KB Home delivered a first-quarter earnings report this morning that, while it beat Wall Street's estimates, reflects the deep downturn in the U.S. housing market.

KB's revenue was down 19% to $1.77 billion, compared to the first quarter of 2006. There was a 16% decrease in unit deliveries to 6,655 from 7,905 and a 5% drop in average selling price to $261,400 from $276,200. Net income was down sharply, falling 84% to $27.5 million from last year's $173.3 million. Earnings per share were $0.34, well ahead of the $0.25 that analysts expected.

KB's net orders were off 12% to 7,677, with most of the decline coming in the Southwest and Central regions. Net orders increased on the West and in France while remaining essentially flat in the Southeast region. KB's cancellation rate improved dramatically, falling to a historically traditional 31% in first quarter 2007 from 48% in last year's fourth quarter and 53% in the third. Backlog levels declined 31% to 18,406 units with future revenue value of $4.78 billion from 26,536 with future value of $7.24 billion at the end of last year's first quarter.

Gross margins from home building fell to 17.7% from 18.8% in last year's fourth quarter.(SEE THE RESULTS HERE) Margin levels were much higher in France, some 22%, which puts the U.S. margin at approximately 16%. Land impairments were in line with historical norms and were not broken out in the earnings release. In a midmorning conference call with analysts, the company said charges for land impairment were in the $8 million range. It also noted that house pricing in the U.S. had fallen 8% compared with last year's first quarter.

"Our 2007 first quarter results reflect the sharp downturn in the housing market that began in 2006 and that continues to pressure the sales and profit margins of domestic home builders today," said Jeffrey Mezger, president and chief executive officer, in the company's earnings statement. "Profit margins on our 2007 first quarter deliveries were constricted due to the persistent imbalance in housing supply and demand that is fueling intense competition and pricing pressure among home builders and other participants in the new home and resale markets. We believe these conditions will likely continue for at least the remainder of 2007."

In the statement, Mezger warned against reading the data on orders and cancellations too positively. "Despite the recent improvement in our first quarter net order experience and a lower cancellation rate, these trends should be viewed with caution," he said. "Having now entered the spring selling season, we continue to observe instability in the marketplace. Moreover, recent problems in the subprime mortgage market combined with tightening credit requirements could exacerbate the already difficult conditions in the home building industry. The rise in delinquency and foreclosure rates may increase the supply of homes on the market, generating additional downward pressure on prices. Under these conditions, it is hard to predict when the housing markets will stabilize."

He was a bit more upbeat in the conference call with analysts, saying that he believed "the fundamental economic drivers for housing remain healthy." He also noted that KB's exposure to the subprime mortgage market in its backlog is less than 5% and that going forward, "we start the home after the loan is approved." He added, "Our backlog is solid and we're just building homes."

Mezger also said "we anticipate seeing government loans filling the void" left by lenders exiting the subprime market, citing FHA and VA loans as examples. When asked about exposure in the Alt-A mortgage market, Mezger said, "There is no question that the underwriting guidelines have tighented up." But he referred questions regarding the Alt-A market to KB's mortgage partner, Countrywide Financial Corporation. He said the company believed that most potential home buyers had money in the bank or could borrow money from relatives to make a required down payment.

Also during the conference call, the company reported that it had whittled down its land holdings from a high of 173,000 lots to 103,000, equivalent to a 3-1/2- to 4-year supply, with 50% of that under option. And it reported that its average loan-to-closing-value ratio is 91% and its average buyer's FICO score is 700.

In a research note, Margaret Whalen, the home building analyst at UBS, said, "Higher than expected revenues drove the EPS surprise, as 38% of the backlog was converted to sales." The note went on to say, "In our view, operating conditions will remain challenging until inventory levels subside in late 07. That said, we continue to believe KB is well positioned to gain share once demand normalizes given management's disciplined approach during this downturn."

Similarly, Michael Rehaut and the home building and building products team at JP Morgan put out a note stating, "While these results do not fully reflect the recent volatility in the subprime market, we do believe that they reflect the industry's improvement vs. the 3Q06 trough, which, combined with the industry's current tight supply practices, we believe better prepares the sector to deal with this issue."