 4,160 homes in the nine months ended August 31, 2012, up from 3,817 homes delivered in the year-earlier period. The year-over-year increase in the number of homes delivered reflected the relatively higher backlog level at the beginning of 2012, which was up 61% on a year-over-year basis largely due to a 39% year-over-year increase in net orders in the latter half of 2011. Our overall average selling price for the nine months ended August 31, 2012 rose to $234,100 from $217,400 for the nine months ended August 31, 2011 for the reasons described above with respect to the three months ended August 31, 2012. Operating Income (Loss). Our homebuilding operations generated operating income of $10.9 million for the three months ended August 31, 2012, compared to $1.4 million for the year-earlier period. The substantial year-over-year increase in our operating income reflected higher gross profits, partially offset by slightly higher selling, general and administrative expenses in the 2012 third quarter.
Gross profits from our homebuilding operations increased to $73.6 million for the three months ended August 31, 2012, up $12.0 million from $61.6 million for the year-earlier period. Our housing gross profits for the three months ended August 31, 2012 reflected our recognition of a probable insurance recovery of $16.5 million related to costs we have incurred to make repairs on and to handle claims for previously delivered homes, including homes affected by allegedly defective drywall material, which was partly offset by inventory impairment charges of $6.4 million. We expect to receive the cash from this insurance recovery in the fourth quarter of 2012. In the three months ended August 31, 2011, our housing gross profits included $7.4 million of favorable warranty adjustments, which were partially offset by $1.2 million of inventory impairment and land option contract abandonment charges. Our housing gross profit margin for the third quarter of 2012 increased by .6 percentage points to 17.5%, up from 16.9% in the year-earlier quarter. Our housing gross profit margin, excluding inventory impairment charges improved to 19.0% in the third quarter of 2012, compared to a housing gross profit margin, excluding inventory impairment and land option contract abandonment charges, of 17.2% in the third quarter of 2011. . . .